Increasingly, American workers and retirees face a real risk of running out of money during their retirement. Gone are the days when the majority of Americans had a pension to provide them a reliable income through the entirety of their retirement. Instead, American workers and retirees rely upon self-directed investment plans to create income after they stop working. These accounts provide minimal protection against market crashes resulting in a real risk that retirees outlive their assets. So how does one ensure Downside Risk Protection in retirement?
According to Investment Company Institute data, over 50 percent of all retirement assets now reside in 401(k), IRAs and other self-directed retirement investment vehicles. With the vast majority of those self-directed assets are owned by current and future retirees leaving them exposed to the risk of running out of assets during retirement.
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Many individuals plan for 20 to 25 years of retirement but according to Social Security Administration data, 50 percent of today’s sixty-year-olds will live beyond this time frame. Since one cannot know how many years lie in the future at retirement, individuals must plan for 40 plus years of retirement to be certain that they will not outlive their assets. To avoid early account depletion in self-directed plans, a new approach is required to limit investors’ risk during periods of market distress.
Retirees with self-directed accounts are dependent on their investments to produce income in retirement and because they need to take regular withdrawals from their they are particularly susceptible to market crashes early on in their retirement years.
Our approach, called downside risk protection, is comparable to an insurance policy, in which investors would pay a premium to insure retirees from incurring large losses in their accounts. By reducing the occurrence downside risk in these accounts, investors greatly lessen the possibility of early account depletion during their retirement years.
For example, in an all-equity portfolio, investor losses are capped at a maximum of 15 percent on annual basis in the years that the retirement accounts sustain losses. In the years when the accounts post gains, account holders give up 10 percent of the gain to the financial institution offering this form of account protection against the potential of negative retirement portfolio performance.
Our model of downside risk protection has found that the likelihood of individuals outliving their assets over a45-year retirement period reduces the risk of asset depletion by over 70%. In addition, by cushioning the effect of market downturns, the application of downside risk protection increases the overall rate of return for investors while reducing the volatility of their investments.
Our approach also will benefit financial institutions offering this tool to investors, allowing them to create a differentiated service in today’s highly competitive asset management marketplace.
Using this approach could increase the likelihood of accumulating and retaining customers since it’s currently not available in the marketplace and provides a material benefit to account holders in times of market distress. Early adoption of downside risk protection would give institutions a competitive advantage by offering a valuable tool to protect investors’ retirement assets.
With downside risk protection, investors no longer need to worry about sustaining heavy losses in their retirement portfolio due to a severe market correction. It’s indeed a win-win situation that limits potential investor losses in the market’s most popular retirement accounts and significantly reduces the likelihood of outliving one’s retirement assets, as well as providing financial institutions another way to drive growth in an increasingly competitive environment.
The author is the CEO of Data Science Partners, a New York-based financial and economic consulting firm.
Article By Alex Rinaudo