With the ever-declining number of defined benefit pension plans in North America, the ultimate goal for most investors is a well funded retirement. The idea that a lifetime of disciplined saving and investing leads to a comfortable retirement is generally accepted, and the accumulation of a significant nest-egg should be viewed as an achievement. However, the goal of a fully funded retirement won’t have been surely achieved until death. In an ideal world, each investor would use their known annual rate of return and life expectancy to draw down their pool of retirement assets to zero (or some other amount that they wish to leave as a legacy) on their last day.  In reality, nobody can predict what the market will do tomorrow, let alone how long a person will naturally live; these two variables become two of the greatest challenges in planning for, and achieving, a fully funded retirement.

Market risk, the risk that equity markets as a whole could decline, has obvious effects on a portfolio’s ability to maintain sufficient levels of capital through the drawdown period.

Investors are not able to control or predict market movements, but market risk can be managed to a certain degree by adjusting the mix between stocks and bonds – a portfolio with less exposure to stocks will not decline in lock step with the market, but it will also have a lower expected return. In some cases, the higher expected returns associated with equities are necessary for investors to match their portfolio’s longevity with their own lifespan and income needs.

Longevity risk, the risk of outliving an investment portfolio, is much more difficult to manage than market risk.

There are benefits to living a long and healthy life, but unlike market risk there is no expected financial return associated with human longevity. People find ways to maintain a healthy body and mind with advancing age, but there is no sure-fire way to influence the natural expiry date. Planning around this is extremely difficult, and it makes drawing down a retirement portfolio a dynamic task. In some cases annuities can be introduced to the overall asset mix to take some longevity risk off the table, but annuities also decrease overall flexibility and can reduce expected returns.

Market risk and longevity risk work together to make the transition from a pool of capital to a stable long-term retirement income a challenge. These risks can be managed through the thoughtful development of a mix between stocks, bonds, and insurance products, and a carefully planned and monitored withdrawal rate. In any case, the drawdown process should be approached with care.