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Retirement Planning

A framework to address retirees’ biggest fear

Kate Beattie

December 20, 2024

KEY TAKEAWAYS

  • Many pre-retirees and retirees are concerned about their investments lasting throughout retirement.
  • The building blocks framework gives pre-retirees and retirees tools to understand, quantify and prioritize retirement spending and legacy objectives.
  • By discussing the building blocks framework, financial professionals can collaborate with clients to build greater confidence in their retirement journey.

Of all the concerns that keep retirees up at night, one of the biggest might be the fear of running out of money. Questions like “How long will I live?”, “Will my investments hold up?” and “Will unexpected costs or events erode my savings?” speak to this concern.

 

Answering these questions is a central challenge of the retirement industry today. At Capital Group, home of American Funds, we encourage retirees and financial professionals to shift their perspective from viewing retirement assets as one lump sum meant to cover all expenses. Instead, think more about a ‘building blocks’ approach that focuses on addressing retirement needs in more manageable, strategic stages. Four blocks frequently prioritized by retirees are basic living expenses, discretionary expenses, unplanned emergencies and leaving a legacy. 

The building blocks of a confident retirement

We believe that thinking about asset allocation in terms of building blocks can help retirees adopt a mental accounting framework for their assets — making it easier to understand, quantify and prioritize their retirement spending and legacy objectives. Our approach has been validated by in-depth qualitative research conducted by the Life Insurance Marketing and Research Association (LIMRA), showing that hundreds of retirees and pre-retirees across multiple income segments continue to identify these categories as important to their retirement.1

1. Living: Are the essentials covered?

 

Living expenses typically include day-to-day necessities such as food, housing, transportation and health care. Investors might prefer to have full confidence in covering these types of expenses from the beginning, even though they may have some flexibility in addressing them over time.

 

2. Lifestyle: What are your optional expenses?

 

The lifestyle block includes discretionary spending such as travel, spending on grandchildren, dining out and entertainment. What constitutes a lifestyle expense will vary from retiree to retiree, as will their comfort level with variations in income and spending as their lifestyle evolves over retirement.

 

3. Emergency: Do you have a cash cushion?

 

An emergency fund can provide retirees with more confidence in their ability to weather unexpected market, health or household expenses. Investors should plan for the unexpected and have ample cash and/or more readily liquid reserves on hand.

 

4. Legacy: Do you plan to pass on your wealth?

 

For some, leaving a legacy is a defining goal of a wealth planning strategy. Many others simply plan to leave behind “whatever is left” after also accounting for living and lifestyle expenses in a single portfolio of assets invested together to balance income, growth and capital preservation objectives.

Testing retirement income confidence

One way a financial professional may assess the reliability of a withdrawal rate in supporting both living and lifestyle expenses is through a Monte Carlo simulation. The simulation calculates probabilities based on various hypothetical return scenarios. If a client is particularly concerned with downside risks, the simulation would emphasize the lowest 10th percentile of possible outcomes to plan for a potential worst-case scenario.
 

According to the simulation, a standard 4% withdrawal rate may be overly optimistic for retirees. Considering a proposed allocation between 60% of income to living expenses and 40% to lifestyle expenses, weighted for a combined success rate of 90%, the simulation indicates that a withdrawal rate of 3.60% or lower could provide greater confidence in sustaining spending needs. The analysis suggests that a financial professional should discuss the trade-offs and implications of reducing spending objectives, delaying retirement and/or adjusting the portfolio. Additionally, exploring opportunities to increase the level of protected income could improve overall confidence for a client in retirement.

Retirement income confidence (30-year time horizon)

Chart titled “Retirement income confidence (30-year time horizon)” shows three degrees of confidence: High, Medium and Low

Source: Capital Group. Chart is for illustrative purposes only. Taxes and fees not considered in this hypothetical.
 

A Monte Carlo simulation was used to calculate the probable range of outcomes for a hypothetical portfolio comprised of 60% stocks and 40% bonds supporting the withdrawal rates indicated in the chart for 30 years.  Withdrawals are increased by 2.25% per year. For further information about the assumptions used to create this chart, please see below.

Building retirement confidence — one client at a time

Given the many unknowns of retirement, a building blocks framework may help investors better define their retirement income needs. With insights gleaned from this framework and the benefit of professional advice, investors should be able to invest in portfolios that align with their desired lifestyle and legacy goals and objectives as they navigate through retirement. For financial professionals, that means creating portfolios designed to help clients pursue overall income security, meet their essential living expenses no matter how long they live, and invest for a high degree of confidence.

 

READ THE FULL PAPER

Read important disclosures

KTEB

Kate Beattie is a senior retirement income strategist with 18 years of investment industry experience (as of December 31, 2024). She holds a bachelor’s degree in economics with a business administration minor from Colorado State University and holds the Certified Financial Planner™ and Retirement Income Certified Professional® designations.

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PRO

1Source:  LIMRA, Fact Book on Retirement Income: A Review of Trends and Activity in the Retirement Income Market, 2022.

A Monte Carlo simulation was used to calculate the probable range of outcomes and probabilities for hypothetical portfolio reliance. A Monte Carlo simulation is a statistical technique that, through a large number of random scenarios, calculates a range of outcomes that are based on a set of assumptions. This simulation is provided for informational purposes only and is not intended to provide any assurance of actual results.

The following assumptions were used in the Monte Carlo simulation:

  • The investor withdraws a fixed percentage of the initial portfolio value each year for up to 30 years. The initial withdrawal amount is increased by 2.25% each year.
  • The hypothetical portfolio is composed of 60% global equities and 40% U.S. fixed income (rebalanced annually).
  • Assumed hypothetical returns for the equities portfolio were 6.5% with a standard deviation of 15.6%; assumed hypothetical returns for U.S. fixed income were 4.1% with a standard deviation of 3.9%.
     

Hypothetical results are for illustrative purposes only and in no way represent the actual results of a specific investment.

The portfolio success rate in the hypothetical illustration is the percentage of simulations where the hypothetical portfolio sustained the applicable withdrawal percentage each year for 30 years (inclusive of a 2.25% annual increase). While we believe the calculations to be reliable, we cannot guarantee their accuracy. Simulation results may vary. All assumptions are for market asset classes only and are reviewed at least annually. These figures represent the views of a small group of investment professionals based on their individual research and are approved by the Capital Market Assumptions Oversight Committee. They should not be interpreted as the view of Capital Group as a whole. As Capital Group employs The Capital SystemTM, the views of other individual analysts and portfolio managers may differ from those presented here. They are provided for informational purposes only and are not intended to provide any assurance or promise of actual returns. They reflect long-term projections of asset class returns and are based on the respective benchmark indices, or other proxies, and therefore do not include any outperformance gain or loss that may result from active portfolio management. Note that the actual results will be affected by any adjustments to the mix of asset classes. All market forecasts are subject to a wide margin of error. Annualized standard deviation (based on monthly returns) is a common measure of absolute volatility that tells how returns over time have varied from the mean. A lower number signifies lower volatility.

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