Planning For Retirement in a Volatile Market

For many of our oil and gas clients, retirement conversations start a couple years prior to their desired exit date. Their specific situations include pension complexities, stock options, possible NUA (Net Unrealized Appreciation) elections, 401(k) rollovers, Roth 401(k) rollovers and a variety of other nuances that can affect retirement and should be carefully analyzed by a professional.

For around ten years before 2022, we saw a bullish market cycle and interest rates hovering around zero. This had positive implications for our pre-retirees who have lump sum pensions that benefit from low interest rates.

But in 2021, inflation started to pick up dramatically. At the time, the buzzword for this increase in inflation was “transitory,” meaning the Federal Reserve (the people who are in charge of monetary policy) thought inflation was temporary due to supply chain disruptions caused by the coronavirus in 2020.

As it turns out, inflation has proven to be stickier than originally thought, and the Fed has since raised interest rates dramatically in 2022 and has continued to in 2023 to combat inflation that has reached 7 or 8%. In doing so, this has had a negative impact on lump sum pensions offered to many of our oil and gas pre-retirees.

You may work for a company that offers a pension either in the form of a lump sum or regular income payments for life. Let’s explore how interest rates can affect these numbers.

Interest rates can affect lump sum pensions in a few ways. If you’re considering taking a lump sum payment instead of a regular income, the interest rate at the time you make the decision can impact the value of the lump sum. If interest rates are high, the value of the lump sum may be less than if interest rates were lower, because the pension fund would be able to earn a higher return on the money if it was invested.

On the flip side, if you choose to take the annuity option which pays you a fixed amount of money for the entirety of your life (and possibly to your beneficiaries depending on what option you select), it’s important to consider inflation in this scenario as there are typically no cost of living adjustments. At Baird Retirement Management, we run various hypothetical scenarios on both options to guide what’s right for you.

Many defined benefit pension plans offer a lump sum option instead of monthly pension payments. The monthly pension payments are generally calculated from a formula based on age as well as years of service and salary at the sponsoring company. The lump sum option forfeits these ongoing payments in exchange for a one-time payment that can typically be rolled over into another retirement plan tax-free. You will need to account for discount rates and mortality assumptions in order to come up with the lump sum amount. When discounting a pension payment into a lump sum, it is important to know that the higher the interest rates, the lower the lump sum. As we mentioned above, in late 2021, the Federal Reserve began raising the Federal Funds Rate to combat inflation. This led to corporate bond market yields increasing sharply in 2022. In November 2021, the segment rates were 1.02%, 2.72%, and 3.08%. One year later, the November 2022 segment rates were 5.09%, 5.60%, and 5.41%. Based on a quick calculation for a 65-year-old, we estimate the lump sum discounted in November 2022 to be around 14% less than a lump sum discounted from the same monthly pension in November 2021.

While we don’t believe the segment rates will be this high permanently, we also do not believe they will go back down to where they were anytime soon, if ever.

Now that we’ve covered how interest rates affect lump sum pension amounts, let’s talk about another source of anxiety a lot of our oil and gas retirees have: retiring into a bad market and/or recession.

The current method of calculating a lump sum comes from the Pension Protection Act of 2006. There are three segment rates that are published monthly here. They are based on corporate bond yields of varying credit quality and maturity. All defined benefit plans that offer a lump sum option must use these segment rates to discount the lump sums, but each plan works them into the calculation a little bit differently. For instance, some plans use a rolling average of three months of segment rates while others only use the segment rates of each quarter end, though these details are not necessary for our purposes. The first segment discounts the first five years of life expectancy, the second discounts the next fifteen years of life expectancy, and the third discounts any life expectancy after that. The current mortality charts used for the calculation can be found here.

Sequence of Return Risk

The order in which you earn your returns in retirement can have a significant impact on your retirement assets. Our strategies are designed with the worst case scenario in mind in order to help you mitigate this risk.

It’s no secret that 2022 ended on a sour note. The volatility and swings of the markets were enough to make the average investor nauseous and enough to make someone thinking about retiring downright fearful.

Here’s the thing – we never know when a bad market is going to rear its head, and we must remember they are a necessary and healthy part of the cycle. When we sit down with our clients who have already retired or are about to retire, we remind them of THE most important part of our analysis: we plan for the worst case scenario. What does the worst case scenario look like? It looks like the 2008/2009 financial crisis. It looks like the 2022 high-inflation environment.

More often than not, our oil and gas clients have run their own retirement scenarios. They tend to use a static return they assume will be an average return over the span of their life as an investor. For this example, let’s take 7%. We know each market year produces different market returns, and we don’t know what the future holds. However, the most important piece of this puzzle is what we call “sequence of return risk.” What this means is that different returns at different periods of time in your retirement can make a huge difference in your overall return.

Consider a $1,000,000 portfolio getting varying market returns that average out to 7% at the end. The hypothetical withdrawal rate in this example is around 4% on the portfolio, and let’s also assume a 3% inflation rate (realizing it’s much higher right now but should stabilize in the future).

In Scenario 1, things seem to have worked out pretty well for our hypothetical retiree. They were able to spend what they wanted and were left with more money than when they started.

Now let’s look at a second scenario, where we’ll change just two variables. We’re going to move the year-30 return of -17.68% to year 1 of retirement, and we’ll also take the year-16 return of -10.99% and move it to year 2 of retirement.

Let’s take a peek at what happens now. We’re still assuming an average 7% return at the end, but those two negative returns are now placed at the beginning of retirement.

The sequence of investment returns has dramatically impacted the retirement of our hypothetical retiree. By achieving bad investment results early in retirement, our retiree immediately fell below the initial $1,000,000 investment and never again had a portfolio worth that much – even after returns improved in years 3, 4 and 5. Additionally, while the first scenario took our retiree through 30 years comfortably, the second case – with the bad returns early – ran out of money early in year 28.

In a best-case, albeit unrealistic scenario, the markets (and your portfolio value) go up and to the right for the entirety of your retirement. Unfortunately, we know from history, and from very recent history, this will never be the case. Planning for a best-case scenario could leave investors susceptible to Scenario 2 discussed above, in which our hypothetical retiree ran out of money.

What we, at Baird Retirement Management, have never subscribed to is the “risk questionnaire” so many other firms administer to their clients and prospects, to decide how much in stocks they should hold and how much in bonds/cash they should hold. How you “feel” at any given moment about the markets is very fluid. If we asked our clients how they felt about the markets at the end of 2021, the majority would say very good. Fast-forward to the end of 2022, and the same question posed to the same clients would probably get a drastically different answer.

Since we know retirement is already an emotional and difficult decision, we try to take the emotion out of planning and investing for our clients. Quite simply, we let the math do the work for us on how we allocate for retirement and, most importantly, WHY we allocate the way we do. Through various hypothetical illustrations of real-world data, we show which asset classes are best for accumulation of money and which asset classes are best for distribution of money. Furthermore, we don’t show illustrations of just bull markets – quite the opposite. The only way to plan for worst-case scenarios in retirement is to look back at previous worst-case scenarios to test the planning technique. The 1970s and the 2000s (the “lost decade”) are prime examples of decades that had minimal to no growth in the equity markets and a few years of very bad market returns for investors.

We have ten CERTIFIED FINANCIAL PLANNERS™ here to talk through your unique situation, and we never charge for planning. Through a series of meetings, we’ll explore what retirement looks like for you and we will show you compelling data on why our planning techniques have worked for our clients for decades. While no two retirees are the same, the teams here manage some 2,000 retirees that have all gone through a similar process.