﻿ RFI: Downside Risk Analysis

# RFI Downside Risk Analysis

In RFI Fundamentals we touched on using RFI scenarios to model what could happen to a retiree's spendable funds and asset balances in a "bad case" scenario. RFI "bad case" scenarios can be used to help retirees understand the downside risks inherent in any spending plan.

At a high level, let's assume that a retiree wants to plan their retirement spending based on 50th percentile historical returns. If a retiree is considering a 10 year deferred annuity, they would refer to the historical rate distribution table (described in detail in Risk Profiles an Historical Returns) to find the 50th percentile rate of return of 8.0% (this is for a portfolio which is 50% stocks and 50% bonds). This is the rate entered in the "Assumed Rate of Return" column of the scenario definition table (rows 42-50).  When the scenario is calculated, RFI computes an initial value for monthly spendable funds that meets the following constraints:

• Some portion of financial assets are used to purchase a 10 year deferred annuity

• The remainder of financial assets are invested with an annual return of 8.0%, and are drawn down during the deferment period to fund spending

• Spendable funds increase by 2% every year (this can be changed - see Withdrawal Patterns for details)

• Hence, the initial annuity payment is 2% higher than the last payment made out of financial assets

• Financial assets are depleted at the end of 10 years (unless you specify a set-aside as described in RFI Set-Asides)

From a risk perspective there is a 50% probability that the rate of return on the portfolio will be greater than or equal to 8.0%. What will happen if portfolio returns during the deferment period turns out to be less than 8.0%? RFI allows you answer this question by defining scenarios where that rate is less than 8.0%.  In the example below we define 4 scenarios using a "Rate that Materializes" of 8.0%, 5.1%, 2.7%, and 0.7%; these rates of return correspond to historical return percentiles of 50th, 20th, 5th, and 2nd, respectively. The scenario entries are shown below:

(Note: An alternative way of viewing the 2nd percentile rate assumption is that there is a 98% chance that actual results will be better than the projected results.) When these scenarios are calculated, we get the chart below:

Since all 4 scenarios have the same assumed rate of return, they all have initial monthly spendable funds of approximately \$4,200/month. And since the same annuity is purchased in all four cases, the annuity amounts beginning in year 10 are the same at about \$5,150. But within the first 10 years, the three scenarios with realized rates of return below 8% show declining monthly payments that may or may not be tolerable to the retiree.

If the retiree does not want to incur even the small risk because the payment would drop to about \$2,300, an option is to drop the assumed rate that dictates where the payment begins. That would limit the drop in the riskiest case.

If we start off with an "Assumed Rate of Return" of  3.9% (the 10th percentile historical return) and define 2 scenarios using this assumed rate, we get the following results:

In this bad case scenario using the 2nd percentile historical return of 0.7% the lowest spendable funds amount is about \$3,700/month rather than \$2,300.  Of course, the tradeoff is that initial (and all subsequent) spendable funds projections are lower (initial spendable funds of about \$3,900 as compared to about \$4,200 in the original scenarios)

There is another approach to dealing with potential declines in payment amounts when realized returns fall. If the retiree has a home, a credit line on a HECM reverse mortgage could be used to offset payment declines. See Using a HECM Reverse Mortage to Augment Financial Assets for guidance on this topic.