Best Practices in Retirement Planning

Transcription

1 Best Practices in Retirement Planning Wade D. Pfau, Ph.D., CFA The American College instream Solutions McLean Asset Management Retirement Researcher blog (

2 Retirement Requires a Different Approach / Toolkit Professor Mandell, editor of Financial Services Review, invited me to contribute an article related to financial research for the individual for the first issue of this journal. Since the subject is not my specialty, it was uncharacteristically risky of me to have accepted the invitation. But an evening of reflection convinced me that there were clear differences in the central features of investment for institutions and investment for individuals, that these differences suggest differences in desirable research methodology, and that a note on these differences may be of value. Financial Services Review, 1991

3 What s different? Academic Justifications and Practice Validations expand beyond the traditional focus on Wealth. Traditional financial management is a special case of the larger financial framework that has been developed and formalized since the 1950s. Retirement Management reintroduces minimum consumption in the financial equation. Francois Gadenne Retirement Income Industry Association presentation

4 [Retirement Income Planning] is a really hard problem. It s the hardest problem I ve ever looked at. William Sharpe CFA Institute Conference, 2014

5 The Mountain Climbing Analogy

6 What s different about retirement? Reduced earnings flexibility Visible spending constraint Heightened sequence risk Need for liquidity Unknown longevity Compounding inflation Declining cognitive abilities

7 Deciding How to Spend Down Assets in Retirement Capital Market Expectations Planning Horizon Asset/Product Allocation Funded Status Spending Flexibility / Risk Capacity Emphasize spending or bequest, downside or upside

8 Retirement Risks

9 Challenges for an Individual Pension Plan Asset Returns Pension Manager Pool returns across generations Advisor One whack at the cat Longevity Risk Pension Manager systemic increases in longevity Advisor Idiosyncratic longevity risk

10 Sequence Risk Most vulnerable to returns when wealth is largest Pre-retirement dollar cost averaging reverses in distribution phase

11 Lifetime Sequence of Returns Risk Explanatory Power for Each Year's Return Year

12

13 Retirement Income Philosophies Prioritization Among Goals Investment Approach Measuring Retirement Success Safe Withdrawal Rate Probability-Based Focus on overall lifestyle spending goals Focus on a total returns investing for the entire financial portfolio to maximize returns for an acceptable level of volatility Focus on determining an acceptable probability of failure for the overall retirement plan The historical record suggests that 4% or 4.5% is about as bad as it gets Safety-First Distinguish retirement spending goals between essential needs and discretionary expenses Match assets to different goals so that risk levels are compatible. Allows a wider role for holding individual bonds and using income annuities. Seeks to minimize harms in worst-case scenarios by avoiding failure for essential needs Unknown and unknowable. Risky assets are inherently risky and the historical success of a strategy does not provide sufficient confidence

14 Source: Wade Pfau and Jeremy Cooper, The Yin and Yang of retirement income philosophies

15 Investment Approach for Retirement Income Systematic Withdrawals Time Segmentation Essential vs. Discretionary

16 Systematic Withdrawals

17 Systematic Withdrawals Lifestyle Goal Spending ($) Diversified Portfolio Age

18 The 4% Rule William Bengen Journal of Financial Planning, October 1994

19 William Bengen s 4% Rule Figure 2.1 Maximum Sustainable Withdrawal Rates For 50/50 Asset Allocation, 30-Year Retirement Duration, Inflation Adjustments, No Fees Using SBBI Data, , S&P 500 and Intermediate-Term Government Bonds 9 8 Maximum Sustainable Withdrawal Rate SAFEMAX Retirement Year

20 Trinity Study, 1998 Historical Sustainability of Desired Distribution 100% Stocks Portfolio Success Rates Inflation-Adjusted Withdrawals For Various Withdrawal Rates, Asset Allocations, and Retirement Durations Using SBBI Data, , S&P 500 and Intermediate-Term Government Bonds 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 15 Years Years Years Years Years Years % Stocks 15 Years Years Years Years Years Years % Stocks 15 Years Years Years Years Years Years % Stocks 15 Years Years Years Years Years Years % Stocks 15 Years Years Years Years Years Years

21 Underlying Philosophy of 4% Rule Focus on overall lifestyle spending goal Failure = Not Meeting Full Spending Goal for 30 years Retirees want smooth spending, appetite for market risk Market Risk Management: Diversified portfolio and precautionary savings. Historically, 50-75% stocks maximizes the probability of plan success Focus on total returns Longevity Risk Management: 30 Years is sufficiently beyond life expectancy Confidence in the Historical Record as Precedent

22 Problems with 4% Rule Market/sequence risk could create new worst outcome Horizon may extend beyond 30 years Requires asset and distribution management into an advanced age Assumes a constant (inflation-adjusted) spending need Practical tradeoffs about when spending will maximize retirement satisfaction Assumes rational investor always rebalances on schedule to target asset allocation and is able to earn underlying index returns without fee drag No accounting for magnitude of failure Implied self-annuitization does not get any boost from mortality credits Incongruity of funding a smooth spending stream from a volatile portfolio this is a unique cause of sequence of returns risk Strategy is inefficient as spending should adjust based on portfolio performance and time horizon

23 Time Segmentation

24 Time Segmentation Lifestyle Goal Spending ($) Bond Ladder Diversified Portfolio Age

25

26

27

28

29 Time Segmentation Not a superior investment strategy Avoids selling stocks when markets are down; builds in time buffer for market recovery Uses bonds to provide income at expected date rather than as stocks-lite However, does time diversification work? Guyton: Is there any there there? Benefits are behavioral Easier for clients to understand (mental accounting) Helps clients to stay the course

30 Essentials vs. Discretionary

31 Essentials vs. Discretionary Lifestyle Goal Diversified Portfolio Spending ($) Basic Needs Income Annuities Age

32 Essentials vs. Discretionary Prioritizes Goals Matches risk characteristics of assets used to fund different liabilities Don t use stocks to fund essential needs! Modern Retirement Theory: essential needs should be met with assets that are secure, stable, and sustainable More willing to use income annuities for longevity / market risk protection

33 Modern Retirement Theory by Jason K. Branning, CFP and M. Ray Grubbs, Ph.D. Legacy Fund Assets Funding Priority Fund for Discretionary Expenses Contingency Fund Fund for Essential Needs

34 Household Balance Sheet Assets Liabilities (Present Values) Human Capital Financial Capital Social Capital Legacy Discretionary Contingency Fixed

35 The Safe Withdrawal Rate -??? Unknown and unknowable. Risky assets are inherently risky Retirees cannot rely on averages as they only get one opportunity for a successful retirement Just because something would have worked in our limited historical record does not make it safe

36 It s important to recognize that just because something works in the typical case or has always worked in the past, it will do your client no good if they are in the unlucky tail of the distribution. With risky prospects, the word risk is there for a reason. Michael Zwecher, Retirement Portfolios

37 Safer withdrawal plan Source:

38 Fighting the Retirement Risk Juggernaut Spend Conservatively Adjust Spending to Market Returns Reduce Volatility Match Assets to Liabilities Mortality Credits and Longevity Risk Pooling Preserve Liquidity Monitor Funded Status Insurance for unexpected expenses

39 Thank you! Any Questions? Wade D. Pfau The American College McLean Asset Management instream (Twitter)