Best Practices in Retirement Planning Wade D. Pfau, Ph.D., CFA The American College instream Solutions McLean Asset Management Retirement Researcher blog (www.retirementresearcher.com/blog)
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
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
[Retirement Income Planning] is a really hard problem. It s the hardest problem I ve ever looked at. William Sharpe CFA Institute Conference, 2014
The Mountain Climbing Analogy
What s different about retirement? Reduced earnings flexibility Visible spending constraint Heightened sequence risk Need for liquidity Unknown longevity Compounding inflation Declining cognitive abilities
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
Retirement Risks
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
Sequence Risk Most vulnerable to returns when wealth is largest Pre-retirement dollar cost averaging reverses in distribution phase
Lifetime Sequence of Returns Risk 16 14 12 10 8 6 4 2 Explanatory Power for Each Year's Return 0 0 10 20 30 40 50 60 Year
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
Source: Wade Pfau and Jeremy Cooper, The Yin and Yang of retirement income philosophies
Investment Approach for Retirement Income Systematic Withdrawals Time Segmentation Essential vs. Discretionary
Systematic Withdrawals
Systematic Withdrawals Lifestyle Goal Spending ($) Diversified Portfolio Age
The 4% Rule William Bengen Journal of Financial Planning, October 1994
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, 1926-2010, S&P 500 and Intermediate-Term Government Bonds 9 8 Maximum Sustainable Withdrawal Rate 7 6 5 4 3 2 1 SAFEMAX 0 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 Retirement Year
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, 1926-2010, S&P 500 and Intermediate-Term Government Bonds 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 15 Years 100 100 100 90 82 73 70 59 46 37 20 Years 100 100 91 80 70 61 47 42 30 17 25 Years 100 98 80 69 59 49 38 30 20 8 30 Years 100 93 75 63 50 36 30 18 7 5 35 Years 100 90 73 53 47 29 24 12 6 2 40 Years 100 89 70 54 37 30 24 11 2 0 75% Stocks 15 Years 100 100 100 97 85 75 63 52 42 23 20 Years 100 100 94 79 67 52 44 27 15 5 25 Years 100 100 82 66 54 41 26 13 3 0 30 Years 100 98 75 54 41 29 7 2 0 0 35 Years 100 92 65 49 31 20 2 0 0 0 40 Years 100 91 65 43 30 7 2 0 0 0 50% Stocks 15 Years 100 100 100 100 83 73 54 39 24 3 20 Years 100 100 98 77 59 38 29 6 2 0 25 Years 100 100 84 56 38 20 8 2 0 0 30 Years 100 100 66 39 16 4 0 0 0 0 35 Years 100 96 53 27 0 0 0 0 0 0 40 Years 100 85 43 15 0 0 0 0 0 0 25% Stocks 15 Years 100 100 100 99 75 59 41 21 8 1 20 Years 100 100 94 61 42 23 9 2 0 0 25 Years 100 100 62 39 16 10 2 0 0 0 30 Years 100 86 38 11 4 2 0 0 0 0 35 Years 100 67 12 0 0 0 0 0 0 0 40 Years 98 39 4 0 0 0 0 0 0 0 0% Stocks 15 Years 100 100 99 89 61 35 25 14 3 0 20 Years 100 94 74 35 27 12 3 0 0 0 25 Years 97 77 31 20 10 3 0 0 0 0 30 Years 80 38 13 4 2 0 0 0 0 0 35 Years 69 18 0 0 0 0 0 0 0 0 40 Years 57 4 0 0 0 0 0 0 0 0
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
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
Time Segmentation
Time Segmentation Lifestyle Goal Spending ($) Bond Ladder Diversified Portfolio Age
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
Essentials vs. Discretionary
Essentials vs. Discretionary Lifestyle Goal Diversified Portfolio Spending ($) Basic Needs Income Annuities Age
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
Modern Retirement Theory by Jason K. Branning, CFP and M. Ray Grubbs, Ph.D. www.modernretirementtheory.com Legacy Fund Assets Funding Priority Fund for Discretionary Expenses Contingency Fund Fund for Essential Needs
Household Balance Sheet Assets Liabilities (Present Values) Human Capital Financial Capital Social Capital Legacy Discretionary Contingency Fixed
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
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
Safer withdrawal plan Source: http://www.bobsfinancialwebsite.com/saferplan2.html
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
Thank you! Any Questions? Wade D. Pfau The American College McLean Asset Management instream Solutions wadepfau@gmail.com @WadePfau (Twitter) www.retirementresearcher.com