“Defining a style and aligning strategies with it represents an important step forward in ensuring that individuals and their retirement income strategies are aligned. Developing an appropriate strategy is a process and there is no single right answer. There is no approach or retirement income product that is best for everyone.” — Alexander Murguia and Wade D. Pfau
What surprises me most about my wife’s catering business is how much food is normally left over. I often ask, “Is there a better way to manage food costs?” Her answer is all the time the identical: “It’s better to have leftover food than to eat too little.”
She has a unprecedented ability to estimate how much all and sundry will eat, but she will never be absolutely sure how many individuals will come or how much of an appetite they’ll bring with them.
When we help our clients plan for his or her retirement, we also don’t know the way much they’ll need, but we never want them to miss out. To be sure they’ve enough, we want to assist them consider quite a few aspects. These include:
- How much income will they need?
- How long will they need it?
- What will inflation seem like?
- How much do they need to go away to their beneficiaries?
Answering these questions will be daunting and is inherently inaccurate. Different financial applications attempt to model the various scenarios, but regardless of how accurately our customers predict their needs, the order of investment returns won’t ever make certain. And that’s probably the most vital aspects for achievement in retirement.
The order of returns is the order by which returns are realized, and as clients accumulate wealth it plays little role. Let’s say a client initially invests $100,000 in stocks. In the next scenario 1, they achieve negative returns firstly of their investment horizon, while in scenario 2 the order is reversed and the negative returns occur at the tip of the investment horizon.
Regardless of the order, the ultimate value for the client is identical: the typical return in each scenarios is 6.05%. However, as clients retire, they need to account for distributions. And that changes mathematics.
With equal returns, they now have an actual income distribution of $50,000 per 12 months, with an annual inflation adjustment of two%, based on an initial nest egg of $1,000,000.
The “average” return is identical in each scenarios, but with very different results. If the client achieves a negative return right from the beginning, as in scenario 1, they’ll run out of cash. Which is a disaster. But in scenario 2, their capital grows to $1.6 million. Which begs the query: “Did they maximize income?”
This situation reflects the order of return risk (SoRR) in retirement. The lesson from this phenomenon is straightforward: the order by which returns are generated is more crucial to success or failure than the typical return. SoRR in addition to longevity risk and unexpected expenses are key aspects in whether clients have the funds for to fund their retirement.
To address these aspects, various strategies have been developed. Generally, they fall into one among six categories, each with its own benefits and downsides: certainty, static, temporary, variable, dynamic and reassuring.
1. The certainty strategy
Many institutions use asset liability management (ALM) to finance their future liabilities. To put it simply, customers invest their money today in such a way that they will meet a future obligation with a high degree of certainty. For example, for instance they wish to cover $50,000 of income in a single 12 months and the present rate of interest is 3%. If the rate of interest and principal are guaranteed, we may recommend that they invest $48,545 – $50,000/1.03 – today to fulfill this future obligation.
However, this can not protect them from inflation. So you would invest that $50,000 in one-year Treasury Inflation-Protected Securities (TIPs) today, covering the liabilities while protecting yourself from inflation risks.
Despite all the understanding, this strategy does have some disadvantages. To make sure the client doesn’t run out of cash, we might should determine what number of years we are going to finance, an almost inconceivable – and morbid – task. The strategy also requires a big initial capital commitment, which most Americans don’t have.
2. The static strategy
If clients lack the capital to fund the ALM strategy or cannot estimate how long their retirement will last, an alternate approach is to discover a “safe” portfolio withdrawal rate. Using historical returns from a 50/50 stock-bond portfolio, William P. Bengen calculated an optimal starting payout rate of 4%. So, to make an annual income of $50,000, a client would want $1,250,000. Every 12 months thereafter, they adjusted the previous 12 months’s payout based on inflation.
As with any retirement income strategy, there are several assumptions involved. Bengen estimated a 30-year retirement horizon and annual rebalancing back to the 50/50 portfolio. The biggest challenge for retirees is getting back into stocks after a pointy decline. Such loss aversion-inspired tactics could derail the strategy.
While Bengen’s 4% withdrawal rate was quite effective, stock market valuations have recently risen and bond yields have been low Christine Benz and John Rekenthaler, amongst others, caused the initial payout rate to be adjusted downwards.
3. The bucket strategy
To overcome the fear of rebalancing in a declining market, retirees may prefer implementing a bucket strategy. This approach exploits the cognitive bias of mental accounting, or our tendency to assign subjective values to different pools of cash no matter fungibility – consider the Christmas account. Clients arrange two or more areas, corresponding to a cash-like short-term area funded with two to 3 years of income needs, and a long-term, diversified investment area with their remaining retirement funds.
In retirement, the client draws his income needs from the short-term budget 12 months after 12 months, while his long-term counterpart replenishes these funds at certain intervals or over certain balance thresholds.
This bucket strategy won’t eliminate SoRR, but it is going to give clients more flexibility to handle market downturns. Bear markets often force retirees to shift to more conservative allocations to cut back risk. However, this reduces the likelihood that the losses can be recovered or future earnings will increase.
By separating categories, customers could also be less liable to making irrational decisions and will be confident that their current income won’t be affected by market downturns and that there can be time to replenish funds within the long-term category.
4. The variable strategy
Most static retirement income programs simply adjust a client’s income distribution based on inflation, ensuring their income stays the identical no matter need. But what if their income needs change from 12 months to 12 months?
Such a staggered spending scenario makes intuitive sense. Retirees will initially spend more on travel and entertainment, then reduce their spending as their health and mobility decline. The longer they retire, the upper their healthcare costs can be, which is able to make up a bigger portion of their expenses.
With this in mind, clients should want to adopt a variable spending plan that accommodates retirement savings. This leads to the next initial income, but may require overcoming certain behavioral patterns to achieve success. We are inclined to be creatures of habit and find it difficult to adapt our spending habits to lower incomes. Furthermore, it will not be clear from the models how much of a discount in income one should expect.
5. The dynamic strategy
While a variable income strategy provides phases of income, a dynamic strategy adapts to market conditions. One type of dynamic income planning uses Monte Carlo simulations of possible capital market scenarios to find out the probability of success of a distribution. Customers can then adjust their income based on the probability levels.
For example, if 85% is taken into account an appropriate success threshold and Monte Carlo calculates a distribution success of 95%, the distribution might be increased. Alternatively, the distributions might be truncated if Monte Carlo simulates a 75% probability. A 100% success rate is in fact ideal, but is probably not achievable. That’s why it’s a very important query to search out out what level of self-confidence suits the client. Once this is set, we will run the Monte Carlo at predefined intervals – annually, semi-annually, etc. – to extend or decrease income. As with the variable income option, this assumes that a customer can and can limit their spending each upwards and downwards.
6. The insurance strategy
Ultimately, the pension fund serves to generate income and most strategies thus far have assumed a retirement horizon. But this horizon can’t be predicted. The only option to eliminate a client’s longevity risk is to secure their retirement income source. In this scenario, the client works with an insurance company and pays a lump sum upfront to make sure a gradual income over a single or joint lifetime.
To evaluate the strategy, we must weigh the convenience of earning an income no matter market performance or longevity against the potential cost. Accessibility of capital, payouts to the beneficiary, creditworthiness and costs are only among the aspects to think about.
Of course, these strategies are hardly exhaustive. They simply provide a framework that we will use to assist our customers understand the various approaches.
Whatever strategy or strategies our clients use will depend on their personal preferences and a wide range of variables. Even if we’ve answers to those subjective questions, we will never be certain in what order the returns, time horizon, and biases might cause a selected plan to fail. Unfortunately, there isn’t a “one-size-fits-all” approach. Ultimately, any retirement strategy requires a balance between what life wants and ensuring our clients don’t fall wanting expectations.
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Photo credit: ©Getty Images / BrianAJackson
