Taking Portfolio Spending into the Real World For Retirees
In February of 1998, the Trinity study established the idea of focusing on success and failure rates, building into our psyche the idea that your retirement is a failure if the investment portfolio is depleted.
This has put too much emphasis on the portfolio and spending conservatively to keep failure rates low. This is not the whole story for retirement income. Certain circumstances, which we will explore, may allow retirees to accept a higher probability of “failure,” and spend more aggressively from their investment portfolio. Depleting the investment portfolio is not always catastrophic.
We must evaluate the trade-off: Reduce spending to better protect future spending potential or enjoy the highest possible living standard despite the risk of cutbacks later in retirement.
Withdrawal rate studies have typically focused on the probability of depleting the portfolio while still alive, without giving consideration to what is lost in terms of life satisfaction by using a lower withdrawal rate and spending less.
The fact is, when using low withdrawal rates, retirees will typically leave behind a large pot of wealth (unless their retirement returns sequence matches the worst-case scenario). This is not usually included in the analysis, other than to recommend using a higher stock allocation to increase the average legacy.
When taking portfolio spending out of the vacuum, there are four interrelated factors that we must consider:
- Longevity risk aversion: How fearful are you about outliving your investment portfolio in retirement? This is an emotional characteristic unrelated to whether you may outlive your portfolio in an objective sense.
- Reliable income sources: What proportion of your retirement spending is covered through reliable income sources from outside the investment portfolio?
- Spending flexibility: Is it possible to reduce portfolio distributions without harming your standard of living in a significant way?
- Availability of reserves: What other resources are available that have not been earmarked to manage spending and can be used to cover contingencies?
These factors all relate to what is an acceptable probability of success, or probability of failure, for the retirement plan. For someone who worries about outliving their portfolio, doesn’t have much additional income from outside the portfolio, faces mostly fixed expenses without much room to make cuts, and doesn’t have much in the way of back-up reserves, it may be necessary to plan for a high probability of success. This will imply using a lower stock allocation and a lower spending rate.
However, for someone who has less fear about outliving their portfolio, has additional income sources outside their portfolio, has the flexibility to cut portfolio spending without adversely impacting their lifestyle, and has sufficient additional reserves, then a higher spending rate accompanied by a lower probability of success could be quite satisfactory and “optimal.”
The first to explore this were Moshe Milevsky and Huaxiong Huang in their March/April 2011 Financial Analysts Journal article called, “Spending Retirement on Planet Vulcan: The Impact of Longevity Risk Aversion on Optimal Withdrawal Rates.”
By referring to Planet Vulcan from Star Trek, they mean to discuss the decisions made by a fully rational investor when facing longevity risk but not market risk. The individual does not know how long he or she will live, but the investment returns are known in advance.
The retiree has to decide how much to spend from the portfolio each year in the face of an uncertain lifespan. The authors summarize the rational investor’s decision-making process as, “Wealth managers should advocate dynamic spending in proportion to survival probabilities, adjusted up for exogenous pension income and down for longevity risk aversion.”
Several important points are packed into that sentence. The first idea is that retirees should intentionally plan to spend more when they are sure to be alive, while planning for reduced spending later on when survival is less certain.
Since survival probabilities decline with age, it is rational (on Planet Vulcan) to spend more earlier on while you are more likely to be alive, and to spend less later on when the probability of still being alive is lower. You should intentionally plan to decrease spending as you age to account for the lower probability of living to each subsequent age.
Otherwise, retirees sacrifice too much by cutting spending in early retirement to allow for the same spending much later on when the odds of being alive are low. With lower future spending, the initial withdrawal rate can be increased. This idea will resonate with some readers, and it will sound like a terrible idea to other readers.
A greater desire to reject this notion implies that someone has greater longevity risk aversion. Even if the probability is low, this person does not want to be in a position to make significant spending cuts or to become a burden to their children at an advanced age.
Most retirees will have income streams available from outside their financial portfolios, known as “exogenous pension income.” Social Security and other defined-benefit pensions or annuities are an example of exogenous pension income.
These income streams reduce the lifestyle impact of depleting the investment portfolio, which could make a retiree more comfortable with the idea of spending more aggressively than a “safe” spending rate analysis would suggest.
Finally, both of these factors will be tempered somewhat to the extent that a retiree is particularly fearful of outliving their financial portfolio. Greater longevity risk aversion requires spending less in order to maintain the portfolio over a longer time horizon.