Wade Pfau, Ph.D., CFA

The Retirement Researcher Manifesto – Part One

As I have attempted to summarize the key messages and themes that have underscored my writing and research, I find that the following eight guidelines serve as a manifesto for my approach to retirement income planning. It is helpful to start with these guidelines because I will ultimately talk about how to implement these guidelines in practice.

Play the long game

Retirement income plan should be based on planning to live, not planning to die. A long life will be expensive to support, and it should take precedence over assuming one will not live long. Fight the impatience that could lead you to choose short-term expediencies carrying greater long-term cost. This does not mean, however, that you sacrifice short-term satisfactions to plan for the long term. Many efficiencies can be gained from a long-term focus that can support a higher sustained standard of living.

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Retirees must still plan for a long life, even when rejecting strategies that only help in the event of a long life. Remember, planning for average life expectancy is quite risky—half of the population outlives their expectancy. Planning to live longer means spending less than you otherwise would. Developing a plan that incorporates efficiencies that will not be realized until later can allow more spending today in anticipation of those efficiencies. Not taking such long-term, efficiency-improving actions will lead to a permanently reduced standard of living.

Do not leave money on the table

The holy grail of retirement income planning is finding strategies that enhance retirement efficiency. I define efficiency as follows: if one strategy allows for more lifetime spending and a greater legacy value for assets relative than another strategy, then it is more efficient. Efficiency must be defined from the perspective of how long you live. Related to the previous point, a number of strategies can enhance efficiency over the long term (but not necessarily over the short term) with more spending and more legacy.

Use reasonable expectations for portfolio returns

A key lesson for long-term financial planning is that you should not expect to earn the average historical market returns for your portfolio. Half of the time, realized returns will be less. As well, we have been experiencing a period of low interest rates, which unfortunately provides a clear mathematical reality that at least bond returns are going to be lower in the future. This has important implications for those who have retired. (These implications are relevant for those far from retirement as well, but the harm of ignoring them is less than for retirees.) At the very least, dismiss any retirement projection based on fixed 8 or 12 percent returns, as the reality is likely much less when we account for portfolio volatility, inflation, and a desire to develop a plan that will work more than half the time.

Be careful about plans that only work with high market returns

A natural mathematical formula that applies to retirement planning is that higher assumed future market returns imply higher sustainable spending rates. Bonds provide a fixed rate of return when held to maturity, and stocks potentially offer a higher return than bonds as a reward for their additional risk. But a risk premium is not guaranteed and may not materialize. Probability-based retirees who spend more today because they are planning for higher market returns than available for bonds are essentially “amortizing their upside.” They are spending more today than justified by bond investments, based on an assumption that higher returns in the future will make up the difference and justify the higher spending rate.

For retirees, the fundamental nature of risk is the threat that poor market returns will trigger a permanently lower standard of living. Retirees must decide how much risk to their lifestyle they are willing to accept. Assuming that, a risk premium on stocks will be earned and spending more today is risky behavior. It may be reasonable behavior for the more risk tolerant among us, but it is not a behavior that will be appropriate for everyone. It is important to think through the consequences in advance.

Build an integrated strategy to manage various retirement risks

Building a retirement income strategy is a process that requires determining how to best combine available retirement income tools in order to meet retirement goals and to effectively protect against the risks standing in the way of those goals. Retirement risks include longevity and an unknown planning horizon, market volatility and macroeconomic risks, inflation, and spending shocks that can derail a budget. Each of these risks must be managed by combining different income tools with different relative strengths and weaknesses for addressing each of the risks. There is no single solution that can cover every risk.

This article is part of a series; click here to read part Two.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

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