Two Philosophies for Retirement Income Planning Part One: Probability-Based
Within the world of retirement income planning, the siloed nature of financial services between investments and insurance leads to two opposing philosophies about how to build a retirement plan. There is an old saying that if the only tool you have is a hammer, then everything starts to look like a nail. This tendency is alive as those on the investments side tend to view an investment portfolio as a solution for any problem, while those on the insurance side tend to view insurance products as the answer for any financial question.
As a basic introduction to these schools, a simple litmus test can be applied. Monte Carlo simulations are often used in financial planning contexts to gain a better understanding of the viability of a financial plan in the face of market and longevity risks. Monte Carlo simulations create randomized series of market returns to test financial plans and their sustainability through various market environments. Suppose a Monte Carlo simulation identifies a retirement plan’s chance of success as 90 percent. Both sides of the debate might accept this as the correct calculation from the software, but they will have dramatically different interpretations of what to do with this number.
For probability-based thinkers, a 90 percent chance is a more than reasonable starting point, and the retiree can proceed with the plan. It has a high likelihood of success, and that’s enough for them. If future updates determine that the plan might be on course toward failure, a few changes, such as a small reduction in spending, should be adequate to get the plan back on track.
Those identifying with the safety-first school, however, will not be comfortable with this level of risk, focusing instead on the 10 percent chance of failure. They make a distinction between essential expenses and discretionary expenses and seek a solution that practically eliminates the possibility of failure for meeting essential expenses. Jeopardizing success, they say, is only reasonable for discretionary expenses.
Financial service professionals and retirees should understand which school they most identify with and to what extent their own thinking might incorporate views from each school. Consumers of the financial services profession must understand whether they and their advisor are speaking the same language. Advisors able to communicate effectively from both sides will be more likely to deliver successful retirement income outcomes by being able to tailor comfortable plans for their clients.
The Probability-Based School of Thought
How much can retirees withdraw from their savings, which are invested in a diversified investment portfolio, while still maintaining sufficient confidence that they can safely continue spending without running out of wealth for the length of retirement?
In the early 1990s, William Bengen read misguided claims in the popular press that average portfolio returns could guide the calculation of sustainable retirement withdrawal rates. If stocks average 7 percent after inflation, then plugging a 7 percent return into a spreadsheet suggests that retirees could withdraw 7 percent each year without ever dipping into their principal. Bengen recognized the naïveté of ignoring the real-world volatility experienced around that 7 percent return, and he sought to determine what would have worked historically for hypothetical retirees at different points. He used data extending back to 1926 for US financial markets for his research, which introduced the concept of sequence-of-returns risk to the financial planning profession.
The problem he set up is simple: a new retiree makes plans for withdrawing some inflation-adjusted amount from his or her savings at the end of each year for a thirty-year retirement period. For a sixty-five-year-old, this leads to a maximum planning age of ninety-five, which Bengen felt was reasonably conservative. What is the highest withdrawal amount as a percentage of retirement date assets that, with inflation adjustments, will be sustainable for the full thirty years? He looked at rolling thirty-year periods from history (1926 to 1955, 1927 to 1956, etc.). He found that with a 50/50 asset allocation to stocks and bonds (the S&P 500 and intermediate-term government bonds), the worst-case scenario experienced in US history was for a hypothetical 1966 retiree who could have withdrawn 4.15 percent at most. That is if distributions are taken at the end of each year. More realistically, if distributions are taken at the start of each year, this sustainable withdrawal rate falls to 4.03 percent. Thus was born what is known as the 4 percent rule.
Bengen’s work pointed out that sequence-of-returns risk will reduce safe, sustainable withdrawal rates below what is implied by the average portfolio return over retirement. Its popularity has coalesced into what we are calling the probability-based approach.
The probability-based approach is based closely on the concepts of maximizing risk-adjusted returns from the perspective of the total portfolio. Asset allocation during retirement is generally defined in the same way as during the accumulation phase—using modern portfolio theory (MPT) to identify a portfolio on the efficient frontier in terms of single-period trade-offs between risk and return. Different volatile asset classes that are not perfectly correlated are combined to create portfolios with lower volatility. The efficient frontier identifies the asset allocation combinations with the highest probability-weighted arithmetic average return (often called expected return in finance literature) for an acceptable level of year-by-year volatility (often called risk). Investors aim to maximize wealth by seeking the highest possible return given their capacity and tolerance for volatility over a specific time horizon.
For retirement planning, spending and asset allocation recommendations from the efficient frontier are based on historical or Monte Carlo simulations of failure rates in order to mitigate the risk of wealth depletion inherent in drawing down a portfolio of volatile assets. The failure rate is the probability that wealth is depleted before death or before the end of the fixed time horizon which stands in for a maximum feasible lifespan. Asset allocation decisions are generally guided by what can minimize the failure rate in retirement. Advocates of the probability-based approach take this as license to use more aggressive asset allocations in retirement.
Advice from Bengen and subsequent studies is to have a stock allocation between 50 and 75 percent, but as close as possible to the higher end. Probability-based advocates are generally more optimistic about the long-run potential of stocks to outperform bonds and provide positive real returns, so investors are generally advised to take on as much risk as they can tolerate in order to minimize the probability of plan failure. This school of thought was the focus of my book How Much Can I Spend in Retirement? A Guide to Investment-Based Retirement Strategies.
In my next article, we will discuss the other philosophy of retirement income planning: The Safety-First School of Thought.
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.