Wade Pfau, Ph.D., CFA

Two Philosophies for Retirement Income Planning Part Two: Safety-First School

This article is part of a series; click here to read Part 1.

The safety-first school of thought was originally derived from academic models of how people allocate their resources over a lifetime to maximize lifetime satisfaction. Academics have studied these models since the 1920s to figure out how rational people make optimal decisions. In the retirement context, the question to be answered is how to get the most lifetime satisfaction from limited financial resources. It is the basic question of economics: how to optimize in the face of scarcity? More recently, Nobel Prize winners such as Paul Samuelson, Robert Merton, Franco Modigliani, and William Sharpe have explored these models.

Safety-first arrives from a more academic foundation, so it is often described with mathematical equations in academic journals. As a result, it has been slow to enter the public consciousness. The safety-first approach is probably best associated with Professor Zvi Bodie from Boston University, whose popular books such as Worry-Free Investing and Risk Less and Prosper have brought these ideas alive to the public. Michael Zwecher’s Retirement Portfolios is also an excellent resource written for financial professionals about this school of thought.

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Advocates of the safety-first approach view prioritization of retirement goals as an essential component of developing a good retirement income strategy. The investment strategy aims to match the risk characteristics of assets and goals, so prioritization is a must.

Prioritizing goals has its academic origins in the idea of utility maximization. As people spend more, they experience diminishing marginal value with each additional dollar spent. The spending required to satisfy basic needs provides much more value and satisfaction to someone than the additional spending on luxuries after basic needs are met. Retirees should plan to smooth spending over time to avoid overspending on luxuries at the present and then being unable to afford essentials later.

In developing Modern Retirement Theory, financial planner Jason Branning and academic M. Ray Grubbs created a funding priority for retiree liabilities. Essential needs are the top priority, then a contingency fund, funds for discretionary expenses, and a legacy fund. They illustrate these funding priorities with a pyramid. Building a retirement strategy requires working from the bottom to properly fund each goal before moving up to the next. There is no consideration of discretionary expenses or providing a legacy until a secure funding source for essentials and contingencies is in place.

The purpose of saving and investing is to fund spending and other goals during retirement. Safety-first advocates move away from asset allocation for the investment portfolio to broader asset-liability matching, which focuses more holistically at the household level and emphasizes hedging and insurance along with investing for upside. In simple terms, hedging means holding individual bonds to maturity, and insurance means using annuities and life insurance as solutions for longevity and market risk.

With asset-liability matching, investors are not trying to maximize their year-to-year returns on a risk-adjusted basis, nor are they trying to beat an investing benchmark. The goal is to have cash flows available to meet spending needs as required, and investments are chosen in a way that meets those needs. Assets are matched to goals so that the risk and cash-flow characteristics are comparable. For essential spending, Branning and Grubb’s Modern Retirement Theory argues that funding must be with assets meeting the criteria of being secure, stable, and sustainable. In this regard, another important aspect of the investment approach for the safety-first school is that investing decisions are made in the context of the entire retirement balance sheet. This moves beyond looking only at the financial portfolio to consider also the role of human and social capital. Examples of human and social capital include the ability to work part-time, pensions, the social safety net, and so on.

An important point is that volatile assets are seen as inappropriate for basic needs and the contingency fund. Stated again, the objective of investing in retirement is not to maximize risk-adjusted returns, but first to ensure that basics will be covered in any market environment and then to invest for additional upside. Volatile (and hopefully, but not necessarily, higher returning) assets are suitable for discretionary expenses and legacy, in which there is some flexibility about whether the spending can be achieved.

Asset allocation, therefore, is an output of the analysis, as the entire retirement balance sheet is used, and assets are allocated to match appropriately with the household’s liabilities. Asset-liability matching removes the probability-based concept of safe withdrawal rates from the analysis, since it rejects relying on a diversified portfolio for the entire lifestyle goal.

In fact, the general view of safety-first advocates is that there is no such thing as a safe withdrawal rate, such as the 4 percent rule, from a volatile portfolio. A truly safe withdrawal rate is unknown and unknowable. Retirees only receive one opportunity to obtain sustainable cash flows from their savings and must develop a strategy that will meet basic needs, no matter the length of life or the sequence of postretirement market returns and inflation. Retirees have little leeway for error, as returning to the labor force might not be a realistic option. Volatile assets like stocks are not appropriate when seeking to meet basic retirement living expenses. Just because a strategy did not fail over a historical period does not ensure it will always succeed in the future.

The idea is to first build a floor of low-risk, contractually protected income sources to serve basic spending needs in retirement. The floor is built with Social Security and any other defined-benefit pensions, and by using financial assets to do things such as building a ladder of TIPS or purchasing an annuity with lifetime income protection. Not all of these income sources are inflation adjusted, and you need to make sure the floor will be sufficiently protected from inflation, but this is the basic idea.

The objective for retirement is first to build a safe and secure income floor for the entire retirement planning horizon, and only after that does one include more volatile assets that provide greater upside potential and accompanying risk. Once there is enough flooring in place, retirees can focus on upside potential with remaining assets. Since this extra spending (such as for nice restaurants, extra vacations, etc.) is discretionary, it will not be the end of the world if it must be reduced at some point. The protected income floor is still in place to meet basic needs no matter what happens in the financial markets. With this sort of approach, withdrawal rates hardly matter.

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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