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. This approach was originated in the 1920s in the research of people like Frank Ramsey and Irving Fisher. 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 fundamental question of economics: How do you optimize in the face of scarcity? In more recent history, Nobel Prize winners such as Paul Samuelson, Robert Merton, Franco Modigliani, and William Sharpe have explored these models.
Safety-first comes 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 brought these ideas to a wider audience.
How are goals prioritized?
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. 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 in one year and being unable to afford essentials later.
In developing Modern Retirement Theory, financial planner Jason Branning and academic M. Ray Grubbs create 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.
Their pyramid is recreated in Figure 1. There is no consideration of discretionary expenses or providing a legacy until a secure funding source for essential needs and contingencies is in place.
What is the investment approach?
Traditionally, investing in the accumulation phase has built on the tools of Modern Portfolio Theory (MPT) and portfolio diversification to find a suitable balance between investment returns and the volatility of those returns. Investors seek strategies that will support the highest expected wealth, subject to the investor’s tolerance and capacity to endure downward fluctuations in the portfolio value. But, this was never the complete story.
In 1991, Nobel laureate and MPT founder Harry Markowitz wrote about how MPT was never meant to apply to the investment problems of a household. Rather, it was for large institutions with indefinite lifespans and no specific spending objectives for the portfolio. This should have been a eureka moment for the entire retirement income industry, but MPT is still misapplied today.
People have finite lifespans. The purpose of saving and investing is to fund spending during retirement. MPT does not address this more complicated issue. The alternative is asset-liability matching, which focuses more holistically at the household level and also emphasizes hedging and insurance. In simple terms, hedging means holding individual bonds to maturity, and insurance means using income annuities as a solution 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 such a way that meets those needs. Assets are matched to goals so that the risk and cash flow characteristics are comparable.
For essential spending, Modern Retirement Theory argues that funding must be with assets meeting the criteria of being “secure, stable, and sustainable.” Funding options can include defined-benefit pensions, bond ladders, and income annuities. 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 household 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 household 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.
The idea is to first build a floor of very low-risk guaranteed income sources to serve your basic spending needs in retirement (or, as Moshe Milevsky says, “pensionize your nest egg”). The guaranteed income floor is built with Social Security and any other defined-benefit pensions, and through the use of your financial assets to do things such as building a ladder of TIPS or purchasing an income annuity. Not all of these income sources are inflation-adjusted, and you need to make sure the floor is sufficiently protected from inflation, but this is the basic idea.
Once there is a sufficient floor in place, you can focus on upside potential. With any remaining assets, you can invest and spend as you wish. Since this extra spending (such as for nice restaurants, extra vacations, etc.) is discretionary, it won’t be the end of the world if you must reduce spending at some point. You still have your guaranteed income floor in place to meet your basic needs no matter what happens. With this sort of approach, withdrawal rates hardly matter.
What is the safe withdrawal rate from a diversified portfolio of volatile assets?The general view of safety-first advocates is that there is no such thing as a safe withdrawal rate 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 (one “whack at the cat” as Michael Zwecher has memorably described it) and must develop a strategy that will meet basic needs no matter the length of life or the sequence of post-retirement 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 objective for retirement is first to build a safe and secure income floor for the entire retirement planning horizon, and only after that should you include more volatile assets that provide greater upside potential and accompanying risk. In terms of this floor for essentials and contingencies, pensions, bond ladders, and income annuities should take the lead. Failure should not be an option when meeting basic needs. Thus, income annuities serve as a fundamental building block for retirement income.
Income annuities are especially valuable because of their ability to provide longevity protection through the provision of mortality credits. People do not know their age of death in advance. They can learn about their remaining life expectancy, but that is just a projection of the average outcome and there is a surprisingly large distribution of actual lifespans around the average. Individual retirees cannot self-insure to protect from longevity risk, and without annuitization they are obliged to plan for a long lifespan.
The annuity provider, however, can pool longevity risk across a large group of retirees, and those who die earlier than average subsidize payments to those who live longer than average. These are mortality credits. Because the annuity provider can pool the longevity risk, they are able to make payments at a rate much closer to what would be possible when planning for remaining life expectancy.
A retiree seeking to self-annuitize must assume a time horizon extending well beyond life expectancy (such as thirty years with the 4% rule), to better hedge against the consequences of living beyond their planning age. A retiree must spend less when on the self-annuitize path.