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.

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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.


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