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

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

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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