Two schools of retirement income thought

You may not be aware of it, or in which you fall, but there are generally two retirement income schools of thought. One school of thought is the “safety first” school and the other is the “probability based” school of thought. Neither is right or wrong, it essentially comes down to each retiree’s decision.

safety firstSafety First School of thought.

This school of thought basically says that making sure you have money to cover your expenses is paramount. Thus, purchasing an immediate annuity or establishing a bond ladder made up of safe bonds are suggested by these proponents. Pensions and Social Security are often also used to ensure income as long as you live, however many times there is a gap between the income from these sources and your total monthly expenses. Paying off the mortgage, for example is one common method in this school, to close that gap by lowering expenses by the amount of the mortgage payment (principal and interest).

probabilityThe Probability Based School of thought.

This school of thought is based on probabilities of the markets, often called Monte Carlo simulations (stochastic modeling), establishes a “safe withdrawal rate” based on research that began in the mid 1990’s. This school of thought recognizes that markets go up and down and the research suggested that 4% was reasonable. Today’s low interest rates has been challenging this “safe” rate of 4% (in its original form it established an “initial” dollar amount of income and then applied an inflation adjustment each year to that initial dollar amount).

Dan Moisand has a great explanation that goes into a bit more detail about the probability based approach. My research contributions to this Probability Based School of thought is that the “fixed initial rate with inflation adjustment” needs refinement. Newer research is doing just that … refining the probability based school so it is more dynamic to reflect real life and market reality better.

The “prudent” withdrawal rate changes, it can go up, as the retiree ages because their expected lifespan shortens. My collaborators and I also added a second probability function to the research by including the probability of the person (longevity) along with the probability of the portfolio (markets). Market risk does not go away and returns can’t be controlled; in other words market risk does not get safer over time and market risk can’t be controlled.

However, research now shows that prudent allocation may mitigate market risk by including bonds (those very same bonds that the safety first school uses (the markets are the same for everyone afterall)) to reduce portfolio volatility; and volatility appears to be an important factor. The main concept here is that money is fungible, or interchangeable, so it does not “know” what its source of income is: dividends, interest, capital gains, etc. Another key concept is to use multiple different indexed funds to ensure your portfolio is not concentrated in any given area.

What’s the difference?

Dirk Cotton explains the differences between the schools as this: “The decision comes down to this: Are you willing to risk losing your retirement standard of living in exchange for a chance to improve it?” However, what this is really saying is that you may be locking in today’s standard of living for the rest of your life, and may be exposing your conservative nature to inflation risk, the classic fixed income trap, where future costs of living exceed the fixed income previously set up.

Essentially, the Safety First school seeks to guarantee your income, even though expenses may eventually go up, thus you need to cut spending elsewhere. The Probability Based school seeks to set up a prudent income plan that can adjust income in order maintain control over the assets with a prudent assurance of having those assets last your lifetime. Yes, under the Probability Based approach, when markets are down, income should be reduced a little too. Otherwise, the resulting higher spending reduces your money faster. Pension plans are under funded presently because the higher guaranteed spending is not supported by lower returns. In other words, the same investments that support both schools of thought are similarly affected by the same economic events; the difference is how well the retiree sees those effects.

As I previously said at the beginning, your feelings about your situation is really the determinant into which school of thought you choose. By the way, you may transition from the Probability Based school to the Safety First school because you keep more control of your assets under the Probability Based school (buying an immediate annuity requires giving up the assets for example); transitioning from the Safety First school to the Probability Based school typically is harder, especially if you transferred control of your assets.

PS. You may think I have a tendency to favor the Probability Based school over the Safety First school, and you would be right. Primarily because I think transparency and flexibility with your money is important. Having said that, since I mentioned that it is the retiree themselves, not me, who dictates which school of thought they are in, I work with retirees under both schools.

PPS. Please also see Too Big to Fail blog … is Safety First really that safe?


About Larry Frank, Sr.

Larry R Frank Sr., MBA, CFP®, is an experienced financial advisor and a published author on Retirement Planning Research. Have a financial question? Click Here to Ask Larry

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4 Responses to Two schools of retirement income thought

  1. Larry Frank, Sr. February 25, 2013 at 3:50 am #

    I post a comment here to emphasize that the Probability School is made up of two camps.

    The older camp based on the early research (sets an initial withdrawal rate to establish a beginning retirement income dollar amount, and adds an inflation adjustment to the dollar value each subsequent year – thus there is little further reference back to the existing portfolio value).

    The newer camp (of which my collaborators and my research is part) updates the data for 1) period life table changes, 2) portfolio value, 3) market data, and 4) current year spending needs are dynamically updated. This more acurately reflects life’s events.

  2. Dirk Cotton June 15, 2015 at 7:01 am #

    “However, what this is really saying is that you may be locking in today’s standard of living for the rest of your life, and may be exposing your conservative nature to inflation risk, the classic fixed income trap, where future costs of living exceed the fixed income previously set up.”

    Larry, this isn’t what I’m suggesting. When I recommend a floor of safe spending, I recommend TIPS bonds or fixed annuities. I rarely recommend the latter except for under-savers, but when I do, I recommend inflation-protected annuities and, of course, TIPs are inflation-protected. For near-term spending, short term bonds and CD’s have little inflation risk. I never recommend that retirees accept inflation risk. Those of us who were (barely) adults during the hyper-inflation of the 70’s seem to be hyper-sensitive to hyper-inflation.

    And I don’t recommend “locking in” anything early in retirement except, again, for under-savers who have little choice in the matter and need a life annuity. Like you, I believe that spending rates from volatile portfolios should be re-evaluated regularly, not “locked in.” A floor of TIPs bonds doesn’t lock in a strategy, either. A retiree can always re-size the floor by selling or buying bonds and then selling or buying stocks.

    Floor-and-upside doesn’t lock-in a standard of living. If the upside portfolio performs well, a retiree’s standard of living can increase. But it does give up some of that upside potential to reduce downside, which is a rational financial decision.

    I do believe that the most basic question to be answered by retirees is, “are you willing to risk losing your retirement standard of living in exchange for a chance to improve it?”, or more precisely, “how MUCH are you willing to bet?” The probability school says, “You probably won’t go broke.” The Safety First school says that 90% or 95% probability of success isn’t good enough. For my own finances, those probabilities aren’t safe enough, but it is truly an individual decision depending on risk tolerance and risk capacity.

    There is little to say that a retiree can’t change her strategy as her economic situation changes (I think you and I agree that, in fact, she should) except to the extent that she purchases life annuities.

  3. Larry Frank, Sr. June 15, 2015 at 9:22 am #

    I agree with your first paragraph assuming you’re referring to the Safety First perspective (as I describe it above) where conservative options are elected at the beginning of retirement. The Probability Based School tends to provide more on the upside for that component of the overall resources so today’s standard of living has an opportunity to grow (more on floor and upside below).

    I too structure the first few years of retirement income based on less volatile asset classes (primarily short term bond funds that tend to be more broadly diversified than an individual can do on their own, have higher yields in general compared to other short term options, and because they’re short term they have less fluctuation in value with interest rate changes as well as mature faster so principal from maturing bonds may be reinvested at the new prevailing interest rates (in today’s environment, presumably higher). The inflation risk component comes mostly from the stock allocation.

    Agree with everything else you say as well. We simply interpret implementation a bit differently … and YES, the situation and people’s attitudes, etc. dictate quite a bit how to approach the retirement income problem for them.

    We recently discussed the “floor and upside” concept you mention. As I mentioned to you, I see two floors. The first is Social Security which has an inflation adjustment upside. Pensions, for those who will have them, is another part of the first floor for income (often don’t have inflation adjustments (tend to be corporate), although some do (tend to be state, federal and teachers)). The second floor comes from the portfolio assets typically invested in 401k, 403b, 457, IRA and Roth, and sometimes other non-tax deferred accounts. The two floors are added together to form the combined spending floor for retirees.

    My ocean analogy applies to the portfolios invested as such. Many people envision losing all their money when markets misbehave and that’s a main point about the analogy and the original post describing it (Note: to open links in a new window and retain keep this current window open too … please hold the shift key and then click links: ). When properly diversified (as opposed to allocated … What’s the difference? ) it is unlikely the portfolio would go to zero value.

    Becoming comfortable with possibilities is a reality we have all lived with our whole lives … what if I do this or did that? Life is full of choices with their own consequences and possible outcomes. Proper diversification is a choice when it comes to portfolio management. I don’t disagree with anybody’s structure as to how they attempt to accomplish supporting their income needs during retirement because that freedom and availability of many choices is what keeps the markets liquid and operating.

    Thanks for writing!

    PS. There’s another post on this topic of the two schools which diagrams some of the differences in a visual manner … that may help some readers discern the differences we’re talking about here. Also note that the profession has not yet settled on how to label or even how many schools of thought there are.


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