Retirement income management boils down to basically two schools of thought … Probability Based School and the Safety First School. Wade Pfau has a summary on his blog, and I’ve written on the comparisons as well. Wade is an advocate of the Safety First School in general while I’m an advocate of the Probability Based School.
I discuss in detail the analogy of ocean waves to visualize retirement planning in this blog post.
Rather than writing a description of the two, here’s a graphic that illustrates that both schools are talking about the same ocean (ocean analogy explained more). They simply are viewing it from different parts of the ocean.
(Please click on graphic to enlarge – or hold shift, then click graphic to enlarge in a new window).
- Notice that both graphs have retirement starting on the left side of the figures and ending on the right side of the figures.
- That numbering difference explains a number of differences between the schools of thought.
- The upper graph numbers (along the very top) from higher to lower values from start to finish of retirement – represents counting down the number of years remaining in retirement.
- The lower graph numbers (along the very bottom) traditionally from lower to higher values from start to finish – represents count the number of years since retirement began.
- Stocks in both graphs are labeled in the blue zones while bonds/cash are labeled in the black or brown zones in either graph.
- The upper blue stock zone decreases in emphasis while the bonds/cash zone increases in emphasis as one moves from left to right – represents a declining stock allocation exposure as one ages.
- The lower blue stock zone increases in emphasis while the bonds/cash zone decreases in emphasis as one moves, again, from left to right – represents an increasing allocation to stocks as one ages.
- Sequence risk may be visualized in the graphs as being represented by the wave height between peaks and troughs (this blog post discusses how to measure and use this visualization and information).
- Probability based (upper graph) views sequence risk as being more problematic at older ages (the lower numbered years – upper right). Most also don’t believe sequence risk goes away at any age – it’s ever present. Thus exposure to the risk is managed through a higher allocation to non-stock holdings; in other words, a declining equity glide path with age.
- Safety first (lower graph) views sequence risk as being more problematic at younger ages (again, the lower number years – but now, lower left). Proponents view sequence risk as going away after 7 to 10 years. Thus exposure to stocks at older retirement ages; in other words, a rising equity glide path with age.
- Most safety first proponents envision spending patterns as following the waves (portfolio value) and spend a percentage of the portfolio value as balances change up and down between peaks and troughs. This would lead to constantly changing spending amounts since the portfolio value is constantly changing.
- A more stable spending pattern may be obtained by calculating the trough portfolio value and base spending percentages on that more stable value. Balances above that trough value may be spent on a discretionary basis when conditions permit. This is a method for probability based proponents to manage sequence risk and variable portfolio values.
The difference primarily is when do they envision the “surf zone” or the low numbered years of retirement? How to address those surf zone years is not in dispute – use of Single Premium Immediate Annuities (SPIAs) and/or Deferred Immediate Annuities (DIAs). Most in the profession view application of these during the early years of retirement (bottom segment of the graph, and numbering at bottom, representing safety first view). Others, including myself based on lifetime expected cash flow analysis, view application of these as an option to be made later in retirement (upper segment of the graph, with numbering at the top, representing probability based view).
Another difference between the schools is whether stock exposure should rise or decline during the retirement years. Again, research supports either view – differences primarily due to simulation design, assumptions and data interpretation.
Differences also come in as to when to adjust calculations for the present year’s income and to what point is that income calculation in reference to … when retirement began (safety school), or from the present year through simply redoing the forward looking calculations each year?
How are actuarial lifespans calculated and applied … at the beginning of retirement using a conservative age less likely to be outlived (i.e., a safe fixed period), or each year with a new reference to the life tables to recalculate the probable time now left in retirement?
What is the reference point for decision rules about when income may be increased or possibly decreased, based on market and spending patterns … with reference to a past point (Guyton), or with reference to the present calculations’ percentage of simulations that fail the calculation (hint: higher failure rates signal spending that’s probably too high)?
Basically, the Safety First School continually refers back to the beach as its reference point (bottom view) as one makes future decisions. The Probability Based, dynamically updated, School refers to how long until one reaches the beach (upper view).
Notice that the application of insurance products that insure income such as Single Premium Immediate Annuities (SPIAs) and/or Deferred Immediate Annuities (DIAs) are applied at opposite ends of the retirement spectrum, when the numbered years are in their low values (recall that the top and bottom numbering of the graphs are in opposite directions). Those are the years viewed most at risk but they are at opposite ends of retirement because of how either views where one is at the beginning and where they end … in deep water going towards the shore? Or from the shore going into deep water? The differences emerge primarily how either school views sequence risk and how to manage it.
Thus, visually from the graphic above …
1) Counting retirement years up: is the retiree mentally moving from the beach (safety first) into deep water, and can they emotionally adjust from shore to deep water differences once they’ve aged?
2) Counting retirement years down: is the retiree mentally moving from deep water (probability based) towards the shore as they age?
Neither approach has been proven to be superior to the other, and I think neither should be because either approach may be appropriate to different client situations and having either arrow in the quiver is likely to be essential to address diverse situations and circumstances.
However, understanding the fundamental differences is important.
Note: It is unlikely one would reach very low time remaining numbers from the life tables because one always has an older expected longevity age and time frame based on current age. Explained a bit more in this paragraph from linked blog post: “Notice in Figure 4 (of linked blog) that the initial expected retirement time period at age 60 is 33 years (couple of the same age using Annuity 2000) – yet when the retirees reaches age 93, there’s still a possibility of 11 more years! The longevity table at the bottom of Figure 4 shows the percent of cohorts expected to outlive (i.e., percentile) time periods at those ages. For example, 50% of cohorts may expect to outlive 33 years at age 60, while once at age 93 20% of those cohorts may expect to outlive another 11 years (as couples). Again, life tables for individuals are different and would apply when one of the couple dies, or would be used immediately if the person were single. The time periods would be shorter, so withdrawal rate and cash flow would be higher relative to couples. Males would compare “better” to females for the same reason (do you want more money, or more life?).”
PS. I’d like to thank Dirk Cotton for his comments as I wrote this post.