Many people focus on just returns, thinking that the higher the return the better their results. The consequences of such a focus while saving money are not felt as much (buying low) as they are once retired (selling low) and trying to manage the pot of money to give income for the rest of one’s life.
Let’s take a look at this common thought of seeking returns alone in retirement.
Investment returns are paired with standard deviation, a measure of how much, and how far apart, the returns fluctuate over time. One can’t have one without the other. The higher the return sought, the greater the spread between the highest year’s return and the lowest year’s return – we know that some years are better than others.
So, how does the spread between returns affect retirement income? Let us look at setting one variable in Monte Carlo simulations at a constant value so that results may be compared based on that common setting; in this case the percentage of simulations that fail to reach the end of the period simulated (POF). This is set at 10% in the figure below.
This means that 90% of the simulations for each and every age retain money for spending at the end of the expected time frame (the end age). The simulation period for each age is not stated in the graph, but each age has its own unique time frame that comes from period life tables (this separate simulation for each age is what makes this model different than a single simulation incorporating all ages). As you get older, you should expect to get even older and this dynamic also affects prudent income management over your lifetime.
(Please click on “View Fullscreen” button at the bottom right of the graph to enlarge).
Looking at the figure above, you can see that the higher returns that come from the 60% stock/40% bond portfolio (two columns on the right side) do not provide the best withdrawal rate at any age for this 60 year old couple. For the first decade or so, the 40% stock/60% bond allocation (two middle columns) results in the best withdrawal rates.*
So this result does dial back stock market exposure at retirement relative to common thinking that the higher return is better. The reason for this is that, because of the greater fluctuation in returns, there is a higher likelihood for poor returns; and because of setting the failure percentage at a fixed rate, spending has to be reduced for higher fluctuating portfolios in order to reach the target failure (or success) rate in order to have sufficient money at the end of the simulation to carry forward into future spending needs.
You can also see at the younger retirement years early on, that getting too conservative at 20% stocks/80% bonds (two left allocation columns), results in less money available because, in this case, the returns are not sufficiently high enough to provide for future spending needs.
As one ages, allocation to stocks gets less because volatility has a greater effect on shorter expected lifespans.
II. Withdrawal rate adjustments for potential longer life.
The yellow segments for each allocation shows a transitional strategy my research collaborators and I looked at to retain portfolio values for future spending. The withdrawal rate is unadjusted at first, and then adjusted around the mid-70’s on. As time periods get shorter due to aging (one has fewer years left as one ages), the withdrawal rates grow exponentially. Note that the Required Minimum Distribution (RMD) rates also grow exponentially suggesting a taxation agenda rather than sustainable prudent retirement income agenda in those tables. The result of this exponential growth is taking too much income during later years without regard to possible time remaining … one may be in the group of their cohorts that continually outlives their life expectancy.
I led research work on how portfolio income may be managed into, and through, older retirement ages because most of the work on retirement income has been on the younger ages, not transition into and through older ages. The summary of that work may be found in the Journal of Financial Planning (Dec 2012),”Transition Through Old Age in a Dynamic Retirement Distribution Model,” by Larry R. Frank Sr., MBA, CFP®; John B. Mitchell, D.B.A.; and David M. Blanchett, CFP®, CLU, AIFA®, QPA, CFA.
A simple, yet practical, method to adjust spending into old ages is two-fold: 1) adjust the withdrawal rate by a 1/n factor … i.e., WR% adjusted = WR% raw * (1 – 1/n) where n equals the time period from the period life table in use; and 2) adjust the percentile used from the period life table where fewer cohorts are expected to outlive the given age … e.g., basic expectancy by definition is the 50th percentile where 50% of cohorts are expected to outlive the time period or age. Slowly adjusting the percentile where fewer cohorts are expected to outlive the time period results in a lower withdrawal rate from the portfolio, thus extending the higher resulting portfolio balance into future years for future spending needs.
The result is that the yellow bar shifts to the adjusted withdrawal rates, regardless of allocation, for older ages to aid in conserving the portfolio value from harmful exponential effects due to aging and having shorter expected life spans.**
III. Decreasing equity exposure with age.
Finally, the bold values in the graph show the need to re-evaluate exposure to stocks as one ages and have less time remaining for recovery from market misbehaviors. The couple should not have a 60% stock allocation because the simulations suggested a less volatile allocation provides more income during their younger retired years. Likewise, as they age, reducing the equity allocation to reduce volatility results in better withdrawal results during their older retirement years.
The result is that the bold values shift from higher to lower stock allocation exposure even more as one ages.
Summary so far.
The overall result of revisiting and re-calculating the prudent retirement income for the upcoming year is that one reduces failure and improves success of having retirement income for your future, older years. Please see the below figure. Even though the percentage of simulations that fail is set at a constant value, the prudent management of resources allows one to extend success beyond the early time frame of the younger retirement years into the older time frames that result because one has continued to live.
Source: Journal of Financial Planning (April 2009), “The Dynamic Implications of Sequence Risk on a Distribution Portfolio,” by Larry R. Frank Sr., MBA, CFP®, and David M. Blanchett, CFP®, CLU, AIFA®, QPA, CFA.
IV. Very old age concerns.
As one continues to age, another dynamic that should enter the calculation comparisons would be a Single Premium Immediate Annuity (SPIA). The objective is to compare lifetime potential income from your managed portfolio, with the lifetime potential income from a SPIA.
SPIAs always produce a higher monthly income at any age – however, that income is fixed and doesn’t adjust for the loss of purchasing power due to inflation. The longer one has a fixed income without inflation adjustment, the less that fixed income can purchase far in the future. The longer one has an invested portfolio, the more likely the total may keep up with inflation and continue to be able to buy goods and services in the future. Comparing lifetime income sums between the two in today’s dollars allows one to see when a transition using all or partial SPIA use becomes prudent at an older age. Of course, bequest motives impact this decision too since SPIAs are not inherited by designated heirs (the money goes to others getting income from the same SPIA pool of money through what are called mortality credits). Essentially one is transferring risk to an insurance company rather than retaining it themselves (Kitces) through a managed portfolio.
Another variant to this is to use a Deferred Income Annuity (DIA) or longevity annuity. The difference between a SPIA and DIA is that income is deferred with a DIA while it starts immediately with a SPIA. The challenge is certainty of living until the deferred income begins. The earlier the deferred income begins, the more the loss of purchasing power begins to affect that fixed income because that deferred income is calculated based on having to last a longer period of time.
So rather than jump into an annuity early, recognize that you should have portfolio money at anytime at a later age to purchase an annuity at that later time because you are measuring and monitoring progress along the way during each year’s annual review.
Journal of Financial Planning (April 2014) “Lifetime Expected Income Breakeven Comparison between SPIAs and Managed Portfolios,” by Larry R. Frank Sr., MBA, CFP®; John B. Mitchell, D.B.A.; and Wade D. Pfau, Ph.D., CFA
An Ocean View: A broad description of comparing portfolio management with a later transition to annuity use with use of annuities early on may be found at Summary: Two schools of thought on retirement income and Is ALL of your portfolio at risk of loss?***
*Other allocations besides the three above are not illustrated to conserve space in the figure. They do exist and should be considered during annual reviews. Additionally, diversification should also be considered – allocation and diversification are not the same.
**One’s own specific portfolio characteristics based on your own holdings should be used in Monte Carlo simulations rather than using withdrawal rates based on portfolio characteristics unlike your specific holdings. Improvement of your portfolio characteristics involves use of proper diversification math mentioned in * above.
***Application of withdrawal rates are commonly applied to the present portfolio value. With the Ocean View perspective mentioned above, this approach results in following the portfolio value “wave” up and down between peaks and trough portfolio values – thus changing income. Most budgets are not flexible in this way, and therefore I suggest calculating a “trough” portfolio value and apply the withdrawal rate from each annual review to each year’s calculated trough value. This trough approach results in a more steady income most of the time, depending on standard deviation probability. The difference between income from the trough portfolio value and the peak portfolio value would represent possible discretionary income during the year depending on what markets have done during that given year. The wave action of the portfolio follows sequences of returns, but your spending is based on a more steady portfolio value generally unaffected by general market movements.
Note: How income may compare between Dynamic and Safe approaches illustrates income comparisons in today’s dollars, or real dollars, terms. You may be asking yourself why the results above suggest a declining stock allocation exposure with age instead of a rising stock allocation suggested by other research. The reason is simple. The above method adjusts spending rates with reference to time remaining resulting in more utilization of money available to spend at any given moment. The method resulting in increasing equity doesn’t adjust spending other than for a possible inflation factor often resulting in portfolio values that grow over time which are under-utilized relative to possible spending. Therefore, that “unused-for-spending” value may take on greater stock exposure because it is not used for spending support.
Note: Here’s a consolidated site with links to all supporting research and working papers supporting the above discussion. Here are other blogs applying the research linked to in this note.
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