Investing at retirement is different from investing for retirement. This column will examine recent insights from academics on building a retirement income portfolio. Professor Wade Pfau, PhD, at the American College, is one of the nation's thought leaders for retirement income planning. I am indebted to his research and articles on this topic. This information can be accessed at wpfau.blogspot.com.
Dentists entering retirement are presented with a confusing array of investment strategies intended to meet their needs for the highest retirement income with the highest probability of success throughout an unknown life expectancy. In thinking about the retirement problem, it has been helpful to me to build a continuum to rank retirement strategies.
Maximum Safety is on the left side of the continuum, and Maximum Terminal Wealth is on the right side. This continuum focuses on the retirement strategies, not the retirement tactics. For example, merely building a portfolio of high-dividend paying stocks is focused only on retirement income, not the issues of safety or terminal wealth.
Safety first
As an example of investing at the extremes of the continuum, suppose a dentist at age 65 is retiring with $3 million and wants to examine strategies during 30 years of retirement for having the highest safety for retirement income. While safety in investing is always a relative term, not an absolute one, an approach to Safety First would be to simply create a laddered TIPS (Treasury Inflation Protected Securities) portfolio for a 30-year period. TIPS are fixed income instruments guaranteed by the U.S. government and adjusted for future inflation.
While perhaps not quite this straightforward, this dentist could think in terms of a retirement income for 30 years of $100,000 per year in real inflation-adjusted dollars. With incredibly low current yields for bonds in general, perhaps the easiest way to estimate the annual income for TIPS would be to simply divide the $3 million in savings by the number of retirement years (30). This is a low income on a large retirement portfolio. But if inflation-adjusted safety is the issue, this ranks among the safest strategies. A laddered bond strategy means having bonds that mature each year in the future.
Probability-based
At the other end of the continuum, Maximum Terminal Wealth, the retiring dentist could invest in a 100% stock portfolio. My retirement probability software estimates that the retiree could withdraw $150,000 per year, adjusted by an annual 2% inflation for 30 years, and expect a median $14 million remaining at death with a 95% probability of success. Of course, an investor who retired in 2007 would have had to live through the loss of perhaps half of his or her portfolio during subsequent market activity. Could a retiree live through that and not flinch?
Safety First advocates say that it is not acceptable to have a 5% probability of retirement failure, while probability-based advisors adjust the portfolio stock/bond allocation to limit volatility. Still, how do mathematical probabilities at any level resonate with our case study dentist? He or she likely does think in terms of an annual retirement income, not a minimum subsistence safety-first retirement payment.
Insurance-based solutions
Where do annuities fit on the continuum? Our case study dentist, at age 65, could purchase an immediate annuity from an insurance company, paying perhaps 6% per year, or $180,000 on a non-inflation adjusted basis. The annuity would be payable for life. But when the basic annuity structure payments stop at death, the dentist could choose from various certain payment periods with a lesser annual payment.
Academicians have four concerns about annuities: 1) the savings no longer belongs to you; 2) the insurance company can declare bankruptcy; 3) the need for an insurance company profit may make the payments unfair; and 4) it is difficult or impossible to access the savings for unexpected large withdrawal needs.
What is compelling about current academic research for meeting retirement income needs is the possibility of combining different strategies to better fit each retiree's view of risks, income needs, and future goals. For example, a retiree could ladder a bond portfolio for basic subsistence spending, add a probability-based portfolio for "wants" or "legacy," and include an annuity-based solution for a guaranteed income stream. The key is diversification and finding your preferred location on the safety vs. income-and-wealth continuum.
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Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064 or [email protected].
