By Brian Hufford, CPA, CFP
With a majority of baby boomers entering or approaching retirement, there has been an avalanche of articles and books recently about how best to plan for a safe income throughout retirement years. In this article, I would like to summarize some of the best thinking about this topic from financial economists and provide resources for further reading.
Currently, one of the nation's thought leaders for funding retirement income is Wade Pfau, PhD, a professor of retirement income at the American College. His blog, which can be accessed at wpfau.blogspot.com, features numerous articles on retirement topics. Another leading author on retirement investing is William J. Bernstein, whose 47-page book titled The Ages of the Investor: A Critical Look at Life-Cycle Investing is one of the best academic summaries for funding retirement objectives. Unfortunately, this book is a difficult read for the layperson.
In a recent article titled Two Schools of Thought on Retirement Income in the Journal of Financial Planning, Professor Pfau contrasted two vastly different approaches to funding retirement income that clients and their advisors must examine. It is always interesting to me when planning for an uncertain future that there are only pros and cons, not absolute best paths to retirement confidence.
In some regard, all of us must pay our money and make our choices based upon our personal views of risks and priorities in regard to retirement risks and aligning retirement priorities. Professor Pfau identifies two schools of retirement investing. These are 1) Probability-Based and 2) Safety First. Let me summarize each of these.
As the name implies, the Safety First approach to funding retirement income is built on the belief that the safety of retirement income is too important to be left to mathematical probability or Monte Carlo simulations. Risk management with this approach should include hedging and insurance-based alternatives (annuities).
Typically, the Safety First model thinks in terms of a pyramid of retirement income needs: essentials, contingencies, discretionary spending, and legacy. Basically, essentials and contingencies are covered with ultra-safe investments or insurance. It is only for discretionary spending or legacy that stocks and risk-assets come into play.
Financial economists think much differently about Safety First than the public does. To the general public, for instance, Safety First means annuity products from insurance companies. To the public, a guaranteed income stream for life from an insurance company is the safest way to provide for retirement income needs.
Author William Bernstein lists four large disadvantages of annuities: 1) Annuities do not allow withdrawals for emergencies; 2) The participant gives up ownership of his or her money; 3) The insurance company must make a profit and the insurance pay-outs may not be fair; and 4) The insurance company may go bankrupt. Many annuity sales people tout the stated insurance guarantees to add to the safety argument, but Bernstein points out that in a systemic crisis, the guarantee might only be a speed bump on the way to default.
Along with the four buckets of retirement income needs in the Safety First approach, financial economists identify two buckets of investments: a Liability-Matching Portfolio (LMP) and a Risk Portfolio (RP).
The purpose of the LMP is to provide a near-riskless stream of cash for essentials and contingencies, the most critical buckets throughout retirement. The three strategies for providing cash flow for the LMP are building laddered bond portfolios, deferring Social Security to age 70, and purchasing inflation-adjusted annuity products. Authors have identified pros and cons for all of these strategies.
To me, the really depressing characteristic of Safety First is that in our current world of historically low interest rates – and with normal levels of retirement savings at age 65 – the amount of "essentials" that can be covered would likely be very low. In some respects, the retiree exchanges the prospect for an exciting retirement for more of a subsistence level of spending. This is not a typical trade-off embraced by baby boomers. The amount of savings required for a high level of essentials would be daunting to many savers, which leads to the thinking behind the Probability-Based approach.
In an article in the October 1994 Journal of Financial Planning, author William Bengen championed the idea that throughout most of the 20th century a retirement withdrawal rate of 4% of retirement assets that was increased by subsequent inflation would have had a high probability of success during a 30-year period of retirement. Based upon historic returns of stocks and bonds, Bengen suggested a balanced portfolio of between 50% to 75% in stocks and the balance in bonds, maintained throughout the retirement years would have had a high probability of success.
Advocates of Probability-Based retirement strategies have two basic beliefs: First, the lower the withdrawal rate percentage (4%, 3%, 2%), the higher the success probability; and second, most retirees have an absolute retirement income goal in mind. Stripping the hoped-for income goal down to essentials or discretionary spending feels like failure. Who can distinguish between needs and wants in retirement without feeling deprived? Most of us work and save with a planned annual retirement income in mind, not just essentials.
With the Probability-Based approach, constructing a portfolio that is customized to the retiree involves "expected returns" for stocks, bonds, and cash, along with modeling the percentage probabilities of a successful outcome within the retiree's tolerance for risk. This is also a mathematical equivalent. The big question among advisors is what percentage of successful outcomes is appropriate? Should a success probability of 85% be considered appropriate?
In his book, The Little Book of Bulletproof Investing, author Ben Stein summed up his cynical thoughts on safe withdrawal rates: "The only safe withdrawal rate from retirement assets is 0%." He went on to state that the only safe retirement strategy is a job. This comes from an author who is proffering a book on bulletproof investing.
Which approach is best for you?
If you have followed me this far in my writing, I am sure that you have several questions about the place of other tactical strategies within the Safety First and Probability-Based approaches.
For instance, what about dividend-paying stocks, rental real estate, or a multitude of other sources of retirement income? In most cases, every source of retirement income has its own position on the Safety First/Probability-Based continuum: way left or way right and everywhere in between. Most financial economists, while acknowledging the characteristics and certain advantages of specific strategies such as dividend-paying stocks in a retirement strategy, tend not to include them as a central theme.
Perhaps the reason for this is that retirement investors who favor a specific strategy tend to violate important principles of diversification and subject themselves to a higher risk of failure. An investor, for instance, whose entire retirement strategy consists of owning 10 rental houses in his community, suffers the risks of a lack of liquidity and a lack of diversification – both geographically and in types of rental properties. A REIT (Real Estate Investment Trust) solves the liquidity and diversification-of-properties problems, along with adding professional management, but still is only one asset class that suffers from the risks of inadequate diversification overall.
Our approach had been to incorporate many of the elements from both strategies, Safety First and Probability-Based, into client retirement planning. We believe that laddering bond portfolios, maximizing Social Security income with client-specific planning and considering Contingent Deferred Annuities (CDAs) to provide a retirement income annuity, guarantee all to be worthwhile considerations.
Contingent Deferred Annuities solve many of the direct risks of annuity products, such as the loss of portfolio ownership. With a CDA, the retiree always owns his or her portfolio. The insurance company merely provides a retirement income guarantee. Where CDAs can add value is when the retiree simply cannot stomach stock market volatility.
In the Probability-Based world, as stated in William Bengen's article, the probability of success for a retirement portfolio increases when the percentage of stocks is in the 50% to 75% range for a 30-year retirement. This level of stock market risk may not be acceptable to many investors. The income guarantee of the CDA might help overcome this barrier. The one challenge of this approach is the cost of the insurance.
In summary, what every retiree wants is certainty that a retirement investment strategy will provide the income needed without worries. The year 2008 was a reminder that certainty is a fragile commodity when planning for the future. It's better to acknowledge the uncertain world that exists and factor that reality into better planning. The central themes of today's retirement investing are awareness of the challenges and diversification of strategies in meeting them.