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2 Schools of Thought on Retirement Income

2 Schools of Thought on Retirement Income 

Originally Posted April 2014


by Wade D. Pfau, Ph.D., CFA

Wade D. Pfau, Ph.D., CFA, is a professor of retirement income at The American College and the 2011 recipient of the Journal’s Montgomery-Warschauer Award. He hosts the Retirement Researcher blog at


Dueling paradigms and contrary views are a fact of life in the world of retirement income. Two opposing schools of thought coexist with regard to retirement, with advocates of each often talking past one another with opposite answers for basic and fundamental client questions. As theories about retirement income planning continue to develop, it is important that those working with clients have a basic understanding of both viewpoints, so they can speak on the same wavelength as their clients and prospective clients. This is true even if, after careful reflection, one builds their practice in terms of one school or the other.

The two schools are probability-based and safety-first. To provide some initial context, these two schools can be mapped into the three basic withdrawal strategies defined by theJournal of Financial Planning.

The probability-based school has the most in common with systematic withdrawals. It is most linked to traditional investment concepts such as modern portfolio theory. The idea is to diversify investments based on a client’s willingness to endure market volatility, with an emphasis on managing the total return of the client’s portfolio. Withdrawals can include interest, dividends, and principal, and one seeks a conservative withdrawal strategy that will avoid portfolio depletion.

At the other end, essential-versus-discretionary income strategies represent the safety-first approach. Investments with fixed maturity dates or annuity guarantees are selected to fund essential expenses. A mix of more volatile investments with greater upside (and downside) are used to fund the discretionary expenses.

The third strategy, time segmentation, seeks a compromise, though in practice it tends to share more characteristics of probability-based thinking. With time-based segmentation, separate pools of investments are set up based on time horizon. Low-risk, fixed-income investments are used to fund the entire lifestyle spending goals in the near term. Meanwhile, distant spending goals are covered by more aggressive investments with greater growth potential. As time passes, growth assets are sold to extend the fixed income ladder covering upcoming expenses.

Origins of the Schools

The probability-based school of thought developed as an empirical investigation by practitioners and planners in the 1990s. Notably, in an October 1994 Journal article, William Bengen looked at a hypothetical individual retiring at different points in history and found that just over 4 percent of retirement date assets, with this amount adjusted for subsequent inflation, was the most one could sustainably spend over 30 years from a balanced portfolio of stock and bond funds in the worst-case scenario from history.

Subsequently, an entire cottage industry developed around the idea of the 4 percent rule as a basic rule of thumb to guide retirement income planning. Its key perspectives on managing risks for a successful retirement include portfolio diversification as it relates to modern portfolio theory, and precautionary savings as connected to the idea of saving enough to meet goals with a conservative withdrawal strategy over a long planning horizon. Key names associated with the probability-based approach include Michael Kitces, Jonathan Guyton, William Bengen, and Harold Evensky.

Meanwhile, the safety-first school arguably has roots going back much further in history, although it is still playing a game of catch-up in the public’s mind as an alternative to the 4 percent rule. It is based on the academic model of lifecycle finance, which focuses on how individuals allocate their limited resources over an uncertain lifetime to obtain the most lifetime satisfaction possible.

The key argument for the safety-first school is that risk management for retirement must extend beyond diversification and precautionary saving to also encompass hedging and insurance. Looking through the Journal archives, key articulators of this viewpoint have included Laurence Kotlikoff, Zvi Bodie, and Paula Hogan, along with Jason Branning’s and M. Ray Grubbs’ modern retirement theory.

With these basics, let’s look at four important questions in which advocates for each school provide opposing answers.

Are Financial Goals Prioritized?

For the probability-based approach, financial goals tend not to be prioritized. The view is that a client has an overall lifestyle goal in mind, and failure to meet that goal will represent an unsuccessful retirement in the client’s mind. It is difficult in practice to distinguish between wants and needs, and efforts to dedicate more resources to lock in spending for needs may eliminate the possibility for obtaining enough upside portfolio growth to cover wants.

In contrast, prioritization is key to safety-first planning. Branning and Grubb’s modern retirement theory illustrates this with its hierarchical funding pyramid for base expenses, contingencies, discretionary expenses, and legacy. Advisers should climb upward with their clients ensuring that assets with appropriate risk characteristics are matched to lower levels before reaching to higher levels of the pyramid.

How Is an Investment Portfolio Constructed?

For the probability-based approach, portfolio construction focuses on maximizing returns subject to client risk tolerance as it relates to return volatility. This means being as aggressive as the client can stomach, as the growth potential from stocks helps to reduce the probability of asset depletion. The chance for stocks to outperform bonds grows as the planning horizon lengthens. The traditional tools of modern portfolio theory are relevant, as single-period wealth management techniques are assumed to extrapolate over the long term.

With safety-first, the portfolio construction process is completely different, because the focus is on meeting spending goals over an uncertain time horizon, and this does not always have a direct correspondence to what might maximize wealth. The relationships between upside and downside become more complicated. Risk is not a temporary portfolio loss, but a permanent reduction to the client’s lifestyle. In a sense, modern portfolio theory is a limited case only applying to infinitely lived institutions with no withdrawal needs. As the Retirement Income Industry Association puts it, “Retirement management re-introduces minimum consumption in the financial equation.” An income floor must be considered before seeking upside wealth maximization.

Financial goal prioritization is intricately tied into the investment approach, as safety-first advocates use the concept of asset-liability matching to link the risk characteristics between assets and financial goals. In the words of Branning and Grubbs’ modern retirement theory, basic needs should be covered with assets that are “secure, stable, and sustainable.” This may include Social Security, bond ladders, and income annuities. Volatile (and hopefully higher returning) assets are not appropriate for covering these basic needs, but they may be suitable for discretionary expenses for which there is some flexibility about whether the spending can be achieved. Advocates do view stocks as growing in risk over longer time horizons, as the depth to which stocks may plunge in the worst-case scenarios grows with time.

Role of the Household Balance Sheet?

The probability-based approach generally focuses only on financial assets, with the implicit assumption that financial portfolio depletion will have catastrophic consequences for the client. Meanwhile, the safety-first school incorporates the entire household balance sheet, also including Social Security and pensions, part-time work, family resources, and so forth.

Asset allocation for the financial portfolio cannot be determined without knowing the client’s capacity for risk, and this requires knowledge of all household resources. The availability of resources to fall back on from outside the portfolio provides the client with a greater capacity to invest and spend more aggressively.

What Is the Safe Withdrawal Rate from a Diversified Portfolio of Volatile Assets?

Probability-based advocates are more comfortable basing spending decisions on what would have worked in the historical record. As noted, historically in the United States, a 4 percent initial withdrawal rate would have worked, and with an additional allocation to small-capitalization stocks, even 4.5 percent has been historically sustainable.

Focusing on the probability of asset depletion, the historical record has also suggested that a more aggressive asset allocation improves a client’s chances for success. The basic story has remained the same since Bengen’s initial 1994 article in which he suggested a stock allocation between 50 percent and 75 percent, but as close as possible to 75 percent. As this has held up during the Great Depression and the inflationary stagnation of the 1970s, advocates have suggested it may be irresponsible to increase client conservatism beyond this to plan for even more extreme investing environments.

For safety-first advocates, the concept of a safe withdrawal rate from a volatile portfolio is inappropriate, at least in the context of meeting basic needs. Retirees only have one opportunity to experience retirement, and failure is not an option. Essentially, it is not possible to use asset diversification to safely secure a constant spending stream from a portfolio of volatile assets. This can only be achieved through hedging with bond ladders and risk pooling with income annuities.

And so, which school do you most closely identify with?

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How much do you need to retire happy?

How much do you need to retire happy?

By Offain Gunasekara •
Originally posted: Posted: Sept. 5, 2012 at

M. Ray Grubbs

What is your number?

That question is often directed at people dreaming about how much savings they will need to achieve retirement bliss. But M. Ray Grubbs, professor of management at Millsaps College in Jackson, Miss., says the query misses the point. There is no magic amount of money than can guarantee a secure retirement for everyone. Individual wants, needs and circumstances dictate how much cash will be enough to see you through the golden years.

In the following interview, Grubbs discusses how to zero in on the precise amount you need to retire comfortably.

Is it financially smart to set a retirement date when retirement planning?

Absolutely. A specific retirement date is essential, as it provides an absolute target or goal for the retiree and advisers. If I set a date to retire on Jan. 1, 2018, I make important decisions each day and each month that lead to that goal. If I do not, then my decisions made today will likely be different.

For example, if a 25-year-old has a vision of retiring at the age of 50, this will drive a disciplined approach to investing and spending that can yield that goal over a 25-year work life. I may take a pass on that Porsche in favor of a Ford. However, if that same 25-year-old had a vision of retiring at the age of 75, then day-to-day, month-to-month and year-to-year financial decisions will be different.

What is the ideal amount needed to retire presently? What do you think the amount will be in 25 years?

Let me be very clear with this response: I have no idea! And neither does anyone else. There is an infinite number of variables for individuals and families, (so) there is no way to specify a single number that will suffice for retirement.

I have seen cases where a retiree had negative net worth, certainly not an ideal amount in anyone’s calculation. But that person retired comfortably with two pensions and Social Security in amounts well in excess of their expenses. In this case, zero dollars was an ideal amount. In another case, a retiree had a net worth in eight figures. That retiree is now bankrupt due to poor — really too soft a word here — spending habits. They spent themselves into bankruptcy, so in this case, eight figures was not an ideal amount.

When pre-retirement expense planning, what are a few ways to reduce your monthly costs and save more money for your retirement?

I … can offer no advice about how to cut an individual’s expenses. I have enough trouble doing that for myself to give others advice. But I can offer some experience that is serving me well.

The framework that follows is the Modern Retirement Theory pyramid — a priority-ordered series of funds established for specific expense purposes.

I keep a spreadsheet of all my expenses on a monthly basis. As I go through my monthly expenses, I take note of what I may reduce.

Then I look at all expenses and separate all those that I define as base expenses — those expenses that I must incur month to month to live with my chosen lifestyle. It is important to develop income that is stable, secure and sustainable to cover base expenses, and slightly more if that makes an individual comfortable.

As I come to a comfort level for my base expenses, I direct my attention to what Modern Retirement Theory calls contingencies. These are unknown expenses that can serve to derail retirement plans. Contingencies are such issues as disabilities, inflation, market returns, long-term care and death of a spouse that all retirees should think deeply about before initiating their retirement.

Next, my attention turns to discretionary expenses. Discretionary expenses are those lifestyle expenses that are wants and not needs, such as a new car, a cruise or a month in Tuscany, Italy. By definition, these expenses are not necessary to live and can be delayed if circumstances warrant, but not discarded.

Finally, if there is anything left, I contemplate legacy expenses. If I have resources available after providing for base, contingency and discretionary expenses, I can leave assets to a charity or to family members.

For people who want to travel during retirement, what tips can you offer so they can live out their dreams of being world travelers and still be financially stable?

I can only answer this in the context of the Modern Retirement Theory pyramid. If that person has covered their base and contingency expenses first and has resources to dedicate to discretionary expenses, I say book the trip now. But do not (book trips) and leave base and contingencies uncovered.

Is there an advantage to using a retirement planning coach?

I suggest there is benefit to using anyone who can help the retiree understand the context within which decisions can and must be made. But take the time to understand the perspective of the coach or adviser. To many insurance salespeople, there is an insurance solution to most all questions. If you seek advice from an investment broker, advice usually takes similar forms regardless of individual needs. Just be cautious about a coach or adviser, and know how they think.

We would like to thank M. Ray Grubbs, Ph.D., professor of management at Millsaps College in Jackson, Miss., for his insight.

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