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 wpfau.blogspot.com. (email@example.com)
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?
MRT is not exclusively an income solution; it is a comprehensive retirement planning framework and process. Therefore, retirement income is a derivative of the MRT planning framework. Presuppositions propel and shape outcomes. The MRT paradigm was developed to address the beginning point of most retirement plan models that are sanitized, unrealistic and unhelpful. MRT believes unknown realities of the individual retirees in the real world form the context for all retirement planning.
There are two fundamental truths that must form the foundation of financial planning, particularly retirement planning. First, the individual will never know with precision how long they will live and correspondingly how long their money will need to last. It just simply cannot be done in the individual case. It can be approximated for large groups of people but never for the individual. It must be accepted and acknowledged that longevity will never be known for the individual, therefore, any financial planning framework must accommodate planning in the face of the unknowable.
Others have proffered dynamic withdrawal guidelines advisors can use for client portfolio withdrawals. These models are helpful if clients and advisors accept the premise that historical group results via longevity tables and portfolio Monte Carlo simulations should be applied to individual retirees. These models are only helpful if an individual believes that using group statistics for their plan is appropriate. In our view these models fail to help individuals steward all their wealth resources and attempt to predict the future for individuals through group statistics.
Secondly, once the retiree and their advisor accept the irrefutable fact that they cannot foresee the retiree’s longevity, they must also acknowledge that they cannot foresee what the retiree will face during the remaining year (or months or days) they have left. This is what we refer to as “conditions within longevity”. You just don’t know and can’t know when your spouse will die, when your child will be in an accident, when you will become disabled, when you will be laid off from your job, if you will have a negative sequence of returns upon retirement, etc.
MRT is specifically designed with these two unknowables as the basis of retirement planning for individuals. No one knows how long they will live (Longevity) nor what life will be like (Conditions within Longevity). MRT approaches the problems of retirement planning from this realistic, individual centered perspective.
MRT offers a plan that thinks through the individual retiree’s whole situation by helping thoughtfully to assess, weigh pros/cons, and navigate implications of possible decisions. So often, the modeling that is shown in research is like a sterile, sanitized lab. Instead, retirement is more like an organic garden environment where weeds and storms exist. MRT simply recognizes that the future for individuals is unknown. Planners and individuals cannot always know when a storm is coming, but can take steps to minimize the effects of unpredictable natural occurrences through careful planning using the MRT framework and planning process.