Retirement income: 6 strategies | Looking for Alpha

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Defining a style and matching strategies to it is an important step forward in ensuring that individuals and their retirement income strategies are aligned. Building an appropriate strategy is a process, and there is no one right answer. No one retirement income approach or product is right for everyone. —Alejandro Murguia and Wade D. Pfau

What surprises me the most about my wife’s catering business is how much food is usually left. I often ask, “Is there a better way to manage food costs?” His answer is always the same: “Better to have food than to lack food”.

She has the exceptional ability to estimate how much each person will eat, but she can never be absolutely sure how many people will come or what appetites they will bring.

When we help our clients plan for their retirement, we also don’t know how much they will need, but we never want them to fall short. To make sure they have enough, we need to help them consider many factors. These include:

  1. How much income will they need?
  2. How long will they need it?
  3. What will inflation look like?
  4. How much will they want to leave to their beneficiaries?

Answering these questions can be intimidating and is inherently inaccurate. Various financial applications attempt to model the different scenarios, but no matter how accurately our clients anticipate their needs, the sequence of investment returns will never be certain. And it’s one of the most important factors in determining their retirement success.

The sequence of returns is the order in which returns are made, and as clients accumulate assets, it hardly matters. Let’s say a client starts with $100,000 invested in stocks. In Scenario 1 below, they experience negative returns at the beginning of their investment horizon, while in Scenario 2 the sequence is reversed and negative returns come at the end of the horizon.

Chart showing hypothetical investment returns over 20 years

CFA Institute

Regardless of the sequence, the end value for the customer is the same: the average return in both scenarios is 6.05%. But when clients retire, they have to account for distributions. And that changes the math.

Using the same yields, they now have a real income distribution of $50,000 per year, with a 2% annual adjustment for inflation, from a starting nest egg of $1,000,000.

Chart showing two scenarios for the return of a $1 million retirement account over 20 years

CFA Institute

The “average” yield in the two scenarios is the same, but with very different results. If the client experiences negative returns initially, as in Scenario 1, they are short of money. Which is a disaster. But in Scenario 2, their capital increases to $1.6 million. Which begs the question, “did they maximize their income?” »

This situation reflects the sequence of risk returns (SoRR) at retirement. The lesson of the phenomenon is simple: the order in which returns are generated is more critical to success or failure than the average return. SORR along with longevity risk and unexpected expenses are key factors in determining whether clients have enough money to fund their retirement.

To address these factors, various strategies have been developed. Typically, they fall into one of six categories, each with their own merits and flaws: Certainty, Static, Bucket, Variable, Dynamic, and Assertive.

1. The strategy of certainty

Many institutions use asset-liability management (ALM) to fund their future liabilities. Simply put, clients invest money today in a way that is designed to meet future liabilities with a high degree of certainty. For example, suppose in one year they want to cover $50,000 of income and the current interest rate is 3%. If the interest rate and principal are guaranteed, we might advise them to invest $48,545—$50,000/1.03—today to meet this future obligation.

But that will not protect them from inflation. So they could invest that $50,000 today in one-year US Treasury Inflation-Protected Securities (TIPS), thereby hedging liabilities while protecting against inflation risk.

For all its certainty, this strategy has a few downsides. To make sure the client doesn’t run out of money, we would need to figure out how many years to fund, an almost impossible and morbid task. The strategy also requires a large initial capital commitment that most Americans do not have.

2. The static strategy

If clients lack the capital to fund the ALM strategy or cannot estimate their retirement length, an alternative approach is to determine a “safe” portfolio withdrawal rate. Using historical returns from a 50/50 stock and bond portfolio, William P. Bengen calculated an optimal starting drawdown rate of 4%. Therefore, to maintain a real annual income of $50,000, a client would need $1,250,000. Each year thereafter, they would adjust the previous year’s withdrawal for inflation.

Like any retirement income strategy, this involves several assumptions. Bengen estimated a 30-year retirement horizon and annual rebalancing toward the 50/50 portfolio. The main challenge for retirees is to rebalance stocks after a major decline. Such tactics inspired by loss aversion could derail the strategy.

Although Bengen’s 4% drawdown rate has been quite effective, recent high stock market valuations and low bond yields have led Christine Benz and John Rekenthaler, among others, to revise that initial drawdown rate downward.

3. The Bucket Strategy

To overcome the fear of rebalancing in a bear market, retirees may prefer to deploy a bucket strategy. This approach takes advantage of the cognitive bias of mental accounting, or our tendency to assign subjective values ​​to different masses of money, regardless of their fungibility – think Christmas counting. Clients set up two or more compartments, for example, a funded short-term cash-type compartment with two to three year income needs and a long-term diversified investment compartment with their remaining retirement funds.

In retirement, the client derives their year-to-year income needs from the short-term compartment while their long-term counterpart replenishes these funds over specified intervals or balance thresholds.

This bucket strategy will not eliminate SoRR, but it does give clients more flexibility to deal with market downturns. Bear markets often force retirees to rebalance toward more conservative allocations as a means of mitigating risk. But it reduces the likelihood that losses will be recouped or that future income will increase.

By separating compartments, clients may be less inclined to make irrational decisions, knowing that their current income will not be affected by market downturns and that there is time to replenish the compartment’s funds over the long term.

4. Variable Strategy

Most static retirement income programs simply adjust a client’s income distribution for inflation, keeping their real income the same regardless of need. But what if their income needs change from year to year?

Morningstar CFA David Blanchett’s analysis found that expenses don’t stay the same throughout retirement. He identified a common “retirement spending smile” pattern: clients spend more early in retirement, reduce spending in mid-retirement, and then increase spending later in retirement.

A progressive spending scenario like this makes intuitive sense. Retirees will first consume more travel and entertainment, then reduce spending as their health and mobility decline. As their retirement lengthens, their health care expenses will increase and account for a larger portion of their expenses.

With this in mind, clients may wish to deploy a variable spending schedule that anticipates retirement spending smiles. This will produce a higher initial income, but may need to overcome some behavioral biases to be successful. We tend to be creatures of habit and find it difficult to adjust our spending habits in response to falling income. Moreover, the models are not clear as to the magnitude of the revenue reduction to be expected.

5. The dynamic strategy

While a variable income strategy establishes phases of income, a dynamic strategy adjusts based on market conditions. One form of dynamic income planning uses Monte Carlo simulations of possible capital market scenarios to determine the likelihood of a distribution’s success. Clients can then adjust their income based on the probability levels.

For example, if 85% is considered an acceptable success threshold and the Monte Carlo calculates a distribution success of 95%, the distribution could be increased. Alternatively, if the Monte Carlo simulates a 75% probability, the distributions could be clipped. A 100% success rate is ideal, of course, but it may not be achievable. That’s why determining what level of trust is right for the client is an important issue. Once this is decided, we can run the Monte Carlo at predefined intervals – annually, semi-annually, etc. – to increase or decrease income. As with the variable income option, this assumes that a client can and will moderate their spending at a time and down.

6. Insurance strategy

Ultimately, the retirement fund is used to generate income and most strategies so far have assumed a retirement horizon. But this horizon is impossible to predict. The only way to eliminate a client’s longevity risk is to secure the retirement income stream. In this scenario, the client works with an insurance company, paying a lump sum up front to secure regular income on a single or joint life.

To evaluate the strategy, we must balance the comfort of receiving income independent of market performance or longevity against the potential costs. Accessibility of principal, payouts to beneficiaries, creditworthiness and expenses are just a few factors to consider.

Admittedly, these strategies are hardly exhaustive. They simply provide a framework that we can use to help our clients understand the different approaches.

Whatever strategy or strategies our clients deploy will depend on their personal preferences and a host of variables. Even though we have answers to these subjective questions, we can never be sure of the sequence of returns, the time horizon, and the biases that can derail a particular plan. Unfortunately, there is no “one size fits all” approach. Ultimately, any retirement strategy requires balancing life’s desires while ensuring our customers don’t miss out.

Warning: Please note that the content of this site should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of CFA Institute.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.