The retirement income assumption that can lead to sub-optimal portfolios

Financial planning tools and retirement research primarily assume that retirement spending is effectively static, where the amount of annual spending increases each year with inflation, regardless of portfolio performance. This simplifying assumption is clearly unrealistic and can lead to incredibly flawed advice on optimal portfolios for clients.

In some recent research, we have explored how incorporating flexible spending into retirement modeling can impact the definition of the optimal retirement portfolio. First, we divide the retirement income goal into two types of expenses: “needs” and “wants”. Needs are relatively rigid expenses that the retiree cannot do without, such as housing and health care costs. Needs-related spending is sometimes referred to as essential or non-discretionary spending. Think of wants as more flexible expenses that the retiree would like to have but are willing to adjust depending on the situation, such as travel or entertainment. Adjustments can include both increases, if the portfolio is doing well, and decreases, if the portfolio is doing poorly.

Most models treat retirement expenses entirely as needs, which assumes that retirees are unwilling and unable to reduce their expenses over time. It’s just not realistic. Although part of each retiree’s income goal is likely to be for essentials (we estimate around two-thirds on average), this will vary by retiree. For example, the percentage of the total retirement income goal that is considered a need tends to decrease at higher income levels.

When determining optimal portfolio allocations, it is important to think more holistically about client assets and liabilities (as well as income goals) to ensure that risk levels are appropriate. The retiree assets under consideration should include guaranteed income and savings, as well as anything the retiree has to fund expenses. Responsibility should be broken down into perceived flexibility, such as needs and wants, or potentially even further, into needs, wants and wants.

For many retirees, expenses can be covered by existing sources of guaranteed income, such as Social Security retirement benefits or a pension. This leaves the retirement portfolio (whether a 401(k), 403(b), IRA, etc.) to cover the remaining expenses of needs and desired expenses.

An expense-focused retirement portfolio can generally be more aggressive than a needs-focused portfolio, especially for a younger retiree (eg, someone who is 60 versus 75). A retiree who focuses on covering spending needs with their retirement portfolio will generally place more emphasis on consistency and may therefore prefer a little less risk, on average. A retiree who invests the portfolio to cover expenses (because needs are covered by guaranteed income) will likely be willing to take more risk, on average, because the potential pain of lost earnings is not as great and is offset by the expectation of higher returns.

There are also other important wallet considerations when thinking about needs and wants. For example, real assets, which include asset classes like TIPS, real estate, commodities, infrastructure, etc., are generally going to play a larger role in a retirement needs portfolio, compared to a wallet of desires, which may look more like the traditional wallet. accumulation-oriented portfolios.

In summary, assuming that a retiree’s spending goal is static does not correspond to reality and can lead to portfolio recommendations that are significantly different than if a more realistic model is considered.

David Blanchett is Head of Retirement Research for PGIM DC Solutions. PGIM is the global investment management business of Prudential Financial, Inc. David is also currently an Adjunct Professor of Wealth Management at the American College of Financial Services and a Fellow for the Alliance for Lifetime Income.

This material is for informational, illustrative and educational purposes only, and is not intended as investment advice and is not a recommendation on the management or investment of retirement savings .

©2022, PGIM. Used with permission.