Income in Retirement - the Integrated Approach
Welcome to a brief three-part series where we’ll cover an integrated approach to retirement income planning. I know that's a bit vague, so hang with me for a bit.
Crafting your plan for income in retirement is no simple matter. You can't just save to "your number" and then expect everything to work out just fine.
Retirement income planning is an evolving science; not only do we need to consider the straight-up-math, but we also have to find a way to incorporate the hard-to-quantify human factors such as comfort, cognitive and physical declines, unexpected expenses and etc.
Furthermore, we need to account for hard to predict factors like inflation, volatility and etc, and develop a plan to hedge against several different risks.
For most non-billionaires, crafting a strategy for retirement income is one of the most important facets of a good financial model.
This is a little detached from reality, but for the purposes of this series we’re going to assume there are two “sides” of the retirement planning industry which are vying for management of your retirement dollars.
Reality is a little more mixed, but my hope in separating these two sides for our brief time together is you’ll develop a better understanding of the advantages and disadvantages of each. Furthermore, the final aim of this series is to show how, for most people, an integrated approach (a meshing of the two) will provide superior results.
The Two Towers - Investment & Actuarial
When most folks think about planning for retirement, their thoughts gravitate to saving into their 401ks, IRAs or other qualified retirement plans. For the purposes of our series, we’re going to call this the “Investment” side of the world.
Remember those commercials where people walk around carrying giant “orange” numbers? What’s your number? Is that even a real thing? Probably not.
The investment industry is all about attracting your retirement dollars to save into a retirement account where the money is invested into mutual funds, ETFs, stocks, bonds and and etc.
When "Investment" folks talk about retirement, they're normally targeting a “number” or “sum” at a specific age or point in time. They use basic financial calculations to arrive at this number, typically by assuming an average rate of return on the investment account and a rate of inflation.
When you eventually do hit that number (yeah, right…), they will help you figure out a “safe withdrawal” rate, which purportedly will allow you to withdrawal income & principal from your accounts with a low statistical risk of running out of money.
On the other side of the world, you have people who are solving the problem of retirement income with an actuarial approach.
I realize a few of you might be saying "act-u-what-l"? Well, briefly: actuaries can study any variety of statistical happenings/populations, but in our case here we mean the actuarial study of longevity a.k.a. human life span.
We're talking about insurance companies here - they craft products & strategies that typically use risk pooling mechanisms to insure against longevity risk. Basically, when you have a large enough group of people, you can predict average life expectancy with a high degree of accuracy/certainty. Therefore, if the people in that group pool their retirement assets, the unfortunates who die early help subsidize the people (the fortunates?) who live longer.
The actuarial industry (read: insurance companies) is all about attracting your retirement dollars into life insurance and/or annuity products. Their pitch is that actuarial products offer increased safety of principal and certainty of income regardless of life span - a claim that their investment focused counterparts cannot make.
Pros/Cons of Each Side of the World
Now, each side of the world has several, completely valid arguments for their respective approaches. Naturally, there are also several disadvantages to discipling from only one side. To continue our trajectory of demonstrating why an integrated approach works best for most, let’s unpack these a little more.
Investment World Advantages
The "Investment" folks are usually going to focus on the growth potential of the investment account. What we mean is, on average, investing in equities and market indices will normally provide the highest ending lump sum of money, and thereby the highest potential retirement income from that sum.
Another key advantage is that the equity markets, over the long haul, will typically increase in value at a rate that is faster than the general rate of inflation. This means that your investment dollars do not lose purchasing power as time goes on. Furthermore, portfolio balances are relatively liquid and available for withdrawal, as opposed to being tied into contractual agreements with an insurance company.
Investment World Disadvantages
Most disadvantages of the investment world come in the form of risks. When it comes to creating your retirement income plan, we’re primarily talking about Sequence Risk and Longevity Risk.
Remember when I said that the investment guys might calculate a sum for you based on average returns? Ok, so maybe you drifted off a few paragraphs back and you don’t remember. But they do. Here’s the problem - average returns are almost never your actual realized return. The market may average 8% a year, but by no means does it go up by 8% every single year.
This brings us to Sequence Risk - basically, the idea that you may need the money at a point where the market is not doing so hot.
The market will live forever, and you will die at some point. Ideally, you’d like to spend some of this money before you die, so you’ll need to exit the market. Ergo, your time horizon is different from the market's (which is indefinite) and you might need to “cash out” at precisely the wrong time.
Sequence Risk is the real deal; just ask people who tried/wanted to retire around 2008. The average returns over a 30-year investing career can be fruitful, but if a retiree experiences a decline or bear market in their early retirement years, it can substantially impact the success of an investment-only retirement strategy.
So, certain groups of retirees (again, like those 2008 folks) may go through dramatically different retirement income pictures than other retiree groups who retire at a later date.
The second (and just-as-big) risk is Longevity Risk. This is more self explanatory; its the risk of outliving your money. With continual improvements in our life expectancies, this is also a "real deal".
So the deal with relying only on investments is we have to account for the possibility that you'll outlive the money. In our modern age of technology, almost all advisors are now able to run “Monte Carlo” simulations for their clients. Basically, we can run 1000s of random trials with random return, inflation, spending & etc data. This allows us to create a “level of certainty” with respect to the success of a particular retirement income strategy.
Michael Kitces, noted financial planner, author & speaker, has put together an awesome summary of this here.
Pulled from the Kitces' article, the above chart here is a good depiction of the “old” (read: too simple) way of analyzing a retirement income strategy. Here, he is using a straight-average return of 10% for the stock market, 5% for bonds and 3% for inflation.
- Strategy A = 100% Immediate Annuity
- Strategy B = Portfolio of 50% Bonds / 50% Stocks
- Strategy C = Portfolio of 100% Stocks
If a potential retiree were to look at this chart, why wouldn’t he/she pick Strategy C? It’s clearly the best, right? Well, if we run a Monte Carlo simulation using these same variables, the picture changes a bit:
This chart shows the likelihood of success of each strategy. It simply changes the measuring stick.
If we go back to the first chart, we’re only evaluating each strategy based the amount of total lifetime income - again, who wouldn’t choose Strategy C? If this chart was all they were shown, “C” is the obvious choice.
I suspect many people would walk back on choice "C", however, if they knew it had a 25% probability of failure. Again, failure here is due to the dual impact of Sequence and Longevity risk.
This is echoed by Wade Pfau, CFA, author of the white paper “Optimizing Retirement Income by Combining Actuarial Science and Investments”. He says, “However, the dual impact of sequence and longevity risk creates a very real possibility with investments that one cannot support their desired lifestyle over the full retirement period.” Well said, Wade. We're going to come back to him and that white paper in parts two & three.
Insurance companies can create the large groups of retirees necessary to be able to pool the risks of both sequence and longevity. As a result, they can provide a retiree with income certainty - meaning that however long the retiree may live they will have a guaranteed income stream.
Furthermore, they can provide a guaranteed legacy for a retiree who wishes to do so. Overall, retirees with guaranteed income streams report being much happier throughout retirement - one of those “human” factors I was alluding to at the beginning.
It’s not that you can’t create an income stream or a legacy value in the investment world, but doing so is typically less efficient and definitely less certain. You're just taking a financial tool and trying to make it do a job its not primarily designed for; e.g. I could probably hang a picture with a plumbing wrench, but it would be much easier with a hammer.
Outside of retiring with a guaranteed pension or claiming your Social Security benefits, there is no other retirement income scenario with as much certainty as that of the actuarial strategy. When we run a Monte Carlo analysis with a retiree utilizing some form of guaranteed lifetime income, the outcomes are much more predictable and the chance of failure is zero for all practical intents.
So, since that sounds so rosy, why on earth would anyone use anything else? Great question. There are some substantial drawbacks to relying on only actuarial products for retirement (again: annuities and life insurance).
The most meaningful drawback is the lack of growth on the money. Guaranteed income streams are normally not adjusted for inflation and, if they are, the math degrades to the point where its not a good idea.
Also, the growth of annuity and life insurance accumulation values is typically muted compared with their investment counterparts due to the cost of the actuarial component. As a result, folks who rely solely on these types of products for retirement typically find their purchasing power to be much less at the end of retirement due to the eroding effect of inflation.
Another significant drawback is the lack of liquidity; in a guaranteed income stream your money is typically only available via that next monthly check. If you have an unexpected emergency, want to take a big trip, etc - you’ll need to find the money elsewhere.
So, even though we have eliminated the Sequence and Longevity risks through the use of this strategy, we have not removed all forms of risk. Rather, we have simply assumed a different type of risk - Liquidity and the Loss of Purchasing Power (Inflation).
We’re going to wrap up the first part of our series here. Hopefully you have a better understanding of the pros/cons of both investments and actuarial products. As I will attempt to demonstrate in parts two & three, a combination of both of these strategies will yield the most fruit for the most retirees.
Like anything else in financial planning, its virtually impossible to devise a strategy which is superior in all situations for all people. What we’re trying to do here is craft a general framework which should be the best route for most people. As always, I would be happy to connect further on your individual situation.