Many questions arise when you’re creating a retirement income plan. But two are especially important to answer.
1. What’s the best investment strategy for your portfolio? Should it be wealth-focused or income-focused?
2. What’s the best spending strategy? Should it be a fixed spending strategy similar to the infamous 4% rule created in 1994 by Bill Bengen, a flexible spending strategy, or some other strategy?
Those are the questions Mathieu Pellerin, a senior researcher at Dimensional Fund Advisors (DFA), sought to answer in his recently published research paper, Investing for Retirement Income: A Comparison of Asset Allocations and Spending Strategies.
And for preretirees as well as retirees, one key takeaway from Pellerin’s research is this:
- For all spending strategies studied, the income-focused portfolio — a portfolio with 25% invested in stocks at retirement and the rest in inflation-protected bonds — delivered similar retirement income as the wealth-focused portfolio while offering better protection against market, interest rate, and inflation risk.
In other words, you don’t have to invest your assets aggressively during retirement to generate your desired income. You can do so by investing in the right type of bonds and a moderate percent (25) in stocks.
How did Pellerin come to that conclusion?
By looking at different combinations of three investment strategies with four different spending strategies. In his study, Pellerin examined:
- two wealth-focused investment strategies (one where the asset allocation at retirement was 50% stocks and 50% bonds and one where it was 25% stocks and 75% bonds);
- an income-focused investment strategy where 25% was invested in stocks at retirement and the remainder in an inflation-indexed bond portfolio that used something called liability-driven investing or LDI. An LDI portfolio is one where the assets, the inflation-adjusted bonds, mature when the liability, in this case the retirement expense, comes due. By way of background, the income-focused glide path sought to reduce the volatility of retirement income, rather than the volatility of assets, as the investor approaches retirement.
- And four spending strategies: fixed spending, similar to Bill Bengen’s famous 4% rule; flexible spending; a nominal annuity; and an inflation-indexed annuity.
What’s the probability of you achieving your retirement income goal?
In an interview, Pellerin and his colleague Savina Rizova, global head of research at DFA, discussed the paper and its implications. “Our general view is that when we look at retirement income as the goal then, of course, you should measure your progress in terms of that goal,” said Pellerin. “What is your probability of achieving that? And what are the risks around that?”
Pellerin, for instance, measured the risk of running out of assets before death using the different investment strategies and the different spending strategies and found the following:
- For the fixed spending strategy, the income-focused allocation had the lowest failure rate: 20.1% versus 27.7% for the wealth-focused portfolio with a 25% stock/75% bond asset allocation and 30.1% for the wealth-focused portfolio with a 50% stock/50% bond asset allocation “For people who follow the 4% rule, that’s where the benefits of the income-focused approach comes in,” said Pellerin.
- For flexible spending, where the retiree is changing how much they spend in retirement every year based on their account balance, the income-focused allocation outperforms the moderate-equity wealth-focused portfolio on all measures, despite having similar equity exposure.
And if you had to choose between those two spending strategies, the flexible spending approach would generally have better outcomes than the fixed spending approach, according to Rizova, because you’re using more information” over the course of retirement.
Wealth-focused portfolios are volatile and don’t manage longevity risk
Pellerin did, however, find that the high-equity wealth-focused portfolio (50% stocks/50% bonds) offered the highest average income in retirement but at the cost of much higher volatility.
What’s more, Pellerin discovered that having high equity exposure in a retirement portfolio is an inadequate tool to manage longevity risk, the risk of running out of money. By contrast, annuities are a more appropriate tool to manage longevity risk. What’s more, annuities can “generate higher average income because of mortality pooling, though they require the investor to give up control of her annual spending and assets,” according to Pellerin.
The research doesn’t suggest completely avoiding equities. “The big message is really about having the right (equity) exposure at the right time,” said Pellerin. So, for instance, if you’re young and growth of assets is important, and you have more capacity for bearing risk, a high equity exposure might make sense, he said.
But as you transition toward retirement you can have a moderate equity exposure and generate the income needed. And that’s a key finding in the report. “The trade-off is not that steep in terms of what you give up and you have much tighter risk control around your goal,” said Pellerin. “So, basically, by having high exposure to equities early in life, and a more moderate exposure as you transition to retirement, you get a better trade-off between risk and return.”
But having a moderate asset allocation has to be paired with an income-focused allocation, not a wealth-focused allocation, said Rizova. “That combination is best in terms of delivering sustainable income,” said Rizova.
No agreement regarding the best asset allocation and spending strategy
To be fair, there doesn’t seem to be much agreement among researchers regarding the right asset allocation for retirement nor spending strategy for that matter. There’s no best practice.
At one end of the spectrum, some researchers say a high allocation to equities is the better approach. In 2013, Wade Pfau, a professor at the American College for Financial Services, and Michael Kitces, publisher of The Kitces Report, argued in a paper, Reducing Retirement Risk with a Rising Equity Glide-Path, that a rising equity glide path in retirement — where the portfolio starts out conservative and becomes more aggressive through the retirement time horizon — has the potential to actually reduce both the probability of failure and the magnitude of failure for client portfolios.
At the other end of the spectrum, at least one researcher has argued the opposite case. In 2011, W. Van Harlow, then-research director of the Putnam Institute, argued in his research that the appropriate range of equity allocation in retirement is between 5% at the low end and 25% at the high end if an investor’s primary goal is to not outlive his or her assets.
What’s the best decumulation strategy for you?
There is, of course, no easy answer. There are plenty of possible strategies to use but no best practices. What’s more, some strategies are backed by sound research and some are backed by what some might call junk science, or worse — anecdotal evidence.
On paper, Pellerin’s strategy is sound and makes sense for those who value income over, say, the volatility of their portfolio. It makes sense for those who want to manage longevity, inflation, market, interest rate, and inflation risk. It makes less sense for those who are unconcerned about the volatility of their assets or the aforementioned risks.
If you do decide to implement Pellerin’s strategy, remember: One, determine not just your desired level of income but the risks you must manage in retirement. Two, stick with it; don’t try this approach and then try another one. Three, monitor and adjust the strategy as your facts and circumstances change. And four, don’t hesitate to use a financial adviser — even if it’s only as a sounding board — if you need some help implementing this or any other strategy.
As one adviser once told me, you only get one chance at retirement and you’ll never know if you made mistakes until it’s too late.