Thursday, April 24, 2014

The Next Evolution in Defined Contribution Retirement

Welcome to this week's video blog made in cooperation with The Wealth Channel at the American College. Today I provide a discussion of the Society of Actuaries (SOA) and the Stanford Center on Longevity report written by Steve Vernon called, “The Next Evolution in Defined Contribution Retirement.” 



For email readers, the videos never show up in the email, but you can see the video by clicking here.

What now follows is not an exact transcript. It is the written version of what I meant to say above, though as I was not reading from a script, I sometimes veered away from the plan when speaking:

The Next Evolution in Defined Contribution Retirement

The Society of Actuaries (SOA) and the Stanford Center on Longevity recently released the research report, “The Next Evolution in Defined Contribution Retirement.” This report is aimed to help 401(k) and other employer savings plan participants to figure out how to build a retirement income strategy with their savings. The report was written by pension actuary and consulting research scholar for the Stanford Center on Longevity, Steve Vernon. I contributed analytic results comparing the cash flows and wealth levels supported over retirement by different “retirement income generators” in order to provide unbiased guidance about the distribution of outcomes with different retirement strategies.

In the words of Steve Vernon, “Different retirement income methods produce significantly different amounts of income depending on the method chosen. Employers can help retiring employees understand the pros and cons of each method as well as the amount of retirement income, so retiring employees can make informed decisions.”


Though the report is designed to help plan sponsors understand the outcomes of different retirement income tools on average, as well as in bad luck and good luck outcomes, I believe that anyone with an interest in building a retirement income strategy may benefit from the report. One matter which is emphasized in the report is that there may be large differences in pricing for institutional and retail retirement income solutions, such that employers can offer greater benefits to their employers through access to the cheaper institutional offerings.
 

One important point made is that 91% of plan sponsors view defined contribution pensions as savings plans, while only 9% see then as a vehicle to provide retirement income. This indicates that “pension” is not an appropriate term for what is going on. The report stresses that employers and plan sponsors must operate their plans as true retirement plans.
 

More generally, the report aims to provide education. There is no one-size-fits-all solution. Each retirement income generator provides a tradeoff between the safety of income provided and the potential for greater portfolio growth.  In particular, the work I contributed to the report shows the performance of six different retirement income generators:
 

  • Systematic withdrawals with a constant inflation-adjusted spending amount
  • Systematic withdrawals with spending equal to a constant percentage of remaining assets
  • Systematic withdrawals based on remaining life expectancies
  • An immediate inflation-adjusted income annuity
  • An immediate fixed income annuity
  • A variable annuity with a guaranteed minimum withdrawal benefit


 

Thursday, March 27, 2014

Retirement Income Strategies

The following chart is a first draft of something I hope to develop more. It is a list of different approaches to retirement income which I've come across. I'm still thinking about if there are ways that I could improve the classifications, and I've probably forgotten to include something worthwhile. I'm open to feedback and suggestions.




Monday, March 24, 2014

Retirement Risks

This week I've made two posts about different ways to think about risks in retirement. The first post ("Retirement Risks: It all starts with Longevity") is at Forbes and treats longevity risk as the overarching risk facing retirees, since the longer retirement lasts, the more exposed retirees are to other risks. The other main categories I described there are related to macro/market risks, inflation risk, and personal spending.



The second post ("Breaking down retirement risks") is at RetireMentors. In this post I distinguish risks with regard to whether they are risks to the asset (wealth) or liability (spending needs) side of the household balance sheet, and whether they are macroeconomic (impacting everyone simultaneously) or individual specific. 




Wednesday, March 19, 2014

Framing Safe Withdrawal Rates: Spend More Today vs. Spend More Tomorrow

Dirk Cotton's The Retirement Cafe blog is now a must read blog for innovative thinking on the safety-first side of retirement income planning. In his two recent posts "The Downside of Upside" and "Diminishing Returns" he makes good arguments that it is foolish to invest aggressively in retirement just for the sake of being able to ramp-up spending in late retirement. I agree with that, but the issue I have is that I didn't think this is really used as a justification for probability-based approaches. I thought it was more of an unintended side effect. In my mind, the justification for probability-based approaches is to be able to spend more today as well. 

For this discussion, the relevant characteristic of probability-based vs. safety-first is that the probability-based approach uses a total returns investing strategy with a diversified portfolio of financial assets aiming to support the entire lifestyle spending goal for the retiree. The safety-first approach, on the other hand, differentiates between essential expenses and discretionary expenses. Volatile assets (with higher expected returns but also higher volatility and greater downside risk) should not be used to finance essentials. As Modern Retirement Theory describes it, essentials should be covered by assets that are secure, stable, and sustainable.

The important question is: why use risky assets as part of the retirement income strategy? Dirk frames the probability-based justification as being that people like to dream they will be able to increase their spending in the future. I agree that this is the implication of the strategy. The logic of this is explained in Stock and Watson's Floor-Leverage Rule, as they argue that the desire to have sustainable spending and also equity investments for greater upside seems to be the reason for using a probability-based 'safe withdrawal rate' type of approach. But they argue that this approach is convoluted, and if these are really the goals of a retiree, the retiree would be better served by first locking in a safety-first style safe spending floor with the majority of assets, and to then invest very aggressively with remaining assets with the hope of being able to raise the spending floor further in the future. 

Dirk rightly points out that in practical terms there really isn't any point to do this. His posts are about how investing more aggressively when you are 65 so that you might be able to enjoy a higher standard of living when you are 80 really doesn't make all that much sense. 

I agree. But the point of this post is that I'm not convinced that this is the way most people are thinking about retirement spending. My thought is that people are logically wanting to 'amortize' their future (speculative) market gains by spending more today. I think this is the way matters are considered in the original Bill Bengen research and also in follow-ups like Jonathan Guyton's decision rules. The emphasis was about how if you are willing to cut spending in the future when markets underperform, then you could spend more today. Let's get today's spending higher.

There are two ways to be aggressive with a retirement strategy. Spend more today, or invest assets more aggressively for greater upside potential. In this context, I think the following figure basically explains the logic behind the probability-based approach:


The more aggressively one wishes to spend, the more aggressive is the asset allocation which minimizes the probability of failure. [Note, this particular figure is based on historical average returns, and it is not the figure I would suggest using in today's market environment to decide on a withdrawal rate].

And so, for those with a more aggressive lifestyle goal, the reason to invest more aggressively is to improve the odds that the goal will be met, accepting all of the accompanying downside risk this creates. I'm not saying this is the right decision to make, I'm only saying that my understanding of the logic of probability-based approaches is that this is what people actually have in mind.

In some sense, this post may be trying to make a distinction about something relatively minor and unimportant. But I think this is an important question:  how to retirees who accept the probability-based approach and who do not otherwise have large bequest goals think about the decision to invest for upside?

Is it with the hope that they will be able to continue increasing their spending as they age?

Or, is it with the hope that this will justify them spending more today than they could otherwise lock-in with safe assets, since their portfolio will hopefully enjoy the upside they seek?

Monday, March 17, 2014

Big News in the Financial Planning Research Journal World

There has been a lot of news in the world of research journals over the past month. Though not directly related to retirement income, it's worth discussing here as these are some of the key outlets where retirement income research will be published.

News Story 1: New Editors at the Journal of Personal Finance

This story involves me. With the publication of the Spring 2014 issue of the journal, Professor Michael Finke of Texas Tech University has now passed editorship of the journal to myself and Joseph Tomlinson. The October 2014 issue will be the first published under our purview. The journal will be published twice a year and will mostly include academic research in the field of financial planning. Currently, past issues can be downloaded in their entirety at the journal archives, and I'm looking forward to updating that to include a list of each article with a direct link to the article. I think that will make the journal much more accessible to the public and media. 

News Story 2: Journal of Financial Planning Revamps Webpage and Eliminates Links to Past Articles

[Update: The loss of links to past articles from the JFP was an accident and they are now actively working to restore those links. So the situation described in this section is being resolved.]

For this story, I hope it is something which will just be short-term and hopefully even this post will help lead to change... my blog includes probably hundreds of links to past JFP articles. I've been saying for a while that the JFP was my favorite journal, and a primary reason was that they made their past articles (at least going back about 4 years or so) freely accessible. But as of now, all those links to past journal articles re-direct the reader to the current issue at the journal homepage. And it seems that one must now be a member of the Financial Planning Association to see any articles published prior to the current issue. There are other journals in the financial planning area which take the strategy of using their journal as a members-only benefit and lock away access to the articles from non-members. And dare I suggest that this is one of the key reasons why those other journals are never discussed in media articles or at Bogleheads, etc? I talk with the media quite frequently these days, and it was always convenient to share a link to a JFP article that we discussed on the phone.  As of March 1, it's not possible to do this anymore...

News Story 3: CFP Board Plans to Develop a Research Institute and Publish an Academic Journal Through Wiley

This is potentially a big story. On March 13, the CFP Board issued a press release indicating that they plan to create a Center for Financial Planning to help support and guide academic research in financial planning. This has the potential to grow to be something similar to the research arm of the CFA Institute, which has been very effective. As well, the CFP Board aims to create a new journal focused on the academic side of financial planning. This overlaps with the Journal of Personal Finance, as well as other journals like Financial Services Review and Journal of Financial Counseling and Planning. But what is notable about this new journal is that they've already gained a partnership with Wiley, which will help the journal to generate lots of revenues through university library subscriptions. Most every other journal in financial planning is independently published through a professional organization. It will be interesting to watch how this develops.

Tuesday, March 11, 2014

Video Interview About Safe Savings Rates

I recently came across the following video about "Safe Savings Rates" and "Getting on Track for Retirement." This video was recorded in August 2012 when I visited the American College for a job interview. It's a 23 minute explanation about the concept of safe savings rates.



For financial advisors who are reading, creating a financial plan using safe savings rates is now one of many features provided by the inStream Solutions financial planning software. A new column by Andy Gluck at Advisors4Advisors also provides more details about the many features of inStream.

For email readers, this is the link to see the video interview.