Friday, April 27, 2012

Choosing a Retirement Income Strategy


This post picks up from a line of thought started in “Variable Withdrawals in Retirement.” I’m going to present a simplified scenario for two different withdrawal rates and explain about some quantitative ways to answer the question: How do you decide which spending path is more desirable?
The classic 4% withdrawal rate rule is about constant inflation-adjusted withdrawal amounts. The benefit of this approach is that it provides a smooth and predictable income stream for as long as wealth remains. But wealth can run out. 

Another rule is to spend a constant percentage of the remaining portfolio each year. This allows for spending to increase when wealth grows. As well, though spending amounts may drop to uncomfortably low levels, this spending rule prevents wealth from ever running out. The main disadvantages of using this rule are that the spending path is unpredictable and spending fluctuates widely over time.

The simplified scenario I will discuss consists of one set of paths for the real income and real remaining wealth provided by these two strategies. This is one simulation out of 10,000 or so that might typically be part of a Monte Carlo simulation study on retirement income. I will consider the case for a 65-year old female. In this simplified case, she can see the evolving path from these two outcomes when she is ready to retire. She wants to know which is better. 


She retires at 65. A market boom in the first year of retirement allows her spending to rise from the initial level of 5. Her wealth grew from a retirement date value of 100 to nearly 140 in the first year. After year 8, her wealth begins to decline. Though the constant inflation-adjusted amount stays the same at 5, the constant percentage spending amount fluctuates quite a bit. In the 34th year of retirement (her 98th year), she uses the last of her wealth with the constant amount strategy. Should she make it to 99, nothing is left. With the constant percentage strategy, she still has income through at least 105 (40 years after retiring) that is somewhere around 30% of the initial retirement value of 5. 

The big uncertainty she faces is that she doesn’t know how long she will live. She has to choose her income strategy in advance without knowing this. Also, though the constant inflation-adjusted withdrawals can result in no income at some point in the future, we can suppose that while this is a very undesirable outcome, there is a safety net in place such that she does not necessarily need to absolutely prevent this outcome. How can she decide in a systematic way about which of these strategies to use?

Failure Rates

Traditional safe withdrawal rate studies focus on failure rates, often over a fixed retirement duration. For the constant amount strategy, failure is represented by wealth depletion. In this case, if the retirement duration is 30 years, her failure rate is 0%, but with a 40 year horizon her failure rate is 100%.  Trying to apply this same concept to the constant percentage strategy doesn’t really work though, since the strategy never runs out of wealth. It fails in the sense that spending is below the desired real amount of 5, but it succeeds in the sense that it always provides some spending power and some remaining wealth. Basically, we need to throw the failure rate concept out the window when considering retirement income strategies with variable spending amounts.

Average Lifetime Spending and Average Bequest Value

Retirees may like a strategy that provides the highest average lifetime income and the highest amount of remaining wealth to leave as an inheritance. To calculate these, we need to incorporate mortality data.

Average lifetime income is the average of income in each year of retirement multiplied by the probability of surviving to that age.

Average bequest is the wealth remaining in each year of retirement multiplied by the probability of that being the final year of the 65 year old’s life.

These survival and death age distribution probabilities, derived from the Social Security Administration Periodic Life Table from 2007, are shown in Columns G (survival probabilities) and Column H (death probabilities)  in the spreadsheet at the end of this post.

For the constant amounts strategy, average income is the sum of Column C times Column G, divided by the sum of Column G. It is 4.97. Though wealth runs out in year 34 of retirement, the probability of the 65 year old female surviving to her 99th birthday is 3.9%. Earlier income receives a greater weight because it has a higher probability of being achieved. Likewise, for the constant percentage strategy, the average lifetime income is 5.23 (sum of Column C times G, divided by sum of Column G). The extra spending early in retirement accounts for a lot.

As for expected bequests, for constant amounts, this is the sum of Column D times H, the wealth remaining in each year times the probability that it ends up being the final bequest (i.e. the probability of death). It is 73.97. As for constant percentages, it is the sum of Column F times H. That is 69.75.
The constant amounts strategy has a slightly lower average income, but a slightly higher bequest.

Spending Shortfall Below a Desired Floor Level

Average bequest may be helpful since it gives some indication about the surplus provided by the strategy, but average lifetime income may not be completely satisfactory.

A risk averse retiree may instead choose to focus on how often and by how much spending power may fall under a minimally acceptable flooring level. This floor may vary from person to person, and it represents the spending level that you really hope to avoid broaching because it may mean a serious reduction in your quality of life, such as a need to move to a cheaper home or give up some important spending.

To demonstrate this, I will use an income floor of 3. It is arbitrary, but our hypothetical retiree really hopes she can avoid experiencing spending shortfalls below the level of 3. Surely, she would like to be able to spend more than 3, and 3 is just her basic level of necessities. With this measure, we focus on downside and forget about the upside. Over the 40 year period, the total amount of spending shortfall below the floor of 3 with constant amounts is -18. There are 6 years with income of 0, which represents a shortfall of 3, and 6 x 3 = 18. The corresponding sum for the constant percentage strategy is -20.83.  If we add up the shortfalls weighted by the probability of surviving to the age of the shortfalls, we get a deviation with constant amounts of -.016, and the deviation for constant percentages is -.1051.  Constant percentages had more shortfalls earlier in retirement (the first shortfall happened in the 24th year), and there are higher probabilities for experiencing these shortfalls.
While this measure tells us about the downside, and in a sense it provides a modified form of failure rates that can be applied to variable withdrawal strategies, it does ignore any upside potential.

The Value of Spending (a.k.a. utility maximization)

A final measure I will look at provides an attempt to translate spending amounts into something that may more closely represent the value of that spending to the retiree.

A couple of issues will be at work here. First, more spending is better than less, but the additional value provided by more and more spending diminishes as spending increases. The additional value of increasing spending from 1 to 2 is very high, because this is helping you to fulfill same basic needs that vastly improve your quality of life. But the same 1 unit increase in spending from 9 to 10 may not provide much more value. That high spending might mean living in a home with 1800 sq. ft. instead of 1600, or it might mean 50 bottles of champagne per year instead of 30. The additional life-improving value provided by spending will surely be less as spending grows.

Another important aspect is that I will include the floor described in the previous section. Again, I will consider a floor of 3 as a reference point. Spending may fall below 3, but the value plummets for spending below 3. A spending drop from 4 to 3 is not nearly as bad as a drop from 3 to 2.

To discuss the value of spending, I will adopt the same basic function used by Joe Tomlinson in his February 2012 Journal of Financial Planning article, except I will reconfigure it to a new context. He calculated one value based on the lifetime outcome of how much wealth or total shortfall remained at death. I will translate each year of spending into a utility value and then add these up after multiplying them by the probability of surviving to that age.

In other words, this measure is similar to average lifetime spending, except that I don’t use spending from each year directly. Instead, I translate each year’s spending into a corresponding value based on the relationships seen in the following figure for two different loss aversion ratios (which measure the impact of how bad it is to fall under the floor of 3).


A few things to note about this: First, it will be hard to identify the precise shape of the function for real retirees. The shape depends on several parameters including one which explains the steepness of the curve, and also one which defines the appropriate floor level, and the loss aversion ratio that defines how bad it is to fall below the floor. More research is needed on this aspect. But we can still gain some insights by looking at outcomes. Also, note that this is only about spending power, and bequests are not incorporated into the calculations at all. But an important aspect here is that the measure does incorporate both downside risk and upside potential. Unfortunately, there is no connection between the value of spending in successive time periods. Real people may grow accustomized to a particular spending level, so that their frame of reference changes as spending changes. More research can eventually incorporate this aspect, as well as the possibility that the minimum acceptable floor could change over time. Finally, please keep in mind that the numbers defining the utility value are abstract and don’t have any direct meaning. What matters is the relative value of different spending levels, and not their absolute value. We don’t have to worry about utility being negative for levels below the income floor, it’s all relative.

This being said, we can calculate the “expected utility” of each spending path using this function which translates spending into a corresponding value, and then weighs these values by the probability of surviving to that age. With loss aversion of 2:1, the constant amount strategy provides expected lifetime utility of 0.387, while the corresponding value for the constant percentage strategy is 0.361.  Again, these numbers by themselves have no meaning. What matters is that 0.387>0.361 and the constant amount strategy provides higher expected utility in this case. With loss aversion of 10:1, a value function that more strongly punishes spending deviations below 3, the constant amount strategy provides utility of 0.364, which is more than the constant percentage’s strategy of 0.161.

As a final point about utility maximization, Michael Kitces recently wrote:

The reality is that utility functions are not new to the analysis of economic and financial problems, but these research papers are some of the first instances that we have seen in trying to apply utility functions in the context of financial planning, and potentially represent a significant step forward in determining effective solutions for clients. 

Putting it all together

For these two spending paths, we’ve considered 8 ways to quantify which strategy provides a more satisfying outcome. Failure rates were inconclusive, and the constant percentage strategy provided a higher average lifetime income. For the other six measures, the constant amount strategy performed better.

But understand that this is not the whole story. This was only one simulation. It doesn’t provide a final answer. We need to consider the outcomes for many more simulations, such as 10,000. Then we can look at the distributions of these measures and think more systematically about which strategy gives the best chance for the most satisfactory outcomes. 

We can also include more asset allocation and withdrawal rate choices, and more retirement income strategies such as partial annuitization with SPIAs or GLWBs, strategies which use buckets for different time horizons, the impacts of delaying annuitization, the use of bond ladders, the decision about when to begin Social Security, and so on.

Please stay tuned and keep reading, because all of this will be considered here in the coming weeks and months.

William Bernstein's "The Retirement Calculator from Hell"

I'm working on several different projects now, and while nothing is finished enough to post yet, I'm hoping to describe lots of interesting results in the coming weeks. 
 
A couple minor notes... Congratulations to Michael Kitces, who joins a rather elite list of individuals in Investment Advisor's Top 25 list for most influential people for advisors in 2012 and beyond. 

Doug Nordman wrote a very interesting piece, "How much will military veterans leave on the table?" which explores some of the themes I've been describing here recently.

He also mentions William Bernstein's classic 5 part "The Retirement Calculator from Hell" series, which was written around 10 years ago. I finally read all of these, and they are quite worthwhile. A few comments on each:


Part I is no surprise to people who've been following my blog, but it certainly was big news when he wrote it. In 1998, people were rediscovering the notion that constant inflation-adjusted withdrawals above 4% were prone to wealth depletion much faster than expected. He shows examples of this. It's all about Bill Bengen's sequence of returns risk.
  
He describes about using Monte Carlo simulation as an alternative to historical simulations. Also, importantly, he suggests building in forward-looking assumptions to the simulations to account for the current return environment. He suggests using lower volatility for stocks than seen historically to account for the mean reversion in stock prices that is otherwise missing from the simulations. That is interesting, but after thinking about, I think maybe this isn't such a great idea again because of sequence of returns risk. Even with longer-term mean reversion, the impacts of what happens in the early retirement period have the biggest impacts, and there you want to make sure your stock returns have enough volatility to show the full range of possibilities.
 
Maybe this is the most famous part of the series. Here he suggests forgetting about success rates above 80% when thinking about 30-40 retirement periods. Your simulations show you about the investment risk, but they ignore the various possible political, economic, and military failures that can happen over such a long period. This is a very important point.

I also like this quote, which I think ties in well with the idea that minimizing failure rates is not necessarily the most important objective for retirees:

The historically naïve investor (or academic) might consider reducing his monthly withdrawals to a very low level to maximize his chances of success. But history teaches us that depriving ourselves to boost our 40-year success probability much beyond 80% is a fool’s errand, since all you are doing is increasing the probability of failure for political, economic, and military reasons relative to the failure of banal financial planning.


This one is about demography. Raising the retirement age is the only practical solution the aging population, because even if everyone saves a lot, there is still a limited number of younger people producing goods and services for the older people to consume. Also, what matters is not just the absolute amount of your savings, but rather how much you saved relative to everyone else. Important food for thought.

This is about how happiness is related to where you stand relative to your peers, not in absolute terms. As standards of living increase, this means saving even more just to stay at the same level of happiness. If real per-capita GDP grows at 2%, then a 2% investment return is really more like a 0% return in terms of your relative position in society.