Wednesday, September 26, 2012

Efficient Frontiers for Other Retirement Spending Goals

The other day, I posted about a new research paper called, "An Efficient Frontier for Retirement Income." This paper provides a framework for retirees to choose how to allocate their retirement assets between stocks, bonds, inflation-adjusted SPIAs, fixed SPIAs, and VA/GLWBs.

In the case study used the article, a 65-year old heterosexual couple requiring a 4% withdrawal rate to meet their lifestyle goals (and whose minimum spending needs were set equal to the lifestyle goal) was best served by combinations of stocks and fixed single-premium immediate annuities (SPIAs). At current product pricing levels, there is little need for bonds, inflation-adjusted SPIAs, or immediate variable annuities with guaranteed living benefit riders (VA/GLWBs).

Since writing about this, I've been receiving lots of great feedback through blog comments, emails from readers, and a great discussion thread at the Bogleheads Forum. I'm now going to start trying to respond to some of the suggestions and requests for additional checks about the robustness of the results.

Today I will look at an issue raised by Mike Piper at Bogleheads. One of the things he asked about is how results may change if there is a change in retirement spending goals. This could be in terms of either the lifestyle goals or the minimum needs. I will look at a few further examples.

But first, today Mike wrote about the article at his blog. He is great at distilling complex issues down to their most basic level, and he also made a great point in his post. Here is what he said:

In other words, for individual investors, the takeaway is not that you should dump all your bonds in favor of stocks and/or fixed lifetime annuities. Rather, the takeaway is simply that a portfolio completely eschewing bonds in favor of lifetime annuities might not be completely-off-the-wall-crazy. And, given how far such a portfolio would be from conventional retirement recommendations, that’s very interesting.

Yes, he articulated that much better than me. Back to spending goals.
All of the details for the 65-year old couple are the same as in the article, including that they have a Social Security benefit equal to 2% of their retirement date financial assets. What I am changing now is their spending goals.

First, suppose the couple can meet their spending goals with a lower withdrawal rate. In the following figure, both the lifestyle spending goal and the minimum needs are 3% above Social Security instead of 4% above Social Security. We can see that the Stocks / Fixed SPIAs combo holds as the points on the efficient frontier.

Next, as I stated in the article, if the couple is in a really great situation and can meet their lifestyle goals with a 1% withdrawal rate of above Social Security, then the probability of not fully meeting the lifestyle goal is quite small. Goals are still fully met at the 10th percentile of outcomes in this case. The efficient frontier is basically one point: 100% stocks. This is a good place to mention again that the points on the efficient frontier are not always feasible for real world retirees. If a retiree is not comfortable with 100% stocks, then a constrained version of the efficient frontier could be created which disallows allocations that the retiree finds unacceptable. The figure is not so exciting, but I am providing it here again showing how it is still the case that stocks / fixed SPIA combos support higher financial asset holdings than stocks / bonds combos. Here it is:

Next, the couple is more pressed and must use a withdrawal rate of 5% above Social Security to meet both the lifestyle spending goal and the minimum needs. Though 5% is really more than can be considered as reasonably sustainable in the current economic environment and so the efficient frontier does not come close to fully meeting the goals, we can see that the Stocks / Fixed SPIAs combos still hold as the points on the efficient frontier.

The next interesting matter is if we make the minimum needs level lower than the lifestyle spending goal. This introduces some interesting new issues to consider about lifestyle vs. minimum needs, especially if the lifestyle goal is at an unsustainable level like 5%. I'll come back to this in my next post on efficient frontiers.