Wednesday, May 8, 2013

Dynamic Retirement Strategies - Inflight Brainstorming


There is an important distinction between static and dynamic retirement strategies. Static strategies belong to a "set it and forget it" group. A basic example would be the 4% rule, which suggests withdrawing 4% of one's assets at the retirement date, keeping track of how much income this represents, and then adjusting this income amount by inflation in subsequent years to determine future withdrawals.  What I investigated in my recent article on the efficient frontier for retirement income was also static in nature. I assumed that the retiree made all of their decisions at the retirement date (how to divide financial assets between stocks, bonds, and different types of annuities) and stuck with this decision for their remainder of their retirement.

In contrast, dynamic strategies allow for changing plans throughout retirement. I have a bit of trouble defining what a dynamic strategy is. For example, a constant percentage strategy, in which one decides at retirement to withdraw 4% of their remaining portfolio balance in each year of retirement, could be considered a dynamic strategy since future inflation-adjusted withdrawal amounts fluctuate dynamically in response to the market returns and past withdrawals taken from the portfolio. At the same time, to me, deciding at retirement to withdraw 4% of remaining assets each year does sound like a "set it and forget it" type approach as well. Nonetheless, it is dynamic in the sense that the ongoing realized experience of retirement will impact decisions in a way that doesn't happen for a constant inflation-adjusted spending amount strategy.

But there are other types of strategies, which while still representing behaviors which respond to a set of decision rules developed at the time of retirement, could really be considered more dynamic in nature since there is no telling what will happen. Blanchett, Kowara, and Chen (2012) developed the most advanced version of this type of decision rule framework in relation to taking withdrawals from their portfolio with their "mortality-updating constant probability of failure" model. With this sophisticated model, withdrawals in each year of retirement are determined by remaining life expectancy and an updated portfolio value, with the idea of choosing a withdrawal amount each year that will maintain a constant probability of failure looking forward from that point of time. 

Another important area where dynamic strategies can play an important role relates to the decision of if and when to annuitize, with an effort to combine systematic withdrawals and annuities into a more complete retirement income framework. This is an area which has been explored quite extensively in highly mathematical academic studies, but the findings of such studies have not yet received detailed scrutiny from the wider investing public about the applicability of the assumptions found in the models. Nonetheless, without getting into specifics about assumptions and so forth, a general finding of such studies is that the annuity decision should indeed be dynamic, with chunks of annuitization taking place throughout the retirement period in response to the updated situation faced by retirees. These studies also tend to find that for any one-time annuitization decisions, it is often better to wait until one is in their 70s.

When thinking about dynamic retirement strategies, there are two different ways to try to simulate strategies to determine which approaches may be superior. The less sophisticated approach would be to test different sets of decision rules in a somewhat ad hoc fashion using Monte Carlo simulations to see what comes out best based on the outcome measures chosen by the researcher. A more sophisticated approach involved using "dynamic programming," in which one works backward through retirement. Determine what the optimal decisions are at the end of retirement, and then work backward to determine what is optimal earlier on based on the probabilities of different subsequent outcomes and how one would optimize in those outcomes. In this approach, you may act differently now when you specifically incorporate how you might respond in the future to the realized outcomes of your retirement. 

But without getting into greater details about the modeling approach, it is somewhat clear that dynamic retirement strategies, both with regard to the amount to withdraw from the portfolio and with regard to decisions relating to when and how much to annuitize, will be optimal to strategies in which future decisions are unrelated to the ongoing experience of the retiree. Dynamic decisions about annuitization must also incorporate the irreversibility of the decision and the real option value of waiting, and so it is a matter of figuring out the types of conditions that should trigger annuitization. The conditions experienced at the start of retirement, such as the extremely low bond yields facing today's retirees, could also impact the optimal decision rules for a dynamic retirement income strategy.

Now, in an effort to brainstorm, what all should be incorporated in a modeling approach which seeks to determine an optimal dynamic retirement income strategy? Here is an effort to start a list.

First, the decision rules to guide a dynamic retirement income strategy should allow for a way to make updated decisions each year about the appropriate asset allocation,  how much of remaining financial assets to annuitize (and which of the many different types of available annuity products to use), and also how much insurance to have for long-term care, health, and life.

Those decisions should relate to updated information available about:

-the remaining portfolio value of financial assets, which is influenced by realized market returns, asset allocation, and past withdrawal decisions

-beliefs about appropriate future assumptions for market returns, which may be influenced by past realized market returns, and which also will affect assumptions about the future evolution of annuity prices

-an updated budget for spending needs over the remainder of the retiree's life, which could be impacted by unexpected surprises in one's past budget (such as new unexpected expenses), updated realizations about how future spending needs may change, and some sort of hedonic adjustment which gets at the idea that people may get used to whatever their current budget is and have a harder time making future reductions (which would imply greater caution about increasing one's budget in response to good market outcomes)

-updates about health status and remaining life expectancy both for oneself and for society (which affects future annuity prices)

-some sort of reflection about one's relative position in society. For instance, if there is a big market drop, then many people may tighten their belt at once and so the relative impact is less severe. Does one have a strategy which will mimick societal changes or which is contrarian in nature? What I mean, for example, is that complete annuitization may cause one to fall behind in a relative sense when markets go up, but would also cause one to experienced increased relative wealth when others' portfolios drop

-a retiree's cognitive skills are important, and any dynamic strategy which moves away from a "set it and forget it" approach must incorporate the notion that retirees will experience increased difficulty to implement complex dynamic strategies as they continue to age

-the tax basis for one's investments as well as one's tax situation will continue to evolve throughout retirement

-risk aversion could change throughout retirement as well, and is not necessarily constant. Finke, Pfau, and Williams (2012) talks about risk aversion in retirement as it relates to "spending flexibility."  That also relates to the idea of risk capacity, which gets at how one is able to ride out drops in their wealth. When dynamically updating a retirement income strategy, it is important no monitor changes in this risk aversion. Some of the factors relevant here include how a retiree feels about the idea of outliving their financial assets (longevity risk aversion) and what income would still be available if that happened, any changes in the volatility of unknown future spending needs (such as the need to care for other family members, to cover out-of-pocket health expenses, in some sense the potential losses which could still be experienced by one's investment portfolio, long-term care needs, and potential for any voluntary job loss if one is still relying on part-time labor income).  Also relevant here is a psychological matter of how adaptable one feels about the idea of reducing living expenses if necessary.

It's a tall order, and only some of these matters may be incorporated in the financial planning software available to help today's retirees, but if researchers can keep plugging away at it, we will hopefully get to the point where more dynamic retirement income strategies can be vetted and compared on a basis that fulfills the needs of real retirees and their unknown future experiences.