Scott and Watson's Floor-Leverage Rule

Welcome to this week's video blog made in cooperation with The Wealth Channel at the American College. As you can tell from the green leaves outside the window, this footage is a bit old. But the video blogs are back on track. Today I provide a discussion of Jason Scott and John Watson's article, "The Floor-Leverage Rule for Retirement,” from the September/October 2013 Financial Analysts Journal.



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:

Scott and Watson's Floor-Leverage Rule
 
Jason Scott and John Watson are both important developers of work from William Sharpe’s Financial Engines which explains why the 4% rule, that is, spending a constant stream of income from a portfolio of volatile assets, is an incredibly inefficient retirement income strategy. In their new article called “The Floor-Leverage Rule for Retirement,” from the September/October 2013 Financial Analysts Journal, they make an effort to develop a retirement income strategy which can better meet the competing retiree preferences that have turned the 4% rule into the default strategy for retirement.
 
Retiree preferences which increase the seemingly attractiveness of using the 4% rule include:
   

• A desire for sustainable and non-decreasing spending over retirement
• An appetite for taking equity risk in the hope of supporting a higher sustainable spending stream
• A strategy which will be relatively simple to implement and to understand

The fundamental problem is the trade-off between wanting downside protection to ensure a sustainable spending stream and also wanting portfolio growth and greater upside. Stock and Watson argue that their floor-leverage rule provides a more effective way to satisfy these preferences than using a traditional portfolio with something like a 50/50 allocation to stocks and bonds.

So what is the floor-leverage rule? Essentially, it is a barbell strategy. With traditional rebalancing, one buys stocks after they lose value which can lead to portfolio depletion in worst-case scenarios. With the floor leverage rule, one doesn’t buy stocks after they fall in value, but rather only sell stocks after they gain in value. This is accomplished by building a safe and secure spending floor with 85% of the assets in the financial portfolio. This provides a lifetime floor which spending can never fall below. Next, they put the remaining 15% of financial assets in a highly-volatile 3x-leveraged equity portfolio. Finally, they conduct annual portfolio reviews. If the equity portion of the portfolio exceeds 15% of the portfolio asset allocation, then sell enough equities to return to the 15% allocation and use the proceeds to ratchet up the spending level supported by the secure spending portfolio. Otherwise, do nothing.
 
With this approach, spending can increase, but it can never decrease. It is possible for the leveraged equity allocation to be wiped out, but the initial secure spending floor is still in place and the retiree is exposed to, at most, a 15% drop in their financial assets.
 
Let’s consider the spending floor created by the 85% allocation. Depending on client preferences, spending could be supported in constant or in inflation-adjusted terms, or some combination of the two. The level of spending depends on the longevity risk aversion of the client. The more fearful they are of outliving their assets, the longer their bond ladder would need to be. This will mean less spending. With greater longevity risk aversion, including an income annuity will support greater spending since the mortality-risk pooling offered by the insurer allows payouts to be based on terms closer to one’s life expectancy. The use of longevity insurance, also called a deferred income annuity, also provides a way to increase sustainable spending by allowing for a shorter planning horizon with the bond ladder, with the longevity tail covered by the annuity.
 
Scott and Watson’s arguments in favor of this approach are very compelling. A caveat, of course, is that in today’s low interest rate environment, the amount of safe and sustainable spending that many retirees could build with 85% of their assets could be low. That’s the bad news. The good news is that even though initial retirement spending is low, the spending level is secure and there is a good chance that it could increase later in retirement.