Best Practices

in Retirement Planning

Wade D. Pfau, Ph.D., CFA

The American College

inStream Solutions

McLean Asset Management

Retirement Researcher blog

(www.RetirementResearcher.com/blog)

“Professor Mandell, editor of Financial Services

Review, invited me to contribute an article related

to financial research for the individual for the first

issue of this journal. Since the subject is not my

specialty, it was uncharacteristically risky of me to

have accepted the invitation. But an evening of

reflection convinced me that there were clear

differences in the central features of investment

for institutions and investment for individuals,

that these differences suggest differences in

desirable research methodology, and that a note

on these differences may be of value.”

Financial Services Review, 1991

Retirement

Requires a

Different

Approach / Toolkit

“Academic Justifications and

Practice Validations expand

beyond the traditional focus on

Wealth. Traditional financial

management is a special case of

the larger financial framework

that has been developed and

formalized since the 1950s.

Retirement Management re-

introduces minimum

consumption in the financial

equation.”

Francois Gadenne Retirement Income Industry Association presentation

What’s

different?

“[Retirement

Income Planning] is

a really hard

problem. It’s the

hardest problem I’ve

ever looked at.”

William Sharpe CFA Institute Conference, 2014

The Mountain Climbing Analogy

What’s different?

• Reduced earnings flexibility = decreased risk capacity

• Portfolio spending constraint is more visible

• Heightened vulnerability to sequence of returns risk

• Unknown longevity and time horizon

• Even low inflation compounds dramatically over time

• Flexibility and liquidity required for unplanned expenses

• Decreasing cognitive abilities with age hamper portfolio

management skills and other financial decision-making

Deciding How to

Spend Down Assets in Retirement

•Capital Market Expectations

•Planning Horizon

•Asset/Product Allocation

•Funded Status

• Spending Flexibility / Risk Capacity

•Emphasize spending or bequest,

downside or upside

Retirement Risks

Challenges for an

Individual Pension Plan

•Asset Returns

• Pension Manager – Pool returns across generations

• Advisor – One whack at the cat

Longevity Risk

• Pension Manager – systemic increases in longevity

• Advisor – Idiosyncratic longevity risk

Sequence Risk

•Most vulnerable to returns when

wealth is largest

•Pre-retirement dollar cost

averaging reverses in

distribution phase

Lifetime Sequence of Returns Risk

0 10 20 30 40 50 600

2

4

6

8

10

12

14

16

Year

Expla

nato

ry P

ow

er

for

Each Y

ear's R

etu

rn

Retirement Income Philosophies

Prioritization

Among Goals

Focus on overall lifestyle

spending goals

Distinguish retirement spending goals

between essential needs and

discretionary expenses

Investment

Approach

Focus on a total returns

investing for the entire financial

portfolio to maximize returns

for an acceptable level of

volatility

Match assets to different goals so that

risk levels are compatible. Allows a

wider role for holding individual bonds

and using income annuities.

Measuring

Retirement

Success

Focus on determining an

acceptable probability of failure

for the overall retirement plan

Seeks to minimize harms in worst-case

scenarios by avoiding failure for

essential needs

Safe Withdrawal

Rate

The historical record suggests

that 4% or 4.5% is about as bad

as it gets

Unknown and unknowable. Risky

assets are inherently risky and the

historical success of a strategy does

not provide sufficient confidence

Probability-Based Safety-First

Source: Wade Pfau and Jeremy Cooper, The Yin and Yang of retirement income philosophies

Investment Approach for

Retirement Income

Time Segmentation

Essential vs. Discretionary

Systematic Withdrawals

Systematic Withdrawals

Diversified

Portfolio

Age

Sp

end

ing

($)

Lifestyle

Goal

Systematic Withdrawals

The 4% Rule

William Bengen

Journal of Financial Planning, October 1994

William Bengen’s 4% Rule

1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990

0

1

2

3

4

5

6

7

8

9

SAFEMAX

Figure 2.1Maximum Sustainable Withdrawal Rates

For 50/50 Asset Allocation, 30-Year Retirement Duration, Inflation Adjustments, No FeesUsing SBBI Data, 1926-2010, S&P 500 and Intermediate-Term Government Bonds

Retirement Year

Maxim

um

Susta

inable

Withdra

wal R

ate

Trinity

Study,

1998

Historical

Sustainability

of Desired

Distribution

Portfolio Success Rates

Inflation-Adjusted Withdrawals

For Various Withdrawal Rates, Asset Allocations, and Retirement Durations

Using SBBI Data, 1926-2010, S&P 500 and Intermediate-Term Government Bonds

3% 4% 5% 6% 7% 8% 9% 10% 11% 12%

100% Stocks

15 Years 100 100 100 90 82 73 70 59 46 37

20 Years 100 100 91 80 70 61 47 42 30 17

25 Years 100 98 80 69 59 49 38 30 20 8

30 Years 100 93 75 63 50 36 30 18 7 5

35 Years 100 90 73 53 47 29 24 12 6 2

40 Years 100 89 70 54 37 30 24 11 2 0

75% Stocks

15 Years 100 100 100 97 85 75 63 52 42 23

20 Years 100 100 94 79 67 52 44 27 15 5

25 Years 100 100 82 66 54 41 26 13 3 0

30 Years 100 98 75 54 41 29 7 2 0 0

35 Years 100 92 65 49 31 20 2 0 0 0

40 Years 100 91 65 43 30 7 2 0 0 0

50% Stocks

15 Years 100 100 100 100 83 73 54 39 24 3

20 Years 100 100 98 77 59 38 29 6 2 0

25 Years 100 100 84 56 38 20 8 2 0 0

30 Years 100 100 66 39 16 4 0 0 0 0

35 Years 100 96 53 27 0 0 0 0 0 0

40 Years 100 85 43 15 0 0 0 0 0 0

25% Stocks

15 Years 100 100 100 99 75 59 41 21 8 1

20 Years 100 100 94 61 42 23 9 2 0 0

25 Years 100 100 62 39 16 10 2 0 0 0

30 Years 100 86 38 11 4 2 0 0 0 0

35 Years 100 67 12 0 0 0 0 0 0 0

40 Years 98 39 4 0 0 0 0 0 0 0

0% Stocks

15 Years 100 100 99 89 61 35 25 14 3 0

20 Years 100 94 74 35 27 12 3 0 0 0

25 Years 97 77 31 20 10 3 0 0 0 0

30 Years 80 38 13 4 2 0 0 0 0 0

35 Years 69 18 0 0 0 0 0 0 0 0

40 Years 57 4 0 0 0 0 0 0 0 0

Underlying Philosophy of 4% Rule

• Focus on overall lifestyle spending goal

• Failure = Not Meeting Full Spending Goal for 30 years

• Retirees want smooth spending, appetite for market risk

• Market Risk Management: Diversified portfolio and precautionary savings. Historically, 50-75% stocks maximizes the probability of plan success

• Focus on total returns

• Longevity Risk Management: 30 Years is sufficiently beyond life expectancy

• Confidence in the Historical Record as Precedent

Problems with 4% Rule • Market/sequence risk could create new worst outcome

• Horizon may extend beyond 30 years

• Requires asset and distribution management into an advanced age

• Assumes a constant (inflation-adjusted) spending need

• Practical tradeoffs about when spending will maximize retirement satisfaction

• Assumes rational investor always rebalances on schedule to target asset allocation and is able to earn underlying index returns without fee drag

• No accounting for magnitude of failure

• Implied “self-annuitization” does not get any boost from mortality credits

• Incongruity of funding a smooth spending stream from a volatile portfolio – this is a unique cause of sequence of returns risk

• Strategy is inefficient as spending should adjust based on portfolio performance and time horizon

Time Segmentation

Time Segmentation

Bond

Ladder

Diversified

Portfolio

Age

Sp

end

ing

($)

Lifestyle

Goal

Time Segmentation

• Not a superior investment strategy

• Avoids selling stocks when markets are down; builds in time buffer for market recovery

• Uses bonds to provide income at expected date rather than as “stocks-lite”

• However, does time diversification work?

• Guyton: Is there any there there?

• Benefits are behavioral

• Easier for clients to understand

(mental accounting)

• Helps clients to stay the course

Essentials vs.

Discretionary

Essentials vs. Discretionary

Age

Sp

end

ing

($)

Lifestyle Goal

Basic

Needs

Diversified Portfolio

Income Annuities

Essentials vs. Discretionary

• Prioritizes Goals

• Matches risk characteristics of assets used to

fund different liabilities

• Don’t use stocks to fund essential needs!

Modern Retirement Theory: essential needs

should be met with assets that are “secure,

stable, and sustainable”

• More willing to use income annuities for

longevity / market risk protection

Modern Retirement Theory

by Jason K. Branning, CFP® and M. Ray Grubbs, Ph.D.

www.modernretirementtheory.com

Fund for Essential Needs

Contingency Fund

Fund for

Discretionary Expenses

Legacy

Fund

Funding

Priority

Assets

Household Balance Sheet

(Present Values) Assets

Human Capital

Financial Capital

Social Capital

Liabilities

Legacy

Discretionary

Contingency

Fixed

The Safe Withdrawal Rate - ???

• Unknown and unknowable.

• Risky assets are inherently risky

• Retirees cannot rely on averages as they only get

one opportunity for a successful retirement

• Just because something would have worked in

our limited historical record does not make it safe

“It’s important to recognize

that just because something

works in the typical case or

has always worked in the

past, it will do your client no

good if they are in the

unlucky tail of the

distribution. With risky

prospects, the word risk is

there for a reason.”

Michael Zwecher,

Retirement Portfolios

Safer withdrawal plan

Source: http://www.bobsfinancialwebsite.com/SaferPlan2.html

Fighting the Retirement Risk Juggernaut

• Spend Conservatively

•Adjust Spending to Market Returns

•Reduce Volatility

•Match Assets to Liabilities

•Mortality Credits and Longevity

Risk Pooling

•Preserve Liquidity

•Monitor Funded Status

• Insurance for unexpected expenses

Thank you! Any Questions?

Wade D. Pfau

The American College

McLean Asset Management

inStream Solutions

wadepfau@gmail.com

@WadePfau (Twitter)

www.retirementresearcher.com