I’ve finished a new research paper called,
“An Efficient Frontier for Retirement Income.”
First, the punchline: with a 4% withdrawal
rate to meet lifestyle spending goals, a 65-year old heterosexual couple is 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).
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.
The basic idea is not original to me. As I
often say: Moshe Milevsky already did it. In this case, he developed the ideas
of product allocation and the efficient frontier for retirement income. But I
think I’ve made some useful enhancements and improvements to his underlying
framework.
As I’ve been thinking about financial goals
for retirement, I think they can be boiled down to two objectives. It’s not
just a matter of avoiding financial wealth depletion as is assumed in safe
withdrawal rate studies. Rather, the two competing objectives are (1) to
support minimum spending needs and lifestyle spending goals as best as
possible, and (2) to maintain a buffer of financial assets either for a legacy
or to use as a reserve for managing risks, such as expensive health shocks,
divorce, unexpected needs of other family members, severe economic downturns,
or other types of emergency needs. Generally, there is a tradeoff between these
objectives, and retirees need to determine how much they value each objective
and where they find the appropriate balance between them.
This research will help with the decision
by plotting how 1,001 different product allocations perform with respect to
meeting the two objectives, and then identifying the efficient frontier of
product allocations. This efficient frontier tells you the allocations which
support the highest reserves of financial assets for a given percentage of
spending needs which can be satisfied, or, alternatively, the highest
percentage of spending needs which can be satisfied for a given reserve of
remaining financial assets. Any of the product allocations on the efficient
frontier represent a potentially optimal point, and retirees can then choose
which one they think best balances their own objectives.
The basic case study I use is a 65-year old
couple who has an inflation-adjusted lifestyle spending goal of 6% of
retirement date assets. Following the arguments made by noted financial
planners such as Michael Kitces, Jonathan Guyton, and Harold Evensky, I also
assume that this couple will be quite sad if they can’t meet their lifestyle
goal, and so I assume their minimum spending needs are also 6%. They have a
Social Security benefit equal to 2% of their retirement date assets, and so to
meet their lifestyle goal, they need to generate additional income equal to 4% of their retirement date assets.
The following figure shows how their 1,001
product allocation possibilities perform. I’ve highlighted in blue all of the
allocations which only consist of stocks and bonds without any annuitization.
These outcomes reflect some of the worst possible results for meeting spending
needs. Also, I’ve highlighted most of the efficient frontier with a red curve. These
are the allocations between only stocks and fixed SPIAs.
With the characteristics of this case
study, what I find supports my earlier intuition that optimal retirement income
strategies consist of partial annuitization with SPIAs. More strongly, it consists
of mixing stocks with fixed SPIAs. I
was surprised that fixed SPIAs perform better than inflation-adjusted SPIAs,
but Joseph Tomlinson explains that this is because inflation-adjusted SPIAs are
relatively overpriced. Also, interestingly, there is no need for retirees to hold bonds. SPIAs are like super
bonds with no maturity dates and which boost retiree returns with mortality
credits. Also, confirming my earlier intuition, GLWBs don’t really help and retirees can find some combination of stocks and fixed SPIAs which will better
support both financial objectives than any allocation that includes a
portion devoted to GLWBs. Again, these results are specific to the case study
in question. Changing lifestyle goals, minimum spending needs, age and marital
status of the retirees could all change which product allocations are on the
efficient frontier.
Improvements I’ve tried to make to existing
studies include basing both the annuity prices and the market return
assumptions on current market conditions so as to avoid biasing the results
against annuities, using low cost versions of each strategy as are available
from companies like Vanguard, and discussing results in terms of different
percentiles from the distribution of outcomes, rather than just the mean or median.
Also, I think the way I’ve defined the percentage of lifetime spending needs
which are satisfied is a step forward to more properly define the magnitude of
success and failure. It is broader, as it can deal with both inflation-adjusted
and fixed guaranteed income sources, and also it can better account for what
happens with strategies using variable spending patterns.
If you are interesting in the process of building retirement income strategies, please have a look at this new article.
