Dirk Cotton's The Retirement Cafe blog is now a must read blog for innovative thinking on the safety-first side of retirement income planning. In his two recent posts "The Downside of Upside" and "Diminishing Returns" he makes good arguments that it is foolish to invest aggressively in retirement just for the sake of being able to ramp-up spending in late retirement. I agree with that, but the issue I have is that I didn't think this is really used as a justification for probability-based approaches. I thought it was more of an unintended side effect. In my mind, the justification for probability-based approaches is to be able to spend more today as well.
For this discussion, the relevant characteristic of probability-based vs. safety-first is that the probability-based approach uses a total returns investing strategy with a diversified portfolio of financial assets aiming to support the entire lifestyle spending goal for the retiree. The safety-first approach, on the other hand, differentiates between essential expenses and discretionary expenses. Volatile assets (with higher expected returns but also higher volatility and greater downside risk) should not be used to finance essentials. As Modern Retirement Theory describes it, essentials should be covered by assets that are secure, stable, and sustainable.
The important question is: why use risky assets as part of the retirement income strategy? Dirk frames the probability-based justification as being that people like to dream they will be able to increase their spending in the future. I agree that this is the implication of the strategy. The logic of this is explained in Stock and Watson's Floor-Leverage Rule, as they argue that the desire to have sustainable spending and also equity investments for greater upside seems to be the reason for using a probability-based 'safe withdrawal rate' type of approach. But they argue that this approach is convoluted, and if these are really the goals of a retiree, the retiree would be better served by first locking in a safety-first style safe spending floor with the majority of assets, and to then invest very aggressively with remaining assets with the hope of being able to raise the spending floor further in the future.
Dirk rightly points out that in practical terms there really isn't any point to do this. His posts are about how investing more aggressively when you are 65 so that you might be able to enjoy a higher standard of living when you are 80 really doesn't make all that much sense.
I agree. But the point of this post is that I'm not convinced that this is the way most people are thinking about retirement spending. My thought is that people are logically wanting to 'amortize' their future (speculative) market gains by spending more today. I think this is the way matters are considered in the original Bill Bengen research and also in follow-ups like Jonathan Guyton's decision rules. The emphasis was about how if you are willing to cut spending in the future when markets underperform, then you could spend more today. Let's get today's spending higher.
There are two ways to be aggressive with a retirement strategy. Spend more today, or invest assets more aggressively for greater upside potential. In this context, I think the following figure basically explains the logic behind the probability-based approach:
The more aggressively one wishes to spend, the more aggressive is the asset allocation which minimizes the probability of failure. [Note, this particular figure is based on historical average returns, and it is not the figure I would suggest using in today's market environment to decide on a withdrawal rate].
And so, for those with a more aggressive lifestyle goal, the reason to invest more aggressively is to improve the odds that the goal will be met, accepting all of the accompanying downside risk this creates. I'm not saying this is the right decision to make, I'm only saying that my understanding of the logic of probability-based approaches is that this is what people actually have in mind.
In some sense, this post may be trying to make a distinction about something relatively minor and unimportant. But I think this is an important question: how to retirees who accept the probability-based approach and who do not otherwise have large bequest goals think about the decision to invest for upside?
Is it with the hope that they will be able to continue increasing their spending as they age?
Or, is it with the hope that this will justify them spending more today than they could otherwise lock-in with safe assets, since their portfolio will hopefully enjoy the upside they seek?