Modern Portfolio Theory Is Not for Retirement Income Planning: New Paper

Once retired, however, individuals will begin distributing from financial assets to cover spending, and a market downturn has the opposite effect by increasing the number of shares to be sold to meet a fixed expense.

"This is sequence-of-return risk and its practical impact is to amplify investment volatility by making retirement outcomes disproportionately dependent on the market returns experienced in the early retirement years, even if the retirement lasts 30 years or more," Murguia and Pfau explain. "When funding essential expenses from an investment portfolio, the phrase 'investing for the long term' is incomplete."

In sum, individuals will very likely approach investing during retirement differently from investing for retirement because retirees tend to worry less about maximizing risk-adjusted returns and worry more about ensuring that their assets can support their spending goals for the rest of their lives.

"Risk tolerance questionnaires are an accumulation-based tool, and they pre-suppose that all retirees maintain the same views about maximizing risk-adjusted returns in a manner that may only be partially correlated with the concerns related to meeting the differential financial goals for the portfolio," Murguia and Pfau write.

The Role of Style Awareness

According to Murguia and Pfau, an entirely new approach is warranted when it comes to assessing a retired individual's preferences for structuring their approach to retirement income. They propose a framework called "retirement income style awareness," or "RISA" for short.

As spelled out in the new paper and in Murguia's and Pfau's prior work, the primary factors that best capture an individual's retirement income style are whether the person prefers probability-based thinking and planning versus a safety-first approach, and whether they prefer optionality versus commitment.

Murguia and Pfau note that the probability-based versus safety-first factor explains whether individuals are more comfortable with market growth or with contractual protections as an income source for their essential retirement spending. The optionality versus commitment factor, on the other hand, describes whether individuals place an emphasis on keeping options open to be able to make changes or whether they prefer to commit to a strategy known to solve for a lifetime retirement goal.

Murguia and Pfau suggest that these factors can be identified and reliably measured as consistent across a variety of demographic subgroups, as based on age, gender, relationship status, net worth and retirement timeline. They also argue these factors can be combined in a manner that describes a number of distinct "retirement styles," which can be mapped into the core retirement income strategies offered in the broader retirement literature.

They provide this mapping of preferences to styles and to strategies, following with an analysis of the frequency of these styles within the broader population and for different demographic subgroups.

Four of the broad strategies identified include a total return preference, in which a person spends systematically from a diversified investment portfolio focused on total returns; an income protection preference that involves building a lifetime income floor with fixed annuities; a risk wrap approach, which builds a lifetime income floor with variable annuities offering lifetime withdrawal benefits wrapped around a risk-based portfolio; and a time segmentation preference that resembles a bucketing strategy that uses less volatile assets for shorter-term expenses and riskier assets offering higher growth potential for longer-term expenses.

According to Murguia and Pfau, approximately 35% of individuals between ages 50 and 80 identified most closely with the income protection approach. This is followed by 33% who preferred a total return approach, 17% who preferred time segmentation and 15% who favored a risk wrap strategy.

"With this distribution of preferences, it is misguided to narrowly promote one type of retirement strategy as above others," Murguia and Pfau conclude. "Though so much of the consumer media focus about retirement income is on systematic withdrawal strategies described by the total return approach, two-thirds of the population are looking for ways to source their essential retirement spending in a manner that provides greater protections and commitment."

Murguia and Pfau suggest retirement styles remain consistent by age and before and after retirement. Women seem to have a stronger income protection focus than men, which is important because they tend to live longer and are more likely to be the remaining survivor of a heterosexual couple.