Page 33 - Investment Advisor January/February 2022

A retiree has two choices. will be cut). Also, a portion of essential expenses is fixed (such
as property taxes for retirees in many states, a mortgage, etc.)
They can spend less or they or declines in real terms with age.
Creating a smooth income from bonds can be achieved with
can take investment risk. bond funds, or with greater precision using a liability-driven
investing approach that matches the duration of the cash
The good thing about taking flow with the duration of the bond investment. This approach
risk is that investors have will require significantly more capital to implement than an
approach that mixes bonds with annuitization.
For example, a 65-year-old healthy man could buy a 25-year
historically been rewarded PIMCO ZROZ zero-coupon bond today for about $13,000. But
with a big return bonus (the he has a 41% chance of being alive at age 90. By pooling mor-
tality risk with other retirees through, say, a deferred income
equity risk premium) for annuity, he could instead pay 0.41*$13,000 = $5,330 to get an
insurance company to promise a $20,000 payment at age 90 if
investing in stocks. he’s still alive. That gives him more money early in retirement
to spend on fun stuff.
The remaining $22,000 of spending can be funded using a
weeks later, that probability had fallen to 65%. traditional portfolio of stocks and bonds. The asset allocation
The market recovered, but a retiree can’t bet their lifestyle of this portfolio, again, should match a retiree’s willingness
on the certainty of immediate recoveries from future bear to trade off the likelihood of more spending from accepting
markets. The implication is that when asset returns don’t meet investment risk with the possibility of spending less if markets
expectations, a retiree must be willing to spend less each year. don’t cooperate.
And not all retirees can make deep cuts in spending to
maintain a comfortable probability of success. Beginning the Still Think the 4% Rule Isn’t Risky?
retirement income planning process with a conversation about Advisors who still prefer a portfolio-based to a goal-based
the lifestyle a client hopes to lead and the amount of spending approach to creating retirement income should reflect on
flexibility they’re willing to accept is more important than the amount of risk they are asking their clients to accept. An
hitching their lifestyle to a faith in the market’s ability to con- interesting thought exercise may be to ask an advisor or their
sistently deliver a return on risk when they need it most. parent firm: “Would you be willing to accept the risk of mak-
ing income payments adjusted for inflation to any client who
Matching Investments to Spending Flexibility outlives their savings?”
“How much do you need to live on?” or “How much of your This might motivate these advisors and firms to revisit their
monthly spending is essential?” should be the first step in a confidence in the safety of a 4% withdrawal rule. If the advisor
goal-based retirement planning process. For most mass-afflu- assures the client that the rule is perfectly safe, she should be
ent retirees, this number is a relatively high percentage of their willing to put her own wealth on the line as a backstop.
pre-retirement lifestyle — around 70%, according to my own This is a thought exercise because, as we know, no invest-
unpublished research based on the Consumer Expenditure ment firm would be willing to provide this guarantee. To do so
Survey (CEX). would require that they set aside a portion of profits every year
Consider this example, also based on CEX research: A and invest this money in a mix of assets that can be used in the
worker earns $120,000 before retirement. A close look at their future to protect against the risk that many clients will outlive
spending reveals that consumption is about 60% of their gross their savings (for example, by buying bonds and interest rate or
salary, or about $72,000. Fifty thousand dollars of this amount longevity swaps and put options).
is inflexible. They have $30,000 in Social Security, leaving a It is expensive to hedge long-term portfolio and longevity
$20,000 gap in basic spending needs and a $22,000 gap in risk, which is why insurance companies charge a fee to pro-
more flexible spending needs. vide the protection of a guaranteed minimum lifetime income
Stocks aren’t appropriate for funding the first $20,000. And benefit on a risky portfolio. If asset managers had to provide
this is where things get interesting. Are bonds truly the best this same lifetime income protection, they’d charge a fee, too.
way to fund the $20,000 gap? A final benefit to following a goal-based retirement income
Researchers like Blanchett and me are fine with funding approach is clarity. Retirees want to know how much they
the $20,000 using nominal dollars because $25,000 of basic can safely spend each month. They don’t want to worry about
expenses are funded using inflation-adjusted Social Security cutting back on the most important part of their lifestyle if the
payments (we also don’t believe that Social Security benefits stock market has a bad month, a bad year or a bad decade.

JANUARY/FEBRUARY 2022 INVESTMENT ADVISOR 31