Page 34 - Investment Advisor January/February 2022

Cover Story

8 Important Facts About Risk-Based

Retirement Income Guardrails

BY JEFF BERMAN

f retirement distributions are going to be more flexible on an ongoing basis, a critical issue for
clients is how to best set retirement-income guardrails to make portfolio adjustments when
Inecessary, according to Derek Tharp, lead researcher at Kitces.com.
Setting up guardrails helps keep client retirement spending plans “on track,” he said in a recent
webinar. These guardrails are planning strategies that set predefined thresholds triggering an
increase or decrease in retirement spending as needed.
Here are some facts he emphasized:
Risk-based guardrails combine the best of guardrail strategies, he noted. Decreasing the initial withdrawal
1 both methods. rate is the most effective means of reducing downward adjust-
A significant advantage of risk-based guardrails is that they ment risk, as adjusting the upper/lower guardrails themselves
combine the best elements of Monte Carlo and withdrawal rate have less impact than intuition may lead us to believe, he added.
strategy guidelines for advisors to manage client risk, Tharp said.
Risk-based guardrails reflect the retirement distribution “hatch- Upper/lower guardrails matter less than
et” or whatever “shape” a client’s retirement spending takes. 6 advisors might think.
They can also be used to project sustainable cash flows, he said. The “probability of success” means something quite different
when applied to a one-time plan vs. an ongoing plan, according
Risk-based guardrails overcome the to Tharp. If an advisor has only one shot at setting a retirement
2 limitations of withdrawal rate guardrails. spending level, then the probability of success as commonly
While the typical Monte Carlo result is a 90% probability of suc- reported is a relevant metric, he noted. But if you update a plan
cess, that actually “doesn’t tell us very much” about a client’s spe- on an ongoing basis, then the traditional probability-of-success
cific situation, he said. “By contrast, guardrails provide an actual metric is far less relevant. The “key takeaway”: If you plan on
plan for action” that advisors can communicate clearly to their an ongoing basis, initial withdrawal rates matter much more
clients, which provides clients with greater “peace of mind,” espe- than guardrail thresholds, he added.
cially when the market is experiencing turbulence, he explained.
There is a formula for how to set
They are not limited to a single analytic method. 7 risk-based guardrails.
3 Another strong advantage of risk-based guardrails is If the goal is to avoid downward adjustment, one should
that they aren’t limited to one analytic method, such as histori- decrease initial withdrawal rates, and guardrail thresholds may
cal returns or a Monte Carlo strategy, he pointed out. have less impact than expected, according to Tharp. If the objec-
tive is to increase legacy, one should decrease initial withdrawal
They also can be easily adjusted based on rates and use higher guardrail thresholds. If the objective is to
4 multiple factors. prioritize current income over legacy, one should use higher
Risk-based guardrails adjust for changing risk levels with age, initial withdrawal rates and lower guardrail thresholds, he said.
he said. They also will capture any unique client spending
patterns or goals and can be adjusted to fit a client’s risk pref- There are more nuances to risk-based
erences. The guardrails and target can be changed to reflect a 8 guardrails that we still need to learn.
client’s willingness or capacity to take risk, he added. There are certain details about risk-based guardrails that
remain unclear, he said. For example: How do different guard-
These strategies depend on the objectives rail parameters impact lifetime income experience? Also, how
5 of a retiree. do spending floors/ceilings impact retirement income experi-
Different guardrails strategies can be used to fulfill different ence? Some preliminary machine learning research suggests
objectives of a client, such as reducing the chances of a down- that using lower probability of success levels (such as 20%) for
ward adjustment, increasing legacy, or prioritizing current lower guardrails may be beneficial in some cases, he added.
income over legacy, he explained. Reducing the risk of down-
ward adjustment is often a major concern when evaluating Jeff Berman can be reached at [email protected].

32 INVESTMENT ADVISOR JANUARY/FEBRUARY 2022 | ThinkAdvisor.com