Planning for an uncertain retirement income
For decades, modern portfolio theory (MPT) has guided the investment decisions of pension funds and other large financial services institutions.
In its simplest form, MPT is about finding the balance between maximizing your return and minimizing your risk. It’s a great way to look at things.
But, unlike pension funds, investors don't simply want to grow their portfolios forever.
Instead, they’re looking for ways to turn the assets they’ve been able to set aside into a steady income in retirement, maintains Sherrie Grabot, CEO of GuidedChoice, a provider of managed-account services for U.S. retirement plans.
Could something like MPT help make sense of the income side of the retirement equation? Absolutely, she says, providing you account for the increased complexity and variability of retirement income versus retirement investing.
Her goal is to make building a retirement investment strategy less of a secret recipe and instead a process that most people can follow -- likely with the help of some sort of advisor.
While Guided Choice’s services aren’t yet available in Canada, pension plan providers here are watching its development closely.
The goal of the traditional investor is simple: maximize the potential gains for a given degree of risk. For those facing retirement, however, it's really the inverse: minimize the risk to attain a given investment goal.
A solution to this problem is at the heart of what Grabot has dubbed "financial guidance theory" (FGT), an offshoot of MPT.
As with any type of financial planning, modelling income starts with setting goals. What kind of specific results would represent the optimal retirement income?
In FGT, the "outcome" isn't a fixed dollar amount per month or year, nor is it a percentage drawdown. Rather, it's a total amount of money distributed in a somewhat variable manner over the whole period of retirement.
Rather than set a fixed rule, FGT establishes the spread between the minimum necessary income and the desired, best-case income. FGT also allows the income projections to float between the two through a process of adjustments that Grabot calls "consumption smoothing."
A consumption-smoothing framework focuses on probable spending and saving needs over time, accounting for things such as a changing household structure or an increase in travel.
That means factoring in more spending during your working years, when there are all those mouths to feed, and less in retirement, when it's just you and your spouse, or perhaps just you alone.
Of course, nobody contemplating retirement wants to emulate King Lear by beginning with a very large income and ending up with next to nothing.
To accommodate different levels of involvement, these “needs” and “wants” can both
be chosen by the retiree, or calculated by the model based on current income.
Once goals have been defined, the model tries to identify the investment mix that's most likely to keep you as close as possible to your maximum income within an acceptable degree of risk.
This extrapolation would look at the decisions that are available to you: how to invest the portfolio among asset classes over time, and how much money to take out of it at regular intervals.
At the same time, because lifespans are impossible to predict, the model uses standard actuarial mortality figures, then adds 10 years to provide a margin of safety.
This is an important consideration, particularly for couples.
Roughly, 80 per cent of all men die married, while 80 per cent of all women die single. Either way, at the death of the first spouse, the surviving spouse will face a significant reduction in both private and public pensions -- a factor often ignored in “back of the envelope” plans.
Following your stated income needs, the model generates a “consumption history” for each investment result, attaching a score that describes how successful each is in producing income by focusing on the size of the retirement paycheque throughout each history.
That score, when plotted on a graph with all possible outcomes of a given policy, produces the same curve found in MPT's "efficient frontier" illustrations.
The curve drops off rapidly where scores represent a minimum retirement income or less, Grabot says, because a less than minimum income is unacceptable.
And the curve tapers off gradually as scores approach the maximum, because exceeding the maximum delivers little or no real value. In other words, money the model suggests you can't spend is better left invested to improve real-life returns.
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