In his October 2, 2015 blog post, Dr. Wade Pfau, Professor of Retirement Income at The American College, reprinted his article from the Journal of Financial Planning, Making Sense Out of Variable Spending Strategies for Retirees. The stated purpose of this article was to “assist financial planners and their clients in figuring out which sort of variable spending strategy will be most appropriate for their situation [by using] simple metrics to evaluate and compare strategies.” See my post of March 19th of this year for my initial thoughts on this paper. Today’s post will supplement my earlier post with additional thoughts on this article.
Perhaps the most interesting part of Dr. Pfau’s article is his suggestion that financial advisors use his “XYZ Formula” approach to help clients select a combination budget setting strategy (variable spending strategy) and investment strategy. Under this approach, the financial advisor uses Monte Carlo modeling and the client’s specific information to help the client select the combination budget setting and investment strategy that has an “X% probability that spending falls below a threshold of $Y (in inflation-adjusted terms) by year Z of retirement”, where the client (with the advisor’s help) chooses the values of X, Y and Z, presumably in accordance with the client’s risk preferences. The XYZ formula approach assumes that the client’s spending will exactly equal the client’s spending budget so determined each year.
Even though it is based on the unrealistic assumption that retiree spending will actually equal the spending budget resulting from application of variable spending strategy, I believe that Dr. Pfau’s approach can provide some value to retirees. However, rather than providing a broad analysis of various combinations of budget setting strategies and investment strategies for hypothetical clients with different situations, Dr. Pfau instead holds investment allocations constant, fixes values of X,Y and Z and looks at a client that (with one notable exception) has no pension/annuity income. The purpose of fixing these items was presumably to isolate differences attributable to differences inherent in the variable spending strategies.
I was pleased to see the Actuarial Approach advocated in this website included in Dr. Pfau’s list of examined variable rate strategies (albeit grouped with other so-called actuarial strategies). I was also pleased that Dr. Pfau concluded, “The actuarial methods were found to spend down wealth more efficiently.” However, I feel compelled in this post to (i) respond to a specific comment made in the article about application of smoothing to my approach and (ii) point out why my approach is superior to the “PMT approach” with which my approach was grouped.
In his article, Dr. Pfau says, “Steiner (2014) suggested that users may smooth spending adjustments relative to the changes implied by this formula. Not all would agree, as Waring and Siegel (2015) noted that a less volatile asset allocation is a safer way to smooth spending fluctuations.” While I certainly don’t have a problem with the position that a less volatile asset allocation is a reasonable way to manage volatility in spending budgets, I believe Waring and Siegel’s suggestion that spending budgets not be smoothed is ridiculous. For most retirees, a spending budget is simply a suggestion as to how much the retiree may want to spend for the year. Only retirement academics and other Monte Carlo modelling advocates assume that retirees will actually spend their spending budget each year (and only as a calculation expediency). It therefore makes no sense to me to require a spending budget to be based on strict (non-smoothed) application of a formula if the retiree can then choose to spend whatever he or she wants.
Actuarial Approach vs. PMT Approach
Waring and Siegel’s ARVA (PMT) approach is essentially mathematically equivalent to the simple spreadsheet included in my website if the retiree has no fixed dollar pension or annuity income. If the retiree has a fixed dollar pension benefit, a fixed dollar immediate annuity or a fixed dollar deferred annuity, the PMT approach can’t properly handle it.
It is ironic to me that the approach that appears to produce the most favorable results in Dr. Pfau’s article (at least in terms of initial spending rates under the given XYZ specifications) is the “Annuitize Floor and Aggressive Discretionary Spending” approach. This isn’t really a different variable rate spending approach, but rather a combination of a different investment strategy (partial annuitization) with the Guyton decision rules. As noted in previous posts (most recently my post of April 26, 2015), I’m not a big fan of the Guyton decision rules, but inclusion of this final option does illustrate the potential benefits of partial annuitization for risk averse clients. It also indirectly points out the importance of using a variable spending strategy that properly coordinates with fixed dollar pension and annuity benefits. And once again, I will end a post by noting that the Actuarial Approach is the only one of the variable spending strategies listed in Dr. Pfau’s article that does this.