Last week, as part of his continuous effort to challenge financial advisors to provide better service to their clients, Michael Kitces shared an interesting blogpost entitled, How DO You Measure Which Retirement Income Strategy Is Best? In his post, he examined possible “best” strategies for a 65-year old couple “trying to decide how much to spend for a 30-year retirement from their $1,000,000 portfolio, and how that portfolio should be invested.” He looked at three possible strategies:
A) Spend an inflation-adjusting $30,000/year from the portfolio, by putting 90% of it into an immediate annuity and keeping the other 10% in cash reserves
B) Spend an inflation-adjusting $45,000/year from the portfolio, and invest it 50/50 in stocks and bonds
C) Spend an inflation-adjusting $60,000/year from the portfolio, and invest it 100% in stocks
Making assumptions about future inflation (3%) and expected returns on cash (3%), intermediate bonds (5%) and stocks (10%) and relevant standard deviations and correlations (undisclosed) for Monte Carlo projections, Michael determined which of the three strategies was “best” based on eight possible ways to measure the outcomes (including three levels of how risk-averse the retiree is). His analysis is summarized nicely in a chart. Michael concludes that “careful thought about how a strategy will be evaluated is actually an essential aspect of the process in crafting financial planning recommendations.”
Kudos to Michael for suggesting such an approach. I worry, however, about how comprehensive and meaningful the process would be in actual practice. The results are very much dependent on the assumptions made for future expected returns of the various asset classes. Projections of future experience that are based on poor assumptions will yield poor results. How would the results change, for example, if instead of assuming a 7% expected risk premium for stocks, Michael had assumed “only” 4%? If current annuity purchase rates are used for the most conservative options, expected future returns should properly reflect current economic conditions as well to make sure that comparisons are “apples to apples.” Perhaps a more comprehensive process would involve several charts illustrating variations in expected assumptions (a suggestion that I would also make for Monte Carlo simulations in general).
As Michael points out, the situation is further complicated by the fact that “most clients have multiple and complex goals and preferences.” Certainly, many retirees may have different risk preferences for different types of budget expenses (essential vs. non-essential for example), so the strategies examined may have to be more complicated than the three examined by Michael in his example. In addition, the existence of other sources of retirement income can further complicate the analysis as can funding for long-term care and unexpected expenses.
Finally, even if simple strategies are chosen, care should be taken to make sure that they represent potentially best strategies. For example, if I go to annuityquickquote.com, I get a quote of $555 per month per $100,000 premium for a 65-year old male payable as a fixed dollar immediate 15-year certain and life annuity and a quote of $502 per month per $100,000 premium for a 65-year old female payable as a fixed dollar immediate 15-year certain and life annuity. If I split Michael’s $900,000 premium equally for the husband and the wife, I’m looking at total annual payments from the contracts of $57,078 as long as both the husband and wife are alive. Using the Actuarial Budget Calculator spreadsheet from this website and inputting $100,000 invested in cash (and Michael’s 3% assumptions for expected return on cash and desired future increases to adjust for expected inflation), I come up with a total amount spendable in the first year of retirement of $41,774. (Note that in order to provide inflation increases throughout the 30 period of retirement, a significant portion of initial year’s annuity payments would have to be saved). This strategy would provide about 39% higher benefits than Michael’s Strategy A. I would imagine that this strategy would fare better under Michael’s comparisons than Strategy A.
While I believe that Michael chose these three strategies to illustrate how his process night work, I become skeptical when someone tells me that I can spend 33% more in retirement if I simply increase my investment in equities from 50% to 100% (Strategy C vs. Strategy B). Unless you are very conservative with your investments, I recommend that you assume about the same rate of future investment return that is “baked” into insurance company life annuity pricing, as this is approximately the discount rate at which you can “settle” your future budget liabilities. My rational for making this recommendation is that while you might expect to achieve higher rates of investment return by investing in riskier assets, you are taking on more risk, and this increased risk tends to counterbalance the positive effect of higher expected returns when it comes to determining how much of your assets you can afford to spend.
FYI, you can use the Actuarial Budget Calculator to determine that the future deterministic real rate of investment return implied by Michael’s Strategy B is about 2.3% per annum, while the future deterministic real rate of investment return implied by Strategy C is about 4.8%.