This post is a follow-up to our post of January 31, 2020—How to Develop and Implement a Strategic Plan for Your Retirement. In that post we encouraged our readers to assume responsibility for their own retirement by developing a strategic plan that aligns their spending and investment strategies with their retirement goals. In this post, we will encourage you to also consider your tolerance for risk and other preferences you may have, as recently suggested by two prominent retirement researchers. We will also discuss how you can accomplish this task relatively easily if you are using our Recommended Financial Planning Process. If you are not familiar with this process, you can find a description of it here.
Background
In their recently posted paper, A Model Approach to Selecting a Personalized Retirement Income Strategy, Drs. Alejandro Murguia and Wade Pfau set forth a process for what they believe to be a better approach for measuring risk tolerance and identifying personal preferences to help clients select specific retirement income strategies. They call this process the Retirement Income Style Awareness (RISAtm). Under their proposed process, results can be used to align various RISAtm scores with one or more of many possible retirement income strategies.
As discussed in many of our previous posts, including our last post, we are not big fans of retirement income strategies that involve Strategic Withdrawal Plans (SWPs). Because SWPs do not coordinate with other sources of income and do not consider non-recurring spending desires, these approaches aren’t likely to be consistent with our spending goals. Therefore, we are not particularly interested in employing a relatively complicated risk tolerance measurement process as suggested by the authors, the objective of which is to help us select a SWP that may not even be consistent with our spending goals. However, we do agree with Drs. Murguia and Pfau that good financial planning should consider one’s tolerance for risk and relevant psychological preferences.
Instead of completing a risk tolerance questionnaire, however, we believe the choices (or trade-offs) involved in developing your strategic retirement plan are better indicators of your tolerance for risk and other preferences than information that may be gleaned from a questionnaire. In the next sections, we will discuss some of these choices and how to better align your strategic plan with your tolerance for risk and other preferences (in addition to your spending goals). For purposes of this discussion, we assume that you will be using our Recommended Financial Planning Process (or something similar) to develop your strategic plan.
Essential vs. Discretionary Expenses
An important step in our recommended planning process is to categorize expenses considered by the retired household to be “essential” vs. those considered to be “discretionary.” Separate funding of essential expenses in a Floor Portfolio of relatively low-risk investments theoretically drives the household asset allocation between relatively non-risky and risky investments used to fund discretionary expenses in the Upside Portfolio. The higher one’s estimated essential expenses, the larger the Floor Portfolio and the smaller the Upside Portfolio, all things being equal. As noted by our late friend Dirk Cotton, “the correct balance [between Floor and Upside Portfolios] will depend on how willing you are to risk losing your standard of living for a chance of having an even higher one.”
Using the “safety-first” approach can be reassuring to those retirees whose preferences include being able to sleep well at night but also want the potential benefits of investing in equities. On the other hand, as discussed below, many retirees’ preferences include avoidance of life annuity forms of payment and therefore they may favor the “probability based” approach, as described in the Murguia/Pfau article. It should be noted, however, that these two approaches can produce approximately the same total levels of investment in lower-risk and higher risk assets, and therefore, the supposed distinction between the two approaches may be overstated.
It is also important to note that essential expenses are those expenses considered by the retired household to be essential and may not be essential to a different household. This selection/balancing process, then, is a key indicator of your tolerance for investment and longevity risks. For example, if your initial selection of essential expenses produces an undesirable allocation of your total assets with more than desired weighting towards low-risk investments, you may decide to reduce your estimate of your essential expenses and acknowledge that, as a result of this choice, you may be assuming more investment and longevity risk with respect to funding of your essential expenses (or alternatively, that you won’t have as much of a problem as you thought reducing some of your future essential expenses).
Spending from Your Upside Portfolio
The Upside Portfolio (invested in more risky investments) is expected to fund current and future discretionary expenses. As discussed in our post of November 12, 2019, you can be more aggressive when determining annual spending from the Upside Portfolio. This is because, theoretically, it should not pose an undue hardship for you to reduce your future discretionary expenses if the need should arise, and it is reasonable to expect to earn higher rates of return on your more-risky assets.
The assumptions you use (investment return, inflation, lifetime planning period and annual future increase rate) to determine annual amounts that may be paid from your Upside Portfolio (and your actual payments from this portfolio) are another good indication of your tolerance for risk.
Front-Loaded Spending vs. Back-Loaded Spending
The basic spending axiom in retirement is that if you spend more earlier in retirement, you (or your heirs) will have less to spend later in retirement, all things being equal. Therefore, your strategic plan must balance your non-recurring spending desires (to travel early in retirement for example) with your desires to leave money to your heirs or to fund long-term care costs or unexpected late-in-life medical costs. These spending choices, then, are also a good indication of your tolerance for risk.
Actual Spending vs. Spending Budget
You may use conservative assumptions and the actuarial methodology we advocate (that reflects what you believe to be all your future spending liabilities) to determine how much you can afford to spend each year. Yet, you may not feel comfortable spending this “maximum” affordable budget amount. You may like to continue saving during retirement (and building an ever-increasing Rainy-Day Fund) for whatever reason. That is ok with us, but it is a decision that reflects your risk tolerance and psychological preferences.
Other Psychological Preferences
You may decide that certain types of investment or spending strategies will provide more “flexibility” or are inherently better (even adjusted for increased risk). While most of us don’t have a problem buying home insurance, car insurance or health insurance, many individuals balk at the thought of buying longevity insurance in the form of life annuities. And many others would rather have a large lump sum distribution from their pension plan rather than a smaller monthly life annuity. Retirees who prefer non-annuity contract investments will generally be well served by balancing their investment risk by investing a portion of their assets in bonds or cash. The choices you make relative to the funding of your Floor Portfolio may be a good indication of both your tolerance for risk and your preferences in general, depending on how conservatively the assets are actually invested.
Summary
Drs. Murguria and Pfau have produced an interesting article which outlines many of the factors that may affect retiree decisions with respect to spending and investing strategies in retirement. We agree with these gentlemen that aligning one’s strategic plan in retirement with personal spending goals, tolerance for risk and other preferences is an ongoing process in retirement. We believe that this can be relatively easily accomplished by employing our Recommended Financial Planning Process.
