Dr. Wade Pfau Response Subsequent to publishing this post, we received an email from Dr. Wade Pfau. Dr. Pfau indicated that he believed our post contained several misunderstandings about the Retirement Income Style Awareness (RISA), including:
Dr. Pfau indicated that our readers who would like to know more about the RISA are invited to attend an upcoming Retirement Income Challenge that is not available to the public. This special invite can be reached by clicking this link. We thank Dr. Pfau for his feedback and look forward to learning more about the RISA and its applications. |
As retired actuaries, we understand that perhaps not everyone thinks the same way we do. No, don’t worry, we will not be talking in this post about politics, masks or vaccinations. We will, however, once again offer our thoughts on why we believe our Recommended Financial Planning Process is a relatively simple process that can be used to align your strategic retirement plan with your spending goals, your tolerance for risk, and your other preferences without requiring a lot of complex regression analyses or risk tolerance questionnaires.
Impetus for this post was the September 21, 2021 Advisor Perspectives article by Drs. Wade Pfau and Alex Murguia entitled, “Why Risk Tolerance Questionnaires Don’t Work for Determining Retirement Strategies.” In this article, the authors discuss how they propose to use “ordinary least squares regression analysis” to assess household “retirement income preferences” that are then used to identify how one wants to “source retirement income.” For example, if the household exhibit a preference for what the authors refer to as a “Safety-First” style, then the household will prefer strategies involving protected income. The authors refer to their model for selecting retirement income strategies as the Retirement Income Style Awareness® (RISA®) Profile. We previously discussed RISA in our post of April 5, 2021.
We remain unpersuaded that the authors’ relatively complicated Retirement Income Style Awareness Profile is absolutely necessary for the purpose of assessing risk in retirement or for measuring household tolerance for risk and other preferences. After the background section that follows, we will discuss how risks can be assessed and tolerance for risk and investment preferences measured using our Recommended Financial Planning Process.
Background
In two of his 2019 Forbes articles, our late friend, Dirk Cotton noted, “the most important decision you will make in retirement planning is how much of your resources to allocate to the Upside and Floor Portfolios. The correct balance [between floor and upside portfolios] will depend on how willing you are to risk losing your standard of living for the chance of having an even higher one.”
We agree with Mr. Cotton’s “correct balance” assessment and believe an important component of this decision, and one that is a good indicator of both the household’s tolerance for risk and its investment preferences, is how the household classifies their Essential vs. their Discretionary Expenses for the purpose of building its Floor Portfolio and the choices it makes to fund any Floor Portfolio shortfall.
Under our Recommended Financial Planning Process, we suggest that you consider building a Floor Portfolio invested in low-risk or protected investments to fund your future (self-selected) Essential Expenses. Consistent with basic financial economics theory and liability-driven investment principles, we recommend that the assumptions used to determine the present value (or cost) of Floor Portfolio assets and Essential spending liabilities be consistent with assumptions used to price inflation-indexed lifetime annuities, so that the expected benefit stream from the Floor Portfolio assets matches the expected Essential Expense stream in amount, timing and probability of payment.
In the next sections we will discuss two approaches that can be used with our Recommended Financial Planning Process to assess risks in retirement and to determine household risk tolerances and investment preferences just as effectively, in our opinion, as a complex questionnaire or an ordinary least squares regression analysis.
Assessing Risk and Tolerance for Risk through Floor Plan Calculation and Actions Preferred to Address Funding Deficiency
Since most retirees in the U.S. participate in Social Security and many participate in pensions, almost all retirement strategies will involve some blending of investment in protected (or non-risky) assets (including Social Security and pensions) with investment in risky assets. So, the authors’ RISA process is really a process intended to help households and their financial advisors determine how best to invest assets that reside in their investment portfolios, not necessarily how to allocate their total assets. Because the authors ignore Social Security and perhaps pensions, we see this as a potential deficiency in their approach.
If a household has a Floor Portfolio funded status of say 75% of the present value of their Essential Expenses through their Social Security and pensions benefits, they have a mismatch of non-risky investments and essential expenses, and therefore they have a lifestyle funding risk. The following choices with respect funding the remaining 25% of their Floor Portfolio (assuming they are actually aware of their Floor Portfolio and interested in funding it) are available to them to manage this lifestyle funding risk. They can:
- Defer commencement of their Social Security benefits,
- Not take a lump sum present value of their lifetime pension benefits, if available,
- Use some of their investible assets to purchase one or more immediate or deferred income life annuities
- Invest some of their investible assets in low-risk bonds or cash,
- Take the lump sum present value of lifetime pension benefits and invest proceeds in low-risk investments, if available,
- Reduce their estimate of their Essential Expenses, or
- Some combinations of the actions above
The above available actions to fund the remainder of the household Floor Portfolio are generally shown in decreasing order of risk management effectiveness. For example, deferring commencement of Social Security (#1) is generally considered to be the best way to manage investment, longevity and inflation risks, while risk management effectiveness of taking the pension benefit in a lump sum and invest in low-risk investments (#5) will generally not be as effective. If the lump sum is invested in risky investments, this choice will increase investment and longevity risks relative to lower-numbered choices, but may reduce inflation risk. Simple lifetime income annuity products protect a household against longevity and investment risks, but involve commitment of significant funds. Other types of low-risk investments (like bonds) generally do not provide as much longevity risk protection but they involve lower levels of commitment and therefore generally more spending flexibility.
The action that is actually taken by our hypothetical household to fill in the remaining Floor Portfolio funding is a pretty good indication of their tolerance for risk and/or their preferences for or against annuity products.
Assessing Risks and Determining Tolerance for Risk Through Stress Testing
Many retirees don’t understand probabilities, but can relate well to worst-case type scenarios and actions that may be needed to avoid them in the future. Thus, stress testing one’s retirement plan can often be an effective way to communicate retirement risks and give households a better sense of their true tolerance for risk. This was discussed in Mr. James B. Sandidge’s paper, “Odds Are Retirees Don’t Care about the Odds” that we previously discussed in our post of January 29, 2021. Specifically, Mr. Sandidge said,
“Advisors should articulate how their retirement income strategy would have performed in a recent worst-case environment, emphasizing short- and long-term principal erosion”,
and
“Balancing [retiree] goals requires planning for the worst-case and actively managing risk and cash flow to adapt to the environment.”
Perhaps not all retirees want their plans to help them sleep well at night, but surely many of them do. Therefore, stress-testing can be an important step in measuring one’s true tolerance for risks. We included an example of investment risk stress testing in our post of January 29, 2021 and we discussed longevity stress testing (using longer Lifetime Planning Period assumptions) in our post of September 27, 2021.
Conclusion
Assessing and managing financial risks is an important part of retirement planning. We believe a robust household retirement planning process (like the one we recommend) should do this and more, including:
- Consider all household assets and all spending liabilities (Essential, Discretionary, Recurring and Non-Recurring)
- Enable retired households to properly price the cost of their expected future Essential Expenses vs. future Discretionary Expenses,
- Provide a straight-forward process to help households decide how much of their resources to allocate to the Upside and Floor Portfolios,
- Align household spending goals with total household assets, household tolerance for risk and other preferences,
- Be self-adjusting from year to year with respect to the amount the household can afford to spend (subject to possible smoothing),
- Enable households to stress test their assumptions about the future for the purpose of assessing their financial risks, and
- Enable households to properly manage their financial risks in a manner consistent with their household preferences and tolerance for risk, where possible.
