Balancing Retirement Risks

How much should a new retiree spend each year? This is a simple question with no simple answers. One approach is to start with a retiree’s wealth and work backward to a safe withdrawal rate. If you have $2 million in assets, estimate a safe withdrawal rate that worked in most historical periods (say 4% inflation-adjusted) and withdraw a fixed percentage (starting at $80,000) of assets each year. It is easy to run very impressive looking Monte Carlo analyses using historical asset return data to show that retirees will most likely avoid running out of money before they die. Especially if they invest a healthy share in equities.

This approach is what William Sharpe, finance professor at Stanford University, calls “financial planning in fantasyland.” The fantasy is that the simulations we conduct using these data can provide a useful estimate of retirement income sustainability. He isn’t alone. Zvi Bodie, finance professor at Boston University, has criticized the belief that equities are less risky when held for a long period of time. My own analyses of safe withdrawal rates, in the July issue of Research magazine, show that a sustained period of low real asset yields would decimate a traditional safe withdrawal strategy. In a series of articles using asset return data from Europe and Asian markets, professor Wade Pfau estimates safe withdrawal rates of only 2-3%.

So if a 4% strategy isn’t always safe, what is? If advisors aim downward, they run the risk that the client will spend too little and die with too much of their wealth unspent. Boston University economics professor Laurence Kotlikoff has criticized the traditionally low safe withdrawal strategy as self-serving because it favors asset preservation at the expense of a comfortable retirement. If advisors are compensated based on the amount of assets managed, they have no incentive to encourage higher levels of spending. They also avoid the psychic cost and liability of guiding a retiree toward poverty.

It would seem to most advisors that academics enjoy criticizing commonly used strategies but can’t agree on a better solution. While academics disagree about assumptions and methods, most would agree that focusing solely on a single safe withdrawal rate doesn’t make much sense. Economists assume that the ultimate goal is to maximize happiness in retirement. They see retirement as a game where the objective is to get as much enjoyment out of the money we have while dealing with uncertainty about longevity and asset returns. A happiness-based retirement income plan wouldn’t begin by focusing solely on assets. It would focus on what we spend.

Douglas Bernheim of Stanford and his co-authors in 2001 found that rich retirees really didn’t spend that much more as a percentage of their pre-retirement income than less wealthy retirees. The primary difference between wealthy and less wealthy retirees is that the rich die with a lot more money—even if they don’t have a particularly strong desire to leave an inheritance. This is surprising to most economists, who assume that the reason people accumulate money is to spend it. Data from the Consumer Expenditure Survey collected by the Labor Department show that wealthy retirees only spend a lower share of their income on categories such as food and clothing, but do spend significantly more on discretionary expenses like vacations and gifts.

One way to think of retirement income is as a continuum of spending that begins with what we would consider essentials (food, insurance, basic health expenses, shelter), moves up to semi-discretionary expenses (clothing, eating out, basic transportation, cable subscription) and then to discretionary expenses (vacations, gifts, hobbies). We’d all agree that the discretionary expenses are what make life worth living during retirement. But we won’t enjoy them much if we can’t eat.

Acceptance of investment risk means that returns could be higher or lower than safe investments. Translated into spending, a riskier portfolio means that we could have more money to spend on vacations and eating out. But we could also be forced to cut back if our portfolio takes a turn for the worse. That uncertainty is the essence of Bodie’s argument against traditional retirement portfolios that place a good portion of a retiree’s wealth in equities. If equities perform as they have in the past then you’ll be fine. If they don’t, then a retiree may have to cut back on the basic spending that is crucial to happiness.