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How to risk proof retirement

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It wasn’t too long ago that rules-of-thumb dominated retirement planning and retirement income management. “Save 10 percent of your pay;” “Don’t spend more than 4 percent of your assets each year;” and “Your fixed income allocation’s percentage should equal your age” are well-known examples.

Some of these adages have held up well and investors who followed them suffered no harm. But as the boomers and their money aged, advisors and academics began to generate research that brought additional rigor and insight to retirement planning and retirement income management. We also saw the emergence of competing approaches to retirement income planning, typically grouped as the drawdown or systematic withdrawal method, the bucket approach, and flooring (also known as the essential versus discretionary expense approach).

Michael J. Zwecher’s book, “Retirement Portfolios: Theory, Construction, and Management” (Wiley Finance, 2010), is an example of a book that links the academic underpinnings of retirement planning with the practical aspects of managing client portfolios. If you use the flooring approach or want to learn more about it, he builds a solid case for adopting that method and also advises on its implementation with clients.

At the risk of oversimplifying Zwecher’s position, he argues in favor of risk-proofing the income needed to provide a retiree’s lifestyle floor. The floor isn’t an approximate amount supported by expected returns, he stresses: “…flooring is defined here as guaranteed minimum payment, either nominal or real, for some specified amount of time. How much is included in a client’s floor? He defines this as “the minimum amount of funding required for the client to keep their lifestyle viable” regardless of what happens in the markets. The floor “isn’t necessarily what they want to spend to maintain a lifestyle; it is what they need to spend to maintain their lifestyle” (emphases added). The advisor’s job, he maintains, is to build the client’s guaranteed income floor while still offering potential upside, assuming the client’s finances allow for that secondary goal.

Proponents of the systematic withdrawal approach can argue that their simulation-tested portfolios meet clients’ essential income needs and provide growth potential. Zwecher cites several reasons behind his preference for flooring. First, sequence of returns risk—i.e., a series of significantly negative investment returns as the client retires—can deplete a portfolio much more rapidly than anticipated. Second, people tend to retire after a bull market run and near a market peak—not unlike the current environment—increasing the likelihood they’re about to encounter a bear market. Third, unexpected financial shocks can cause serious problems for a retirement income plan. Finally, drawdown plans’ success is sensitive to longevity. While it’s possible to reduce a client’s spending rate to offset this risk, the reduction might result in an unacceptably low income for the client.

After building the case for the flooring method, Zwecher draws on his experience in financial services to show how traditional accumulation portfolios can be adapted for retirement income without disrupting a client’s portfolio or the advisor’s business. He covers insurance solutions, both annuities and longevity products, but he also discusses investment strategies for flooring needs and discretionary wealth. The book spends some time on the academic theory behind flooring, but the heavy-duty material is reserved for an appendix. It’s not a fast read—I had to read the more technical sections several times—but it’s a very informative guide to an important retirement income planning method.