Retirement planning is not for the passive

The most bitterly fought ideological skirmish in the investment world is that waged between advocates of active and passive investment management. But whatever view one takes on that controversial subject, active financial planning for and of retirement is an absolute necessity.

For many retirees, Social Security is their main source of income. For nearly everyone, Social Security income is very important. Accordingly, the decisions one makes and the strategies one uses with respect to Social Security benefits can have enormous impacts upon the benefits ultimately received (well into six figures in many cases).

For example, when both spouses work outside the home, each spouse will likely be eligible for Social Security benefits based on his or her own work record, for a spousal benefit based on a living spouse’s work record, and for a survivor benefit based on a deceased spouse’s record.

Divorcees can get something too, with some different rules, if the marriage lasted at least 10 years, but those with multiple marriages and/or young children who have received Social Security benefits need to watch out for a family maximum benefit based on one earner’s record. This example—only one among many—is more than enough to highlight why it is so crucial to get Social Security claiming and related decisions right. Doing so requires an activist approach.

Questions of when and whether to purchase guaranteed income (usually in the form of an annuity) also require great care. Economists generally argue that annuity solutions should be utilized far more often than they are (they call it the “annuity puzzle”), but the enormous numbers and variety of annuity products, many of which are simply not suited for most consumers, makes the choices really difficult. There rarely is a perfect solution, and the need for active management of the process by which one decides about guaranteed income cannot be minimized.

When retirement income is to be derived for an investment portfolio, the need for ongoing active management of that entire process is also critical. The so-called “4% rule”—a common rule of thumb among financial planners suggesting that annual retirement withdrawals of 4% of initial retirement portfolio value, adjusted for inflation, ought to survive a 30-year retirement 90-95% of the time—has long been the most common approach to retirement income planning among professionals.

But two financial crises since the turn of the century and the severe market corrections that came with each have scared retirees generally, and more recent retirement planning research (most prominently by Wade Pfau of the American College, among others) has demonstrated the risks and weaknesses of such an approach.

For example, by traditional thinking, a couple with $1 million in investment accounts that withdraws $40,000 annually from these accounts was said to expect clear sailing. But a couple retiring at the end of 1997 saw a very different set of outcomes than a couple taking the exact same approach beginning 10 years later.

A standard 60:40 portfolio returned roughly 18% in 1998 and nearly 14% in 1999, providing a good cushion for the losses that would follow, despite portfolio withdrawals. But a couple going through the exact same exercise in December 2007 endured a much rougher time. A 60:40 portfolio in 2008 lost over 22% before portfolio withdrawals.

Due to this “sequence risk” and just plain bad luck, the planning was the same in each case but the results were quite different. Losses in a portfolio being used for income early in retirement disproportionately impact the failure rates of such portfolios over a typical retirement time horizon.

Careful and ongoing active management of the taking of retirement income is thus mandatory. 

Traditional retirement planning doctrine has also suggested that, as retirees age, their exposure to equities ought generally to be reduced. But a recent and important paper from Pfau and Michael Kitces in the Journal of Financial Planning entitled “Reducing Retirement Risk with a Rising Equity Glide-Path” argues that on account of sequence risk, equity exposure should follow a U-shaped path—decreasing as retirement approaches, staying relatively low early in retirement and then gradually increasing as retirees age.