Retirement-income theories confront reality

I spent part of my post-Labor Day week at the beach catching up on my professional reading. I knocked off eight issues of the Journal of Financial Planning and scored eight hours of continuing education credits by taking the online quizzes available for each issue.

There is something very satisfying about being able to devote long stretches of time to reviewing the latest research, analysis and opinions — particularly when accompanied by a cool beverage on a hot day. Bonus points for the sound of breaking waves in the background. What struck me the most is how financial planning continues to be more art than science, particularly when it comes to retirement-income distributions.

More than two decades ago, William Bengen developed the 4% rule, which evolved into the holy grail of safe initial withdrawal rates for retirees — until persistent low interest rates called even that conservative rule of thumb into question.

Mr. Bengen’s model suggested that if retirees restricted their initial withdrawal to 4% of their nest egg during the first year of retirement and adjusted the dollar amount of those withdrawals for inflation each year, savings should last 30 years, assuming historic averages for a balanced portfolio.

“Most models assume the retiree makes all spending and investment decisions only at retirement and then follows the strategy, without adjustment, until death,” David Blanchett, head of retirement research at Morningstar, pointed out in his article in April 2017 issue of the Journal of Financial Planning. “In reality, a retiree whose portfolio is headed toward ruin would likely reduced withdrawals in an attempt to prolong its sustainability,” Mr. Blanchett wrote.

Wade Pfau, a professor of retirement income at The American College and a principal at McLean Asset Management, explored two competing philosophies about building a retirement-income plan: Whether retirees should place their trust in the risks and rewards of a stock portfolio or the contractual guarantee of income annuities.

In the February 2017 issue of the FPA Journal, Mr. Pfau concluded: “For risk-adverse retirees, risk pooling funded retirement spending goals more cheaply and with contractual guarantees which in turn allows for greater true liquidity for non-annuitized investment assets.” In contrast, “The main advantage for the investment-only risk premium strategy was it allowed for a larger legacy should the retiree die early.”

What’s the take away? “These trade-offs suggest that greater care should be taken by advisers and retirees when considering how a client’s risk aversion and desires for legacy impact the relative advantages of risk pooling and the risk-premium strategies to fund retirement spending goals,” Mr. Pfau wrote.

Jonathan Guyton, a principal of Cornerstone Wealth Advisors Inc., tackled the concept of dividing retirement spending into “essential” and “discretionary” categories, using guaranteed sources of income, such as Social Security, pensions and perhaps an income annuity to cover ongoing living expenses and earmarking remaining financial assets for discretionary expenses.

“The essential-versus-discretionary strategy would work flawlessly if people where spreadsheets and not human beings,” Mr. Guyton pointed out in the April 2017 issue of the Journal of Financial Planning. “But whatever they’re called, one of the most important things our retired clients have taught me is that far more of their expenses when retirement begins fit the ‘discretionary’ definition than I initially realized.”

Contrary to retirement-income theories based on maintaining the same level of spending throughout retirement, actual spending may be higher initially during the “go-go” years and diminish as clients enter their “slow-go” and “no-go” years, with the possibility of a spike in health-care costs near the end of life. Assuming the same level of spending throughout a 30-year retirement could result in overly conservative annual withdrawals, denying clients from enjoying some of the fruits of a well-deserved retirement.

Matt Fellowes, founder of the newly launched United Income robo-adviser, believes he has the answer: big data.

“With technology and data today, we can do a much better job managing money,” Mr. Fellowes told me in an interview. “We can replace generic assumptions with personalized information.”

Deploying huge data sets on investment performance, retiree spending, longevity and other crucial factors to simulate millions of outcomes, the United Income software estimates the chances that each client’s personalized retirement strategy will actually succeed, then refines the plan if it won’t. Its retirement paycheck feature aggregates a client’s varied income sources into a monthly disbursement and reviews the appropriate amount every six months.

Rather than fear the entry of new robo-adviser into the retirement-income space, advisers might take a fresh look at how United Income earmarks separate investment strategies to fund specific retirement spending goals such as a dream cruise, a grandchild’s college fund or potential long-term care expenses. “It beats hands down other retirement-income solutions that treat retirement liability as a lump sum with a single investment strategy,” Mr. Fellowes said.

Technology may improve retirement-income projections, but it will never replace the human touch of an adviser who listens to a client’s hopes and fears and constructs a plan to address both.

(Questions about new Social Security rules? Find the answers in my new ebook.)

Mary Beth Franklin is a contributing editor to InvestmentNews and a certified financial planner.

Related Topics: Retirement Income