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Advice
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Wade Pfau on a Preview of the May 18 A4A Webinar at 4pm |
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Friday, May 18, 2012 06:20
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If the long-term average real return from the stock market is 7%, does that mean one can safely use a 7% withdrawal rate from a 100% stocks portfolio without worrying about running out of wealth or even dipping into the original principal? The answer is No. But answering yes is a common mistake; one which William Bengen set out to dispel.If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
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Stocks do not earn their average real return each year. Some years they go up, and some years they go down. For a retiree who is withdrawing from their savings, the sequence of returns matters. If the market value of one’s assets falls in the early retirement period, then withdrawals will dig a further hole. Climbing out of this hole becomes increasingly difficult even if a subsequent recovery arrives. This is the sequence of returns risk.
William Bengen’s seminal study in the October 1994 Journal of Financial Planning, “Determining Withdrawal Rates Using Historical Data,” helped usher in the modern area of retirement withdrawal rate research by codifying the importance of sequence of returns risk. The problem he set up is simple: a new retiree makes plans for withdrawing some inflation-adjusted amount from their savings at the end of each year for a 30-year retirement period. What is the highest withdrawal amount as a percentage of retirement date assets that with inflation adjustments will be sustainable for the full 30 years?
To answer this question, he obtained a copy of Ibbotson Associates’ Stocks, Bonds, Bills, and Inflation yearbook, which provides monthly data for a variety of U.S. asset classes and inflation since January 1926. He decided to investigate using the S&P 500 index to represent the stock market and intermediate-term government bonds to represent the bond market.
His exceedingly clever trick was to construct rolling 30-year periods from this data. He could consider a retirement lasting from 1926 through 1955, then 1927 through 1956, and so on. This technique is called ‘historical simulations.’ For each rolling historical period, he could calculate the maximum sustainable withdrawal rate. Though he did not produce the following illustration for his article, what he would have been looking at in his spreadsheet is something like this:
To bring greater realism to the discussion of safe withdrawal rates in retirement, he then focused his attention on what he called the SAFEMAX. It is simply the highest sustainable withdrawal rate for the worst-case retirement scenario in the historical period. With a 50/50 allocation for stocks and bonds, the SAFEMAX was 4.15%, and it occurred in 1966. That is the impact of sequence of returns risk. 4% turned out to be a much more realistic number than 7%. It was from these humble origins that the world of financial planning received the 4% rule.
[Note: I am following the same assumptions as in Mr. Bengen’s original research, except that I deduct withdrawals at the start of each year rather than the end of each year. I do think this is more realistic, and since it results in less time for assets to grow, withdrawal rates are slightly less with this assumption. My SAFEMAX is 4.04%.]
One other important issue coming out of William Bengen’s original study is asset allocation. In particular, Mr. Bengen recommended that retirees maintain a stock allocation of 50-75%. More specifically, he wrote, “I think it is appropriate to advise the client to accept a stock allocation as close to 75 percent as possible, and in no cases less than 50 percent.”
I will have a lot more to say about asset allocation (as well as about the 4% rule), and this stock allocation does sound rather high with respect to what we usually hear is reasonable for retirees. It is particularly poisonous to the ears of advocates of a safety-first retirement planning approach such as Zvi Bodie. But for now, let’s understand from where the 50-75% stock allocation recommendation comes.
One starting point to think about this is to consider Figure 2.2, which shows the time path of maximum sustainable withdrawal rates for different asset allocations. It’s hard to see exactly what is going on in the 1960s, but the general idea is that higher stock allocations tended to support higher withdrawal rates with little in the way of downside risk. I mean, the SAFEMAX does not appear to be that much lower with higher stock allocations.
This point can be seen more clearly in Figure 2.3, which shows the SAFEMAX across the range of stock allocations. Low stock allocations resulted in lower SAFEMAXs, with an all-bonds portfolio even falling below a 2.5% SAFEMAX, but there appears to be a sweet spot between about 35% stocks and 80% stocks in which higher stock allocations have no discernable impact on the SAFEMAX. A 4% withdrawal rate tended to work no matter what stock allocation is chosen in this range. On the downside, retirees would have been just as well off with 80% stocks as with 35% stocks.
So why then did William Bengen recommend 50-75% stocks? The answer lies in Figure 2.4, which shows the median remaining real wealth after 30 years as a multiple of retirement date wealth. In this figure, we can see a general upward trajectory in remaining wealth as the stock allocation increases. In the average case, retirees using at least 45% stocks would have found that their entire initial principal had remained intact, even after adjusting with inflation! And with higher stock allocations, wealth tended to continue to grow more and more in the average case. So while Figure 2.3 showed that there was little in the way of downside with higher stock allocations, Figure 2.4 shows that there was a whole lot of upside available with higher stock allocations. This is the source of Mr. Bengen’s recommendation.
Finally, one other way to look at this is found in Figure 2.5. For different stock allocations, I plot not only the SAFEMAX, but also the median sustainable withdrawal rate and the best-case scenario sustainable withdrawal rate. This is another way to see the same point: with higher stock allocations, sustainable withdrawal rates tended to rise, but even the worst-case scenario held their ground even with a more volatile stock allocation.
Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan, and the curriculum director for the Retirement Management AnalystSM designation program. He maintains a blog about retirement planning research at
wpfau.blogspot.com
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Wade Pfau On Why Economists See an Annuity Puzzle |
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Monday, May 14, 2012 03:54
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Economists are known for describing the annuity puzzle. The puzzle is: why do people not purchase income annuities (exchange a lump sum payment for a guaranteed lifetime income stream) to the extent predicted by economic theory? If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
A number of explanations have been offered. Today I will not get too much into the explanations for the puzzle. Instead, I want to focus carefully on the theory behind why the “annuity puzzle” is said to exist in the first place.
Economists describe the annuity puzzle as a problem of maximizing lifetime expected utility. “Utility” can be off-putting, and I am not going to show any mathematical equations. I will focus on the intuition, and what is essential here is getting a good definition for the value provided by spending. Rather than looking directly at the level of spending, economists look at the value it provides, noting that additional spending provides diminishing increases in value. I reviewed these concepts in “Spending Amounts vs. Spending Value.”
For the basic model, one assumption is that people don’t care about leaving bequests (one explanation for the annuity puzzle, then, is that people don’t like to annuitize all of their assets because they want a chance to bequeath something). This means, they don’t mind exchanging all of their wealth at retirement for a guaranteed income stream for life.
For the basic model as well, there is no investment risk. Financial markets are simplified to one asset which always and forever provides the same return. This return is fixed. For non-annuitized assets, your portfolio of remaining wealth earns this fixed return each year. The annuity provider can also earn this return, and so the annuity payout rate incorporates this return as well as the return of principal.
Of course the assumption of a fixed return is not realistic. But the purpose of building models is to simplify reality in ways that still allow us to make some sense out of reality. By using this simplified assumption about asset returns, we can narrow in on the implications of having an uncertain lifespan.
The annuity provider also provides mortality credits. This gets to the heart of the uncertainty in the model. The uncertainty is longevity risk. The retiree doesn’t know their age of death. However, this is a known unknown, in the words of Donald Rumsfeld. That is, retirees and the annuity provider both know the probability distribution for the age of death, and the probability of survival to each subsequent age past 65. Individuals can’t self-insure to protect from this longevity risk. If they don’t annuitize, they have no chance but to plan for a long lifespan. On the other hand, the annuity provider can pool longevity risk across a large population of customers, and those who die earlier than average subsidize later payments to those who live longer than average. Because the annuity provider can pool the longevity risk, they are able to make payments at a rate much closer to what would be possible when planning for remaining life expectancy, rather than planning for a much longer horizon. Annuities should not be thought of so much as an investment, but rather as insurance to protect against running out of wealth while still alive.
I will assume retirement date wealth of $100. This amount doesn’t impact the results. I assume a male retiree at 65 and use the Social Security Administration 2007 Period Life Tables to obtain survival rates past this age. These survival rates for males can be seen in the following figure. Results will differ by age, gender, and mortality data source, but the basic principles will remain the same. I assume a maximum possible retirement length of 35 years, so no retirees live past 100. This doesn’t have much effect, since the probability of a 65 year old male living past 100 is less than 1%.
At retirement, retirees choose their annual spending amounts for ages 65-100. Since they know the future investment returns, this is easy to do. They don’t know how long they will live, but they can decide on how much they will spend each year should they still be alive. There are 4 factors which impact the decisions about the future spending path:
1. Survival probabilities: Since the probability of survival decreases over time, retirees have an incentive to increase spending early in retirement relative to late in retirement. Earlier spending is more likely to actually happen and so it receives a larger weighting in the function that adds up the lifetime value of spending. Higher survival probabilities will reduce annuity payout rates and help push more spending from early to later retirement.
2. The investment return: A higher investment return supports a higher annuity payout rate. As well, knowing that your remaining portfolio will grow at a faster rate allows you to spend at a higher rate earlier in retirement, and also pushes you to delay spending to later in order to leave more wealth in your portfolio to grow at the higher rate and allow for more lifetime spending.
3. The retiree’s impatience: A factor which also impacts retirees separate from survival probabilities is how impatient they are to spend. If the discounting to future spending caused by impatience is greater than the future investment return, then retirees have a strong incentive to shift spending to earlier in retirement. Likewise, more patient retirees who can get a larger return than the discounting from their impatience are willing to delay spending so that their wealth can grow more and they can spend more later on.
4. Risk aversion: This is the technical name for a key parameter in the utility function. It describes the shape of the curve which defines the value of spending. Lower numbers imply a less steep curve so that retirees do get more value from spending and have a greater willingness to increase spending at the expense of future reductions. Higher numbers imply that retirees really get hurt by less spending and this overwhelms the additional gains from more spending early on. In the context of retirement and in describing spending in terms of value, I think we should rename risk aversion as spending flexibility. A small number means the retiree is flexible! They can let their spending fluctuate more as the interaction of the other 3 factors warrants. A larger number provides a stronger push toward consumption smoothing, as retirees care less about upside and really wish to maintain as high of spending as possible in worst-case scenarios.
The Results
In order to keep this short, I think we can see lots of interesting results by focusing on just one scenario. I will consider the case that investment returns are zero, and the discounting factor for impatience is also zero.
With a real return of zero, the annuity payout rate based on an actuarially fair annuity with this mortality data is 5.66%. That is, the $100 of wealth is used to purchase an annuity at retirement for the 65 year old male, the guaranteed income stream each year for life is $5.66. That happens by pooling the mortality risk across the population.
Meanwhile, for someone who doesn’t buy an annuity, they have to plan for a potential lifespan of 35 years. With a zero return on assets, to smooth consumption across their potential lifetime, they could spend 100/35 = $2.86 each year. Much less than an annuity, but that is because the planning horizon has to be longer to protect against the low probability event of living a long, long time.
Now we get into the really interesting part. Something I’ve been trying to get a dialogue going about is whether the general population is aware of one of the key insights coming from lifecycle finance economic models. That is, you should intentionally plan to decrease spending as you age to account for the lower probability of living to each subsequent age. But how much should you plan to reduce your spending? That depends on your spending flexibility / risk aversion.
There are now two competing tradeoffs: you want to spend the same amount every year for as long as you live to get the most lifetime value from your spending, but you also want to frontload your spending to early retirement when you have the highest chance for survival. Again, I’m assuming a case where investment returns and impatience are both zero and both cancel each other out.
The following figure shows the optimal spending path, both for the case with annuitization and for different degrees of spending flexibility for the case when the retiree does not annuitize. This figure shows why economists see an annuity puzzle: why not annuitize since it provides a higher lifetime spending path? But beyond this, we can also see how people optimize without annuities. I need to rename something here, because low values imply greater flexibility rather than high values. Someone with flexibility of 1 is quite willing to let their spending decrease over time to reflect the low probability of survival as they age. Spending starts at the same amount as the annuity but declines to very low levels by one’s late 90s. With flexibility of 2, more effort is made toward keeping a smooth level at $2.86. But again, it is still optimal to front load spending. You can also see for coefficients of 5 and 10 how we obtain greater smoothing even in the face of the decreasing survival probabilities. How much lower would you let your spending fall in your 90s to allow more spending in your 60s? It’s an important and highly personal question! Personally, I’m sort of attracted to the pattern coming with flexibility=5.
One final part of the puzzle is that economists like to note the “annuity equivalent wealth.” That is, how much additional wealth would you need in order to obtain the same expected lifetime value of your spending when you don’t annuitize as when you do annuitize? Clearly, the value of spending is higher with the annuity since it allows greater spending at all ages. I calculate that with flexibility=1, the retiree needs 53% more wealth to be just as satisfied as with an annuity. The corresponding numbers increase up to the flexibility=10 case, where 90% more wealth is needed to be just as happy. That is a key part of the annuity puzzle: with flexibility of 10, you would need 90% more wealth to have the same utility from not annuitizing as from annuitizing. So why not annuitize?
Well, there are many explanations, and I will revisit those at a later date. Or alternatively, here is your homework assignment, class: List potential explanations in the comments for why the “puzzle” may not really be as puzzling as I just made it sound.
Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan, and the curriculum director for the Retirement Management AnalystSM designation program. He maintains a blog about retirement planning research at
wpfau.blogspot.com
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There's A Growing Gap Of Opportunity As The Boomer Population Ages |
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Wednesday, May 09, 2012 16:20
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Tags: Boomers | life planning | retirement
As the age-denying Baby Boomer generation grows older, it may need your help to face reality. The growing gap between the Boomer and Echo-boom generations is highlighting the fact that Boomers’ reticence to deal with the challenges of aging is becoming a burden on younger generations. If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
People across the globe are having fewer children. That means there will be fewer people to fill the jobs Boomers vacate as they retire. Global median age is expected to rise from 29 years old in 2010 to 39 by 2050.
Real life examples are already pointing to some of the demographic issues. As more and more people live beyond age 100, their children begin to face their own aging issues. A 107-year-old may have children in their 80s who are unable to care for them because of their own care needs. The fact that most Americans only have about $25,000 in retirement savings doesn’t make the picture any brighter.
These predictions point to a demographic reality, yet they seem to ignore the fact that the Echo-boom generation is as large in number as the Boomer generation. Although these problems are real and need to be addressed in a timely, one of the biggest gaps seems to be that an industrious younger generation is on the rise and may add unexpected relief. Still, relief relative to the oldest Boomers may not be timely.
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Becoming An Expert On Medicare Legislation And Benefits Could Be Your Next Business Growth Tool |
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Tuesday, May 08, 2012 12:50
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Tags: healthcare | investing | retirement planning
Retirees may be in for a surprise when they discover that Medicare will only pay for 51% of their health care expense instead of the 68% they guessed on a recent survey.
Over half of retirees say their biggest worry about retirement is having enough to pay for health care, yet it is a worry they rarely talk about with their financial advisors. Developing a strategic health care back-up plan for your clients might be an excellent way to position your business for its next phase of strong growth. If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
Getting up to speed on Medicare reforms can be to your advantage, especially in light of the possible 30% cut to doctors’ reimbursements unless Congress extends current laws. It’s yet another aspect of retirement planning that you can help your clients manage.
The first Baby Boomers turned 65 January 1 of 2011. Another 10,000 Boomers will reach that minimum Medicare benefits age every day for the next 20 years. That means there’s already a significant Medicare and health care market that you could be developing. Educating yourself now, before the legislation happens late this year or early next will position you well either way the legislation goes. |
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A Practical, Low-Cost Approach To Helping Couples Resolve Conflicts Over Money And For Working With Clients Whose Behavior Does Not Match Their Goals |
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Monday, May 07, 2012 23:19
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Tags: client communications | financial planning | hehavioral finance | investor behavior | life planning With many life-planning programs providing training to advisors to help them advise clients on the “soft side” of money, here’s a a simple but effective low-cost methdology for helping couples resolve conflicts over money and for coping with clients whose behavior is inconsistent with achieving their goals.
There is no extended training program associated with this technique and there is no certification process connected to it. It is not a proprietary program and it’s open to anyone who feels comfortable using it. If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
 It’s a physical card sort, a different process than a long interview or questionnaire. The approach was developed in connection with the Money and Family Life Project at the Ackerman Institute For The Family.
The cards come with a book entitled, Money and Meaning, by Judith Peck. The book comes with two sets of “Values Card” and the instructions for their use. You can find the cards online for free, but you’ll want to read Peck’s book to learn how to use them in your work with clients.
One deck of cards represents content values and the other deck represents process values. Clients sort both sets of cards into an order reflective of their value priorities, facilitating what can otherwise be a difficult conversation.
This methodology was developed by a consortium of financial planners and therapists, not by any one individual or group. I know many wealth managers who have found this methology of great value, but whether you use it would really depend on how comfortable you are tackling these issues with clients.
Please let me know how if you have questions about using the cards or helping clients with these issues.
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