Tuesday, February 25, 2014


I like hybrids. We bought my wife a Prius and we love it, so I bought a second, larger hybrid that better accommodates my height on long trips. We buy gas, like, once an eon now.

My retirement strategy is a hybrid. I hope to get a lot of mileage out of it, too.

Over the course of my last several blogs about retirement income strategies, I alluded to the fact that a retiree can combine parts of the four basic retirement income strategies to create a “hybrid” strategy customized to his or her needs. The posts were meant to point out the strengths and weaknesses of each class of strategy and the basic tools that are available to build a custom retirement strategy.

In How Many Rungs, I noted that I personally use a floor-and-upside strategy, but only out to ten years. Beyond ten years, I use stocks or intermediate bond funds to fund the secure account. Yes, I expose myself to market risk with stocks or interest rate risk with intermediate bonds, but if I didn't do it this way I would be exposing myself to the poor risk-adjusted returns and volatility of long bonds and the very real risk that I won't live long enough to hold many of the rungs to maturity.

We have to choose our risks.

The volatility of long bonds doesn't matter if you can hold them to maturity, but I might not live 30 more years, or I might have a financial crisis that forces me to sell the long bonds after an interest rate increase. Either my heirs (in the first case) or I (in the latter) might then have to sell the long bonds at a loss.

Ten years of spending in a TIPS bond ladder gives stocks a long time to recover. As Wade Pfau recently demonstrated, bond ladders longer than about 15 to 20 years don't add much more safety, anyway.

More importantly, my finances are such that I could maintain my current standard of living even if my stock portfolio fails, which is the broader objective of floor-and-upside strategies and one I recommend to all retirees.

Mine is a hybrid strategy based on floor-and-upside, substituting the time-segmentation approach of considering the best asset for a given investment horizon for longer TIPS ladder rungs, and tossing in the systematic withdrawals tactic of portfolio mean-variance optimization. I add the latter by ensuring that my ultimate portfolio, to the extent possible, has a bond allocation consistent with my overall portfolio risk tolerance.

Assume I am comfortable with a 60% bond allocation, which will suffer in all likelihood a portfolio loss of no more than 15% in a bear market. If my floor-and-upside strategy resulted in a portfolio bond allocation greater than 60%, I would be concerned about limiting upside spending potential. If my bond allocation were smaller than 60%, I wouldn't sleep well during a rough bear market. So, after allocating the bonds I would need to generate my floor income, I would try to adjust my overall portfolio allocation to around 60% bonds and 40% equities.

My other overall concern is that I not risk my current standard of living in the stock market, which is why I start out with a floor-and-upside strategy.

This combination of three strategies best meets my personal requirements. Fortunately, I am able to meet all of these goals, though that won't always be the case. Sometimes you have to make trade-offs. Because our financial situations vary widely, these are probably not the right tradeoffs for you.

There are lots of ways to create hybrid strategies. You can substitute bond ladders for life annuities, for example, and vice versa. You can substitute intermediate bond funds for long term bonds, increasing interest rate risk a bit, but lowering the risk that you will need to sell long bonds at a loss after interest rates rise. You can shorten or lengthen the bond ladder.

Another way to create a hybrid strategy is to alter your strategy over time. Recent work by Pfau and Michael Kitces, for example, suggests that it might be wise to dramatically lower equity exposure in early retirement and increase it as you age. This is a principle you might be able to apply to systematic withdrawal, time-segmentation and floor-and-upside strategies.

You might also plan in advance to change strategies over time. For example, you might decide to implement a systematic withdrawal strategy early in retirement and switch to a floor-and-upside strategy at age 70 or so, or switch to a life annuity strategy at 70 when annuity rates hit their sweet spot. You might decide to use a longevity annuity to fund retirement after age 85.

In my next few posts, I'll talk about how, why and when you might want to change strategies, and even plan those changes in advance.

Friday, February 14, 2014

Build a Floor, Place a Bet

My past four posts, beginning with Unraveling Retirement Strategies: Systematic Withdrawals, have described the four major classes of strategies for funding your retirement:
  • Systematic withdrawals
  • Purchasing a life annuity
  • Floor-and-upside, and
  • Time-Segmentation.
I'll repeat the charts for potential spending with each strategy from my previous posts. Note which strategies have a “floor”, or downside limit for spending, and which don't.

Also, note that the spending lines move to the right on the charts until you run out of money for all strategies except life annuities. For life annuities, you never run out of money and the line moves to the right for as long as you live.

For floor-and-upside, when you run out of money and where the spending line ends is largely determined by your TIPS bond ladder implementation and to a lesser degree by the stock market. It is determined by the stock market and your spending rate for systematic withdrawals and time-segmentation strategies, which is another way of saying that systematic withdrawal and time-segmentation strategies have more longevity risk.

While there may seem to be a dizzying array of alternative strategies for you to choose from,  I view them all as combinations of these four classes of strategies, or “tweaks” of one of them. I also view the four strategies as lying within two axes that plot longevity risk against the possibility of increasing retirement standard of living if investments perform well.
At the top right is the systematic withdrawals strategy with maximum upside spending potential and maximum longevity risk. In fact, longevity risk mitigation is the mere reliance on what has happened in the stock market in the past.

At the bottom left is the strategy of purchasing a life annuity only. Life annuities provide the greatest longevity risk protection—you cannot outlive your money—but zero upside spending potential.

Nearest life annuities, but with a smidge more longevity risk and some upside spending potential, is the floor-and-upside strategy that can provide secure real income for decades. That's still more longevity risk than a life annuity unless you build a very long and inefficient ladder. Floor-and-upside, however, doesn't have the “premium forfeiture” problem of annuities. You always own and control your bond ladder investments.

Time-segmentation lies near systematic withdrawals, but perhaps with different upside spending potential, downside spending risk and longevity risk. That's because the cash and bond allocation for time-segmentation strategies is determined by spending assumptions while systematic withdrawal strategies base bond allocation on how much overall portfolio volatility a retiree can tolerate. The allocations, and therefore their risk-reward profiles, may be different.

Annuities and floor-and-upside guarantee a minimum amount of income throughout retirement. Systematic withdrawals and time-segmentation do not.

Most strategies in the gaps among these four could probably be achieved by combining strategies.

To a large extent, you can determine the best strategy for your household by understanding how much longevity risk you are willing to accept in exchange for increasing your chances of improving your standard of living if the stock market winds blow favorably throughout your retirement years.

Think of having two accounts to invest your retirement savings in: one account guarantees your future retirement income and the other is a bet on the stock market improving your standard of living over time.

The secure account includes Social Security retirement benefits and other pensions. To these, you can add retirement savings invested in bond ladders, life annuities, or both to provide secure lifetime income.

The bet account consists of stocks, bonds and other risky assets that might improve your standard of living in the future if those assets grow a lot, and might not. It is unlikely that you will ever lose all the money in the bet account if it is properly diversified and not leveraged, although markets have lost 90% of their value and more in the past.

Here's how the strategies use these accounts:
  • Life annuities put all of your savings into the secure account.
  • Systematic withdrawal strategies put all of your savings into the bet account.
  • Floor-and-upside strategies fund the secure account with enough capital to generate 30 years or so of safe retirement income before putting whatever then remains of your savings into the bet account.
  • Time-segmentation strategies fund five to ten years or so of spending in the secure account and then invest the remainder of your savings in the bet account.
The first step to selecting a retirement funding strategy is to figure out how much of your future you feel you need to secure and how much you're willing to bet that the stock market will improve your future standard of living. (I wrote about this in Your Retirement Income: Will You Take the Bet?)

The amount of your retirement savings may limit your choices. If your retirement is underfunded, you may not want to risk what little capital you have. You may not be able to afford ten years of desired secure income, let alone thirty. If you accumulated an 8-figure nest egg, on the other hand, you can probably afford to purchase secure income and take a lot of risk.

The size of your Social Security retirement benefit and any other pension you might have will also play a role in your choice. These are two sources of secure retirement income that might be large enough to enable you to bet more on stocks.

For workers retiring today, systematic withdrawals or time-segmentation will be the best strategy to have selected if we are on the verge of a long bull market. If the market performs badly, life annuities and floor-and-upside will turn out to have been the best choices.

(If only we knew.)

Since running out of money before we die is an outcome to be avoided at all costs, in my opinion, we are perhaps better served not by the strategy that will perform best if we guess correctly about future stock market returns, but by a strategy that takes the worst case scenario off the table. That would be purchasing a life annuity or implementing a floor-and-upside strategy.

Floor-and-upside has excellent protection against longevity risk and offers upside potential for our standard of living if we have saved enough to also fund the bet account. And, we maintain control of our capital.

Though floor-and-upside might not be the strategy that best fits your own finances, you'll only regret this choice if your neighbor bets everything on the stock market and is blessed with a raging bull market throughout retirement.

Monday, February 10, 2014

Unraveling Retirement Strategies: Time-Segmentation

If you've been following my posts on retirement funding strategies, beginning with Unraveling Retirement Strategies: Systematic Withdrawals, you know we have come down to the last of what I consider four major categories of strategies, time-segmentation, or as they are sometimes called, “bucket” strategies.

About a fourth of financial advisers prefer breaking down long retirements into more manageable time periods using a time-segmentation strategy. (Systematic withdrawal strategies are the most popular, though I'm not fond of them.) One benefit is that we can build a plan from multiple smaller plans, in 5-year segments perhaps, instead of a single 30-year financial plan.

Another benefit is the ability to manage our assets for various future time periods, or “buckets”, based on investment horizon, investing in the best asset class for how far into the future our goal is.

In his classic book, Stocks for the Long Run, Wharton professor Jeremy Siegel noted that stocks historically outperform bonds and cash about 65% of the time for one to three year periods, but about 99% of the time for 30-year periods. The table below was created using data from his book. If we are financing a bucket twenty or more years into the future, we are likely to see better results from stocks than from bonds.
Likewise, we are likely to see better results from bonds than cash if our investment horizon is greater than a couple of years or so.

Some have interpreted this data as proving that stocks are safer than bonds if held for twenty years or more, but this data doesn't show stocks are safe. It just shows that they usually provide a higher return than bonds when held a long time. Stocks are risky no matter how long you hold them.

In a retirement investment portfolio, the higher the volatility (risk) of the investment, the greater the chance that the retiree might have to sell that investment after a price decline. Over short periods of time, there is a greater probability of having to sell stocks at a loss than bonds, and bonds at a loss than cash.

Put these risks and returns together and cash appears to be a better investment for liabilities up to three years in the future and stocks appear to be the best bet for funding retirement years roughly 15 or more years into the future. Bonds seem to be best suited to the periods in between.

Time segmentation exploits these characteristics by recommending that we hold enough cash to pay our living expenses for a couple of years or so and then fund the next 8 to 10 years with bonds. Any remaining savings are invested in stocks.

Time-segmentation is a much less-granular approach to liability matching than floor-and-upside. Floor-and-upside matches each future year of liabilities individually, while time-segmentation matches buckets of years. It doesn't match resources to future liabilities so much as it matches asset classes to future liabilities.

Another important difference is that floor-and-upside demands that all years of retirement be financed with the safest possible investments, while time-segmentation would risk the most distant buckets with stock investments in the hope of generating higher returns. Both strategies would invest short term in cash and intermediate term in bonds.

Perhaps the biggest difference between time-segmentation and safe withdrawal strategies is that SW determines a stock/bond allocation using MPT portfolio allocation, optimizing portfolio return at the desired level of risk (volatility). In other words, SW recommends your portfolio allocation based on how much risk you believe you can tolerate.

Time-segmentation calculates the cash and bond allocation based on the amount of desired spending over the next 10 years or so of retirement and invests the remainder in stocks. The two allocations can be meaningfully different.

As an example, assume a retiree saves $500,000 and expects intermediate bonds to return 5% and cash 3%. With a SW strategy, he decides he could live with no more than a 25% portfolio loss in a bear market, so he allocates 60% of his portfolio to stocks and 40% to bonds.

With a time-segmentation strategy and 4% annual withdrawals, he would purchase bonds and cash to provide ten years of spending $10,000 a year. That allocation would be about $155,516 to cash and bonds (31%) and the remaining 69% to stocks.

Given these expected returns, bucket sizes and withdrawal rate, a time-segmentation portfolio will hold about 31% bonds. The same retiree might choose a larger or smaller portion of bonds for a SW portfolio depending on her risk tolerance, providing larger or smaller amounts of upside and downside risk.

The typical spending strategy for time-segmentation is the same percentage-of-remaining-balance method employed by systematic withdrawals. Some advisers, however, choose a desired income, instead. Also like systematic withdrawals, there is no secured floor of spending with time-segmentation and there is upside potential for the retiree's standard of living.

The spending range for a time-segmentation strategy will look similar to that of a systematic withdrawals strategy, but perhaps with more or less less upside and downside risk. The cash and bond allocations needed for time-segmentation may result in a larger or smaller stock allocation than systematic withdrawals would dictate, as described in the example above, resulting in a different expected portfolio risk-return than with SW. (Although this chart indicates less risk than the SW chart shown in my previous blog, in some cases there will be more.)
Time-segmentation strategies are more often advocated by financial planners than economists, who prefer a secure income floor.

Longevity risk management is not as powerful with time-segmentation as life annuities or floor-and-upside. It will be similar to systematic withdrawals, depending on the bond and cash allocation you end up with.

Moreover, studies have shown that the high levels of cash using this strategy are a significant drain on portfolio return, as are the transaction costs of constant selling of securities and bonds to re-balance the buckets.

Many authors tout the behavioral finance benefits of time-segmentation. They say that this approach focuses the retiree on smaller pieces of the larger 30-year funding problem and makes him regularly re-evaluate his finances. In my opinion, if you aren't going to regularly evaluate whatever strategy you choose, you just just buy a life annuity. It's as close to a set-and-forget strategy as you will find and has less potential to get you into trouble if you ignore it.

Cash management strategies are a form of time-segmentation that advocate holding several years of spending in cash, typically at least five. The theory is that having this cash will make a retiree more comfortable in a market crash because she knows she won't have to sell stocks at their bottom.

I don't know about other retirees, but that logic doesn't work for me. When the market tanked in late 2007 and went on to fall well over 50%, I never worried that I couldn't pay my bills for the next five years. I worried that I wouldn't be able to pay them for the 25 years after that. I drew little comfort from my cash on hand as I watched my portfolio fall 15%.

Who would find time-segmentation strategies attractive?

Retirees who want to manage their future liabilities with greater granularity than the systematic withdrawals “large pile of wealth” method might prefer time-segmentation, but I'm not sure it's a lot less work to maintain than floor-and-upside, which manages liabilities on an annual basis.

I like investing money I won't need for decades, as time-segmentation mandates, in stocks more than I like the long bonds of floor-and-upside after a minimum secure floor is established. I hate long bonds and small cap growth stocks. Their returns don't historically justify their risk.

Yes, this introduces sequence of return risk. Long bonds add risk, too. No strategy is perfect. We have to choose our risk (see TIPS and Risk).

Retirees with smaller portfolios may be able to invest more in stocks for greater upside potential with time-segmentation than with floor-and-upside. Time-segmentation strategies will require perhaps half the bond allocation of a floor-and-upside strategy, since the retiree will be funding maybe ten years with bonds compared to 30 years with bonds for floor-and-upside. On the other hand, that makes time-segmentation riskier.

Some retirees will like focusing on the next five years or so of their retirement instead of the bigger picture, but I prefer to start with the bigger picture and work my way down.

In my next post, Build a Floor, Place a Bet,  I'll summarize and compare the four major strategies for funding retirement.

Thursday, February 6, 2014

Unraveling Retirement Strategies: Floor-and-Upside

This original 2014 post was been updated in 2018. Please see Unraveling Retirement Strategies: Floor-and-Upside, instead.

Monday, February 3, 2014

Untangling Retirement Strategies: Life Annuities

In my previous blog post, Unraveling Retirement Strategies: Systematic Withdrawals, I set up a structure for comparing the various retirement funding strategies using eight criteria: primary advocates of the strategy, spending plan, investment strategy, liability-matching, longevity risk, spending floor and upside potential for standard of living.

In this post, I'll talk about the least favorite strategy among consumers for funding retirement, purchasing a life annuity. Ironically, this is the strategy most favored by economists for retirees who don't have a “bequest motive”, in other words, retirees who don't care if they have money left over after they die.

But consumers stay away from life annuities in droves, confusing economists to the point that they have dubbed the problem “the annuity puzzle”. A recent study entitled Optimal Annuitization with Stochastic Mortality Probabilities (try saying that three times real fast!), tries to solve the puzzle by suggesting what retirees know that economists don't that retirees may have health or other financial crises and need access to capital they might otherwise have used to purchase an annuity.


A life annuity is a contract with an insurance company to provide a set amount of annual (or monthly) income for as long as you live in exchange for a large payment in the case of a single premium immediate annuity, or years of smaller payments for a deferred annuity, up front. Unlike the other strategies I will describe, a life annuity is not something you invest in like a stock and it is not a loan, like a bond. It is an insurance policy that you purchase.

As with anything you purchase, the money you use to pay for it then belongs to the seller, the insurance company in this case. Depending on the options you might purchase, the insurance company has varying commitments to return any of that money even if you live only a short time after purchase and don't receive many payments.

Following is a diagram of potential spending from the life annuity strategy. It's a pretty boring chart except for one thing. The lines on the spending charts for other strategies move to the right until you run out of money. This one moves to the right for as long as you (and your spouse if it's a joint annuity) continue living. You never run out of money.
It is becoming typical for annuity contracts to return some of your purchase amount if you live ten years or less. Otherwise, the value of the contract is zero after the annuitant's death, or after the survivor's death if a joint annuity is purchased.

Purchasing a life annuity is the only one of the four major strategies in which the retiree loses control of his or her retirement savings. It is one of the two strategies that guarantee retirement income no matter how long you live and the only one to do that efficiently. You could, for example, set up a TIPS bond ladder that would secure income until you were 120 years old, but that would be a very inefficient use of your capital.

Insurance companies invest your money in bonds, so life annuities are not subject to stock market volatility. Life annuities create a secure floor of income. Because they are not invested in stocks, there is no upside opportunity to improve your standard of living.

Purchasing a life annuity does not provide liability matching. You have one source of consistent income from which to pay all future liabilities.

Some life annuities offer inflation protection at extra cost. Since your income is dependent upon the financial health of the insurance company, there is risk that company might not be able to meet its future commitments to make payments to you. However, this can be mitigated by only purchasing from highly rated insurers and by spreading your purchase across multiple insurers by buying multiple annuities. Furthermore, most states guarantee annuity policies against insurer failure up to $100,000 in many cases and up to $500,000 in New York.

AnnuityAdvantage.com provides a summary of state coverages and the National Organization of Life and Health Insurance Guaranty Associations provides detailed information for each state. If you really want to get into the details, read The Annuity Advisor by Kitces and Olsen.

The cost of a life annuity generally depends on the annuitant's age, prevailing interest rates and health. (Life annuities are like reverse life insurance policies. Poor health generally means better rates with an annuity because the insurance company bets you won't live as long.) A good, low-cost source for life annuities is Income Solutions, available through Vanguard Investments.

A life annuity for a 65-year old couple with 100% survivor benefits recently paid out 5% of the purchase amount annually, or 3.8% annually with inflation protection based on the Urban Consumer Price Index (CPI-U). Note that these are not rates of return, but payout amounts that include return of your capital.

I'm not a huge fan of life annuities, although I can think of some situations for which they are perfect. I would recommend a life annuity for a dependent who simply can't manage money. Someone with a substance-abuse problem, for example. They won't be able to spend it all as soon they get it. They will always have a source of income. You could do this with a trust, but that gets really complicated.

The authors of the paper referenced above conclude that hardly anyone should annuitize and that many should do the opposite of annuitizing buy life insurance. Still, some retirees will be attracted to the concept of never running out of money no matter how long they live.

Based on life annuity sales numbers, however, there aren't a lot of them.

In my next post I'll describe the “floor-and-upside” strategy.