- Systematic withdrawals
- Purchasing a life annuity
- Floor-and-upside, and
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 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 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.