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.

24 comments:

  1. Dirk-
    I always enjoy your posts. I agree 100% with you that the Floor and upside model but have also come to the conclusion that if you can afford to adequately fund this model you don't really have a retirement income problem. In your example above, to fund $10,000 of expenses using an inflation indexed annuity would cost $285,716. This is a 3.5% withdrawal rate. Using TIPS would cost $247,588 which is a 4% payout. If I have enough money to fund that and still fund a $100,000 stock portfolio then I am really only looking at a SWR of 2.6% with the annuity and 2.89% on the TIPS ladder. Both of these rates are virtually guaranteed not to fail over the long term. I think that regardless of the funding method, the problem arises when the retiree tries to maximize their withdrawal to meet lifestyle needs by taking 4, 4.5 or 5% of their portfolio every year instead of 3 or 3.5%. The frugal thrifty retiree who saved enough over their lifetime won't have a problem because she has always lived below her means. The spendy retiree needs to take the maximum because he doesn't have enough to begin with.

    ReplyDelete
    Replies
    1. Mike, thanks for your kind words.

      This is a very-well thought out comment and I have to say that I mostly agree with all of it. However, I’d like to make a few additional comments.

      "I always enjoy your posts. I agree 100% with you that the Floor and upside model but have also come to the conclusion that if you can afford to adequately fund this model you don't really have a retirement income problem.”

      Floor-and-upside is quite expensive because you have to fund 30 years or so of retirement with low-yielding Treasuries. No strategy is cheap. Systematic withdrawals has inherent costs resulting from the need to hold large reserves. But, I disagree with your implication that it is intended for people who have a retirement income problem. Its purpose isn’t to fix a retirement income problem, but rather to prevent one.

      The only strategy that can “fix” a retirement income problem is systematic withdrawals, which has an equal probability of making it worse.

      "In your example above, to fund $10,000 of expenses using an inflation indexed annuity would cost $285,716. This is a 3.5% withdrawal rate. Using TIPS would cost $247,588 which is a 4% payout. If I have enough money to fund that and still fund a $100,000 stock portfolio then I am really only looking at a SWR of 2.6% with the annuity and 2.89% on the TIPS ladder. Both of these rates are virtually guaranteed not to fail over the long term."

      But only virtually.

      I personally don’t care how safe SWR might be with 2.6% withdrawals; it isn’t as safe as floor-and-upside. If I can secure income for the rest of my life AND have plenty of equity for upside income potential, why would I choose to risk any of my standard of living in the stock market? My risk tolerance and resources, of course, may be very different than yours. Otherwise, we’d probably just have one strategy.

      "I think that regardless of the funding method, the problem arises when the retiree tries to maximize their withdrawal to meet lifestyle needs by taking 4, 4.5 or 5% of their portfolio every year instead of 3 or 3.5%. The frugal thrifty retiree who saved enough over their lifetime won't have a problem because she has always lived below her means. The spendy retiree needs to take the maximum because he doesn't have enough to begin with.”

      Agree, except for the value judgment. I know many low-income, frugal people who aren’t able to save enough for retirement. They rarely spend, let alone overspend. But yes, 4-4.5% withdrawals is probably the upper limit of “adequately funded”.

      Excellent comment and thanks for reading!

      Delete
  2. Dirk-
    Another excellent post. I think some discussion (definition) of what "income" level should be 'floored' would enhance the applicability of this post for a wider audience. What I mean is that the floor could be designed for 'essential' expenses only or for 'total' expenses (essential + discretionary). Although you don't distinguish, there seems to be an inference to floor 'essential' expenses. I would personally agree with this approach. However a! Some retirees might not want to tolerate any income variability, making the approach not right for them. Would like to hear you/other's thoughts.

    ReplyDelete
    Replies
    1. Excellent point.

      I didn't intend to imply that a retiree should secure only non-discretionary expenses.

      Some retirees might want to do that to provide more upside potential in the stock portfolio. Some might do it because they can't afford to secure more than those essential expenses.

      I would secure my current standard of living, including the discretionary expenses, because I can. I recently recommended a client secure more than his current spending because he was underspending, given his savings.

      Ultimately, the floor you choose depends on what you can afford and how much standard of living you are willing to put at risk for the opportunity to improve it. I discussed this a year ago in a post entitled Your Retirement Savings: Will You Take the Bet?

      Thanks for reading and for taking the time to comment.

      Delete
  3. Dirk-
    I'd like to see some discussion in this series about variable withdrawal strategies. Didn't see it in your original list of four strategies, and think it's well worth it's own blog.

    ReplyDelete
    Replies
    1. Variable withdrawal strategies are systematic withdrawal strategies. The system used to calculate the withdrawals may change, but the basic characteristics of systematic withdrawal strategies do not. They provide an unpredictable, variable spending amount depending on market performance, they have the most upside spending potential of all strategies, and the worst downside. Longevity risk is greater than other strategies.

      Withdrawal systems do not provide a firm floor below which spending cannot drop. As William Bernstein is fond of saying, there is no risk fairy that will offer you market returns with no downside.

      All rational systematic withdrawal strategies are variable. I don't believe anyone says anymore that you need not lower you spending when your portfolio declines significantly. (Walter Updegrave at Money used to say that all the time, but he changed his tune after the last crash.)

      Wade Pfau wrote a recent piece on variable withdrawal strategies entitled How Much Can Clients Spend in Retirement? at Advisor Perspectives. Guess I can't leave a link here, so you'll need to Google it.

      Thanks for the comment!

      Delete
    2. hi Drik, not a blog reader but taken to this article. thanks for addressing variable withdrawal. but my question is what is this worst down side. is it refering to not keeping up with inflation? i would have thought this variable withdrawal have a lower longevity risk because the rules will keep more money

      Delete
    3. I don't think there is a downside to variable withdrawals based on remaining portfolio balance when compared to fixed withdrawals. I think dynamic withdrawals are better than either, though, and I'll be writing more on this in the next couple of weeks.

      Some might argue that the downside is that the amount you can spend with SWR-variable is unpredictable compared to fixed withdrawals, but if your portfolio declines in value and you keep spending the same fixed amount from it, you may be taking far more risk than the initial 95% success rate you think you have. If you have less money, you probably need to spend less.

      Thanks for writing! Hope you become a regular. Please check out my posts for the next few weeks for more explanation.

      Delete
  4. Dirk--
    I really appreciate your clear analyses. Thank you.

    I wonder whether or not it might be important to think about a possible ninth criteria for judging withdrawal strategies -- flexibility. For example, if the retiree experiences unexpected but necessary ongoing expense (medical treatment) that raises the needed "floor" the annuity strategy falls short. This example also illustrates how thinking that "if you can adequately fund a floor you don't really have an income problem" can be an error because the adequately funded floor that you thought to be in place suddenly needs to be a few stories higher. At any rate, given a potential need for flexibility building a floor with TIPS seems a wiser choice than floor by annuity...

    ReplyDelete
    Replies
    1. Thanks for writing, William.

      You make an excellent point, but I believe you are merging two or three different retirement plan issues.

      First, I wouldn't recommend that anyone pour all of their savings into an annuity or any other strategy without first mitigating other risks, any more than I would recommend a retiree take every penny of her savings to pay off her mortgage. We need some liquidity after we retire. We should set aside a significant amount of money in cash equivalents to cover emergencies. That addresses liquidity risk.

      Next, we need some sort of protection against major health crises and the possible need for long term care. That's difficult to do because LTC insurance doesn't work, but we need to account for the risk in a comprehensive retirement plan.

      Actually, I do believe that "if you can adequately fund a floor you don't really have an income problem". That doesn't mean, however, that you don't have a liquidity problem, a health care risk problem, an LTC risk problem, or any number of other risks that you need to address.

      Floor-and-upside addresses longevity risk and provides a predictable, secure income. You need other strategies in your retirement plan for other risks.

      It is also important to note, given a few comments on the topic, two different "income problems". If you don't have enough savings when you retire, you have an income problem. Floor-and-upside doesn't address underfunding retirement. It can only prevent an income problem developing after you retire.

      Thanks for reading!

      Delete
  5. Since the strategy already secure the floor, it might make sense to invest even more aggressively by long call option instead of stock.

    ReplyDelete
    Replies
    1. If you have a secure floor, you can certainly take more risk with your stock portfolio.

      Jason Scott recently wrote a paper along the lines of your comment entitled "The Floor-Leverage Rule". He suggests a 3x leveraged stock portfolio instead of long calls, but I have the same problem with both strategies.

      While it is unlikely that you will lose everything invested in a diversified stock portfolio, it is entirely possible to lose your entire investment in either a highly-leveraged portfolio or call options. Your diversified stock portfolio might recover some day, but if calls expire worthless or a leveraged portfolio fails after you retire, you are essentially out of the "upside potential" game forever.

      Thanks for writing!

      Delete
  6. This comment has been removed by the author.

    ReplyDelete
  7. thanks for these articles Dirk, they are very helpful.
    One thing I dont understand is about the return on TIPS. You say a 2% TIPS would pay out 4.46% (inflation adjusted). I would have thought 0% coupon would give a 3.3333% return (100 /30years) and so 2% coupon would therefore give a 5.3333% return. So my math is somehow very screwed up. Is there a formula for working this out?

    ReplyDelete
  8. sorry Dirk. please ignore my previous question. I googled bond yield formulas so I should be able to work it out from what has come up. Thanks again for all your helpful articles.

    ReplyDelete
    Replies
    1. Derek, please see my response below.

      Delete
    2. Derek, this question is asked often, so it is probably worthwhile to address it again.

      You don't need a bond formula, you need a present value formula because you will be spending both interest and principal. The percent of your initial portfolio value you can spend each year is the reciprocal of the present value of an annuity paying $1.02 a year for 30 years with a 2% discount rate.

      The value of that annuity is $22.42 and the reciprocal is 4.46%. That is the percent of initial portfolio (bond ladder) value you can spend each year to consume all interest and principal in exactly 30 years.

      As I recall, there is more explanation in the Sharpe and Scott paper, "A 4% Rule--At What Price?"

      It is easiest to see, I believe, with a spreadsheet. You can find one I posted at https://docs.google.com/spreadsheet/ccc?key=0AgL_ENYAvcvidGFNM2JRSzh6cF81M1NJdUI3V1RCQmc&usp=sharing. (Sorry, you will have to cut and paste the link.)

      I suspect your confusion results from the fact that you are also spending principal as each bond of the ladder matures. 4.46% is a payout amount, not an interest rate.

      Thanks for commenting!

      Delete
  9. This comment has been removed by the author.

    ReplyDelete
  10. The first link in this article does not work for me. I believe the correct link is:

    http://theretirementcafe.blogspot.com/2014/01/untangling-retirement-strategies.html

    ReplyDelete
    Replies
    1. Thank you! I repaired the broken link and, yes, you identified the correct one. Appreciate it!

      Delete
  11. Dirk,
    You don't mention one ancillary benefit of floor-and-upside. It makes management of the upside part of the portfolio much easier; as you don't have to be congnizant of a rebalancing requirement as between the risk components and the buffer components of a fully "probabalistic" based portfolio. You can populate the upside portfolio with a diverse set of high beta or high sharpe ratio asset classes - rebalance among them - but otherwise let it run.

    ReplyDelete
    Replies
    1. Correct. Or, said slightly differently, you can invest the upside portfolio more aggressively if you are not trying to optimize it for both spending stability and growth, as a SWR portfolio tries to do. These are conflicting goals.

      Delete
    2. I think these are slightly different but overlapping concepts. If you have a 60/40 SWR portfolio, you still might want to have the 60 part be as rationally aggressive as possible. Say with factor tilts, emerging markets, etc. But you are forced by the (risk dictated) asset allocation to sell off risky assets in a bull market to rebalance. In the upside only portfolio, you can just carry the momentum of a bull market as far as you choose. And maybe just rebalance among the risky asset classes.

      Delete
    3. I think they are vastly different concepts.

      With a floor-and-upside strategy, we allocate assets between a market-dependent upside portfolio and a market-independent floor portfolio consisting of Social Security benefits, annuities, innoculated TIPS bond ladders and the like.

      The upside portfolio allocates resources among capital market-dependent assets with hopefully low correlation to dampen portfolio volatility. Once you have decided on a 60/40 split, I believe you will find that it dominates a sub-allocation of the equity portfolio.

      Rebalancing is a separate issue and hopefully we don't do that often in a bull market.

      "Carrying the momentum of a bull market as far as you choose" implies market timing, a proven poor strategy. Besides, if your floor adequately covers your standard of living, there is little need to sell from the upside portfolio, period.

      Delete