The following post originally appeared on Advisor Perspectives, a blog for financial planners, in April 2015.
Perhaps no other retirement finance concept has gotten more ink than the "probability of ruin", which is interesting because few other economic concepts model the real world as poorly. The gist is that a retiree who spends a constant dollar amount throughout retirement is exposed to the risk of outliving her savings. The problem with the economic model is that no one would actually do that.
A constant-dollar spending assumption served us well when William Bengen formalized the notion of path dependence, but it seems that even he didn't anticipate that planners might implement the strategy by rote. In Conserving Client Portfolios During Retirement, Bengen states, ". . . the adviser should examine the projected current withdrawal rate through the entire time horizon of the clients, not just the first year of retirement." He even put it in italics.
Probability of ruin is largely an artifact of those constant-dollar SWR studies.
(Note: You can hover over yellow terms.)
Once constant-dollar SWR escaped the lab, though, the mainstream press and popular retirement newsletters latched onto the belief that constant-dollar spending was OK. These same publications softened their stances quite a bit after retirements were destroyed in the Great Recession, but I recently received a Kiplinger retirement newsletter still espousing the constant-dollar strategy.
Nearly all retirement income strategies avoid the probability of ruin issue in theory by spreading spending thinner and thinner as savings decline – a rational rationing strategy. Annual Recalculated Virtual Annuity (ARVA download PDF), RMD, Milevsky's formula for sustainable withdrawals without simulation, and the 3D dynamic updating strategy (download PDF) of Frank, Mitchell and Blanchett all spread spending over remaining life expectancy. Constant-percentage SWR doesn't, but won't deplete a portfolio in theory, either.
Unfortunately, these strategies reduce the probability of ruin by reducing spending, our "standard of living."
Life annuities are different because they augment their payouts with a mortality premium and both guarantee a standard of living and provide longevity protection.
I was rereading a study recently about evaluating retirement
strategies and noticed the author suggested that retiree's want an
income strategy that guarantees they will not outlive their savings.
While this is no doubt true, what we really want is an income strategy
that guarantees we won't lose our standard of living. That's a bigger ask than avoiding ruin. A strategy that
ignores standard of living but guarantees the retiree won't go broke is easy to develop, though perhaps not very useful.
Probability of ruin analyses are not good models of rational human behavior. Michael Kitces has often argued that no one actually implements a constant-dollar SWR strategy. If a retiree's portfolio grows significantly after retirement, any rational person would begin to spend a bit more and surely the reverse is true. What rational person would lose a large portion of their savings and believe they wouldn't need to spend less?
Wade Pfau says it a little differently: constant-dollar SWR is a research technique, not a retirement strategy.
Following this line of reasoning to its logical end, I have calculated the true probability of ruin resulting from consistent overspending with sequence of returns risk for nearly all retirees under nearly all economic conditions.
That's the probability I estimate that an actual retiree will just keep spending the same amount every year as she faces clear prospects of ruin. She will, instead, reduce spending and face the prospects of a diminished standard of living. This is a more rational model and the risk that we should be discussing. The probability of a reduced standard of living is more difficult to quantify than probability of ruin with constant-dollar spending, which is why we use the latter in the first place, but ease of calculation doesn't make it a useful metric.
I have given this question a great deal of thought relative to my own
retirement finances and I cannot imagine the impact of outliving my
savings, nor can I assign a probability of doing so that I would
consider "acceptable." I can say that my number is far closer to zero
than to 5%.
A small probability of a catastrophic outcome is not something that most of us can internalize. We only know that we want to avoid it.
Probability of ruin is a useful research technique that can allow us to compare the relevant benefit of two strategies, but translating that to real-life benefit isn't straightforward. The concept can rarely be communicated with a retiree, unless that retiree has an unusually strong understanding of probabilities, and even then an acceptable probability for losing one's savings late in life is just too big an ask.
I wonder if it's time to retire the probability of ruin, or at least drive it back into the lab. It's not clear to me that we are helping retirees by focusing on it.
Michael Kitces has posted two outstanding columns (more, actually) on Social Security benefits at his blog, Nerd's Eye View. The first, Valuing Social Security Benefits As An Asset On The Household Balance Sheet, was posted April 8, 2015. This led me to a 2014 post, How Delaying Social Security Can Be The Best Long-Term Investment Or Annuity Money Can Buy. I highly recommend them, and Nerd's Eye View, in general.