Friday, January 26, 2018

Unraveling Retirement Strategies: Floor-and-Upside (An Update)

When a reader recently quoted me from a four-year-old post, I realized I needed to update a few of them. I've learned some things in the past few years and, like many of us who research retirement finance, my thinking has "evolved."

(My wife would undoubtedly question both claims, but I refer specifically to retirement finance matters at present.)

Sometimes reading an old post is like seeing a photo of yourself from 1975 with mutton chop sideburns a la Neil Young and saying out loud, "What was I thinking?"

One such post is Unraveling Retirement Strategies: Floor-and-Upside[1], from February 6, 2014. I've made a few changes to reflect my updated perspective and to incorporate some of the excellent reader comments that post attracted. Specifically, I've become more enamored with annuitites and less with TIPS ladders.

The floor-and-upside strategy for financing retirement is sometimes referred to as “safety first” and derives from The Theory of Life-Cycle Saving and Investing[1].

The basic idea behind floor-and-upside is that a retiree devotes some of her retirement funding assets to building a lifetime stream of income and the remainder to an investment portfolio to provide liquidity and the possibility of increasing wealth over time.

It's important to note that growth of the upside portfolio isn't guaranteed and, in fact, the "upside" investment portfolio may shrink over time or even be depleted prematurely (an "upside portfolio" also has downside). The "floor" is a safety net that will provide income should the upside portfolio fail. The rest of your retirement plan should ensure that having to live off the floor income alone is very unlikely.

Assets suitable for constructing the floor portfolio include Social Security retirement benefits, life-contingent annuities, and pensions. A TIPS bond ladder is not guaranteed to last a lifetime but it is conceivable that one could be built for 35 years, for instance, that would be highly likely to outlast a joint lifetime. Whether or not the cost of the ladder would be acceptable is another matter.

You could build a really simple floor-and-upside strategy by using part of your retirement savings to buy a life annuity to guarantee a certain amount of income for as long as you live and then investing whatever is left of your savings in an S&P 500 index fund.

In fact, since most Americans are eligible for Social Security retirement benefits, most Americans have a "floor." Those who also have some savings to invest in retirement, therefore, have a floor-and-upside strategy. Social Security benefits alone, however, may not provide as much floor as desired.

Deciding how much floor income you should build into your plan is sometimes easy. I've had clients say, "I don't care about upside potential, I'm not as impressed with my husband's investing skills as he is. I just want a check in the same amount monthly for as long as I live." This is a person who wants nothing but floor.

I also have had clients and readers say, "I believe in my investing skills and that the market will always eventually go up throughout my lifetime." Since some suggest that they should invest their Social Security benefits, too, I assume there is a group of retirees who want no floor at all.

In between these extremes, the decision can be more difficult. The best I can recommend is that you imagine that you are 85 and your upside portfolio balance just went to zero, a victim of sequence of returns risk. What is the least amount of income you could have remaining that would not make your life an economic misery? This is the floor level you wish to have.

The next question, of course, is whether you can afford that much floor and your level of wealth may or may not dictate that you choose a lower level. Interest rates are historically low at present so floors are expensive.

(A reader once commented that anyone who can afford a floor doesn't need one. Not true. Everyone can afford some level of floor even if it consists only of Social Security benefits. No one suggests that your floor cover 100% of what you hope to spend in retirement. That would indeed be expensive. Floor income should cover food, housing, clothing, and the like, but not the annual European vacations you planned before your upside portfolio confirmed your wife's suspicions about your investing skills.)

Here's an example. Let's say you want to spend $60,000 annually in retirement and your household expects $30,000 from Social Security retirement benefits. Non-discretionary spending totals $48,000 of the $60,000 total. (The floor doesn't have to be your non-discretionary expenses, it can be whatever makes you comfortable, but that's a reasonable starting point.) You have saved a million dollars for retirement.

You need another $18,000 of longevity-protected income. Wade Pfau's Dashboard[3] (or a quick online annuity quote from someone like tells us that a single-premium income annuity (SPIA) for a 65-year old couple today will generate about a 5.63% payout at today's rates. Divide 18,000 by .056 and you can estimate that you need to annuitize about $320,000 of your savings to generate the safe floor you desire.

Invest the remaining $680,000 in stocks and bonds (I recommend index funds) and you have a floor-and-upside plan with $48,000 of longevity-protected income (from Social Security benefits and the SPIA) in the unlikely event that you prematurely deplete your savings portfolio.

An update on Floor-and-Upside Strategies.
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There are a few critical concepts to consider at this point. First, the income from both the floor and upside portfolios assumes normal expenses. There will always be a risk of unpredictable, catastrophic expenses — a lawsuit, medical expenses, a child or grandchild who needs your financial support — that can blow up your retirement plan. Insurance may help and a reserve fund might, too, but there is always the risk that neither will be enough. We're planning only for the expenses that we can predict to some extent.

The second important concept is that, if we depend on a portfolio or a TIPS bond ladder for income, their liquidity is somewhat illusory. Both are sometimes referred to as "fettered" assets because we depend on them for future income. We often can't really spend them on something else. Spend from either of these sources when they're intended to provide future income and we give up all or part of that future income.

An annuity will become worthless at death unless you purchase (often ill-advised) options to prevent that. A TIPS bond ladder or an investment portfolio may have a remaining balance at death but that residual balance will be available to our estate, not to us while we are living.

It is true that an annuity provides less flexibility (more liquidity) than a TIPS ladder but the flexibility of the ladder is limited. A large medical expense can't be paid immediately from an annuity, it's true, but paying it from a TIPS ladder isn't much better. You're paying the expense from the source of funding for future years of retirement. An annuity will always provide more income than a bond ladder so you might be better off using the higher income to pay the large expense over time.

Bottom line, if you suffer a huge uninsured expense in retirement, you have a serious problem with any strategy.

A third important concept is that in many scenarios annuitizing part of your savings will result in a larger estate. This is counter-intuitive. In the above example, many retirees would think, "I just took $320,000 out of any future estate value because the annuity will be worthless when I die."

But, the annuity enables the upside portfolio to be invested more aggressively and lowers the retiree's sequence of return risk by reducing the periodic amount spent from savings. This will often lead to a larger estate than a portfolio-spending strategy alone.

Floor-and-upside is a compromise between using all our savings to buy annuities and investing it all in the stock market. We buy enough annuities to provide a safety net and invest the rest.

Annuities will provide for maximum lifetime consumption but have no value at death. Depending entirely on the stock market will provide more consumption and possibly a residual balance at death if the stock market gods favor us and less spending and a smaller bequest if they don't.

How does this fit into the theory of life-cycle saving and investing? That economic theory suggests that households should prefer reducing their consumption a bit in good times if it will improve consumption a bit in bad times ("consumption-smoothing"). We buy health insurance when we are healthy in good economic times, though it may have no immediate benefit, so we will be able to consume more at times when we are unhealthy and have large medical expenses.

Floor-and-upside gives up some of the stock market gains in the good outcomes to make sure we have a bit more income in worse scenarios with poor market returns.

The floor-and-upside strategy will combine the two such that they provide a safety-net level of lifetime income and an opportunity for more consumption if those stock market gods smile down on us.

If they find us annoying, we'll still have the safety net.

In my next post, I'll describe the Constant-Dollar Spending Strategy (the "4% Rule").


From time to time, I am asked for retirement planner references. In the past week, I received such a request as a blog comment. I would prefer you make the request by emailing me at

Also, there are relatively few retirement planners that I know and would trust with my own family and they are scattered around the country. All of them work remotely, primarily via email and phone as I used to, but if you want a planner you can meet in person, it is very unlikely that I will know one near you.



[1] The Retirement Café: Unraveling Retirement Strategies: Floor-and-Upside.

[2] The Theory of Life-Cycle Saving and Investing, Federal Reserve Bank of Boston.

[3] Dashboard,


  1. problem 1 - the inflation offset by tips is not the inflation you will experience. most particularly healthcare expenses are gravely undercounted in the cpi-u, and even more so for an older population. this same criticism applies to social security [ignoring social security's long term funding problems].

    attempted solution- recognize tips limitations in constructing your portfolio.

    problem 2 - inflation indexed annuities don't exist for the most part, and annuities which escalate by fixed percentages are way overpriced.

    attempted solution- buy fixed spia's with the "upside" portfolio especially oriented to offsetting inflation.

    problem 3- whether it is "ill advised" to purchase an annuity with a "period certain" which guarantees payments for a number of years even if the annuitant[s] has died.

    analysis- for certain special situations a period certain may make actuarial sense. annuities are priced to acknowledge an information assymetry- the purchaser knows more about his/her health than the insurer. it is assumed that only the relatively healthy will purchase a lifetime annuity. if, however, the annuitant has reason to believe he has a shorter life expectancy than the median, a period certain which extends beyond that median may make sense.

    1. One comment about healthcare inflation. Healthcare has been creeping up to near 20% of the US economy. At some point soon, it will simply be unable to advance further without crushing the economy. So looking out 30+ years, I don't see healthcare inflation going up at rates substantially higher than inflation over that entire period. The rest of the developed world is able to deliver quality healthcare at a fraction of American healthcare costs.

      I have been waiting a decade or more for American employers awaken to the fact that healthcare is the last major cost that they have not seriously attempted to cut. I think today's news about Amazon-Buffet-JP Morgan teaming up on healthcare is an indication that corporate America might finally be getting serious about controlling healthcare costs. I think it will be a bumpy ride over the next decade, but ultimately I think we will see our healthcare costs come back to the upper range of the rest of the developed world. If increasing efficiency and quality gets serious, then we may see zero inflation at times. A good example of what is possible is cars, where the crappy stuff sold to us in the 1970s has now morphed into much safer and reliable vehicles at a similar cost as back then.

    2. I like your logic and hope you're right.

    3. A follow-up on CPI-adjusted annuities. I often hear people say they don't exist but that simply isn't true. Tonight, I got a quote from (which Wade Pfau uses at his Dashboard) from Principal LIC, rated A+ by A. M. Best, for a 65-year old couple living in Indiana with a payout rate of 3.48%. I see similar quotes all the time.

      There are never more than a few compared to nominal annuities or annuities that pay 2% or 3% a year inflation adjustment, but I rarely "get skunked", as we say in fly fishing.

      They are always expensive and may or may not be right for a specific retirement but the notion that they do not exist is incorrect.

      Several studies have shown that all inflation-protected annuities are probably overpriced. I would assume they would be since insurance companies don't want inflation risk, either, so why sell them at a bargain?

      I would also note that if your retirement lasts a long time with a lot of inflation, you will have been better off paying the high price.

      Regarding period certain, the insurer knows more about the health of people like you. If I had great confidence that I wouldn't live a long time -- and for me that means a bad prognosis -- I wouldn't buy an annuity, at all.

      Many very unhealthy people end up living long lives so I wouldn't bet my retirement on a short lifespan without pretty strong evidence. Funding a short retirement and living a long time is an ugly outcome.

      On the other hand, I recently worked with a friend to purchase a SPIA and the 10-year period certain was nearly the same price as straight life. I wouldn't buy the option, but I'd take it for free.

      Thanks for the discussion!

  2. I agree and I'll add two points. First, I have always been able to find inflation-protected annuities, even CPI-adjusted. They are expensive. Nonetheless, if your retirement experiences high inflation, they will have been worth the cost.

    Second, with today's low interest rates all flooring is expensive, but TIPS bonds are quite a bit more expensive than annuities because they lack mortality credits.

    Appreciate the comments!

  3. Hi Dirk
    As a pending retiree planning to use this strategy with TIPs, I'm very interested in this post and specifically that you now like annuities more and TIPs less. The reasons I see in the post and your response to a reader's comments include annuities provide more income and include mortality credits while TIPs' liquidity is "illusory" and are more expensive. Does that (reasonably accurately) summarize the entirety of the reasons for the evolution in your thinking, or is there a bit more to the story?

    1. That's a fair summary. There are other reasons. A TIPS ladder is quite difficult to purchase and bonds and STRIPS are not available for every required maturity date. (Wade Pfau provides an example here.)

      The most important consideration is that you can outlive a TIPS ladder but not an annuity. TIPS ladders don't hedge longevity. You could build a really long ladder but it would also be really expensive.

      Thanks for writing and good luck with your retirement!

  4. Dirk, Thank you for another clear article and thanks for the direct response you shared with me earlier this week (last? - time passes quickly). I guess without the nomenclature, I've developed a floor-and-upside portfolio w/SS, pensions, a deferred fixed annuity, a bit of income derived from dividends, and a portion dedicated toward growth and income w/Fidelity. My floor is a bit less than our anticipated retirement expenses so I'll hope (i know - hope is not a plan) SS and dividend income grows to offset inflation in essential expenses and we can continue to enjoy life with the growth and income portion as long as we can and hopefully (there I go again) pass anything left down to the kids.

  5. Glad to help!

    It's OK to hope and have a plan. I do!

    I think I need to write a post on floors soon. Your sounds fine. A couple of points, though.

    Floors are very expensive right now because historically low interest rates increase the prices of annuities, TIPS ladders and the like. Not everyone can afford all the floor they would like to have and when you can't, you just need to build the best floor you can.

    The second point is that the rest of your plan should be designed such that living off the floor is a small possibility. Set up your upside portfolio with a reasonable probability of ruin, buy LTC insurance if you can, etc. The more risk you take, the greater the probability that you will need that floor.

    If there is a very low risk of having to live off floor income you can build a lower floor. It's a safety net you hope you don't need.

    Thanks for writing!

  6. I've read some recent articles expressing concern over the viability of annuity underwriters and their state-mandated back-up organizations. I am not well enough read to judge the merit of these opinions and would value your opinion.

    1. Dear helium, this is a question that gets asked a lot but one that probably can't be answered too often. I'm going to make a few comments and then turn it over to an expert.

      First, a general comment: consider the source. If the articles were written by someone with something to gain from selling alternative products, consider the opinion alongside others who disagree. Ken Fisher clearly hates annuities but then he essentially sells stocks. Someone from the insurance industry might be biased toward annuities. I don't know which you read, but I wouldn't have total confidence in either.

      Second, no retirement funding method is perfect. TIPs are safe in the sense that the Treasury probably isn't going out of business but risky in the sense that they don't hedge longevity risk.

      Annuities are risky in the sense that not receiving the income you expect isn't inconceivable and inflation protection is expensive, but they are less expensive than TIPS in terms of the cost of a future dollar of income and they hedge longevity risk.

      After the financial services meltdown of the Great Recession, I will never have total faith in any of them. Giant financial services corporations can fail.

      Consequently, it's better to diversify into multiple assets to ensure that failure of a single strategy isn't catastrophic. You can even diversify among multiple annuity providers for the portion of your resources that you allocate to annuities. I wouldn't recommend betting all your savings on annuities (or anything else) because nothing is risk-free.

      The best resource I know on insurance topics is financial writer Joe Tomlinson. I think this column by Joe in Advisor Perspective covers your question in an informed and unbiased way. I think it's fair to summarize that, historically, few annuity owners have not received their due.

      One final point. Not everyone needs an annuity. As Steve Vernon and Joe Tomlinson recently pointed out, households that are able to maximize Social Security benefits by delaying claiming may have a substantial amount of income that is already annuitized and may not benefit much from more. Households with pensions might be in this situation, as well.

      Full Disclosure: No one is completely unbiased -- Joe is an actuary, but he doesn't sell insurance. Also, I own a small life annuity and have recently recommended them to friends and former clients.

      Thanks for asking!

    2. Another way to establish a floor is income producing real estate. Not publicly traded reit, but rather private syndicated investments open to accredited persons. There is debt available paying decent returns with some risk but not huge risks if one is careful and diversified. This can pay out much better than tips or annuities. If one wants inflation adjusted income they can put some of this money in real estate equity rather than debt with increased risk but also an inflation hedge.

    3. David J, I disagree.

      There is an important difference between an "income portfolio" and a "floor portfolio" and one that seems lost on many. An income portfolio is designed to provide income. A floor portfolio is intended to provide near-certain income in the event that the upside portfolio fails. Huge difference.

      The simple question to ask to determine whether an asset is an appropriate floor asset is whether poor market returns (any market) could significantly impact income. In your case, we're talking about the real estate market and the Great Recession provides recent proof that real estate income is market-dependent and, therefore, not near-certain. (I personally know at least one large rental income business that was bankrupted. I doubt it was the only one.)

      Managing rental properties is a business, a sole-proprietorship for most retirees, and its success is not near-certain.

      There are good reasons to diversify into real estate, though most retirees won't have enough capital to adequately diversify into individual properties and nearly all tend to hold all of their portfolio locally. But real estate is risky, as you yourself point out. Real estate is fine in an income portfolio, but real estate belongs in the risky upside portfolio (in an income sub-portfolio if you prefer to organize it that way), not in a floor portfolio of near-certain lifetime income.

      Thanks for adding to the discussion.

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  8. As a 70-yr old single who has been actually living the floor-and- upside life for 4 years, I'd like to assure other unwealthies (that's your audience, right?) that it can give peace of mind and a comfortable life if you get the mix right.

    My floor is Social Security (2/3) and simple fixed SPIA (1/3); upside is a 50/50 stock/bond portfolio ~ 280,000. I CAN live perfectly well on the floor, although just now I am spending some extra for charities and modest travel. If in 20 years my floor is worth half what it is now due to 3-4% inflation, I'll cut back on those two items and have a lot of my nut covered, still, by the floor. At 90, will I still be hiking the Grand Canyon? Unlikely. And I'll be my own charity by then.

    Absent the big bad health care bogey (and I do have an LTC policy), my upside should be able to supplement my floor, at least enough to cover inflation. I think this is the best I can do, and I don't worry.

    1. That is indeed my target audience and that's the way floor-and-upside is supposed to work.

      Thanks for sharing!

  9. Thanks for the update. Maximize true liquidity. Love it!

  10. Zvi Bodie, an MIT economist, was perhaps the first person to articulate this approach, focusing on the use of Treasury I bonds/TIPS. His books are well worth reading, including "Risk Less and Prosper".

    1. Quite readable, too. I keep a copy by my desk. Thanks for the contribution!

  11. I could not resist commenting. Very well written!

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