Friday, February 23, 2018

Unraveling Retirement Strategies: Variable Spending from a Volatile Portfolio

 In Unraveling Retirement Strategies: Constant-Dollar Spending (4% Rule), I described retirement funding strategies like the “4% Rule” that base portfolio spending on a calculation made at the beginning of retirement that remains unchanged in real dollars regardless of how the household’s finances unfold over time.

Constant-dollar spending is like the Stephen Colbert joke about a man whose beliefs are constant. He believes the same thing on Thursday that he believed on Tuesday ... no matter what happened on Wednesday.

That doesn't work well for retirement planning, either.

Variable-spending strategies are similar to constant-dollar strategies in that they spend periodically from an investment portfolio but differ in that they spend a periodically updated amount based on portfolio performance – they spend more in good markets and less in bad markets.

This is a huge difference. We have two basic choices in portfolio-drawdown strategies: spend a predictable amount annually and risk depleting our portfolio or spend an unpredictable, possibly painful, amount annually to avoid portfolio depletion.

Spending strategies, including these two, explore ways to draw down a portfolio without outliving it but they do so without considering the expense side of the equation.

Regardless of which of these strategies you choose, you will spend the amount you need to spend after retiring. If you need a kidney operation or a new roof or a check for the IRS, you will pay for those things regardless of what your spending strategy recommends. That will increase your chances of outliving your savings but that risk isn't considered by these "income-side" strategies.

There are many variable spending strategies. I recently attended a webinar in which Wade Pfau identified a half dozen of the better known and in Making Sense Out of Variable Spending Strategies for Retirees[1] he compares several more.

Joe Tomlinson, Steve Vernon and Wade Pfau recently recommended using the spending percentage for Required Minimum Distributions (RMDs) from qualified retirement accounts[2]. Vernon provides a summary of the study in "How to Pensionize Any IRA or 401(k)."[6]

RMD is based on the assumption of a retiree and a spouse 10 years younger. Retirees closer in age to their spouse can perhaps use the Modified RMD strategy and spend 10% more. Your investment company will calculate RMDs for your qualified retirement accounts when the time comes or you can find a calculator online.[3] You are required by tax law to use these calculations on tax-deferred retirement accounts but you can, of course, use them on all types accounts if you choose.

Another strategy is to spend a fixed percentage, say the same 4%, of the new portfolio balance each year, though the safe spending rate actually increases as life expectancy decreases. It makes more sense to spend that gradually-increasing percentage of one’s current portfolio balance each year than to always spend a fixed percentage of a changing portfolio balance. It approaches 10% late in retirement but grows slowly at first.

Most Americans are eligible for Social Security benefits so most have a floor. It may not be an adequate floor in the event that your portfolio is depleted, but it is a floor. The variable spending strategies and the constant-dollar strategies, therefore, technically manage the upside portfolio of a floor-and-upside strategy and will rarely be a standalone strategy.

I recommend, once again, reviewing this strategy in Pfau and Jeremy Cooper’s The Yin and Yang of Retirement Income Philosophies[4]. I particularly recommend the introduction to the work of Blanchett, Mitchell and Frank[6] on dynamic spending at the end of the variable spending strategies review. Their strategy periodically updates the critical assumptions of a retirement plan. (Frankly, I don’t see a rational alternative.)

It effectively says, “When the road in front of you turns or ends, modify your car’s behavior accordingly.”

A light pole oddly stood in the middle of the Sears gravel parking lot in my hometown. Some wise person had painted two arrows on the pole curving away in opposite directions. Below the arrows were the words, “Turn. Go left or right.”

Sounds like sage advice.

Variable-spending strategies make a lot more sense.
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The challenge with the dynamic spending strategy is that it is mathematically complex and will be difficult for most retirees or even planners to implement. I suspect, however, that you would achieve similar results with any variable spending strategy if you updated your spending percentage annually to reflect decreasing life expectancy (strategies like RMD do this for you) and based the spending amount on your current portfolio balance. Blanchett, Frank and Mitchell point out that asset allocation plays a smaller role.

The Blanchett-Frank-Mitchell study shows that life expectancy plays a critical role in determining a safe spending amount. Life expectancy declines as we age. Some variable-spending strategies, like RMD and actuarial approaches, consider decreasing life expectancy in their calculations while others, like spending 4% of remaining portfolio balance, don't. I recommend you choose one that does — it's a key factor.

To implement a variable spending strategy, choose a variable spending rule that suits your fancy[1]. Which you choose probably has less impact on portfolio depletion risk than the act of recalculating it annually, so long as it incorporates changing life expectancy.

I personally prefer the dynamic strategy, Modified RMD for simplicity, Milevsky’s formula[4], and actuarial strategies[5].

I’ve written several posts on asset allocation and it has been thoroughly discussed in several threads, including Unraveling Retirement Strategies: Constant-Dollar Spending (4% Rule). You won’t go terribly wrong with an equity allocation between 40% and 60% and it’s difficult to prove that another will work better across a broad range of outcomes. The same rules apply to variable spending portfolios.

I recommend a floor to go along with an upside variable spending portfolio to make sure you can survive if the improbable happens.

Constant-dollar strategies tell you to spend the same amount every year and that you probably won't run out of savings over a fixed thirty-year retirement. They don't consider what happens if you do.

Variable spending strategies tell you to spend more when you have more money and spend less when you have less money. The better variable spending strategies also consider remaining life expectancy and tell you that you can spend a higher percentage of your remaining savings as you age. Annual spending isn't predictable but you are unlikely to outlive your savings.

Again, seems like sage advice. Variable-spending strategies are so much more rational that I personally dismiss constant-dollar spending strategies entirely.

Retirees who have a pension, Social Security benefits or have purchased an annuity, which covers practically all American retirees, will actually be building a floor-and-upside strategy and managing the upside portfolio with a variable-spending strategy. Floor-and-upside strategies, however, will focus more on the floor and will likely recommend one higher than Social Security benefits alone are likely to provide.


[1] Making Sense Out of Variable Spending Strategies for Retirees, Pfau.

[2] Optimizing-Retirement-Income-Solutions-November-2017-SCL-Version.pdf, Pfau, Tomlinson, Vernon. (Very lengthy, consider [6], instead.)

[3] Estimate your required minimum distributions in retirement, Vanguard.

[4] The Yin and Yang of Retirement Income Philosophies, by Wade D. Pfau, Jeremy Cooper.

[5] How Much Can I Afford to Spend in Retirement?: Spreadsheets, Ken Steiner.

[6] How-to-pensionize-any-IRA-401k-final.pdf, Steve Vernon.

[7] An Age-Based, Three-Dimensional Distribution Model Incorporating Sequence and Longevity Risks, David Blanchett, Larry Frank, John Mitchell.

Monday, February 12, 2018

Unraveling Retirement Strategies: Constant-Dollar Spending (4% Rule)

Sustainable Withdrawal Rate (SWR) strategies are based on the work of William Bengen[1], whose research uncovered sequence of returns risk. The basis of the strategy is that there is a constant amount of spending from a stock and bond portfolio that would have been “safe” in 95% of historical 30-year periods of stock returns.

SWR had a colorful beginning. Peter Lynch of Magellan Fund fame posited that a retiree should be able to invest in stocks and spend about 7% of her portfolio forever. Scott Burns quickly showed that a 7% withdrawal rate was far riskier then Lynch imagined.[2]. (The culprit, as Bengen would show, is sequence of returns risk. The order of market losses is more important than the average return.)

Lynch’s response was, “OK, but surely there is some percentage that would work?”

Bengen found that the safe withdrawal percentage rate in the U.S. was historically 4% to 4.5% over rolling 30-year periods of market returns, hence the “4% rule."

Wade Pfau later showed that number only worked in the U.S. and a handful of other countries[5]. More recent work by Pfau suggests that the number at present is perhaps 3% to 3.5% — a sizable range. A range of 3% to 4.5% may sound small but it’s the difference between a safe spending amount of $30,000 and $45,000 a year per $1M of savings. Regardless, it’s well below Lynch’s 7% assertion.

The basic process for implementing this strategy is for a retiree to calculate 4% (or 3% or 4.5%, depending upon who you choose to believe — I'd go with Pfau) of her total investment portfolio value the day she retires and to spend that dollar amount (not percentage) for the rest of retirement, increasing it annually by inflation.

A retiree with a million dollar portfolio who agrees with Pfau's 3.5% could spend $35,000 the first year of retirement. If inflation ran 2% that year, he could spend $35,700 the following year.

This strategy will result in two possible outcomes when simulated, though actual retirees might not behave this way. The strategy will produce a constant, inflation-adjusted income amount from the portfolio until the retiree dies or the portfolio is depleted, whichever comes first. SWR practitioners try to minimize the latter outcome to “only 5% or 10%” of retirements, or 1-in-10 to 1-in-20.

With all due respect to Bengen, whose research exposed sequence risk — an important contribution — I consider this strategy irrational and believe that it probably makes sense only for households with so much savings that they don’t need it. The idea that we can spend an amount calculated at the beginning of retirement and continue spending it regardless of what happens to our financial situation over perhaps 30 years is not only risky but irrational.

Constant-dollar spending strategies are risky for households that aren't wealthy and unnecessary for those that are.
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As retirement progresses, our finances and life expectancy will change, our finances for better and for worse. Life expectancy constantly declines. Constant-dollar spending is a strategy to ignore any of this new information after the original spending amount is calculated.

Larry Frank, David Blanchett and John Mitchell published research[3] showing that our spending should be “dynamically” adjusted as our finances change over time but you probably don’t need to read the research to understand this.

Instead, have this conversation with your 75-year old wife. “How much can we spend this year, Walter?”


“Thanks, but how do you know that, Dear?”

“It’s the amount we could safely spend a decade ago based on our life expectancy and wealth back then.”

Let me know how that conversation works for you.

Wade Pfau and Jeremy Cooper wrote a great explanation of the strategy (and others) for Challenger Ltd[4]. Granted, mine is more cynical, but they’re decades from retirement and I’m a decade into it. I have more skin in the game.

Here are some considerations I have learned by running a gazillion retirement simulations that you probably won’t find elsewhere without a lot of digging.

SWR strategies are based on the assumption that future market returns will be similar to historical returns but there is a lot of reason to believe they will be lower in the future. Even if they are similar, we don’t know the expected market return, whether it changes over time or even the distribution of those returns. We pretend they are normally distributed, largely because it makes the math easier, but empirical evidence shows that there are far more extreme market events than a normal distribution would predict. That’s a lot of uncertainty on which to bet one’s retirement.

Many retirees who like this strategy believe that they are creating their own annuity without committing a large sum of money to an insurance company. There is a specious similarity to an annuity in that both provide constant income but SWR is like an annuity from an insurance company with a 5% to 10% chance of going out of business.

Further, annuities provide maximum lifetime consumption while SWR strategies are economically inefficient. It’s expensive to tie up 96% of your wealth so you can safely spend 4% of it[6].

Self-annuitizers may expect that have more liquidity with a SWR strategy than they actually have. In the same way I explained that the liquidity of TIPS ladders can be illusory, spending from an SWR portfolio to meet large, unanticipated expenses means spending income you were counting on for the future. Certainly TIPS ladders and investment portfolios are more liquid than annuities but there is a price to pay in the future for spending them early.

A high spending percentage increases the probability of outliving the portfolio and reduces the expected terminal portfolio value, which is often part of a planned bequest. At the other extreme, a low spending percentage decreases the odds of portfolio depletion but increases the expected terminal portfolio value. This has some interesting implications. The following charts show the relationship.

Retirees with limited wealth relative to their spending needs may need to spend a larger percentage and accept a greater portability of outliving their savings. They are less likely to accumulate a large terminal portfolio.

Retirees with adequate savings can play it safe with a low withdrawal rate but they are more likely to die with a large portfolio. This is a good thing for households with a strong bequest motive but not so good for those without. Without a bequest motive, a retiree who plays it safe with a low withdrawal rate may find late in retirement that she has an extra million bucks she could have spent to enhance her life.

This may be ideal for a household with so much wealth that they can easily afford their desired standard of living and still expect a large portfolio to leave to heirs but then one must ask why a household this wealthy needs a SWR strategy, at all.

As I explained in Retirement Income and Chaos Theory, constant-dollar spending strategies are probably chaotic when the portfolio is sufficiently stressed. It’s a bit like hanging around the event horizon of a black hole in that scenario where just a little bit of bad luck can nudge your strained household finances into an irreversible downward spiral.

In a post entitled, "Time to Retire the Probability of Ruin" back in April 2015, I wrote that we should stop basing retirement plans on this metric. A short time later, Moshe Milevsky wrote a better piece entitled, "It’s Time to Retire Ruin (Probabilities)"[7].

Constant-dollar spending strategies are quite unpopular among economists and most of the researchers I know. They are sometimes popular among planners who charge fees based on assets under management and retirees who see them as an annuity alternative.

I am none of those and not a proponent of constant-dollar spending strategies. I have many reasons, but the most basic are that it is irrational to ignore new information that comes available as retirement progresses and financially unsound to attempt to derive constant income from a volatile portfolio. The strategy is risky for retirees who are not wealthy and unnecessary for those who are.

Ultimately, it isn't possible to re-create an annuity with a one- or two-person risk pool. Rational strategies to spend from a volatile portfolio will suggest that we spend more when our portfolio grows in proportion to our spending and life expectancy and demand that we spend less when it shrinks. That requires a variable spending rule strategy, which I will address next.


[1] Conserving Client Portfolios During Retirement, William Bengen.

[2] Dangerous Advice from Peter Lynch, Scott Burns.

[3] An Age-Based, Three-Dimensional Distribution Model Incorporating Sequence and Longevity Risks,  Frank, Mitchell, and Blanchett.

[4] The Yin and Yang of Retirement Income Philosophies, Pfau, Cooper.

[5] Journal The 4 Percent Rule Is Not Safe in a Low-Yield World, Wade Pfau.

[6] The 4% Rule - At What Price?, Scott, Sharpe, and Watson.

[7] It’s Time to Retire Ruin (Probabilities), Moshe Milevsky.

Tuesday, February 6, 2018

Will the Market Go Up or Down from Here?

The answer is yes. It will go up or down from here.

Whenever the market has a large setback (this one is 7% so far, but it happened quickly and may or may not be finished) many of us feel a responsibility to tell our readers not to panic.

So, here's my advice: don't panic. (I hope to provide more useful advice below.)

To the extent that history is a guide, the market will be higher sometime in the future but no one knows when that will be.

It could be Friday.

On the other hand, stocks took 25 years to recover from the Great Depression and 16 years to recover from multiple financial crises beginning in 1963[1]. It took only six years for the market to recover from the 2007 sub-prime mortgage crisis.

When you read how quickly the market recovers from big losses, it's important to note that a retiree's portfolio is not the market index. It probably took longer for a retiree to recover from those losses than it took the market because she was selling stocks to pay bills during that period. At the other extreme, someone in the accumulation phase might have recovered sooner than the market if they were not spending but instead contributing additional savings during those years.

Saving during your working career is like periodically throwing more money into your retirement boat. Spending from that portfolio during retirement is like owning a leaky boat.

Three more pieces of advice.

It is important to ignore the advice of those who say this is the beginning of a much larger market decline because they can't know; they're only guessing.

It is equally important to ignore the advice of those who say this is a great buying opportunity because they're guessing, too.

Ignore those telling you this is the beginning of a crash. They're only guessing. Also, ignore those saying it's a buying opportunity. They're guessing, too.
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You should pay more attention to experts who simply admit that they don't know. Unfortunately, no one is going to interview them because they're boring.

My wife received a text message from a friend last night. "Mary wants to know if they should buy or sell?" she asked from the other room.

Assuming Mary was really asking if the market will go up or down from this point, my initial answer was that they should go to a movie. After a little more thought, I admitted to myself that I know little about their finances and maybe there are good reasons for them to buy or sell, though short-term market volatility wouldn't be a good one.

"How much of their retirement savings have they invested?" I asked.

"She says all of it."

OK, so that gets my attention. That portfolio would have fallen over 50% during the Great Recession. I couldn't tolerate that but maybe they could. I usually recommend 40% to 60% equity for a portfolio from which a retiree is spending. If there are no known liabilities to match (future bills to pay) with that portfolio, I might go with 80%.

"She says they'll be fine — they survived the 9/11 market crash."

So, three important points. First, the market fell about 14% after 9/11. It rebounded 21% in three months. Hardly the Great Recession's 50% loss and not much of a test of one's risk tolerance.

Second, Mary and her husband were working back in 2001 and presumably saving for retirement. As I explained above, there is a world of difference in recovery time between the accumulation phase and the distribution phase.

Third, Mary is trying to time the market and research overwhelmingly shows that no one can time the market and that you will likely lose even more money if you try to.

I promised to provide some more useful advice, so here it is. After you refuse to panic per my previous instruction, reconsider your risk tolerance. It should be lower after retirement because you no longer have a safety net of new savings contributions and no job, for that matter. Retirement is riskier.

If this recent market crash made you feel a need to sell, then it has done you a favor — it's telling you that your equity allocation may be uncomfortably high. After you weather this market volatility, consider lowering your equity exposure.

I like William Bernstein's recommendation to limit your equity exposure in retirement to the maximum loss you could tolerate in a severe bear market. The following table was published before 2007 in The Four Pillars of Investing but I held 40% equity back then and my portfolio fell only 15%, as he predicted.

Be forewarned that if you held an uncomfortable equity allocation before the downturn and lower it before the recovery, that recovery will take longer. If your portfolio fell precipitously because you were holding 90% equities and you lower that to 60%, it won't climb as quickly as it fell.

Should that happen it will be the result of a previous error — overestimating your risk tolerance. That past mistake may cost something but you can fix it going forward.

Your risk tolerance changes over time and is generally much lower during a market decline than you expected it would be during the previous bull market.

So, don't panic. If you don't feel panicked, then your equity allocation may be just fine. If you do feel a bit anxious, wait until the smoke clears and then think about whether you have underestimated your risk tolerance. Adjust your equity exposure then.

The worst thing you can do is panic and sell at a market bottom, though that is exactly what many people do.

In the meantime, ignore the guessers.


[1] The Dow’s tumultuous history, in one chart, MarketWatch.

Friday, February 2, 2018

What's a Floor?

After my last post, The Retirement Café: Unraveling Retirement Strategies: Floor-and-Upside (An Update), I received several comments and emails regarding floor portfolios that made me realize that the definition of a floor isn’t universally applied and that I need to communicate the definition that I use more clearly.

In "How retirement savers construct an income floor"[1], Stan Haithcock suggests the following:
"You need a solid income base to build on and to hopefully add to those guaranteed amounts. These income sources can include your Social Security, pensions (if so fortunate), income-producing real estate, dividends from stocks, bonds, and contractual annuity payments."
While I find that the column provides generally sound advice, I don't agree that all the assets in this list should be used to build a floor. Real estate income depends on real estate market performance, stocks have market risk so their dividends do, as well. Bond income has bond market risk unless laddered and held to maturity.

I received other comments from readers that considered potential floor assets to include a rolling 10-year TIPs ladder. Deplete your portfolio and how will you buy future rungs? There was even a suggestion that RMDs are floor income, although they totally depend on portfolio performance.

Some seem to define a floor portfolio as an income portfolio complementing the upside stock portfolio and believe that any investment that yields income is suitable for a floor. I don't view floors that way and I don't believe that Bodie, Merton and Samuelson[2] had that in mind when they envisioned lifecycle finance.

I found the following an excellent explanation from a Bogleheads thread[3]. "bobcat2" explains:
"The life-cycle approach ("floor" plus upside approach) is the general economics approach to financial planning including retirement planning. The older approach (called mean/variance or "probabilistic") is based on risk-return tradeoffs along the efficient frontier and is a special case of the life-cycle approach. In that special case, the floor goal is either non-existent or very low, and the aspirational goal is soft. ("I would like to have this much or more, but perhaps not realizing that the “or more” reduces the chances of meeting the goal.")

There is no pure life-cycle approach. You pick two goals. One goal is what you want [upside]. The other goal is a lower conservative goal that typically you want to hit with very high probability [the floor]. You are serious when you set or reset the goals and you employ investment strategies that are explicitly targeted to meet the goals. If you want to hit the lower goal with near certainty, you are going to have to hedge or insure, not diversify, the risk of reaching that goal. That means you need a matching strategy to reach that conservative goal both before and during retirement." 
We "insure" the "near certain" floor with annuities, Social Security benefits, pensions, and possibly a very long and expensive TIPs bond ladder or a shorter, non-rolling ladder supplemented with a deferred income annuity at its end[4] that's less expensive.

Dividends, bonds or bond funds other than laddered TIPs held to maturity, RMDs, real estate income and rolling ladders are not "near certain" and, therefore, not predictable.

What's a floor, anyway?
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I view a floor portfolio as a safety net of near-certain income in case factors beyond my control should leave me with nothing else.

My grandparents suffered the effects of hyperinflation that destroyed their finances. People used to refer to their predicament as “living on a fixed income” but what they meant was that they no longer received pay increases from an employer to offset inflation. The purchasing power of their pensions and savings accounts eroded quickly.

When I think of a floor portfolio as a safety net, I imagine that my client’s other assets are depleted and that they are forced to live only on income from the floor. I want to make sure that their floor income can withstand some pretty serious inflation, so I consider inflation protection a critical component of a floor portfolio.

A dear friend lost his entire $4M retirement portfolio during the Tech Crash just a few years before his planned retirement. When I think of a floor portfolio as a safety net, I imagine that my client’s investment portfolio is depleted and he is forced to live only on income from the floor portfolio. I consider mitigation of market risk critical in a floor portfolio. Market risk (any market) belongs in the upside portfolio.

For a decade now, retirees have been hurt by historically low interest rates that have left safe income sources like CDs and money market returns barely worth the effort, so I consider the mitigation of all capital market risk to be critical in a floor portfolio.

Growing up in a rural community, I had several relatives and friends of relatives who were trying to get by on Social Security benefits alone. It wasn’t pretty.[5]

They were mostly widows whose husbands, often deceased for a decade or two, likely hadn't been able to afford to delay Social Security benefits or didn't understand the value of delaying, which greatly reduced their spouse’s survivors benefits. When I think of a floor portfolio as a safety net, I imagine that my clients don’t want to end up living off Social Security alone in old age. I recommend they delay Social Security benefits as long as possible. I consider mitigating longevity risk to be a crucial component of a floor portfolio.

It is also worth considering building a floor with as many judgment-proof and bankruptcy-proof assets as you can.

Those three goals, mitigating inflation risk, mitigating capital market risk, and mitigating longevity risk are, in my personal view, essential to a floor portfolio’s design. Combined, they provide a pretty strong safety net of near-certain, real lifetime income.

Of course, not all risk can be mitigated. Spending shocks, for example, can destroy our finances even with an adequate floor. The floor defines the amount of safe income available but it has no sway over costs.

One last but critical consideration is the amount of floor income you target. Don't overdo it. Even small floors can be expensive. Design the rest of your plan such that having to live off floor income alone is very unlikely.

Sleeping on the floor is a more tolerable consideration if the chances of ending up there are small enough. At the other extreme, retirees who plan to spend 5% of their investment portfolio for thirty years in retirement probably want a cushier floor. If I had a 10% chance of losing my bed, I'd keep an air mattress nearby.

I don't get to define what constitutes a floor but it is important to understand the definition I have in mind when I use the term in posts.

It's fine if you or your retirement planner use a different definition as long as you agree and understand how it differs from the lifecycle economics definition. Just know that, with a different definition, some of your floor might not be there in certain scenarios when you need it.

It's challenging to build a perfect floor for several reasons. The cost of retirement is unpredictable and changes over time[6]. You may not claim Social Security the year you retire and filling the safe income gap until you do can be problematic. Pensions provide lifetime income but most aren't inflation-protected. An inflation-adjusted immediate annuity is in many ways the best answer but many retirees won't buy one. Flooring is very expensive in today's economy.

For these reasons, you are unlikely to find a perfect answer and will need to make concessions. But, it's important to begin the process with some basic goals in mind and to imagine the future scenarios in which you might have to live off floor income.

I begin with the goal of a floor portfolio that provides near-certain safety-net income and I try to fill it with assets that in combination mitigate inflation risk, capital market risk, and longevity risk to guarantee that I can survive improbable but worst-case outcomes. Because floors are expensive, I build mine as low as I think I could tolerate and then I structure the rest of my retirement plan to minimize my chances of rolling off the bed.


[1] How retirement savers construct an income floor, MarketWatch.

[2] Videos - Robert C. Merton Finance Class at MIT

[3] Wade Pfau: Lifecycle Finance - Page 3 -

[4] The TIPS plus DIA strategy is discussed in this column by Wade Pfau. It contains links to the original research. Safe Retirement Income with TIPS and a deferred annuity, Wade Pfau.

[5]9 Ways to Retire on Social Security Alone, AARP.

[6] Estimating the True Cost of Retirement, David Blanchett. >