How to align investing and spending post-retirement

Investing post retirement has its own set of challenges. Your investment time horizon shortens while your employment/professional/business income ceases in whole or in part. A mistake at this time can inflict severe damage since you may not have the luxury of time or of earning non-investment income to help you recover. On the other hand your expenses change and typically decrease after an initial flurry of traveling. How should your investments adjust to these new circumstances, and in particular how can you best align your investments with your expenses?

Introduction

Virtually all sources of personal financial advice recommend a reduced allocation of your portfolio to equities in retirement, and this for two reasons:

The longer your investment time horizon, the more aggressive you can be in choosing the percentage of your portfolio invested in shares. So, unless you retire very young, or unless (lucky you) your investments far exceed what you expect to spend over the rest of your life (in which case, the portfolio should be invested in the interests of your heirs), you should typically progressively reduce the importance of the percentage allocation to shares in your retirement portfolio.
Secondly, the loss of other income (i.e. your salary) at retirement encourages a more conservative approach, which again argues for a smaller percentage of your portfolio being invested in equities.

For more, see asset allocation on our site.

Spending

But another characteristic of post- retirement investing is that you must consider the impact of the withdrawal of funds from your portfolio if, as is the case for most of us, your portfolio will be used, in whole or in part, to finance your retirement living.

So what is the best approach to investing that reconciles the objectives of investing for a reasonable return and of spending at a pace that hopefully suits your needs, without exposing yourself to the nightmare of outliving your portfolio because the level of your expenses leads to outflows that proved excessive?

At retirement there are four approaches to this challenge. Starting with the oldest, they are: the purchase of an annuity; the approach known colloquially as the 4% rule; the glide path age-based approach; and a developing approach, the constant mix lock box strategy. For a discussion (sorry, it is quite academic) of these four approaches, you can read the study (to which we will refer many times later) Retirement Financial strategies and rules of thumb, 2007, or as a PDF doc.1651 by Nobel laureate in economics William Sharpe and two his colleagues, Scott and Watson.

Let’s look at all four in turn.

Annuity

Buying an annuity is the oldest method of ensuring a life-time source of income post-retirement. Purchasing an annuity is like buying your personal pension plan. An annuity provides several important benefits, but also brings with it its own disadvantages; in general, on annuities, see our series of commentaries on the subject, the last of which was Life annuities: a buyer's checklist .

The great advantage of an annuity is that you can rely on a known fixed amount of income which will last until the end of your days. It is a major advantage for someone who wants to ensure a source of fixed income on which he can count on to pay his expenses.

There are two major drawbacks.

The first is called adverse selection; in general, see Annuities: think before you leap .This means that it is mostly healthy people who buy annuities (because they think they will live longer and enjoy the annuity income stream longer). The insurance companies realize this and reduce the yield offered on their annuity products (by increasing the price beyond what might be expected according to standard life expectancy tables of the general population) to account for this purchaser-bias. Sharpe suggested in a speech in Hong Kong in 2008 the creation of collective groups of annuity buyers to try to counteract this phenomenon; for more, listen to the following video . He also recommended that the purchase of an annuity be the default option (rather than receiving a lump sum at retirement) under group individual pension plans sponsored by employers.
The second drawback is that many people do not like dealing with insurance companies, who have a monopoly on life annuities, for fear that their insurance company could eventually go bankrupt, or for other reasons. Despite this reaction, Sharpe insists that a pensioner should never refuse to consider purchasing an annuity, unless you are rich and want to leave your money to your heirs.

Annuities should be considered explicitly, rather than ruled out ex cathedra.
Source: Sharpe Scott Watson 2007 Retirement Financial strategies and rules of thumb , p.25 or as a PDF doc.1651.

Despite the benefits associated with annuities, only a small minority of investors are currently buying them. One reason is probably that few financial advisers recommend them to their customers. Since the purchase of an annuity involves a major withdrawal of funds from a customer's account, with a corresponding reduction in opportunities for the adviser to earn management fees or commissions on the future investments of the client, this is hardly surprising.

So what are investors, and their financial advisers, recommending?

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Last Updated ( Sunday, 25 July 2010 )

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