As we reach the year when the highest number of Baby Boomers turn 65 (Peak 65), retirement income planning remains an ongoing challenge. Since there’s no single “best” way to build a strategy for replacing a paycheck in retirement, people need to choose their own plan for turning savings into a lifestyle.
“Lifestyle” incorporates key elements that do—or should—go into retirement income planning. After all, people don’t all share the same appetite for risk in retirement or desire for worry-free spending. By the same token, they have different ideas of what activities they expect to pursue and what life will look like as they slow down.
What strategy can a retiree use to estimate how much they can safely spend? The classic method built into many planning frameworks uses the logic of the so-called 4% rule that assumes a retiree spends the same amount (in real dollars) each year and then estimates the failure rates, or how often the retiree runs out of money under those conditions.
This traditional framework may not be the best way to help retirees choose how to create an investment plan to fund income—and use the money they’ve saved to actually enjoy retirement. It provides no information about what failure means; ignores the need for adjusting spending down if markets fall; and provides little insight into the impacts of either investment risk or guaranteed income on spending. The failure rate lens doesn’t empower individuals to choose the retirement lifestyle they want.
We created IncomePath because people need a more intuitive way to envision how to build their own retirement income plan. IncomePath illustrates lifestyle paths for investment-only decumulation strategies, and it provides unique insight into the value of guaranteed lifetime income. Rather than framing choices as “success” and “failure,” words that shed little light onto lifestyle tradeoffs, IncomePath shows how adjustments to portfolio and longevity risk affect an individual’s lifestyle over time.
A failure rate approach treats lifespan as a measuring stick to evaluate success or failure. If savings last up to the maximum arbitrary lifespan of a longer-lived retiree, then the retiree has succeeded. Unfortunately, no retiree knows how long they’ll live. If they live longer than the lifespan target, they could fail. If they die closer to the average longevity, they’ve succeeded but likely left a significant amount of unspent joy to beneficiaries.
What Is The Right Age To Plan To?
What age should you use to evaluate the probability of failure? If you choose an age such as 95 for a healthy 65-year-old woman, then there is a one-in-four chance that she’ll outlive that date. However, if you push the planning horizon out to age 105, you force the same retiree to adopt a very conservative spending strategy to avoid a high probability of failure. Spending too little to avoid a small chance of failure is a significant sacrifice that most retirees don’t need to make—but may adopt out of fear.
A failure rate approach treats lifespan as a measuring stick to evaluate success or failure. If savings last up to the maximum arbitrary lifespan of a longer-lived retiree, then the retiree has succeeded. Unfortunately, no retiree knows how long they’ll live…
Finally, the calculation of an outcome many years in the future has limited value since portfolio variability and other factors compound with each successive year. Even if there were an ideal planning horizon, any values spit out by an algorithm today wouldn’t be that useful to a retiree planning spending 10 years in the future since their financial situation will change over time.
The failure rate method falls short both for planning and for client communications: this framework is not intuitive and requires significant guidance from the advisor with no guarantee that the client really gets it.
What does failure even mean if any rational client would adjust their spending when their savings starts to dwindle? No advisor in their right mind would recommend a rigid spending schedule in the face of significant portfolio depletion—and no retiree would do it if they had any flexibility in their ability to spend.
Incorporating Spending Flexibility
We describe the importance of spending flexibility in enabling people to make informed retirement decisions in our new paper - Freedom to Spend. Spending flexibility is central to IncomePath because it generates retirement income illustrations that more accurately reflect the lifestyle choices that retirees make over time.Rather than evaluating investment risk and lifetime income through the failure rate lens, IncomePath shows the range of possible lifestyles associated throughout retirement. This approach provides much clearer insight into the tradeoffs of different strategies in an intuitive format that allows clients to understand and decide the best path without requiring technical explanations.
When it comes to estimating their own longevity, people often use imperfect guideposts such as how long their parents or grandparents lived, or (even worse) the average longevity at birth. Focusing on lifestyle over time bypasses the need to estimate a target retirement end date (an essential part of failure rate analyses). Longevity is an important topic but not the most comfortable to broach.
A better approach is to present a range of outcomes that reflect different market environments and include the possibility of adjustments to spending. Those who are lucky will spend more and those who are unlucky spend less, both within a set limit. In the paper, we examine a range of outcomes comparing target withdrawal rates of 4% and 5% for a 65-year-old.
Retirees have many choices when designing a plan to fund spending over an unknown lifespan. They need to understand how investment and longevity risk affect lifestyle in order to make these choices…
All retirees start with the same withdrawal in the first year. After that, their subsequent income adjusts based on performance and longevity. Withdrawing a higher amount early in retirement (5% of the initial balance) creates a flatter median spending path, while withdrawing 4% allows the median retiree to spend more later in retirement. The range of outcomes illustrates the lifestyle adjustments that an individual might make as the retiree responds to changes in their portfolio over time.
Most retirees plan to spend more in the early years of retirement and less as they slow down. Otherwise, they may end up sacrificing enjoyment in their most active years to preserve spending down the road. An illustration that assumes a fixed spending amount throughout retirement will sacrifice lifestyle early in retirement to reduce the small chance of being unable to spend the same fixed amount later in retirement. Adjustments allow the retiree to Retirees have many choices when designing a plan to fund spending over an unknown lifespan. They need to understand how investment and longevity risk affect lifestyle in order to make these choices… spend more early because they don’t “fail” if they can’t spend the same amount later in retirement.
In this case, a 5% target withdrawal rate may suit somebody who generally prefers a flatter spending profile throughout retirement and can tolerate a significant decline in late-life income. By contrast, the 4% target withdrawal starts off with 20% less spending in the early years but, on average, overtakes the other strategy around age 90.
Redefining Income Risk
Flexible spending does not eliminate the longevity and investment risk faced by all retirees. Flexibility reframes retirement risk as the possibility of living a more modest lifestyle later in life. A plan with a high initial income rate is more likely to hit the skids than one with a lower rate. Using spending flexibility as a lever, a retiree can determine that their early retirement goals are worth the potential of even greater belt tightening later on.
A flexible spending strategy can also illustrate the benefit of annuities. Financial products designed to support income later in life reduce the risk of having to cut back on lifestyle. Transferring the risk of late-life spending risk to an insurance company allows the retiree to spend more early in retirement because the consequences of a shrinking portfolio later in life are less severe. This lifestyle benefit of transferring late-life spending risk to an insurer cannot be demonstrated by a fixed-spending model because failure is defined as portfolio depletion rather than lifestyle preservation.
No Credit For The Lucky Years
On the flipside, a fixed spending rule does not allow a retiree to benefit from the upside of taking investment risk. Instead, the extra gains go toward legacy and (at least in the illustration) end up in the hands of heirs even if the retiree doesn’t have a strong bequest goal. Investment risk requires an acceptance of both a possible upside and downside. A lucky retiree should benefit from the upside by spending more if their primary goal is lifestyle. A fixed spending goal assumes that a retiree simply ignores a growing portfolio even if they have little desire to leave wealth to others.
In the paper, we compare a 5% target withdrawal rate with both 40% and 60% equity portfolios, again relying on 4% spending flexibility. As expected, we find that taking greater investment risk increases the range of possible future lifestyles. On the downside, a retiree will have to cut back more on spending late in retirement to preserve savings. On the upside, the retiree will be able to spend more later in life.
Flexible spending provides a more realistic illustration of the benefits and costs of increasing risk. On average, the retiree will be able to spend more by taking greater risk and the income model should allow them to benefit from good fortune.
Presentation of risk using income paths allows the retiree to provide input on the ideal risk allocation instead of relying entirely on a recommendation of an advisor or on a risk tolerance scale that measures the client’s willingness to accept short-term investment loss. Most retirees need equity exposure to meet their lifestyle goals later in retirement, but they should understand the tradeoffs and be allowed to choose to enjoy the benefits of living with a more volatile investment strategy.
Making Sense Of Longevity & Income
None of us know how long retirement will last. Higher-income retirees bear greater responsibility for using investments to pay for the income gap between Social Security and their desired lifestyle. Savers in defined contribution plans can also expect to live significantly longer than the average American. The risk of potentially outliving savings is real.
Retirees have many choices when designing a plan to fund spending over an unknown lifespan. They need to understand how investment and longevity risk affect lifestyle in order to make these choices. The traditional fixed withdrawal approach provides an imperfect lens for understanding these tradeoffs.
Clients need tools that allow them to grasp the decisions they are making and express their own preferences for safety and risk. This especially applies when the client includes guaranteed lifetime income and is able to more safely increase risk within the retirement portfolio and benefit from the upside of equity.
After all, longevity is woven into considerations of retirement planning but we need to start with a better way for clients to understand the choices they face so they can have enough confidence to enjoy spending the money they saved to fund a life in retirement.
