If you were told there was a way to boost your income in retirement by 50% it would no doubt get your attention. It certainly got my attention, in a paper in a recent issue of the Journal of Retirement. The paper was co-authored by one of MoneySense’s panelists for the annual ETF All Stars panelists: Mark Yamada, president and CEO of Toronto-based PUR Investing Inc. The co-author is his colleague Ioulia Tretiakova, the firm’s director of quantitative strategies.
You might find the paper is bit too complex but this column aims to explain it in layman’s terms. While the strategy might be hard to replicate, it may at least get you thinking about your nest egg in a different way and lead to some good discussion with your advisor. It’s a new way to look at whether you should target income generation or maximizing returns when you maintain your nest egg in retirement. The paper is called “Autonomous Portfolio: A Decumulation Investment Strategy That Will Get You There.”
Let’s start with the term “decumulation,” which is short for de-accumulation and hence the polar opposite of accumulation, as in “wealth accumulation.” As this column has often noted, while most of us spend our first several decades accumulating wealth, one of the ultimate objectives of all that saving and investing is to start drawing an income for when your working days are over. (See for example The Decumulation Institute, which we’ve referred to in columns past).
Yamada and Tretiakova observe what many aging Baby Boomers are coming to terms with: that the combination of rising life expectancy, minuscule interest rates and declining availability of employer-sponsored Defined Benefit pension plans is making boomer retirement an anxious proposition. And since 10,000 Baby Boomers retire every day in the United States, and roughly 1,000 a day in Canada, the level of collective anxiety is rapidly growing.
As we noted recently, there are good arguments for retirees to maintain significant positions in the stock market, but of course that entails taking on higher risk. Adding to the anxiety is the fear that a stock market crash may occur when it’s least welcome, resulting in what various retirement experts call “retirement ruin.” In fact, I’ve seen various articles in recent years that raise the spectre of all these Boomers moving into decumulation and thereby contribute to a market decline.
Little wonder that one study cited by the authors (Allianz 2010) found 61% of those aged between 45 and 75 were more afraid of running out of money than of dying! Sure, you can decide to work a little longer, which lets you save more and cuts down the years you’ll need to withdraw an income, but there’s a limit to how long you can work (or find willing employers or clients). Ultimately, health and time are not on your side.
Enter the authors’ Decumulation Investment Strategy, which is designed to let retirees better manage both retirement income and the probability of ruin. The goal is to boost income; it assumes a retiree currently withdrawing 4% of their nest egg can use the strategy to be able to spend 6% without increasing the chance of running out of money before dying.
The authors start by making a novel analogy to self-driving cars, of all things. Autonomous vehicles are all about protecting passengers from surrounding hazards and navigating to a pre-determined destination. But as the paper notes, it’s ironic that “protection and navigation are two things the investment industry does not do particularly well.”
The industry has developed different kinds of diversified Target Date Funds (TDF) and managed accounts that actively rebalance to as aggressive an asset mix as possible: typically 60% stocks to 40% bonds. However, the paper argues that if portfolios were autos, “this would be akin to driving with the pedal to the metal” at all times without regard to terrain, weather or traffic conditions.
Worse, the investment industry relies on historical risk and return data to project future returns, somewhat like navigating a car by peering through its rear-view mirror.
Here is how the authors figure they can get the extra 50% in income. The aim is to keep portfolio risk constant by reducing it when market volatility rises and to increase portfolio risk when volatility falls (hence their term of DCR, which stands for Dynamic Constant Risk).
Their maximum weight for equities is 60% because they assume those over 65 won’t be comfortable with more stocks than that. But within that constraint, equity allocation is raised when the investor is behind the goal (the probability of ruin is higher), and, conversely, allocation to equities falls when the investor is on target.
Another key mechanism in their strategy involves variable spending rules that link “spending” (income generated by the portfolio) to the performance of the portfolio. So, they boost income generation when markets are doing well, and cut it when markets underperform. They look at several “safe” withdrawal strategies, including a modified take on William Bengen’s famous 4% rule (The 4% rule attempted to calculate the maximum amount you can withdraw of your nest egg each year without outliving your money. See earlier Retired Money column on this), as well as variants on this approach from the Yale Endowment Fund, Zolt and Guyton.
The DCR strategy offers the highest withdrawal rates of all these strategies, including a fixed 60% stocks allocation. Combined with a so-called “hybrid” spending (income generation) rule, it provides the best result, an average of 51% more income than a Target Date Fund approach. What’s more, it provides an average of 40% more income than a conservative 60/40 diversified fund over the same “range of ruin” probabilities, and delivers spending that does not decline even when the market does.
To be sure, it’s a complex paper and replicating this strategy at home yourself won’t be easy. I have spared readers the math but as Yamada reminds us, managing retirement money is such a challenge because there are so many variables and unknowns, like how long you’ll live and how long you’ll be healthy. Add to that the complexity of financial markets and the challenge is apparent. Investors can only control certain things and accept the reality that much is beyond their control.
Even if you don’t fully replicate the strategy, it’s food for thought when it comes to how you approach retirement planning. The authors’ approach of aiming to keep portfolios travelling towards income goals rather than maximizing returns is a bit of a paradigm shift compared to traditional practice, as is rebalancing to constant risk rather than cleaving to a predetermined asset mix.
For a link to the paper in the Journal of Retirement, click here.