Retirement is the number one financial worry.
I want to cite Steven Chen, for an article he wrote called “Why Retirement is Broken and Needs to be Reinvented.” Most importantly to highlight a few take aways that coincide with the messaging that we are delivering to clients through our website and blog, the most important problem being uncertainty. Many think about it all the time. And the core problem, is that uncertainty. As Chen points out “people have no idea how much they need, because we’ve created a system around building assets, instead of income. We spend our lives, saving up a big pile of money, in an effort to secure our future against an absolute, just a bewildering set of future risks, that include market returns, inflation, healthcare, longevity.” He’s right, I mean, there’s just no way, to know, all of those things, the extensive amount of risk that clients can run into over the course of their retirement.
Bob Merton, a noted Nobel Prize winner spoke recently in an interview that his thesis that our retirement savings focus on assets and gathering assets, versus planning for income has created a systematic misalignment, and in his mind is the core of the problem. The message is, that in the past, we focused on the income.
What has changed?
The shift from defined benefit pension plans sponsored and run by employers to defined contribution plans – think 401k plans – managed by individual investors. Now we focus on gathering assets. And the reality is, that most people just don’t know what to do with them. Retirees were used to getting guaranteed income from their pension. And the more they got, the happier they were. Or at least that’s what a lot of the studies showed.
Because the certainty and the simplicity of that money showing up every month that was predictable, it wasn’t dependent on stock markets or interest rates. And it let them stay in line, their spending in line with the income that they knew was coming in every month.
And the challenge of the burden of making sure that retirement paycheck showed up for the rest of your life was on the burden of the pension plan. Once 401Ks started to come about and companies began shifting away from defined contribution plans the managing of that money shifted from the pension administrators, who are, were and are, financial experts to the everyday Joe. Who, in most cases, does not have any idea how to build a portfolio for retirement income that needs to last their entire lives.
These challenges are broad and deep. Another article written by Wade Pfau titled “What Is A Safety-First Retirement Plan?” highlighted the importance of structuring and prioritizing goals. The main idea is that your investment strategy would be built to match the risk characteristics of assets and goals so identifying essentials (needs) versus wants is a must. Trying to avoid overspending in some years and not being able to afford basic necessities in other years or future years. It really involves separating the needs and the wants. The essential needs are top priority. Then you could have a separate account for emergencies and one for discretionary expenses. Or maybe a legacy for the kids. But you really can’t think about discretionary spending, trips or travel, or legacies for the kids until the funding sources for those essential needs is in place.
The purpose of saving and investing is to fund the spending in retirement.
And probably the best way to do that is to convert that savings and some of those investments to some sort of solution that’s going to help manage longevity and market risk. Using asset risk matching, we’re not trying to maximize wealth in retirement. We’re not trying to maximize year to year returns. Even on a risk adjusted basis. Nor are we trying to beat some index or benchmark. The goal is to have cash flow to meet the essential spending needs as required. And an investment strategy built to meet those needs. Assets are matched with the goals so that the risk and the cash flow characteristics are compatible.
For essential spending, you want use things like pensions, social security, annuities, bonds, treasuries – very safe, predictable, sustainable, secure investments. Volatile assets are not appropriate to cover basic needs or emergency funds. The objective of investing in retirement, again, is not to maximize returns. But, to ensure that the basics will be covered in any market environment. And then invest for additional upside with what’s left over. Right? So, if possible, what we want to do is buy the income and invest the rest. Volatile assets are ok for discretionary spending. Future trips or things down the road. Or a legacy. Or, where flexibility is possible. And those purchases are not really necessary.
The idea is to remove as much uncertainty as possible.
It can’t be captured in investment simulations or safe withdrawal rate projections. It’s really hard when you get into what’s a safe withdrawal rate from a market-driven, volatile portfolio. When the balance is constantly fluctuating due to the market, trade wars, interest rates or political events. Federal reserve actions. The fears and emotions. Again, the process that we’re suggesting is that there is no such thing as a knowable, 100% safe withdrawal rate from a volatile portfolio. Retirees have one chance at retirement and to develop a strategy that meets the basic needs, no matter how long they live. And no matter what the market does. Retirees have very little room for error. Volatile assets like stocks are not appropriate when seeking to meet short to intermediate timeframe basic retirement living expenses. The objective for retirement is to build a safe and secure income – for as far out as the eye can see. And only after that is taken care of, should you consider including more volatile assets to provide greater upside potential.