Managing your investments after retirement is not a simple process. It entails at least ten steps:
(1) You decide on your target annual income.
(2) You estimate how much of this will be provided by your national social security system, by annuity income received from defined benefit pension plans in which you participated, and by income from any post-retirement employment. If the sum of these sources is less than your target income, the balance must be provided by withdrawals from your accumulated portfolio of real and financial assets.
(3) You decide how much money you want to save, either for precautionary reasons (e.g., to cover possible long-term care costs) and/or to leave as bequests.
(4) You estimate how many more years you and your spouse will live.
(5) You decide whether to convert some or all of your savings to an annuity. You also make a closely related decision: whether to treat your accumulated housing equity as a source of income (via a reverse mortgage), or as part of your precautionary savings and/or bequest.
(6) Now that you know the annual income that your financial assets must produce, you see if there is an asset allocation strategy that has an acceptable probability of achieving your target income (withdrawal) and savings goals, within the risk limits you set. If there is not, then you must either change your goals, or increase the amount of risk you are willing to take.
(7) Once you have identified your optimum asset allocation strategy, you decide whether to use an actively managed or indexed approach to implement it.
(8) You select investments that are consistent with the approach you chose.
(9) You determine the most tax efficient way to hold these investments.
(10) Finally, you check performance and re-evaluate your plan at appropriate intervals to make sure you're on track to achieve your goals.
This list makes two things clear. First, managing your investments after retirement is a complex planning problem that involves trading off three different types of risk (future health and need for long-term care; the risk of dying earlier or later than expected; and future investment returns) against two different goals (achieving your savings and income targets). In comparison, it is a much more difficult challenge than saving before retirement. Feeling a bit intimidated by this strikes us as a perfectly normal reaction.
Second, the way we approach this is different from some of the other studies you may have read. The simple fact of the matter is that there is no clearly superior way to approach post-retirement investing issues. Let's briefly look at some other approaches. One starts with your risk tolerance, and uses it to calculate your "optimal" asset allocation. Based on your relative preference for income versus leaving a bequest, it then divides your assets between annuities (both fixed rate and variable) and an investment portfolio that holds a range of asset classes. The higher your preference for current income, the greater your allocation to annuities. Our problem with this approach is that in real life, things don't usually work this way. In our experience, people start with their current savings and an uncertain estimate of their future needs (e.g., will I or won't I need long-term care?) and their expected life. Using these they derive the asset allocation that will maximize the probability of achieving their income and savings goals. If this probability isn't high enough to make them comfortable, they then evaluate a range of other options (e.g., work part-time, reduce bequest, reduce income, etc.). In addition, in our experience, people's preference for annuities also depends on the current state of their health, as well as their preference for income relative to savings and bequests. Someone who doesn't expect to live very long tends to have a much lower preference for annuitization than this approach assumes.
Another approach to post-retirement investing assumes a fixed time period (say, 30 years), and asset allocation (say, 50% to domestic equities, and 50% to domestic bonds), and then estimates the maximum percent of the portfolio's value that can be withdrawn each year and still produce a 95% chance that something still will be left at the end of the period. To save you the trouble of reading them, we'll tell you the answer usually given by studies that use this approach: about 4.0% to 4.5% (see, for example, "Retirement Savings: Choosing a Withdrawal Rate That is Sustainable" by Cooley, Hubbard, and Walz, or "Making Retirement Income Last a Lifetime" by Ameriks, Veres, and Warshawsky). From our perspective, this approach has a number of shortcomings. First, its maximum time period (usually thirty years) is probably too short, given retirees' healthier lifestyles and increased life expectancy. Second, it fails to include precautionary savings and bequest goals. Third, with only a couple of exceptions, studies using this approach fail to include the impact of partially annuitizing one's savings. Fourth, they use too few asset classes, and fail to consider the potential benefit from greater diversification. Fifth, their calculations are based only on historical asset class returns, rather than a more informative mix of historical and forward-looking estimates. Sixth, they fail to address another critical issue: whether to implement their proposed strategies using index funds, actively managed funds, or direct security holdings. And seventh, they usually ignore potentially important tax issues.
In contrast, we take the approach used by many university endowment funds. We start with the goals you want to achieve, the funds you have available, and the risk limits you would like to set. Then, given our expectation for future asset class returns, we determine the asset allocation that best meets your goals. If this isn't possible, we help you to understand the impact of changes to your income and savings goals, your annuitization decisions, and your risk limits, and to make informed trade-offs between them. Let's take a closer look at some basic retirement planning questions.