Managing Investment and idiosyncratic longevity risks for retirees

Michael S. Finke, Ph.D., CFP®

Professor &Director Retirement Planning & Living

Department of Personal Financial PlanningTEXAS TECH UNIVERSITY

MANAGING INVESTMENT AND IDIOSYNCRATIC LONGEVITY

RISKS FOR RETIREES

Congratulations!

You’re a pension

manager!

Pension Managers

What do they worry most about?

1) Asset Return Risk

2) Longevity Risk

Individual Pensions are Harder

Asset Return Pension Manager – Pool returns

across generations Advisor – One whack at the cat

Longevity Risk Pension Manager – systemic

increases in longevity Advisor – Idiosyncratic longevity risk

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1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Num

ber o

f yea

rs

Females

Denmark France Japan Spain Sweden UK USA

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12

14

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20

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24

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Num

ber o

f yea

rs

Males

Denmark France Japan Spain Sweden UK USA

Systematic Longevity Risk

Source: Robine, 2012

Wealthier Live Longer

Source: SSA, 2008

Idiosyncratic Longevity Risk

Source: Frank, 2013

Idiosyncratic Longevity Risk

How do you deal with idiosyncratic risk?1) Diversification (pool it)2) Retain it Avoiding running out of money by

spending less and accepting portfolio risk

Live it up and accept greater risk of running out of money

Turning Retirement Assets into Income

The 4% Rule (William Bengen, 1994)

Safe Withdrawal Rates (1920s - present)

1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 19900

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9

SAFEMAX

Figure 2.1Maximum Sustainable Withdrawal Rates

For 50/50 Asset Allocation, 30-Year Retirement Duration, Inflation Adjustments, No FeesUsing SBBI Data, 1926-2010, S&P 500 and Intermediate-Term Government Bonds

Retirement Year

Max

imum

Sus

tain

able

With

draw

al R

ate

Philosophy of the 4% RuleRetirees have a lifestyle goal and not meeting that goal indicates failure

Failure = inability to spend lifestyle goal for 30 years

Portfolio risk increases likelihood of meeting spending goal

Use prior returns to establish safe withdrawal rate

Historical Random Returns

13.7%23.5%20.3

% -1.5%

-10.1%

31.0%

8.99%

34.1%

-6.6%

-38.5%3.0%

4.5% 12.4%

7.1%

26.3%

27.3%

Asset Pricing 101

pt = Εt[β * u’(ct+1)/u’(ct) * xt+1]Price at time t (now)= Expectation (now)Of β (how much we discount the

future)* Marginal utility tomorrow Marginal utility today

*Expected payout tomorrow

What This Means

Demand for Consuming

Now Decreases Asset Prices

Demand for Consuming in

Future Increases Asset Prices

What’s Affecting Asset Prices?

How Much Do Global InvestorsValue the Future?

Capital Market is Global

Global Real Interest Rates

Importance of 1st Decade

Source: Milevsky and Abaimova, 2005

Monte Carlo Failure Rates

Historical Real Returns: Stocks 8.6%, Bonds 2.6%

Stock Allocation: 30% 50% 70%

Failure Rates 6% 6% 6%Slightly more realistic: Stocks 5.5%, Bonds

1.75%Failure Rates 24% 24% 27%

A little better than today’s rates: Stocks 6%, Bonds 0%

Failure Rates 47% 33% 28%Early 2013 Rates: Stocks 4.6%, Bonds -

1.4%Failure Rates 77% 57% 46%

Source: Blanchett, Finke and Pfau, 2013

What if Rates Revert in 5 Years?

Start out at current rates (Stocks 4.6%, Bonds -1.4%)

Revert to Stocks 8.6%, Bonds 2.6% Stock Allocation: 30% 50%

70%Failure Rates 22% 18%

18%

What if Rates Revert after 10 years?Failure Rates 43% 32%

38%

Other Problems with the 4% Rule

Source: Blanchett and Finke, 1% fee

No Risk Tolerance, No Optimization

Source: Finke, Pfau and Williams, 2011

Value of a Dynamic Approach

0.0% 20.0% 40.0% 60.0% 80.0%50%

60%

70%

80%

Dynamic ComplexDynamic FormulaRMD MethodStatic

Portfolio Equity Allocation

With

draw

al E

ffici

ency

Rat

e

Source: Blanchett, 2013

Illustration of Dynamic

65 70 75 80 85 90 95 100 105$0

$1,000$2,000$3,000$4,000$5,000$6,000$7,000$8,000$9,000

$10,000$11,000$12,000

Age

Rea

l With

draw

al A

mou

nt

Figure 6Individual Simulated Paths for Spending and Wealth

For a Couple with $100,000 Wealth and a 60% Stock AllocationSimulations Based on Historical Averages

Constant Inflation-Adjusted SpendingGuyton RulesBlanchett Rule

65 70 75 80 85 90 95 100 105$0

$25,000

$50,000

$75,000

$100,000

$125,000

$150,000

$175,000

$200,000

Age

Rea

l Rem

aini

ng W

ealth

Source: Pfau, 2013

Assumes Historical Equity Premium

S&P Dividend Yields

What Does Current P/E Imply?

Source: Asness, 2012

Requires Managing Assets in Old Age

Literacy and Confidence

60 65 70 75 80 850

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90Financial Literacy Confidence

A Better Approach

Prioritize spending categories (basic needs, discretionary expenses, legacy)

Employ risk when a retiree is willing to accept possibility of a loss

Deal efficiently with idiosyncratic risk

Simplicity - make sure real people can handle it, use research to create defaults

Be realistic about future asset returns

Michael S. Finke, Ph.D., CFP®

Professor, Ph.D. Program DirectorDirector Retirement Planning and Living

Department of Personal Financial PlanningTEXAS TECH UNIVERSITY

[email protected]

QUESTIONS/COMMENTS