Decumulation is different from accumulation. Accumulation feels as though it has an indefinite time horizon that can be voluntarily stretched out if necessary. In decumulation, the time horizon is beyond your control, and constantly shortens. Also, an individual’s risk tolerance is reasonably constant through most of accumulation, but risk aversion increases through decumulation.
This article is only about decumulation. Bequests are not taken into account.
This is about people without certainty that they can fund their desired lifestyle with their remaining assets. If you can afford to buy a lifetime income annuity at the desired level or if you can live on the dividend stream from your equity portfolio, you don’t fit.
The long-term goals
I’ll illustrate the principles via a story about a fictitious couple with three long-term goals, even though they can’t all be reached with certainty: longevity insurance, asset growth, and safety. They want to know how much of an annual drawdown is likely to be sustainable, if they take some investment risk.
They start with one short-term goal. What if some emergency arises, and they need instant cash? Many financial professionals advocate having six months of spending as an emergency pot. They decide that the first 2% of their assets will be set aside in cash as their emergency pot. Everything else is now based on the remaining 98%.
1. Longevity insurance
Like most retirees, our couple fears outliving their assets. They fear the consequences of their uncertain longevity, particularly as they’re both in reasonable health. But in Australia (assuming they cannot afford enough in lifetime annuities), they can’t buy pure longevity insurance, so they self-insure.
They look at tables of ‘joint and last survivor’ probabilities, understanding that these show the probability that at least one of them will be alive over various time horizons. They feel that the 50% point is too risky a deal for them. They opt for the 25% point, which gives them a time horizon with a 75% chance of having money long enough.
Why not 10%? That would give them greater certainty. If they plan for the 10% horizon, their annual drawdown will be smaller than with the 25% horizon. So, with hope for asset growth in their hearts, they start with 25%, and remind themselves that, if they approach that point and are still in good health, they will need to take action. More on this later.
2. Growing the assets
They could lock in a lifetime income that’s smaller than their desired lifestyle requires, but they prefer to seek asset growth. They recognise that, even if it’s a reasonable long-term expectation, it isn’t guaranteed. In addition, they’re aware of ‘sequence of returns’ risk, meaning that a few years of bad equity returns in the early part of retirement could condemn them to permanent regret and a permanently much-lower-than-desired lifestyle forever after. That’s a serious and difficult issue.
Clearly, not all their assets can be growthy. How much, then, in safe assets? And what are safe assets, in fact?
The couple anticipates that their psychological attitude towards risk will change over time, as their desired lifestyle settles down. They’re looking forward to the immediate go-go years, when they’re finally able to do so many things they’ve dreamed about. But that stage, that attitude, that degree of robust physical and mental health, won’t last forever.
Most retirements settle down, in time, to a slow-go sequel, in which the lifestyle is downsized – not necessarily any less busy and involved, but more localised. The value of further growth, in terms of what benefit it secures for them, is reduced. Why take the risk if the reward means little? So they decide that they want as much safety as possible in their investments by the time the older one’s age reaches 85.
In addition, they don't want their far-flung adult children to worry about their finances. That suggests a target of 100% in safety-oriented investments, kicking in after the couple’s ‘autumn crescendo’ is over, as Dr Laura Carstensen beautifully describes the early stage of life after work.
That’s the long-term perspective. Back to the short-term sequence-of-returns risk.
3. The ladder of safety
To enable them to focus on growth (before the slow-go), they want a sort of ‘ladder of safety’, a tranche of safe investments from which they’ll make their drawdowns in the early years. This is important psychologically, even though it makes no financial difference to divide their pot conceptually into drawdown and growth segments.
They decide on a ladder that gives them five years of spending. Why five years?
One reason was our couple saw some (admittedly American) numbers that showed that, historically, equities had positive real returns over 5-year periods 75% of the time. That’s in satisfying concordance with their longevity probability stance. Going to a safer 10-year ladder took the percentage up to 88%.
The other was that putting 10 years of spending into their safety ladder reduced the amount in growth so five years was as long as they could afford, if they genuinely wanted growth.
At 80, hoping that they’ll still have a 5-year ladder, they’ll gradually start to cash out of growth, so that they’ll be totally in safe assets by 85.
They hope they can re-extend the ladder every year, so that it’ll always be available as a safety measure. What they’re betting on is mean reversion, the notion that governments or central banks will manage to intervene and prevent a prolonged equity market downturn.
Set the three choices, with annual appraisals
They now have three choices (a specific overall horizon, a specific time at which all assets should decline to safety, and a specific length of ladder) to determine a customised glide path for the growth/safety exposures as well as an estimate of sustainable annual drawdown.
But what if things don’t work out?
The couple plans two sets of nudges to their position, each year.
One is whether to extend the safety ladder. They will if equities have a positive real return. They won’t if it’s negative, but they know there’s deep trouble if five years pass that way.
The second is to reassess their sustainable drawdown each year. They won’t transition to the new number but will spread the difference over their remaining horizon. If there are five lean years in a row, they will have made five adjustments gradually.
Oh, back to one other thing not working out: their longevity estimate! If they’re still in reasonable health at 85, they’ll be entirely in safe assets anyway, not looking for further growth, so they consider an immediate annuity at that point and do away with longevity risk.
All their geeky friends tell them that something like that, with arbitrarily chosen numbers, can’t possibly be optimal. But all they want is a shot at growth combined with sleeping easily at night.
Don Ezra has an extensive background in investing and consulting and is also a widely-published author. His current writing project, blog posts at www.donezra.com, is focussed on helping people prepare for a happy, financially secure life after they finish full-time work.