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The Yin and Yang of retirement income philosophies

Within the world of retirement income planning, there are two major opposing schools of thought: probability-based and safety-first. Understanding the distinctions and thought processes of both schools is important in achieving the best outcomes.

Separating accumulation from drawdown: the difficulties of retirement income planning

In defined contribution schemes, there are differences between the wealth accumulation phase and the income distribution phase. One important difference is that the investing problem fundamentally changes in retirement.

The traditional goal of wealth accumulation is generally to seek the highest returns possible in order to maximise wealth, subject to the investor’s risk tolerance. After retiring, however, the fundamental objective is to sustain a living standard while spending down assets over an unknown, but finite, length of time.

Investing during retirement is a rather different matter from investing for retirement, as retirees worry less about maximising risk-adjusted returns and worry more about ensuring that their assets can support their spending goals for the remainder of their lives.

The two schools of thought

As an introduction to these schools, consider a simple example. Suppose a retirement plan has a 90% chance of success of providing income for a retiree taking into consideration longevity and market risk. Both sides will have dramatically different interpretations about what this number means.

From a probability-based perspective, 90% success is a more than reasonable starting point. It is likely to work. Safety-first advocates, however, will not be comfortable with this level of risk, focusing instead on the 10% chance of failure. They will seek a solution that removes the impact from any possible failure.

Table 1: Retirement income philosophies

JC Table1 211114

JC Table1 211114

The probability-based school of thought

The probability-based approach is closely associated with the traditional concepts of wealth accumulation. In this frame, people do not differentiate between essential needs and discretionary expenses. Rather, people operate on a total budget concept.

Probability-based approaches are based closely on the concepts of maximising risk-adjusted returns from the perspective of the total portfolio. Different volatile asset classes, that are not perfectly correlated, are combined to create portfolios with lower volatility that provide the highest ‘expected return’. It is an assets-only analysis, and the investor’s spending needs are not relevant to determining the appropriate asset allocation.

For retirement planning, spending and asset allocation recommendations are based on mitigating the risk of wealth depletion that is inherent in drawing down a portfolio of volatile assets (ie due to sequence of returns and market risk). The failure rate is the probability that wealth is depleted before death, or before the end of a fixed time horizon.

Probability-based advocates tend to focus on the potential of equities to provide positive real returns and to outperform bonds over the long run. Retirees are thus advised to take on as much risk as they can tolerate to minimise the probability of failure. This has led advocates of the probability-based approach to use more and more aggressive asset allocations.

The safety-first school of thought

Advocates of the safety-first school of thought view prioritising retirement goals as an essential component of developing a good retirement income strategy. Prioritisation will be very important because the investment strategy is to match the risk characteristics of assets and goals.

Retirees’ spending priorities are prioritised like the pyramid in Figure 1. Essentially, spending is required to satisfy basic needs, with additional spending on discretionary items after basic needs are met. The pyramid model requires each goal to be properly funded before continuing to the next level.

Figure 1: Modern Retirement Theory hierarchical pyramid


JC Figure1 211114

The general view of safety-first advocates is that retirees only have one shot at getting sustainable cash flows from their savings. This means they must develop a strategy that will at least meet their needs, no matter the length of life or the sequence of post-retirement returns.

Retirees often have little leeway for error, because returning to the labour force is not a realistic option for many retirees. Volatile investments like stocks are not appropriate when seeking to meet basic retirement living expenses. Volatile (and hopefully, but not necessarily, higher returning) assets are suitable for discretionary expenses and legacy, where the spending is more flexible.

The goal is to have cash flows available to meet spending needs as required. Investment assets are matched to goals so that the risk and cash flow characteristics are comparable. This can include defined-benefit pensions, bond ladders, and fixed rate annuities.

The retirement income challenge

The essential difference between the schools of thought relates to the degree of comfort people have that equities will always perform well enough for a broadly diversified portfolio to meet a retiree’s basic needs, without relying on more secure assets. With essentials-versus-discretionary, lifetime flooring protection is created for essential needs. This is really ‘goal segmentation.’ Systematic withdrawals generally leave the entire lifestyle spending goal at risk, since spending needs must be supported from a portfolio of volatile assets.

Concluding remarks

Super funds and financial advisers alike can help retirees overcome the complexities of generating retirement income by first understanding the different philosophical approaches to retirement. While neither a probability-based nor a safety-first approach is definitively right or wrong, different people will align more easily with one or the other. Nor is it an all or nothing approach. A fund or adviser shouldn’t advocate for only safe assets and no risky assets. The safety first approach is about securing essential spending needs in retirement, with room for more probability-based approaches for discretionary spending.

The full paper by Pfau and Cooper is available here. An extended version of this summary is here.


Wade Pfau is professor of retirement income at The American College and hosts the Retirement Researcher blog at Jeremy Cooper is Chairman, Retirement Income at Challenger Limited.

January 04, 2018

The "safety first" approach leads you down the path of an "annuity-like" product without consideration of the risk that the "annuity provider" fails

How could that happen? Well a failure to exactly match Assets and Liabilities will do it as will a major shift in Life Expectancy. Annuity providers have relatively often, had to top up their capital. It can and does happen.

So "safety first" may not be quite as safe as it is made out to be - if I personally wanted to go down that route, I would go out and buy directly a AAA bond portfolio!!

Graham Hand
November 25, 2014

Lots of comments which is good but please ensure the full paper is read for context rather than this brief summary produced for our purposes (Editor).

Chris Condon
November 21, 2014

In this article the authors observe that there are two schools of thought about investing for retirement. The authors may be correct in this observation, but they should have taken the time to demolish this flawed dichotomy, rather than give life to it.
I am particularly concerned with their statements that the investment problem is different before and after retirement. Peter Vann has already observed that the objective of investment for superannuation is unchanged in the two phases, and that the “wealth accumulation” objective that many funds and members pursue before retirement is bad practice.
I would like to add another concern. The poor thinking that you need different investment strategies (and by extension products) during retirement can create sequencing risk that did not previously exist.
In order to invest in the new retirement products on retirement you need to sell investments you hold at retirement. If this happens immediately after a market fall, then you will suffer a permanent loss, and your future retirement income will be degraded. And if you “glide path” out of risky assets in the years leading up to retirement, you will may well be investing too conservatively as you will not be spending much of your accumulated balance for many decades.
But it gets worse. The price you pay to invest in your new retirement products is also subject to market conditions. Typically these products involve substantial fixed interest assets, which are expensive to buy when interest rates are low. You will be unable to take advantage of cheaper bonds when interest rates revert to higher levels.
Now both of these circumstances could be reversed, and you could benefit from a windfall by making this switch on retirement. But that is still sequencing risk, it is just beneficial.
I call this flawed thinking: “investing TO retirement, not THROUGH retirement”.
With proper information about the retirement income you are likely to receive, you can make modest adjustments to your investment strategy over time (both before and during retirement).
These adjustment can involve retirement products. If the tax laws are reformed (as is likely), deferred annuities may be gradually purchased before and during retirement.
And you can adjust account-based portfolios gradually to reflect your changing circumstances, before and during retirement.
But avoid creating unnecessary sequencing risk associated by making wholesale changes to your investment portfolio at a point in time.

Peter Vann
November 21, 2014

For some time now I have enjoyed following Wade’s blog and the eMails from his blog for their insights showing the forward thinking with respect to managing superannuation assets, etc, for the retirement outcomes.
But with this CuffeLinks article (and with the full paper) I struggle to get past a couple of early statements such as
“ the investing problem fundamentally changes in retirement”
“Investing during retirement is a rather different matter from investing for retirement”
“The traditional goal of wealth accumulation is …… After retiring, however, the fundamental objective is ……”.
I believe that statements of this nature confuse the issues. Why? To start with, the goal of investing before retirement and after retirement is the same, to support an income in retirement.
The fact that the industry has confused the before retirement objective as “wealth maximisation” is simply a function of bad practice. Instead, accumulators should invest in a way that “best” funds the liabilities, i.e. retirement expenditure. This is about the tradeoffs on the likely distribution (probability/safety) of retirement income resulting from various investment strategies.
It should not be primarily driven by tolerance to investment risk since that is the WRONG risk (and is somewhat inversely related to risk of insufficient retirement income, depending on one’s age).
After retiring, this goal does not change and any analysis of the likelihood of achieving your retirement goals likewise doesn’t change. But investment strategy evolves since previous uncertainties have passed, contributions have ceased and withdrawals commenced (and some will be quick to point out that the tax rate changes, but that should have already been embedded in any analysis in pre-retirement).
However, there is one significant difference pre and post the retirement date. Pre retirement you can only estimate the dynamic events through retirement. Post retirement you experience these events and many readers of CuffeLinks will need to monitor and manage the impact of these dynamics on their financial situation.
It appears from comments on Wade’s blog and his research, and from some of his colleagues eg David Blanchett, that this is much better executed in the USA by a knowledgeable cohort of advisers than we see in Australia.
I could also comment on a “unified framework” that merges the probability-based and safety first schools, but will stop here for the moment.

November 25, 2014

Well said Peter. While one can understand the distinction the author is trying to get across a range of concepts seem to be getting confused or at least mis labeled here. For example: Since when has loading up on risk based on ones assumed tolerance been described as a probability based approach? Also, there is no reason that probability and safety first concepts must be mutually exclusive? The first statement in the comparison table highlights this perfectly, why can't a reasonable probability based approach prioritise certain cash flows? And yes, minimising the probability of 'failure' might not be the most practical goal, that's why one should never consider a probability of success calculation without understanding the subsequent magnitude of calculated failures. It also gives the impression that safety first concepts are a distinctly different approach to ones utilising probability assessment. The reality is that for many investors the 100% safe option described will not result in 100% safe outcomes anyway, so what happens when the probability of success for your safety first option is less than 100%......?

November 25, 2014

I assume that you are not familiar with the concept of the Yin-Yang where one cannot exist without the other. If you read the full paper (there is more detail that it is not "an all or nothing approach") you will understand that the both safety and probability are essential in good retirement income plans. The key is understanding that different retirees will have different preferences for the level of safety, and the risk taken when there is only a probability of success.

November 25, 2014

No, not confused Aaron, my point was that the two must exist together as a focus on one philospophy or another is never ideal. I took issue simply with the fact that what is desribed in the paper as the 'probability approach' could actually be considered poor practice and elements of the saftey first principals are required in order for that approach/philospohy to be reasonable in the first instance. In my view no practioner should 'identify' with the probability based school of thought as identified by this paper. Esspecially given the early presumption in the paper that montecarlo based tools are 'commonly' used, because in the financial planning industry the use of such tools is anything but common.

It was a little straw man like in my mind, which was confusing given the overal discussion was very valid and does not require such distinctions (pitching one school against another).


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