User:Quebec/Non-conventional retirement planning

This article describes non-conventional approaches to retirement planning, some of which are inspired by life-cycle finance (e.g., ), and/or by a desire to develop safer ("safety-first"), more income-focused, or more flexible approaches to planning.

According to Pfau, retirees face three main risks:
 * 1) Longevity risk: you don’t know how long you will live and while it is great to live longer, it is also costly.
 * 2) Sequence-of-returns risk: Retiring at the start of a bear market is very dangerous because your wealth can be depleted quite rapidly and your ability to return to the workforce may be limited.
 * 3) Inflation risk: retirees face the risk that inflation will erode the purchasing power of their savings as they progress through retirement.

The approach described here is an alternative to conventional retirement planning methods. Conventional approaches, sometimes called "probability-based" approaches, can lead to big swings in spending (consumption disruption) and high expected returns which do not necessarily result in high actual returns. For the safety-first school, you only have one opportunity to experience retirement, so even a small probability of complete portfolio depletion is not acceptable.

There are two components of this non-conventional approach. The first component establishes a budget containing your essential (non-discretionary) spending. Essential spending should be covered by matching strategies that rely on fixed income or annuity products. This means giving up on some upside potential, and giving up on wealth maximization, on the portion of the portfolio need to provide the income floor.

The second component contains a budget for your discretionary or "preferred" spending. This budget establishes your portfolio to achieve aspirational goals, and therefore is invested in risky assets, or a mix of safe and risky assets.

Using these components together should decrease longevity risk, sequence-of-returns risk, and inflation risk.

This article also discusses an alternative to the SWR (Safe Withdrawal Rate) method during retirement.

Retirement spending
The needed or desired spending level is a key factor in retirement plans. Conventional approaches to retirement planning use an income replacement rate approach, or a single retirement budget. The single budget method mixes needs (essential consumption) and wants (discretionary consumption). It gives a fixed target income, generally indexed for inflation, which can be linked with a withdrawal method that provides such a constant real income. The dual budget method (explained below) is more flexible and can be linked with withdrawal methods that provide variable income. One also needs to consider whether retirement spending should be fully indexed for inflation.

Dual budget model
Dual budget models of retirement spending incorporate two total spending estimates. The first or Essential budget represents the lowest level of retirement spending that can be accepted. The second or Preferred budget represents a higher level of retirement spending that is actually desired. The retiree’s spending in any year is assumed to fall within the range bounded by these two budgets.

The easiest way to estimate the Dual budget models is by using a worksheet designed for this purpose. Each budget category on such a worksheet accepts two entries: an essential spending amount and a discretionary spending amount. The sum of both gives the preferred budget spending estimate.

Spending patterns
Another point to consider is that the actual spending patterns of retirees are not fixed. Based on surveys, the average retiree exhibits a slight drop in real spending at retirement, followed by a steady decline in real spending as they age into their late 70’s or early 80's. This decline in real spending is voluntary and not a result of limited financial resources.

Vettese (2018) reviews longitudinal studies on retirement spending in the UK, Germany and Sweden. Such studies look at the same subjects (actual retirees) over long periods of time, using a large number of households. Based on these studies and other reports, he comes up with the following post-retirement spending guidelines:
 * spending is constant in real terms until age 70 (i.e. nominal spending increases along with inflation)
 * real spending then declines by 1% a year throughout one's 70s (i.e. nominal spending increases, but by 1% less than the rate of inflation)
 * real spending declines by 2% a year in one's 80s
 * real spending is flat from age 90 onward

Of course, you are free to choose any spending model you like for planning purposes, but the general message here is that constant real spending models lead to an overestimation of the total savings needed at retirement.

Liability matching
This section describes the strategy to implement the essential spending component of your budget.

Liability matching strategies allows an investor planning for retirement to meet specific financial targets with near certainty. Matching strategies only work with fixed income and insurance products such as annuities. There must be a known maturity date for the asset so the timing of the asset and liability can be matched.

Matching strategies are very safe, but offer little or no upside potential. An important reason that matching strategies are safer is because typically they use hedging to mitigate risk. By hedging risk you are protected against both non-market and market (systemic) risk.

In the context of retirement, the 'liability' that needs matching is a retirement income floor (the “Essential budget” above), indexed for inflation.

Guaranteed income streams such as Old Age Security (OAS), Canada Pension Plan (CPP), Québec Pension Plan (QPP), and defined benefit pensions (which are not all inflation indexed), if applicable, contribute to this income floor, but for many Canadians that will not be enough. The missing portion to reach the income floor can be obtained by:
 * delaying OAS and/or CPP/QPP, up to age 70, to increase the amounts to be received;
 * with a liability matching portfolio, that will consist entirely of fixed income products;
 * with annuities;
 * a combination of methods.

Aspirational portfolio
The second part of the dual retirement budget, i.e. the preferred budget or “aspirational income goal”, can be met with a mixture of stocks and bonds, with risk primarily managed through diversification. This is called the "aspirational portfolio" or "growth portfolio".. 100% stocks is fine if you have the stomach for it, since you have already guaranteed an inflation-indexed income floor with the liability matching portfolio. Otherwise, use your risk tolerance to come up with an asset allocation.

The amount to commit to the aspirational portfolio during accumulation can be calculated in a similar way that you would for the total portfolio in the conventional approach. Or it can be done with the “After-tax spending plan” spreadsheet. (You would use the spreadsheet to calculate your total savings every year: a fixed amount goes to the liability matching portfolio and the rest goes to the aspirational portfolio)

The amount to withdraw during retirement from the aspirational portfolio can be calculated using a range of methods, including Variable percentage withdrawal.

Variable percentage withdrawal
During retirement, variable percentage withdrawal (VPW) is an alternative to the safe withdrawal rate method. The VPW method adapts to the retiree's retirement horizon, asset allocation, and actual portfolio returns during retirement. It combines the best ideas of the constant-dollar, constant-percentage, and 1/N withdrawal methods to allow the retiree to spend most of his portfolio using return-adjusted withdrawals.

Examples
In Conventional retirement planning we looked at two couples, the Aggs and the Cons. They are all aged 30, want to retire at 65, and their money must last to age 95 or later. Their target retirement income was $60k in today’s dollars.

They redo their planning with the dual budget method, and each couple decides that $50k of gross retirement income would be an acceptable floor. Again, let’s say that OAS will be $7k, CPP will be $13k, and there are no workplace pensions. So both couples are looking at a guaranteed inflation-indexed retirement income of $40k (gross) from OAS + CPP, if they claim both at age 65. Each couple needs to generate another $10k of safe income to meet the minimum floor of $50k.

Beyond that, their aspirational goal is to generate a further $10k of income per year to reach the $60k target, but this extra income will be allowed to fluctuate from year to year.

Delaying CPP/QPP
The easiest strategy to reach the income floor is to delay CPP to age 70. The CPP amount would be 42% larger, so our hypothetical $13k at age 65 would become $18.5k per person by waiting until age 70. If OAS is taken at age 65 but CPP is deferred to age 70, each couple would get $51k of guaranteed income starting at age 70, which slightly exceeds their minimum floor. I.e., an extra $11k of safe income has been obtained.


 * If they had deferred OAS too, the OAS amount would be 36% larger, so a hypothetical $7k at age 65 would have become $9.5k at age 70, for a total of $56k of guaranteed inflation-indexed retirement income per couple.

How much would deferring CPP cost? Starting at age 65, each couple needs to extract $36.9k per year (two times CPP at age 70) from their RRIFs, over five years, to bridge the gap to age 70. Suppose that the real return on GICs and HISAs is zero, for simplicity, and that these are the chosen vehicles for the CPP deferral strategy. Therefore, the amount needed is simply five times $36.9k or $184.6k.

Compare this strategy with not deferring CPP and leaving the money in a RRIF. With a 4% 'safe' withdrawal rate, it takes $250k of capital to generate $10k of yearly income, and there is no guarantee that this income will last to the end. Differing CPP requires less capital, and produces a guaranteed inflation-indexed income for life. What’s the catch? If one spouse dies, the other inherits the RRIF, whereas CPP offers a survivor pension, but it’s not advantageous.

The question of how the $184.6k should be accumulated, and invested, before retirement, is not that obvious. Hardcore adherents to the safety-first school might answer that the capital should be accumulated progressively over 35 years, and invested entirely in fixed income, preferably inflation-indexed bonds (see liability matching below).

Less safety-obsessed investors might want to accumulate the $184.6k over the last 15-20 years before retirement instead, and again put it all in fixed income. This would, in effect, mean investing mostly in stocks from age 30 to age 45 or 50 (to give the aspirational portfolio a head start), and then shifting to more fixed income over time as the CPP-deferral “mental account” takes priority when adding funds to the portfolio. For example, using the $10.7k per year that the Cons were ready to invest with the conventional approach, and real returns of zero for illustration, they would spend the last 17 years accumulating fixed income for CCP deferral. Any savings prior to that would go the aspirational portfolio.

Liability matching portfolio
For the sake of illustration, suppose that for some reason, the Aggs and the Cons decide that OAS and CPP/QPP have to be taken immediately at age 65. Each couple needs a liability matching portfolio that will generate $10k of inflation-indexed income for 30 years (from age 65 to 95). Assuming a real return of zero for simplicity, the liability matching portfolio therefore needs to be $300k at retirement, in today’s dollars (30 times $10k). Each couple has 35 years to accumulate this, so they can set aside about $8.6k a year to reach this target, and invest it all in safe assets such as RRBs. This is a very expensive approach compared to deferring CPP, and longevity risk is not addressed, unless an annuity is purchased (typically between the ages of 65 and 75).

If the annuity route is chosen from the start, the amount is capital needed can be a bit less. For example, using Feb. 2018 quotes, it would cost each couple $247.3k of registered funds to buy an indexed (2%) joint annuity that pays $10k of yearly income at age 65.

Young investors
The liability matching approach (with a complementary aspirational portfolio) seems very well suited for investors approaching retirement, and retirees. However, from a life-cycle perspective, it can seem overly defensive for a 25-30 year old investor, who still has a lot of human capital (future work income).

For a young person with a stable, "bond-like" job in particular, a stock-heavy portfolio would seem acceptable at least until age 40-45. If stocks have high returns during this period, great! The investor can switch to safer investments. If stocks don't do well in the first decades, there is still time to convert human capital into financial capital before retirement.

This approach -- take risk with stocks for young investors, then switch to a "two portfolio" (liability matching portfolio + aspirational portfolio) mode later -- is recommended by W. Bernstein in his book "The Ages of the Investor: A Critical Look at Life-cycle Investing".

An SWR alternative - consumption smoothing
Life-cycle finance begins with the premise that households prefer relatively smooth consumption from year-to-year and have a strong dislike for abrupt shifts in consumption, particularly on the downside. This is known as consumption smoothing.

Consumption smoothing is an economic concept stating that people want to optimize their standard of living over their lifetime. In other words, "people seek to smooth spending over their lifetimes in order to obtain the greatest satisfaction from their limited resources, and the problem to be solved is how high this standard of living can be".

Traditional approaches to retirement planning start either with a savings rate goal (e.g., "save 10% of your income"), or an income replacement goal (e.g., "replace 70% of your pre-retirement salary"). These approaches are likely to result in either a sudden drop or an abrupt increase of purchasing power at retirement, because they can lead the investor to save either not enough, or too much. A more rational approach is to start with the explicit aim to smooth consumption over one’s remaining lifetime, calculate this optimal consumption amount, and adjust other parameters accordingly.

In practice, calculating the constant (in real terms) optimal consumption amount for one’s entire lifetime is probably not feasible because of the many variables it involves, and difficulty in predicting things like future salary increases, investment returns, longevity, etc. But consumption smoothing can still provide a mental framework to think about why you are saving so much for retirement, and why essential consumption, in particular, should perhaps be funded by safe assets. This can be done with liability matching, discussed below.

According to Pfau & Cooper (2014), during retirement, "the spending required to satisfy basic needs provides much more value and satisfaction to someone than the additional spending on luxury goods after basic needs are met. Retirees should plan to smooth spending over time so as to not overspend on luxuries in one year at the cost of not being able to afford essentials in a later year."

The after-tax spending plan
A method of calculating the savings rate each year, that takes into account one’s salary, taxes, portfolio balance, etc. and that smooths future consumption has been developed by FWF member longinvest. He calls this The After-Tax Spending Plan and writes that the spreadsheet "informs us about the 'equilibrium' monthly spending amount, given the current state of things: current age, planned retirement age, current salary, current portfolio balance, and currently accrued QPP (and eventually CPP) pension".