A Paycheck in Retirement

Rick Borden

September 1, 2020

The general subject of a “paycheck in retirement” has been a hot topic at Dimensional Fund Advisors for the last 5 or 6 years, based on Robert Merton’s research in the area of lifecycle finance. It has led to the development of Dimensional’s new Target Date Funds, which are designed specifically to shift investor focus from portfolio balance to inflation-adjusted income in retirement and, in doing so, provide a clearer picture of retirement readiness.

Lifecycle Finance and the 4% Safe Withdrawal Assumption

The basic idea of lifecycle finance is that people have two general sources from which to finance their retirement: human capital and financial capital. The first contributes to the second through savings and investment; as people approach retirement, their human capital diminishes, and, hopefully, their financial capital will be enough to carry them through their golden years.

The goal for most people is to be able to maintain their standard of living in retirement. Traditionally, this has required a person to make an educated guess on the link between portfolio balance and inflation-adjusted spendable income. The accepted convention, based on Bill Bengen’s research published in 1994, is the 4% safe withdrawal rate -- the theoretical percentage of a portfolio that people can withdraw and spend every year without running out of money before they die. Bengen arrived at this number by looking at what kind of withdrawal strategies would have worked through various historical scenarios using a 30-year time horizon and picking the withdrawal rate that would have succeeded in the one worst scenario in history.

Bengen assumed equity allocations between 50% and 75% throughout the investor’s life. He actually concluded that a lower equity allocation was riskier than a higher one. On that basis, the 4% assumption has held up well, which is not surprising, since the long-term return on a 60/40 portfolio has been around 8%. The vast majority of the time, according to modeling, people using that portfolio allocation and the 4% assumption would have ended up leaving a lot of money behind.

The variables to the success or failure of the 4% safe withdrawal rate are: 1) the performance of the market, 2) interest rates, 3) inflation, and 4) the sequence of returns. So far on paper, the 4% assumption has weathered all of these risks successfully, over long term holding periods. But it’s not a guarantee, and for investors closer to retirement, or surprised by unexpected health or career events, it’s not a lead pipe cinch. And even over long term holding periods, it presumes, the maintenance of a consistent and meaningful allocation to stocks.

There’s a big difference between the 4% theory and practice. The biggest risk to the 4% rule, I believe, is investor behavior. It’s one thing to model the performance of a portfolio through time; it’s another thing to actually hold that portfolio through thick and thin – or advise a client to hold it and have them listen to you. It’s very hard to control one’s emotions when the markets are chaotic, as they were in 2008 and March of 2020. Even experienced advisors often capitulate to their clients’ anxiety in times like these.

Unexpected volatility leads me to think about Nassim Taleb and his Black Swan events. In a Q&A on the Fama/French Forum (March 19, 2009), Gene Fama concurred with Taleb (and Mandelbrot) about the occurrence of unexpected events and fat tails: “Extreme returns occur much more often than would be expected if returns were normal” but he goes on to say: “for passive investors, none of this matters,” by which I assume he means that passive investors will simply ignore chaos and stick with an optimal and consistent allocation to stocks.

But what can be done to ensure that your clients are “passive investors”? Will investors accept a 50% to 75% allocation to stocks and stick to it? The DALBAR study, updated annually, suggests that they cannot. Mutual fund investors routinely underperform the funds in which they invest, due to inopportune trading.

Dimensional and S&P: LDI- based Target Date Funds and LDI Mechanics

Dimensional’s Target Date Funds incorporate the immunization strategies used for years by insurance companies. The concept is pretty straightforward – identify the liability, calculate its duration, and construct a portfolio with the same duration. As markets, interest rates, and inflation move up and down, the value of the portfolio adjusts in concert with the liability. This technique is known as liability driven investing (LDI). In the case of retirement planning, the liability is 25 years’ worth of monthly payments, beginning at the retirement date, adjusted for inflation.

Dimensional has partnered in this effort with Standard and Poor’s, so that there would be an index (the STRIDE INDEX) against which to measure the performance of their new TDFs. The methodology that they developed was to calculate the “generalized retirement income liability” (GRIL) of $1 of real retirement income for 25 years starting at the date of each index vintage. The cost of the GRIL can be computed as the present discounted value of the future cash flow (based on the assumption that discount rates are expressed with continuous compounding), discounting the required cash flows by the real rate of return as determined by the TIPS yield curve (and the stripped treasury coupon yield curve) and summing them.

GRIL duration is then derived for a given target date and used to construct a portfolio of TIPs and nominal bonds that match the GRIL duration. A 25-year income stream has the duration of about 12 years on average. If the vintage year is in the future, duration must be adjusted to account for the delay. (see example: Appendix III, S&P STRIDE Index Series Methodology).

As in all TDFs, the Dimensional/S&P collaboration has a glide path which adjusts the portfolio allocations over time. Dimensional’s funds begin with a 90% allocation to stocks which drops to 25% in the decumulation years. In terms of portfolio composition, the principal difference between LDI target date funds and those of the rest of the industry is the inclusion of TIPS and the focus on inflation-adjusted income rather than portfolio balance in the LDI portfolios, and the greater allocation to equities during the decumulation years in the standard target date funds.

Dimensional has developed a Retirement Income Calculator that incorporates these calculations to help investors plan. The result is a probable range of income expressed in inflation-adjusted terms. The calculator assumes that the entire portfolio balance is consumed over the 25-year decumulation period. Over time, while portfolio values can fluctuate substantially, projected income is relatively stable.

If the threshold question is “how much can I spend every year in retirement?” then it’s arguable that the answer should be expressed explicitly in terms of inflation-adjusted income rather than nominal portfolio balance. This is the solution provided by Dimensional’s target date funds. If investors can be persuaded to focus on income rather than portfolio balance, it could make a big difference in peoples’ equanimity in chaotic markets, and a reduction in self-destructive behavior.

A Practical Application

Last year, my sister Joan, who is 77, asked me to take a look at her investment portfolio. She had asked her financial advisor for assurances that she wouldn’t run out of money before she died, and he had run his Monte Carlo simulations and counseled her to cut back on her (already very modest) spending. I wondered if an LDI portfolio might be a better approach to allay her anxiety and meet her needs, so I ran Dimensional’s Retirement Income Calculator, assuming she invested in the appropriate target date fund. The results were interesting. It required only 80% of her portfolio to meet her budget needs with 90% certainty. Her essential expenses thus covered, she could invest the remaining 20% in an all-equity portfolio, which would produce almost exactly the same residual value as a conventional 60/40 portfolio with a 4% withdrawal rate under “regular” market scenarios. But she would be much better off in a market environment in which the “safe” withdrawal rate turned out to be unsafe.

The broader application of LDI

It’s possible that the people who are getting the worst advice in the wealth management business have assets in the $10-100 million range. They often spread their money around to several managers, which contributes to a lack of overall coherence, they are seduced by complexity, they seem to be blind to the fees they are paying, they agree to invest in proprietary deals when the evidence of underperformance is overwhelming, and they have no clear idea how their portfolios have performed (mainly because the presentation of the results seems deliberately confusing), or why they own the investments they own. In general, many seem more interested in the “prestige” of their advisors than in the growth of their wealth. I believe this sector of the wealth management market is ripe for disruption.

The intersection of lifecycle finance and LDI has interesting ramifications for these higher net worth clients. It invites a discussion of a client’s entire financial picture. The definition of balance sheet assets can be expanded to include the discounted present value of future resources like employment income[1], social security, inheritance, proceeds from the sale of a business, etc. Asset allocation can then match risk-appropriate assets to prioritized liabilities, for example, immunizing future “essential spending” with TIPs and “aspirational spending” with equities. Greater clarity on the sufficiency of asset coverage can provide a framework for charitable activities, estate planning, or engaging in more speculative investments. The entire process is transparent and iterative.   

This is the cliff notes version of this approach; my impression is that its application is so far pretty limited. I think if it were fully embraced, it could be transformative to a HNW or UHNW business.