How Do You Measure Which Retirement Income Strategy Is Best?
April 19, 2016
by Michael Kitces
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Given the myriad of products available to today’s retirees, there are a lot of choices to consider about which retirement income strategy to pursue, from portfolio-based withdrawal strategies to annuities with income guarantees and more.
Yet, what seems like a relatively simple question – which strategy is the best – is remarkably difficult to determine. Which is “best” depends heavily on how you measure what “best” means.
For instance, the retirement strategy that produces the greatest wealth is generally to just not spend very much! If the goal is to maximize spending, then the best strategy is to invest as aggressively as possible. Yet portfolios with maximal growth also produce the greatest catastrophes, which means a risk-averse retiree may not want that approach.
Thus, in framing different retirement income strategies – and the trade-offs they entail – it’s important to scrutinize the measuring stick used to evaluate the outcomes. The best retirement income strategy will depend on whether you measure based on wealth, spending, probabilities of success, magnitudes of failure or utility functions that weigh both the upside and downside risks!
Determining how to measure the best retirement income strategy
Assume a 65-year-old couple is trying to decide how much to spend for a 30-year retirement from their $1,000,000 portfolio and how that portfolio should be invested. The choices might include:
A) Spend an inflation-adjusting $30,000/year from the portfolio, by putting 90% of it into an immediate annuity and keeping the other 10% in cash reserves
B) Spend an inflation-adjusting $45,000/year from the portfolio, and invest it 50/50 in stocks and bonds
C) Spend an inflation-adjusting $60,000/year from the portfolio, and invest it 100% in stocks
Accurately assessing which strategy is best depends heavily on how the outcome is measured.
Measuring retirement outcomes by projected wealth
The first way these three strategies might be assessed – and the most common methodology for the first several decades of financial planning – is to project how wealth would accumulate and compound over the 30-year retirement time horizon.
The chart below graphs the remaining wealth in the portfolio across each of the three strategies, assuming inflation averages 3%, and that long-term 30-year investment returns are 3% for cash, 5% for (intermediate) bonds, and 10% for stocks. (The immediate annuity is assumed to have a principal refund feature if death occurs before the payments have been recovered, which winds down over time as the payments are made.)
Strategy C, spending $60,000/yr and investing 100% in stocks, is the best. Ironically, this is true even though in many cases, long-term wealth is maximized by spending less (and allowing the portfolio to grow), as in strategy A. But the growth rate of stocks is so dominant that strategy C creates the most long-term wealth, even though its growth is slowed by the largest ongoing withdrawals.
Measuring retirement outcomes based on cumulative spending
Strategy C created the most wealth – despite taking the largest withdrawals, but retirees should not measure outcomes based on final wealth alone. Otherwise, for any two strategies that have similar returns, the better one will always be the one with the least spending. At the extreme, the most successful strategy would be to never spend a dime of one’s retirement funds.
An alternative approach is to look at the cumulative amount of dollars spent, which more accurately represents the retiree’s opportunity to enjoy his or her wealth. In this context, the best strategy is not the one with the most money in the portfolio at the end, but the one that allows the most money to be consumed.
On this basis, strategy C is the best. As shown below, strategy C produces by far the largest amount of cumulative retirement income spending, in addition to producing the greatest wealth accumulation over time (as shown earlier), thanks again to the long-term return of equities.
Of course, the caveat to this methodology is that it only shows the projected levels of wealth and spending if average returns are earned. Moreover, it ignores volatility. Which matters, because when the best strategy is evaluated not based on linear projections but a different measuring stick – the optimal approach changes again.