Wade Pfau has written an important book: How Much Can I Spend in Retirement?: A Guide to Investment-Based Retirement Income Strategies. It should be read by not just financial planners, but also all investment advisors who work with individual accounts.
The traditional way that investment advisors, as distinct from financial planners, have managed clients’ portfolios has been to try to build wealth, through getting good returns in some fashion, and sometimes, especially when the advisor has learned modern portfolio theory, keeping one eye on investment risk and the clients’ stomach for risk. Financial planners, as professional practitioners distinct from investment advisors, have trained their attention, instead, on funding their clients’ spending needs, of which the greatest is, normally, the costs of funding their lives through retirement.
Although there is a clear need to integrate wealth accumulation with the plans for drawing down that wealth, there has been a dearth of theory to guide practitioners in this integration. Worse, until recent years, there has been little work on how to create retirement income plans, apart from, for the last couple of decades, the formulation and acceptance of the familiar “4%” rule. It’s excusable that investment management has received most of the glory of the attention of trained economists, while retirement planning was neglected, because until the decline of defined-benefit plans and the rise of defined-contribution plans, retirement planning had comparatively little need for intellectual labor. Now, as many are aware, the retirement problem has increasingly attracted serious study, including that of such luminaries of financial economics as William Sharpe, Zvi Bodie and Robert Merton.
Pfau is one of the leaders in the economics of retirement planning, and he has built his still short career in this field. We are fortunate now to have his considered judgement on the totality of investment approaches to funding retirement. (In his preface to the book, he says that he will explore in later books the use of annuities and other insurance products for this purpose. And he has already published a book on reverse mortgages.i)
He addresses his book to the public, not to financial planners and investment advisors, but it is hardly likely that significant numbers of ordinary citizens will find, let alone read this book. I can’t picture my clients reading it. And that’s no great loss. It is important only that practitioners and sophisticated do-it-yourself investors read this book, and perhaps it is because Pfau thought that he was addressing the public that the book is mostly free from jargon and is written very clearly; there is therefore little excuse not to read it. (The ostensible readership may explain the otherwise superfluous brief introduction to fixed income analysis at the beginning of Chapter 7.)
Pfau systematically and at length analyzes virtually every approach that has been suggested for retirement income planning, using both reconstructions from historical data and projections based on Monte Carlo simulations. I have long been wary of Monte Carlo simulations, which have become the magic ingredient in financial planning software in much the same way that chlorophyll became the magic ingredient in chewing gum and oat bran in almost every processed baked food product. I was therefore very glad to see that Pfau, in an appendix to Chapter 3, lays out the processes and assumptions that he has incorporated in his simulations. These are reasonable and were chosen with good judgement. His are Monte Carlo simulations that I trust, knowing their limitations. (The description is only moderately technical; you won’t be able to reproduce his code exactly, but I am confident that his results are reproducible.)
Read the full article here by Adam Jared Apt, Advisor Perspectives
