By Dr. James M. Dahle, WCI Founder

I am often asked to write more articles aimed at those who are retired or approaching retirement. In many ways, spending down your assets efficiently is a lot more complicated than accumulating them in the first place. In recent years, there are more and more articles being published on this topic, with Wade Pfau probably being the most prominent name in the field, at least among Boglehead types. In his 2016 book on Reverse Mortgages, he spent the first chapter on an excellent overview of the challenges of providing retirement income.

In this post, I will borrow heavily from his ideas, so I thought it only fair to plug his book a bit. So uh . . . buy his book. It's really good.


Your Balance Sheet

Your household has a balance sheet. As you'll recall from the mini-MBA they didn't give you in medical school, a balance sheet has the assets listed on the left and the liabilities listed on the right. That balance sheet for someone approaching or already in retirement might look like this:

nest egg balance sheet

Everyone's balance sheet will have a different dollar amount next to each of these assets and liabilities, but there are two keys to solid retirement income planning. The first is to make sure the assets cover the liabilities. If they do not, some adjustments need to be made to one side of the ledger or the other. Secondarily, you want to match the liabilities with the assets in the most “efficient” way possible. By efficient, I mean with the lowest likelihood of failure and the lowest tax bill without leaving money on the table. Even if you are well beyond “enough,” the more efficiently you manage this process, the more you can put toward your legacy.


Tapping Your Assets

You can use your assets to provide funds to spend in retirement in many different ways. Money is fungible, and while there are transaction costs and taxes to mind, you can often change it from one form to another relatively easily. For example, if you prefer to accumulate your assets using mutual funds and spend them as real estate rents, you can simply sell your mutual funds and buy income properties upon retiring.

But even for a given asset, such as home equity, there are a number of different ways you can use it to match your liabilities. By keeping your paid-off home and living in it, you can reduce your basic living expenses and then use the value of the home when you die as part of your legacy. You can sell the house and move into something smaller, investing the difference to help provide retirement income. You can rent out part of it with Airbnb and earn money from it as a retiree. You can take out a mortgage on your home prior to retirement and invest that money, hopefully earning a higher return than the home equity would provide you. You can also take out a home equity line of credit (HELOC) and spend it as you go throughout retirement. A reverse mortgage is another option.

One asset, many different uses. Which is best? Well, it depends on the entire picture of your household balance sheet.


Two Schools of Thought

There are really two schools of thought when it comes to retirement income planning. Pfau describes them well in his book:

“Two fundamentally different philosophies for retirement income planning—which I call “probability-based” and “safety-first”—diverge on the critical issue of where a retirement plan is best served: in the risk/reward tradeoffs of an equity portfolio, or the contractual guarantee of insurance products . . . those favoring investments (the probability-based) rely on the notion that the market will eventually provide favorable returns for most retirees. Though stock markets are volatile, stocks can be expected to outperform bonds over a reasonable amount of time. The investments crowd considers upside potential from a portfolio to be so significant that insurance solutions can only play a minimal role . . . Meanwhile, those favoring insurance (safety-first) believe contractual guarantees to be reliable and that staking your retirement income on the assumption that favorable market returns will eventually arrive is emotionally overwhelming and dangerous. The insurance side is clearly more concerned with the implications of market risk than those favoring investments . . . [they view] investment-only solutions as undesirable because the retiree retains all the longevity and market risks, which an insurance company is in a better position to manage.”

Obviously, this isn't an either/or proposition, despite the fact that many “advisors” basically only look at one side or the other of this continuum. Each of us is likely to find ourselves somewhere different on the continuum between investments and insurance, and that's fine. I get the impression that Pfau leans far more to the insurance side than I do, but that's primarily due to his pessimistic views about future market returns and his distaste for risk [for what it's worth: from 2017-2021, the S&P 500 rose at least 16.26% in four of those five years].

retirement planning

But it doesn't really matter how Pfau feels or how I feel about this issue. What matters is how you feel about it. The more you worry about leaving something on the table by being cautious, the more you'll lean toward the probability side. The more you worry about running out of money, the more you'll lean toward the insurance side.

The advantages of the probability approach include liquidity and the upside potential for increasing your standard of living and your legacy. Less money is also “probably” needed to reach your lifestyle and legacy goals. The advantages of the safety-first approach include less longevity risk, less sequence of returns risk, and less worry about declining cognitive abilities.

Pfau continues:

“For probability-based thinkers, a 90% chance of successfully meeting their goals is a more than reasonable starting point and the retiree can proceed with the plan. It has a high likelihood of success and that's enough for them. If future updates determine that the plan might be on course toward failure, a few changes, such as a small reduction in spending, should be sufficient to get the plan back on track.

Those identifying with the safety-first school, however, will not be comfortable with this level of risk, focusing instead on the 10% chance of failure. They make a distinction between essential expenses and discretionary expenses and seek a solution that practically eliminates the possibility of failure for meeting essential expenses. Jeopardizing success, they say, is only reasonable for discretionary expenses.”

As Bill Bernstein has said, “When you've won the game, stop playing.” It is important that you understand where both you and your advisor sit on this continuum.

At the far left side, you may carry a 100% equity portfolio throughout retirement and even carry a mortgage into retirement to keep more money in the market. If you have income properties, you would prefer to have two with a 50% mortgage on each of them rather than one paid-off mortgage.

At the far right side, you've annuitized almost all of your assets, reverse mortgaged your home, bought a permanent life insurance policy precisely equal to your legacy desires, and own a long-term care policy.

The wise course is likely somewhere in the middle. Pfau concludes his chapter, a masterpiece by itself wedged into a book on a rather specialized piece of it, with this graphic:

Retirement Income Optimization Plan

I love his 4 Ls—the goals of longevity, lifestyle, legacy, and liquidity.

  • Longevity: Make sure your assets can provide your essential expenses for your entire life
  • Lifestyle: Allow you to live “the good life” in retirement
  • Legacy: Leave something behind for those people and causes that you care about
  • Liquidity: Make sure you're covered in case something bad happens

However, I also appreciate the way in which he matches assets to liabilities. The more reliable the income, the more it can be used for essential expenses. Meanwhile, those assets with a higher expected long-term return fund your lifestyle and legacy goals. Then you cover contingencies with a hodgepodge of assets ranging from insurance to the income of your children.

What do you think? Where do you fall on the continuum between probability-based and safety-first? How do you plan to match your assets with your liabilities in retirement? Comment below!

[This updated post was originally published in 2017.]