A Framework for Thinking About Retirement Income

First, credit where credit is due. Most of the ideas in this blog post are not mine, and if they can be credited to anyone, that credit goes to Wade Pfau. I good-naturedly (hopefully good-naturedly) rib Wade a lot because he loves to get into the weeds on retirement spending discussions. I'm much more of a big picture guy on this subject (“start at something around 4% and adjust as you go“, “if you really have to care a lot about this stuff, you probably blew the accumulation phase,” you're going to have to be flexible in retirement, etc.).

But WCIers keep asking for more and more information and discussion of this topic, so let's go into the weeds and hang out for a while.

Before we do that, however, I think it's really important to have a framework in place. You can then take any new ideas and information you encounter and place it onto that framework to make it easier to understand. I know of no better framework than the one that Wade has developed, so we're going to discuss it today. If you want to read more from Wade, you can start with this article, or better yet, get his book, Retirement Planning Guidebook. Buy through that affiliate link, and WCI will even get something like $1 from Amazon—and maybe I can get an extra pickle the next time we order lunch for a staff meeting.

The Big Risk(s) in Retirement

First, let's talk about what worries us all. That's longevity risk. It's an actuarial problem, i.e. that you will last longer than your money. Despite the fact that I basically don't know anyone who started with a seven-figure nest egg (i.e. had a successful accumulation phase) and had this happen to them, everyone worries about it. Frankly, most of them should spend more time worrying about their mortality than their longevity risk, but it is what it is (it's now time to insert that famous Rich, Broke, or Dead graph).

Longevity risk can really be broken down into three categories:

1. Macro and Market Risk
2. Inflation Risk
3. Personal Spending Risk

Macro risk includes things like tax rates going up and your investments being really volatile or having low returns. Inflation risk is simply that your living expenses climb faster than expected. Personal spending risk includes things like massive healthcare or long-term care expenses or the need to take care of your parents or kids. Divorce and fraud also get lumped into this category for lack of a better place to put them, although the real problem with divorce and fraud may be getting your assets cut in half, not having your expenses increase.

More information here:

The Risk of Retirement

Some Sobering (and Scary) Statistics on People’s Retirement Preparedness

Retirees Are Not All the Same

One of Pfau's big realizations is that there is no one-size-fits-all solution for retirement spending. People are different. Some value flexibility (he prefers the term “optionality”) more than others who are fine with making long-term commitments. Some prefer guarantees and safety, whereas others are OK taking some risk if it means they can likely spend more or leave more behind. He uses these two concepts (optionality vs. commitment and safety vs. probability) together to make his trademarked Retirement Income Styles Chart or RISA® Style Matrix.

On the left side of the matrix, we see safety-first retirement spending styles, and on the right, we see probability-based spending styles. On the top, we see optionality-oriented spending styles, and on the bottom, we see commitment-oriented spending styles.

Most of us DIYers have traditionally sat in the upper right box, which Pfau calls the Total Return box. This basically means you're living off a portfolio of stocks, bonds, and real estate that will provide uncertain but probably relatively high returns. This is likely to provide the highest possible standard of living and where you can leave behind the most money to heirs, but there are no guarantees. The way these folks deal with longevity risk is by following and maybe adjusting some sort of spending rule that keeps them from running out of money. Research is pretty clear that the variable rules tend to allow for more spending and less risk of running out of money than the fixed rules, but more on those later.

A big risk for these folks is the Sequence of Returns Risk (SORR). That's the idea that you can run out of money even if your average returns are fine if the crummy return years come first in retirement. Withdrawing from a rapidly declining portfolio can be brutal. This was the whole point of the Trinity Study back in the 1990s, which showed that financial advisors were giving crappy advice to their clients when they were telling them that if their portfolio averaged 8%, they could spend 8% a year and be fine. In reality, if they were spending more than about 4% of the initial portfolio value indexed for inflation, there was a significant risk of them running out of money in some situations.

The Time Segmentation style is often called a buckets strategy, first made popular by financial planner Ray Lucia. The idea is that you have different buckets of money for different time periods of retirement. You might have a cash bucket that provides your spending for the first two years and a bonds bucket that provides your spending in years 3-10. Then, the rest of your money is invested in a risk bucket for later years, perhaps in stocks and/or real estate. There are various methods for deciding when and how to refill the various buckets as you go along. Some criticize this style by pointing out that there is just an underlying asset allocation here just like for the Total Returns folks—that this is all smoke and mirrors—but that's not really true.

The size of the buckets varies by how much you spend, not by how much you have. Bucket No. 1 could be 2% of your portfolio, Bucket No. 2 could be 8% of your portfolio, and Bucket No. 3 could be 90% of your portfolio. Or Bucket 1 could be 10%, Bucket 2 could be 40%, and Bucket 3 could be 50%. Those are very different asset allocations. The Time Segmentation style deals with longevity risk by leaving Bucket 3 to grow in aggressive investments so that when Buckets 1 and 2 are exhausted, there's a whole big pile of money still to spend. It deals with SORR by giving you 10 years (or whatever) for the good returns to show up, so having lousy returns for three or four or even 10 years won't torpedo the plan. TIPS or CD ladders are another method of Time Segmentation that can be used for some or all of the buckets.

The Income Protection style basically converts assets to income. We're not just talking about spending just your dividends, interest, and rents. Assuming they haven't built some sort of bizarro portfolio full of junk bonds and personal loans, those people are generally just spending less than they could in a Total Return style, and they will have very lucky heirs. We're talking about putting guarantees in place. They deal with longevity risk by having guaranteed income; they can never run out of money. They deal with SORR by not having money in the markets where returns vary and matter. Examples of strategies that belong to this style include:

• Delaying Social Security
• Working at a job that provides a pension
• Buying Single Premium Immediate Annuities (SPIAs)
• Buying longevity insurance (i.e. Deferred Income Annuities or DIAs)

You're making a commitment when you do these things and you're losing optionality. You might be lowering the overall amount you can spend, but you're also ensuring you won't ever completely run out of money.

The Risk Wrap style might be the black hole of this chart, where you must use the maximum amount of care to ensure you're not just being sold crummy insurance-based products by slick salespeople. The problem with this space is that you're losing optionality and having to make a commitment, but you're really not getting the solid guarantees that you get in the Income Protection style. You are typically getting some sort of guarantee, but only you can decide whether they cost too much for what you're getting. I think, most of the time, they do, but I am obviously firmly in the Total Return camp like most fee-averse DIY investors. What sorts of things are we talking about here?

• Whole life and other types of cash value insurance policies
• Variable annuities, with or without various guarantee riders
• Index-linked annuities
• Reverse mortgages

There are no firm lines here between these styles. There's no rule that says you can't use more than one of them. In fact, lots of people “put a floor under” some of their spending using income protection techniques like Social Security, pensions, and SPIAs and then manage the rest in a Total Return manner. One of the big issues with the Total Return folks is they underspend due to fear of running out. The other styles provide a lot more “permission to spend” due to their guarantees. If that is a big issue for you like it is for many, you really should give some consideration to incorporating some aspects of those other styles.

More information here:

A Doctor’s Review of the Retirement Income Style Awareness (RISA) Profile

5 Strategies for Managing Volatility and Longevity in Retirement

Now that we've discussed income styles, let's discuss the general strategies to deal with volatility and longevity in retirement. These are:

#1 Spending Conservatively

The less you spend, the less volatility matters and the less likely you are to run out of money. Spend only 1%-2% of your nest egg each year, and you seriously don't have to worry about any of this stuff. These are the people who really won the accumulation stage. We'll be in this boat, and many of you will, too.

#2 Spending Flexibility

The lower your ratio of fixed/mandatory spending to variable spending, the more flexible you can be with your portfolio withdrawals. This is a great reason to not have any debt going into retirement. Even if you're spending 5% of your portfolio, you can cut your spending by 2/3 in the event of a market downturn and can easily handle SORR.

#3 Reducing Volatility

Some assets are more volatile than others. Investing more in CDs and less in Bitcoin is obviously going to reduce volatility.

#4 Buffer Assets

A buffer asset is something you can spend instead of selling assets after they go down in value. Cash might be the ultimate buffer asset, but things like cash value life insurance and home equity (via a HELOC, refinance, or reverse mortgage) can also be used. A buffer asset is just something where the principal value doesn't really change.

#5 Work

This may only work in the first few years of retirement, but that's also when your SORR is highest. You can go back to work, living partly or completely off your earned income and giving your portfolio time to recover. Many retirees find other benefits from working, including purpose and community. It doesn't have to be that old job you hated either. Even a little income can go a very long way.

More information here:

How I Went from a Negative Net Worth in My 30s to Early Retirement

A New Way of Doing Business (and Saving Tons of Money) in My Retirement

Who Should Worry the Most About Sequence of Returns Risk?

Some people should worry more about SORR than others. The more the following characteristics describe you, the more you should be concerned.

• Relatively low level of wealth compared to spending the portfolio needs to support (i.e. less than 33X)
• High ratio of fixed to variable expenses
• Few or no reliable income sources
• Little in the way of buffer assets
• High anxiety levels (greater desire for safety, more worry about market movements, lots of fear about running out of money)

If none of that describes you, you probably don't need to do much about SORR. If it all describes you, it's time to do some things, such as buying SPIAs, with part of your portfolio.

With this framework in place, we can discuss some of the 300ish different ways to spend from your retirement portfolio. Stay tuned!

What do you think? Do you like this framework? Why or why not? Which box of the RISA® do you find yourself most attracted to and why?