Retirement Planning

Retirement Planning

Retirement planning is a modern concept that encompasses both financial and social aspects. It is a crucial part of human flourishing, which involves physical, mental, and spiritual health, as well as social connections.

Phases of Retirement

Retirement planning involves two key phases: accumulation and decumulation. The accumulation phase corresponds to an individual’s working life, where funds are saved and invested. For instance, John, a software engineer, saves a portion of his monthly salary for his retirement. The decumulation phase aligns with retirement, where the saved funds are spent. For example, after retirement, John uses his savings to cover his living expenses.

Accumulation Phase

The accumulation phase involves wealth managers predicting their clients’ future spending plans, including their desired bequests. For instance, a client might want to leave a significant portion of their wealth to a charity. The wealth manager also needs to forecast asset class returns and correlations. For example, they might predict how stocks and bonds will perform in the future. This information is used to construct portfolios that are likely to fulfill the spending plans and bequests.

Decumulation Phase

The decumulation phase requires spending plans to consider both longevity and inflation. For example, a client might live longer than expected, which would require adjustments to their spending plan. This phase is challenging due to factors such as uncertain lifespans, inadequate retirement savings, and unpredictable asset returns.

Measuring Preparedness for Retirement Using Funding Ratios

Funding Ratio

The funding ratio is a measure of funding adequacy. It is the ratio of assets to liabilities. If the Doe’s funding ratio declines by 5% (i.e., if their assets fall by 5% more than their liabilities, or if their liabilities increase by 5% more than their assets), they will only just be able to meet their goals.

$$\text{Funding Ratio} = \frac{\text{Assets}}{\text{Liabilities}}$$

Where:

• Assets represent the total value of all the assets owned by the individual or family.
• Liabilities represent the total value of all the liabilities or financial obligations of the individual or family.

Funding Ratio Return

The change in the funding ratio over time can be expressed as a difference or a ratio. The funding ratio return, the ratio of the final to the initial funding ratio, is influenced solely by the returns of the assets and liabilities. This can be expressed as:

$$\text{Funding ratio return} = \frac{\text{Final funding ratio}}{\text{Initial funding ratio}} – 1$$

Another way to express this is:

$$ \frac{\text{Asset return} – \text{Liability return}}{1 + \text{Liability return}}$$

Funding Ratio in Financial Health Assessment

The funding ratio is a critical metric in assessing an entity’s financial health. It is calculated by considering the impact of contributions and disbursements on assets, as well as the impact of additions and defeasements on liabilities. For instance, a pension fund might consider the contributions from employees and disbursements for retirees to calculate its funding ratio.

$$\text{Asset return} = \frac{ {\text{Final value of assets after adding all contributions} \\ \text{and subtracting all disbursements}}}{\text{Initial value of assets}}$$

$$\text{Liability return} = \frac{{\text{Final value of liabilities after adding all new} \\ \text{liabilities and subtracting all defeasements}}}{\text{Initial value of liabilities}}$$

The final value of assets and liabilities, after considering all additions and subtractions, is represented as the Asset return and Liability return respectively. These are equal to their initial values, indicating that the final value of the funding ratio is independent of the level of the funding ratio. This makes the funding ratio a universal measure of financial health, irrespective of the level of wealth.

Leibowitz, Kogelman, and Bader (1994) advocate for the use of the funding ratio in addition to surplus as a measure of financial health. They argue that investors should construct portfolios that strike an optimal balance between growth in the funding ratio and the risk of it falling below a certain level. This balance can be expressed as a form of mean-variance optimization, assuming that funding ratios are approximately normally distributed. If they are not normally distributed, simulation can be used to solve this optimization problem.

Saving for Retirement

The topic of ‘Saving for Retirement’ underscores the significance of initiating retirement savings early in life to fully leverage the benefits of compound interest. Often hailed as the eighth wonder of the world, compound interest is a powerful financial concept that benefits those who understand it and burdens those who don’t.

The Rule of 72 is a handy tool to comprehend the potency of compounding. It suggests that with annual compounding, an investment at a rate of r% per annum doubles in 72/r years. This rule is applicable not just to lump sum investments but also to periodic savings. For example, if John, a software engineer, saves USD 1 each year, nearly half of the final value of his savings comes from investments made in the first 72/r years of his career. This underlines the importance of early retirement savings.

Terminal Value of an Investment Strategy

Let’s consider that Jenny, a school teacher, saves SGD 1 at the start of each year in a portfolio with a constant annual expected return of \(E[r]\). The expected value of her portfolio at the end of N years can be calculated using :

$$V_N = \text{Annual savings} \times (1 + E[r])\frac{(1 + E[r])^N – 1}{E[r]}$$

Where:

\(V\) = Expected value of the portfolio at the end of N years

\(E[r]\) = Constant annual expected return

\(N\) = Number of years

Power of Compounding in Financial Planning

The power of compounding plays a pivotal role in financial planning and wealth management. It is especially beneficial when determining the necessary savings rates for a client. For instance, if a client aims to accumulate a specific amount by the age of 60, the wealth manager can calculate the required annual savings to reach this goal. This calculation considers the client’s current age, their planned retirement age, and the expected return of the portfolio that matches their risk tolerance.

However, it’s crucial to note that this calculation does not factor in the impact of taxes. The required savings level is calculated by solving a specific equation, which deviates slightly from the standard annuity formula. This deviation occurs because contributions are made at the start of each year, and wealth is measured at the end of the final year.

One significant limitation of this calculation is the assumption of no volatility. This assumption can lead to an underestimation of the target capital or an overestimation of the terminal wealth. Therefore, any predictions made using this method should consider this limitation.

$$\text{Annual savings} = \frac{1}{1 + E[r]} \times \frac{\text{Target wealth} \times E[r]}{(1 + E[r])^{\text{Retirement age – Current age}} – 1}$$

Where:

• Target wealth is the desired amount at a specific age.
• E[r] is the expected return of the portfolio.
• Retirement age is the planned retirement age.
• Current age is the client’s present age.

If a client has a funding ratio over 1, indicating they have sufficient wealth, the wealth manager can recommend an asset allocation that optimally balances surplus growth and surplus risk. This approach is suggested by Leibowitz, Kogelman, and Bader (1994).

Complexities of Retirement

Retirement, a significant life phase, is often accompanied by a myriad of challenges. These challenges can be broadly classified into four primary categories:

• Physical Challenges: For instance, an unexpected health issue like a sudden diagnosis of a chronic disease such as diabetes or heart disease.
• Psychological Challenges For example, a retired professional athlete may struggle to find a new purpose after their sports career ends.
• Social Challenges For instance, a retired teacher may experience reduced social interactions after leaving the school environment.
• Financial Challenges For example, a retiree may face financial uncertainty due to unpredictable medical expenses or fluctuating market returns.

While the financial aspect of managing savings during retirement, also known as decumulation, often takes center stage, it’s essential to recognize that a successful retirement strategy should address all the above challenges. Both wealth managers and their clients are urged to adopt a more holistic view of retirement, rather than focusing solely on the financial aspect.

The Decumulation Problem

The decumulation problem is a financial challenge faced by retirees. It involves the conversion of a retiree’s accumulated wealth into a steady stream of income that lasts throughout their retirement. This problem is complex due to the unpredictability of individual lifespans, leading to over-saving or underspending behaviors.

Criteria for an Ideal Decumulation Strategy

• Maximize the size of periodic payments: For instance, a retiree with $1 million in savings would want to maximize the amount they receive each month.
• Keep pace with inflation: The income should increase with inflation, similar to how Social Security benefits are adjusted annually based on the Consumer Price Index.
• Last for the retiree’s lifetime and that of their partner: The income should last for the retiree’s lifetime and potentially their partner’s, even if they live longer than average.
• Transfer the entire value derived from the retiree’s wealth to the retiree at death: Any remaining wealth should be transferred to the retiree’s estate or designated beneficiaries.

Social Security as a Solution

Social security programs can be seen as a solution to the decumulation problem. They leverage the law of large numbers, which states that as a sample size grows, its mean gets closer to the average of the whole population. This makes the distribution of lifetimes across the population more predictable than an individual’s lifetime. However, these programs face sustainability issues due to static retirement ages and changing population demographics.

Retirement security

Retirement security has become a significant concern globally, with the decline of defined benefit pension plans and the increasing reliance on individual savings and decumulation. This shift is evident in countries like the Netherlands, recognized for its top-ranked pension system by the Mercer CFA Institute Global Pension Index Report. The following notes delve into the intricacies of decumulation strategies, considering the differences in life expectancy and mortality rates between genders and across ages.

Decumulation Approaches

Two primary strategies dominate the decumulation landscape:

1. Portfolio Investment

Individuals can invest their assets in a portfolio expected to yield a positive real return. They can then gradually spend this portfolio, taking into account their expected lifespan. However, this strategy is vulnerable to market volatility. For example, if an individual retired just before the 2008 financial crisis or the Great Depression, their portfolio’s value would have plummeted, permanently lowering their retirement living standards. A similar scenario would unfold if they retired on the brink of an inflation surge.

2. Asset Transfer to an Insurer

Alternatively, individuals can transfer their assets to an insurer in return for an annuity or lifetime payments. This strategy, however, exposes the individual to credit risk. If the insurer goes bankrupt due to unforeseen losses or poor investment decisions, the annuity payments may stop, potentially leaving the annuitant in financial distress.

While neither approach is flawless, and new retirement security solutions are under development, it is crucial to thoroughly understand these strategies before exploring emerging solutions to the decumulation problem.

Decumulation Rule: A Retirement Spending Strategy

The decumulation rule is a retirement spending strategy initially proposed by Bengen in 1994. Using historical data from the US stock and bond markets, Bengen simulated retirement spending starting from 1926 to 1989. His findings suggested that retirees who withdrew 4% of a portfolio consisting of 50% US stocks and 50% US bonds in the first year post-retirement and adjusted the withdrawal for inflation in subsequent years could expect their portfolio to last at least 30 years.

In 2023, Anarkulova, Cederburg, O’Doherty, and Sias repeated the Bengen and Trinity studies using a 38-country sample. They also used data on US male and female life expectancies from the Social Security Administration to simulate a decumulation strategy for 65-year-olds starting in 2022. Their findings suggest that the safe initial withdrawal rate is only 2.26% if future adjustments for inflation are allowed.

A key takeaway from these studies is that the safe withdrawal rate should not be much larger than the real expected return of the portfolio.

Retirement Savings Withdrawal

Retirement savings withdrawal is a crucial aspect of financial planning. It involves determining the amount a retiree can withdraw from their savings each year without depleting their resources prematurely. An alternative rule of thumb suggests dividing the value of a client’s retirement savings by their remaining life expectancy. This rule, however, recommends not withdrawing more than 20% of the portfolio in any given year.

Managing Longevity Risk

Longevity risk, the risk of outliving one’s savings, can be managed by setting a maximum withdrawal rate.

$$\text{Maximum safe withdrawal rate} = \frac{1}{\max(5, \text{Joint life expectancy})}$$

Where:

• Maximum safe withdrawal rate is the highest percentage of the portfolio that can be safely withdrawn in a year.
• Joint life expectancy is the expected length of time that at least one person is alive in the case of a couple.

Bequest Considerations and Tax Advice

For clients wishing to leave a bequest, the maximum safe withdrawal rate can be applied to the difference between their assets and their desired bequest. Additionally, these rules should be complemented with tax advice, especially when a portion of the wealth is held in a tax-advantaged vehicle.

Annuitization

An annuity is a financial product that offers a steady income stream, making it an ideal retirement vehicle. For instance, a retiree might invest a lump sum in an annuity from an insurance company like Prudential, and in return, receive monthly payments for the rest of their life.

Factors Affecting Annuity Price

• The price of an annuity can be influenced by its terms. For example, an annuity that guarantees payments for a longer duration will be more expensive.

Risks and Challenges

• High fees have historically deterred individuals from purchasing annuities. For instance, an annuity from a company like MetLife might have high administrative fees.
• The bankruptcy of an annuity provider can leave an annuitant without any income. This happened to some annuitants when the insurance company Executive Life went bankrupt in the 1990s.
• Insurers face an adverse selection problem with annuities. Those most likely to purchase an annuity are those who expect to live a long time, making the sale potentially unprofitable.

Emerging Trends

• As annuitization becomes more popular, adverse selection is becoming less of a problem, allowing insurers to offer more competitively priced annuities.
• Deferred annuities that start at a future date are becoming more common. These can act as a longevity hedge and can be bought relatively inexpensively if they start sufficiently far in the future.

Retirement Annuities

Retirement annuities are financial products that provide a steady income stream for retirees. There are two types of annuities that can be purchased to cover financial needs post-retirement. The first annuity covers the period from retirement to the expected life (usually till age 85), and the second annuity covers the period from age 85 till death. Not all individuals will collect payments from the second annuity, hence it can be priced attractively.

For instance, consider the proposal by Totten and Siegel (2019) as a cost-effective alternative to traditional pension plans. They suggest that individuals should save enough to sustain themselves from retirement to age 85, after which an inexpensive deferred annuity can support them until their death. This approach takes into account the increasing ability of humans to work longer and advances in healthcare.

Investment of Annuity Lump Sum Payment

When the lump sum payment for an annuity is invested in a portfolio with an expected return E[r], and if the payment from a fixed-term annuity grows at a rate g per annum and is made at the end of each year for N years, the initial payment from the annuity can be calculated using the following formula:

$$\text{Initial payment} = \frac{\text{Lump sum} \times (E[r] – g)}{1 – \left(\frac{1 + g}{1 + E[r]}\right)^N}$$

Special Case

In the special case when the growth rate is exactly equal to the expected return, the above formula gives an indeterminate answer. In such a case, the initial payment from the annuity can be calculated using L’Hospital’s rule from calculus:

$$ \text{Initial payment} = \frac{\text{Lump sum} \times (1 + E[r])}{N}$$

Innovations in Retirement Planning

Traditional pension plans, such as social security, were designed to provide retirees with a guaranteed monthly income after retirement until their death. This was done to ensure that employees could focus on the level of income they would receive post-retirement.

However, the advent of private savings plans, like the 401(k) plan in the United States, brought about a shift in this perspective. People began to think more about the level of wealth they would have at retirement, rather than the income they would receive. This transition from income to wealth is not straightforward, particularly when asset returns and spending patterns are unpredictable.

Over-saving and Under-saving

There is evidence of both over-saving and under-saving for retirement, as well as overspending and underspending during retirement. None of these behaviors are ideal. Over-saving for retirement and underspending during retirement seem to be motivated by the fear of outliving one’s savings. On the other hand, under-saving for retirement seems to be due to a lack of understanding of the benefits of early saving and compounding. Overspending in retirement, meanwhile, appears to be due to a failure to comprehend the level of lifetime income that a certain level of wealth can sustain.

Refocusing on retirement income rather than wealth can help address these issues and provide a more secure retirement.

Understanding Retirement Security

Retirement security is a crucial aspect of financial planning, focusing on ensuring a stable income post-retirement. Three key insights form the basis of most innovations in this field:

• Pooling: This concept transforms individual mortality risk, which is highly unpredictable, into the average mortality risk of a group. For instance, insurance companies use this principle to manage the risk associated with their policies.
• Longevity risk management: This can be effectively handled using deferred annuities. For example, a person might purchase a deferred annuity at 65 but start receiving payments at 85, thus securing income for later life.
• Risk comparison: The risk associated with uncertainty in lifetimes is greater than the risk associated with being fully invested in equities by age 75. This was demonstrated by a study conducted by Collie (2016) in the United States.

Asset Management by Institutions

The institutions like banks and investment firms often manage assets more efficiently than individuals. This efficiency is crucial as even minor differences in management costs can accumulate over time, leading to substantial differences in retirement benefits. For instance, a 1% difference in management fees over a 30-year period can result in a 30% difference in retirement savings.

Risk Management

Risk management is a key aspect of financial planning. Some risks can serve as natural hedges for each other. For example, the risk of needing long-term care and the risk of outliving one’s retirement savings are negatively correlated. This means that as one risk increases, the other decreases, allowing them to be combined into a single insurance product.

Innovations Enhancing Retirement Security

There are three key innovations that can significantly enhance retirement security: Modern Tontines, longevity bonds, and reverse mortgages. While some of these have been implemented in countries like the UK and Canada, none have been adopted globally. These innovations provide valuable insights for governments, wealth managers, and the retirement savings industry.

Modern Tontines

Modern Tontines, proposed by McKeever in 2010, allow a group of individuals to invest a pooled lump sum amount in a portfolio and receive distributions for as long as they live. This concept is similar to annuities, where a lump sum is invested and periodic payments are received over a specified period.

Retirement Security Bonds and Combined Offsetting Insurance

Retirement Security Bonds, a concept proposed by Merton in 2014, are financial instruments that enable individuals to buy small quantities of a forward starting annuity. These annuities are inflation-adjusted, ensuring the purchasing power remains constant in real terms. A real-world example of this is in Brazil, where citizens can buy RendA+ bonds directly from the Treasury’s website. These bonds provide a monthly benefit starting at age 65 for a period of 20 years.

The process of purchasing these bonds is simple. A participant answers four questions on the Treasury’s website, which calculates the bond amount to be purchased. The payment is debited from the participant’s bank account, and their Treasury account is credited with the purchase. Upon turning 65, the participant’s bank account receives the bond’s monthly payout. The four questions include: current age, desired retirement age, desired extra monthly income, and available investment amount.

Combined Offsetting Insurance

Another retirement-focused financial instrument is the Combined Offsetting Insurance, proposed by Hieber and Lucas in 2022. This policy merges long-term care insurance and retirement income into one policy. It is designed to balance the risks between a participant in poor health, who will use significant long-term care but is unlikely to receive much retirement income before death, and a participant in robust health, who will use relatively little long-term care but will receive a significant amount of retirement income. This careful balancing of risks results in a low-risk insurance product that is well-suited to retirees and is robust to adverse selection effects.

Practice Questions

Question 1: Retirement is not just a financial concept but also a social one, with human flourishing being an integral part of it. Human flourishing is a complex function of physical, mental, and spiritual health and activity, as well as connectedness to friends, loved ones, and the broader society. In the context of retirement planning, which of the following best describes the role of human flourishing?

1. Human flourishing is only relevant during the accumulation phase of retirement planning.
2. Human flourishing is only relevant during the decumulation phase of retirement planning.
3. Human flourishing is relevant throughout both the accumulation and decumulation phases of retirement planning.

Answer: Choice C is correct.

Human flourishing is relevant throughout both the accumulation and decumulation phases of retirement planning. Retirement planning is not just about accumulating enough wealth to sustain oneself during retirement, but also about ensuring a high quality of life during this phase. This includes maintaining physical, mental, and spiritual health, staying active, and maintaining connections with friends, loved ones, and the broader society. These aspects of human flourishing are important during the accumulation phase, as they can influence how much one is able to save for retirement and the lifestyle choices one makes. They are also crucial during the decumulation phase, as they can affect how one chooses to spend their retirement savings and the kind of lifestyle they lead during retirement. Therefore, a comprehensive approach to retirement planning should consider human flourishing throughout both phases.

Choice A is incorrect. While human flourishing is indeed important during the accumulation phase of retirement planning, it is not only relevant during this phase. As explained above, human flourishing is also crucial during the decumulation phase, as it can affect how one chooses to spend their retirement savings and the kind of lifestyle they lead during retirement.

Choice B is incorrect. Similarly, while human flourishing is indeed important during the decumulation phase of retirement planning, it is not only relevant during this phase. As explained above, human flourishing is also crucial during the accumulation phase, as it can influence how much one is able to save for retirement and the lifestyle choices one makes.

Question 2: In the process of wealth management, two distinct phases are identified: the accumulation phase and the decumulation phase. During the accumulation phase, wealth managers are responsible for predicting their clients’ future spending plans and constructing portfolios that are likely to fulfill these plans. On the other hand, the decumulation phase involves creating spending plans that account for longevity and inflation, and this phase is often considered more challenging due to several factors. According to Professor William Sharpe, why is the decumulation phase referred to as “the hardest and nastiest problem in finance”?

1. Because it involves predicting future spending plans and constructing portfolios.
2. Because it involves dealing with increasing and uncertain lifespans and healthspans, inadequate retirement savings, and the unpredictability of asset returns and spending in retirement.
3. Because it involves managing the wealth of women who tend to outlive men and are in poorer health in the last few years of life.

Answer: Choice B is correct.

According to Professor William Sharpe, the decumulation phase is referred to as “the hardest and nastiest problem in finance” because it involves dealing with increasing and uncertain lifespans and healthspans, inadequate retirement savings, and the unpredictability of asset returns and spending in retirement. The decumulation phase is the period when an individual begins to spend down their accumulated wealth. This phase is fraught with numerous challenges, including the uncertainty of how long an individual will live (longevity risk), the unpredictability of health care costs (healthspan risk), the potential for inadequate savings to cover retirement expenses, and the volatility of investment returns. These factors make the decumulation phase a complex and difficult problem to solve in the field of finance. It requires careful planning and strategic decision-making to ensure that an individual’s wealth lasts throughout their retirement and meets their spending needs.

Choice A is incorrect. While predicting future spending plans and constructing portfolios are indeed part of the wealth management process, these tasks are typically associated with the accumulation phase, not the decumulation phase. The accumulation phase is the period when an individual is actively saving and investing to build their wealth.

Choice C is incorrect. While it is true that women tend to outlive men and may face additional health challenges in later life, this is not the primary reason why the decumulation phase is considered the “hardest and nastiest problem in finance”. The complexity of the decumulation phase applies to all individuals, regardless of gender, due to the factors outlined in Choice B.

Glossary

• Accumulation Phase: The period during an individual’s working life where funds are saved and invested for retirement.
• Decumulation Phase: The period during retirement where the accumulated savings are spent.
• Bequests: Assets left to beneficiaries in a will.
• Capital Market Expectations: The anticipated performance of investments in the capital market.
• Personal Balance Sheets: A financial statement that lists an individual’s assets, liabilities, and net worth.
• Asset Allocation: The process of dividing investments among different kinds of assets to optimize returns.
• Surplus: The amount by which assets exceed liabilities.
• Funding Ratio: A measure of funding adequacy, calculated as the ratio of assets to liabilities.
• Mean-Variance Optimization: A mathematical process that balances the expected return and risk of different portfolios.
• Compound Interest: The addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest.

Private Wealth Pathway Volume 1: Learning Module 4: Investment Planning; LOS 4(c): Discuss and recommend appropriate wealth management planning approaches for retirement from legal, taxation, and jurisdictional perspectives.