Retirement Planning

The retirement problem is perhaps the most important set of financial decisions that an individual investor will make. At its core, retirement planning should bring clear answers to the following questions:

• What lifestyle in retirement is desired?
• When, and if, retirement could happen.
• How much needs to be saved to achieve the desired outcomes?

The goal is to create a savings and investment plan which will lead to the desired portfolio at the target retirement date which will satisfy the required withdrawals.

This plan will be dynamic as life, and the financial markets change. Frequent analysis and updates are likely necessary to keep a retirement plan on track. Not every investor will be able to achieve this level of financial independence. This has been increasingly true as lifespans have been increasing, and defined benefit pensions are increasingly rare. This is all the more reason to begin creating such a plan.

Retirement Stage of Life

Typical stages of planning, in chronological order, include:

• Education.
• Early career.
• Career development.
• Peak accumulation.
• Pre-retirement.
• Early retirement.
• Late retirement.

The education and early career stages should include a focus on Human Capital. Human Capital represents the net present value of an investor's future expected labor income. This theme is important in the earlier stages as many individual investors in this stage have much more human capital, as opposed to financial capital.

Financial Capital represents the accumulated savings an individual investor has. These are typically in the form of various assets, which should provide an expected return. As investors age, and turn their human capital into financial capital, the latter begins to dominate retirement planning discussions.

Tools Used in Analyzing Retirement Goals

Mortality Tables

Individual mortality tables indicate life expectancy based on specific ages. Mortality tables can be used by wealth managers to estimate a client's expected age at death. They can also determine how much a client will have to spend on retirement living expenses and lifestyle needs during his or her remaining years.

Mortality tables are a visual demonstration of important demographic statistics. Wealth managers will typically use a mortality table to estimate the present value of the client's retirement spending needs. The probability of surviving to a particular age will be used as an additional factor to estimate a final discounted present value of retirement funds needed. As a simplified example, if a client was projected to need $10,000 in today's dollars in a particular year of retirement, and their odds of surviving to that year were 84%, the amount would be adjusted as such:

$$ \$10,000 \times 0.84 = \$8,400 $$

$$ \begin{array}{c|c|c|c}
\textbf{Plan Year} & \textbf{Client} & \textbf{Life} & {\textbf{Survival}} \\
& \textbf{Age} & \textbf{Expectancy} & \textbf{Probability} \\ \hline
0 & 72 & 13.0 & 100\% \\ \hline
1 & 73 & 12.0 & 98\% \\ \hline
2 & 74 & 11.0 & 96\%
\end{array} $$

Annuities

Annuities are streams of fixed cash flows. Whether or not an actual annuity is recommended or purchased, the pricing of an annuity is instructive for wealth managers and their clients. The amount of capital needed on the target retirement date should be the value of an annuity which would provide the desired cash flow streams, those that would fund the retirement lifestyle goal. The pricing of annuities is therefore an exercise that fits well into solving the retirement problem.

Annuities can be either immediate or deferred. An immediate annuity pays an initial lump sum, in return for a guarantee of future monthly payments—beginning immediately—for as long as the contract stipulates. With a deferred annuity, the future monthly payments begin later, rather than immediately.

Monte Carlo Simulations (“MCS”)

MCS is used by wealth managers, not as a means of deciding an initial asset allocation or retirement plan, but as a supplemental tool that shows the expected playing out of the chosen plan over its lifespan.

Once a projected plan has been selected, managers can demonstrate the expected outcomes using MCS. If the results do not match client objectives and constraints, adjustments can be made to the inputs until the desired plan outcome results. MCS lends itself well to the creation of flexible plans, in which variables can be updated throughout the process and used to inform changes to an existing or proposed plan.

Behavioral Considerations

Several behavioral considerations are relevant to retired clients and/or retirement planning. The following are some examples:

• Heightened loss aversion: Some studies suggest that retirees are more risk-averse than young investors.
• Consumption gaps: Many retirees spend less than economists would predict. This occurs due to their worries and concerns about living on a fixed income or with a finite portfolio, which tends to make them more risk-averse.
• The “annuity puzzle”: Many individuals tend not to prefer to invest in annuities. This phenomenon is curious as many individuals could benefit from the mitigation of longevity risk that annuities provide. This is known as the “annuity puzzle.”
• Preference for investment income over capital appreciation: People make distinctions between income and capital when making spending decisions, according to behavioral economists. This is an example of mental accounting and leads to sub-optimal financial decisions.

Question

Which of the following client lifecycle stages is most likely to be dominated by human capital as opposed to financial capital:

1. Early career.
2. Pre-retirement.
3. Peak accumulation.

Solution

The correct answer is A.

In the early career stage, individuals are typically focused on building their careers and increasing their human capital. They are investing in their education, gaining work experience, and improving their skills. Financial capital may be limited during this stage, as many individuals are still paying off student loans, starting to save for the future, and may not have accumulated significant financial assets. Therefore, this stage is most likely dominated by human capital rather than financial capital.

B and C are incorrect. They represent stages where financial capital becomes more dominant as individuals approach retirement and actively accumulate wealth.

Portfolio Construction: Learning Module 4: Overview of Private Wealth Management; Los 4(h) Discuss the principles of retirement planning