A better way to convert savings into retirement income
The defined benefit pension plan, a traditional mainstay of retirement planning, is on its way to extinction.
These plans, with their guaranteed payouts for life, are disappearing across the developed economies, where they now account for less than half of current pension assets. In Canada, an extrapolation of data shows the number of active defined benefit plan members in the private sector will drop to zero by 2026.
That may be good news for companies that are anxious to avoid the long-term liabilities that go along with funding DB plans, but it’s bad news for Canadian who have to plan for a secure retirement.
Now, most people planning their retirement are faced with a difficult double challenge. On one hand, they have to figure out how to make a pool of savings last for what will probably be a long retirement. On the other hand, they want to avoid limiting their spending to the point where they don’t fully enjoy their retirement and leave a large surplus at the end.
Among other things, this challenge leads to consideration of what the optimal asset mix should be to minimize the risk of running out of money.
Expressed simply, the question is how much should be put into the stock market where returns are volatile but historically much higher than safe assets such as GICs and bonds. As an example, the long-term historic annual average real return from safe U.S. T-bills is a paltry 0.46% compared with 8.80% from the U.S. stock market.
Conventional approaches to dealing with this challenge include using a pre-defined split between stocks and bonds, such as 50-50%. A variation on this theme is offered by so-called target date funds. These funds provide for a high exposure to the stock market in your earlier years that is reduced as you get closer to retirement. This “glide path” approach to asset allocation is enormously popular in defined contribution pension plans, attracting more than 50% of pension contributions in the U.S.
However, our new whitepaper shows that both constant allocation and glide path strategies are inferior to what we call target wealth.
With co-authors, Peter Forsyth and Kenneth Vetzal, we explore the target wealth strategy in the whitepaper. We look at the fictional case of Bob, a 50-year-old whose heading for retirement at age 65. Bob is trying to figure out how best to invest his savings to enjoy a comfortable retirement from a steady stream of income that mimics as closely as possible a defined benefit pension plan, while minimizing the risk of running out of money before age 95.
Instead of a strategy where the stock allocation is pre-determined, we propose an adaptive one where it varies according to progress towards a specified wealth goal.
We found that the most successful approach was to target an amount of money that would be left at the end of retirement, hence the description, target wealth. Every year, before and during retirement, we calculated the optimal allocation to stocks in Bob’s portfolio to minimize the risk of a shortfall in retirement income.
We fix the terminal wealth we want to achieve and ask at every time period, “How does the allocation to stocks have to evolve to maximize the chance of reaching this target, while taking minimum risk?” Establishing the target at the outset and sticking to a savings rate is essential for success.
In our case study, Bob would prefer to spend all his money in retirement, leaving perhaps just his house to his heirs. However, it turns out in using the target wealth strategy, it’s better to aim for a surplus at the end of retirement so as to leave a buffer against a sequence of bad years of stock market returns.
Pre-determined strategies such as those used by target dated funds are popular because of their set-it and forget-it approach to asset allocation. But this takes no account of Bob’s actual investment experience over several decades, so it’s not surprising this approach leaves much to be desired in achieving the goal of planning a secure retirement.
Our paper shows that beginning with a goal and then adjusting asset allocation to cope with the vagaries of retirement is a better approach to both accumulating wealth before retirement and “decumulating” it once you’ve stopped working.
For more details about target wealth, I invite you to read our whitepaper.
