Poor future returns and the safety first approach

In today’s post I want to address another approach to dealing with the prospect of poor future returns. In my last post I described the prospect of poor future returns and different risk-based portfolio strategies in such an environment. Today I’ll consider an alternative. The alternatives are various dedicated income approaches that put the retirement income stream at the top of the priority list. For the most part these approaches have been documented only in obscure research papers but thanks to a few retirement researchers that is starting to change. Let’s take a look at some of these safety-first approaches.

I’ve presented a couple of such alternatives on the blog before. First, kind of tongue in cheek I discussed the possibility of living off a 100% cash portfolio. That could definitely be looked at as a safety first approach. I presented a much better option, constructing a portfolio of laddered US TIPs a couple of times (here and here). A 4% SWR from a 100% bond portfolio is definitely something that should be considered. Usually, I think this option can be very appropriate for the most risk averse investors. There are many investors who, despite the higher potential retirement income from risk based approaches, would be much better off emotionally with a safer approach. But in the context of today’s asset valuations and the prospect of poor future returns the safety first approaches to retirement may be the best option for many more investors. Let’s take a look at a few of these safety first approaches.

One of the leading retirement researchers, Wade Pfau, has a new retirement dashboard that simplifies the presentation of many retirement portfolio options. In particular, the  dashboard is the only place I have found where you can get a summary of the safety first approaches. It is a wonderful new resource. Below is the latest dashboard for the safety first approaches.

The table shows SWRs for different safety first approaches and different spending increases during retirement. For example, the 30 year bond ladder with the CPI-U adjusted spending model is the model I presented in my 100% bond portfolio post adjusted to January 2015 prices (except to make it even more realistic he adds a 1.5% markup to buy the bonds though a discount broker). The 100% US TIPS bond ladder currently has an SWR of 3.65%. The two other safety first options presented are a 100% fixed annuity model (SPIA – single premium income annuity) and a combination of a bond ladder and a deferred annuity (DIA – deferred income annuity). An example, would be a 4.03% SWR from a 20 year bond ladder plus DIA. One advantage of the options with the annuities is that the income stream continues until death which addresses one of the biggest issues with retirement planning – longevity risk. OK. We get decent SWRs from a series of very safe options without being involved in the market. The key point is that if the poor future return scenario does play out then SWRs from traditional risky portfolios may very well be lower than these safety first approaches. For example, if you look further down in Pfau’s retirement dashboard you’ll see his forecast for SWRs from traditional portfolios going forward ranges from 2.35% to 3.51%. In this context the SWRs from the safety first approaches don’t look so bad and I think should be considered for certain types of investors. Having said that there are some potential downsides to the safety first approaches.

The biggest potential downside to the safety first approaches in my opinion is the lack of upside. With these approaches your retirement assets are guaranteed to go to zero. With the traditional risky portfolio approach, most of the time you end up with much higher wealth than zero at the end of 30 years. And I’m not just talking about passing on wealth to heirs, charities and such. During the retirement period if things are going better than planned you can up your spending taking into consideration the better than expected performance. The other potential downside with the annuity options is the transfer of risk from your portfolio to the annuity company. This is not as big a risk as some may think, most if not all of these traditional fixed annuities are very well protected by insurance at the annuity company and annuity guarantees at the state level up to certain thresholds. But it is something to consider.

On another note for those younger folks withdrawing from their portfolios every year, like myself, then these safety first options are not options at all. Younger folks will need to live off their risky portfolios until the annuity options become viable (at ages 65-70) or until they enter the final 30 year window of life expectancy. For example, that’s 20 years for me before these become viable options. However I do consider them in my retirement planning even now. For example, the mortality credits from annuities, usually optimal at age 70ish, can lead to me to have higher SWRs from risky portfolios now. Hmm, maybe a topic for another post.

In summary, there are other options for retirement portfolios than just traditional risk based stock, bond portfolios. With lower forecasted future returns and SWRs these safety first options become a consideration for more investors, not just the super risk averse, can’t sleep at night worrying about my portfolio types. I still think the best options for most investors are consideration of alternative types of portfolios like the risk managed IVY type portfolios I discuss often on the blog but these portfolios are definitely not for everyone. And of course, the best path may be the a little bit of this, a little bit of that path. An option would be to build an minimum income stream from a safety first approach and then supplement the rest with a risk based approach. Food for thought.