Managing Investment and idiosyncratic longevity risks for retirees
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Michael S. Finke, Ph.D., CFP®
Professor &Director Retirement Planning & Living
Department of Personal Financial PlanningTEXAS TECH UNIVERSITY
MANAGING INVESTMENT AND IDIOSYNCRATIC LONGEVITY
RISKS FOR RETIREES
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Congratulations!
You’re a pension
manager!
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Pension Managers
What do they worry most about?
1) Asset Return Risk
2) Longevity Risk
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Individual Pensions are Harder
Asset Return Pension Manager – Pool returns
across generations Advisor – One whack at the cat
Longevity Risk Pension Manager – systemic
increases in longevity Advisor – Idiosyncratic longevity risk
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1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
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f yea
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Females
Denmark France Japan Spain Sweden UK USA
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1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
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Denmark France Japan Spain Sweden UK USA
Systematic Longevity Risk
Source: Robine, 2012
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Wealthier Live Longer
Source: SSA, 2008
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Idiosyncratic Longevity Risk
Source: Frank, 2013
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Idiosyncratic Longevity Risk
How do you deal with idiosyncratic risk?1) Diversification (pool it)2) Retain it Avoiding running out of money by
spending less and accepting portfolio risk
Live it up and accept greater risk of running out of money
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Turning Retirement Assets into Income
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The 4% Rule (William Bengen, 1994)
Safe Withdrawal Rates (1920s - present)
1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 19900
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SAFEMAX
Figure 2.1Maximum Sustainable Withdrawal Rates
For 50/50 Asset Allocation, 30-Year Retirement Duration, Inflation Adjustments, No FeesUsing SBBI Data, 1926-2010, S&P 500 and Intermediate-Term Government Bonds
Retirement Year
Max
imum
Sus
tain
able
With
draw
al R
ate
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Philosophy of the 4% RuleRetirees have a lifestyle goal and not meeting that goal indicates failure
Failure = inability to spend lifestyle goal for 30 years
Portfolio risk increases likelihood of meeting spending goal
Use prior returns to establish safe withdrawal rate
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Historical Random Returns
13.7%23.5%20.3
% -1.5%
-10.1%
31.0%
8.99%
34.1%
-6.6%
-38.5%3.0%
4.5% 12.4%
7.1%
26.3%
27.3%
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Asset Pricing 101
pt = Εt[β * u’(ct+1)/u’(ct) * xt+1]Price at time t (now)= Expectation (now)Of β (how much we discount the
future)* Marginal utility tomorrow Marginal utility today
*Expected payout tomorrow
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What This Means
Demand for Consuming
Now Decreases Asset Prices
Demand for Consuming in
Future Increases Asset Prices
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What’s Affecting Asset Prices?
How Much Do Global InvestorsValue the Future?
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Capital Market is Global
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Global Real Interest Rates
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Importance of 1st Decade
Source: Milevsky and Abaimova, 2005
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Monte Carlo Failure Rates
Historical Real Returns: Stocks 8.6%, Bonds 2.6%
Stock Allocation: 30% 50% 70%
Failure Rates 6% 6% 6%Slightly more realistic: Stocks 5.5%, Bonds
1.75%Failure Rates 24% 24% 27%
A little better than today’s rates: Stocks 6%, Bonds 0%
Failure Rates 47% 33% 28%Early 2013 Rates: Stocks 4.6%, Bonds -
1.4%Failure Rates 77% 57% 46%
Source: Blanchett, Finke and Pfau, 2013
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What if Rates Revert in 5 Years?
Start out at current rates (Stocks 4.6%, Bonds -1.4%)
Revert to Stocks 8.6%, Bonds 2.6% Stock Allocation: 30% 50%
70%Failure Rates 22% 18%
18%
What if Rates Revert after 10 years?Failure Rates 43% 32%
38%
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Other Problems with the 4% Rule
Source: Blanchett and Finke, 1% fee
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No Risk Tolerance, No Optimization
Source: Finke, Pfau and Williams, 2011
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Value of a Dynamic Approach
0.0% 20.0% 40.0% 60.0% 80.0%50%
60%
70%
80%
Dynamic ComplexDynamic FormulaRMD MethodStatic
Portfolio Equity Allocation
With
draw
al E
ffici
ency
Rat
e
Source: Blanchett, 2013
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Illustration of Dynamic
65 70 75 80 85 90 95 100 105$0
$1,000$2,000$3,000$4,000$5,000$6,000$7,000$8,000$9,000
$10,000$11,000$12,000
Age
Rea
l With
draw
al A
mou
nt
Figure 6Individual Simulated Paths for Spending and Wealth
For a Couple with $100,000 Wealth and a 60% Stock AllocationSimulations Based on Historical Averages
Constant Inflation-Adjusted SpendingGuyton RulesBlanchett Rule
65 70 75 80 85 90 95 100 105$0
$25,000
$50,000
$75,000
$100,000
$125,000
$150,000
$175,000
$200,000
Age
Rea
l Rem
aini
ng W
ealth
Source: Pfau, 2013
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Assumes Historical Equity Premium
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S&P Dividend Yields
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What Does Current P/E Imply?
Source: Asness, 2012
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Requires Managing Assets in Old Age
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Literacy and Confidence
60 65 70 75 80 850
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90Financial Literacy Confidence
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A Better Approach
Prioritize spending categories (basic needs, discretionary expenses, legacy)
Employ risk when a retiree is willing to accept possibility of a loss
Deal efficiently with idiosyncratic risk
Simplicity - make sure real people can handle it, use research to create defaults
Be realistic about future asset returns
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Michael S. Finke, Ph.D., CFP®
Professor, Ph.D. Program DirectorDirector Retirement Planning and Living
Department of Personal Financial PlanningTEXAS TECH UNIVERSITY
QUESTIONS/COMMENTS