Retirement spending Flashcards
What are the primary financial risks faced in retirement?
- Depletion of human capital.
- Investment risk. Retirees are particularly vulnerable to sequence-of-returns risk. Poor market performance during the period from just before retirement through the first several years of retirement can devastate a portfolio.
- Longevity risk. You don’t know how long you will live, and lifespans are increasing. If you spend assuming you will live to 80 or 85, you could have a decade or more of life with your portfolio exhausted. If you spend to be able to survive to 105, you will have to spend much less and are likely to leave a large estate.
- Spending shocks. Health expenses and home repairs are just two examples of large, unplanned expenses that can occur.
- Inflation. Even low levels of inflation have a dramatic effect on two, three, or even four decades of retirement.
- Declining cognitive ability.
How should retirement be defined?
- Moshe Milevsky defines retirement as the point at which human capital is fully depleted and one begins to spend the resources that had been saved for retirement. (Pensionize Your Nest Egg)
- Alternately, we might say that it is the point at which one chooses to stop redeeming human capital, even if the potential still exists.
- Ultimately it is the point at which one switches from saving to spending one’s nest egg.
- Social Security, pensions, and other forms of income that will be available in retirement may all begin before retirement does.
What are some examples of spending shocks that a retiree might experience?
- Unforeseen need to help family members.
- Divorce.
- Changes in tax law or other public policy.
- Changing housing needs.
- Home repairs.
- Rising health-care and prescription costs.
- Long-term care.
- Auto accident.
- Home damage from fire, earthquake, natural disasters.
What are the characteristics of a Total Return Investment Portfolio approach to spending in retirement?
- It does not protect against longevity risk.
- It does not protect against sequence-of-returns risk.
- It provides some protection against inflation risk.
- It’s vulnerable to declining cognitive abilities.
What are the characteristics of an individual bonds approach to spending in retirement?
- By holding bonds to maturity one can avoid selling at a loss.
- It does not provide longevity protection.
- May provide technical liquidity, but no true liquidity.
- TIPS can provide partial inflation protection.
- It is a complex approach that is subject to declining cognitive ability.
- It may provide behavioral benefits in a down market since income is set.
What are the characteristics of annuities and pensions in a retirement spending plan?
- They provide longevity protection.
- Some include inflation protection.
- They provide sequence-of-returns protection.
- They can protect against declining cognitive ability. Annuities are sometimes called “dementia insurance.”
- There is no growth potential.
- They can have a negative impact on inheritance (should the annuitant die too soon).
- They can have a positive impact on inheritance when the annuitant lives for a long time since having them in place means that remaining investment assets aren’t being relied on for day-to-day income.
- They can improve the quality of life in retirement:
- They provide more spending money than portfolio-based spending plans.
- For some, they will provide enough income to meet all the basic needs for retirement spending. This will allow remaining investment assets to be spent more freely since the portfolio isn’t required to meet any basic needs.
What are the characteristics of Social Security in a retirement spending plan?
- For most, this is a very strong pillar of the retirement plan.
- It provides longevity protection.
- It provides inflation protection.
- It is not vulnerable to sequence-of-returns risk.
- It provides survivor benefits.
- Delaying Social Security until age 70 is the best “annuity purchase” available.
- It is not vulnerable to cognitive decline.
- It has no liquidity.
What are the characteristics of housing wealth as a contributing factor to a retirement spending plan?
- It allows for aging in place.
- It provides some inflation protection.
- It provides some long-term care protection.
- A reverse mortgage can provide liquidity.
- A reverse mortgage can eliminate the principal and interest portion of housing expenses in retirement.
What is the difference between a probability-based retirement spending plan and a safety-first retirement spending plan?
Traditional retirement spending plans that look for sustainable spending from an investment portfolio are probability-based. They rely on projecting rates of return and life expectancies and developing an investment portfolio strategy to support spending. They are founded on the belief that the market will eventually provide favorable returns for most retirees.
We define Safety-first plans the way that Wade Pfaus does. Safety-first plans utilize a portion of the investment portfolio to purchase an annuity. For most retirees, this allows more spending in retirement with far less stress and work.
Should one retire at exactly the “right time” in the market cycle, a probability-based approach can provide a higher standard of living while leaving a larger estate when compared to a safety-first approach. However by retiring at the “wrong time” in the market cycle, one may find their retirement lifestyle has been devastated.
