This article shows that the current practice of shifting soon-to-be retirees into less-risky asset portfolios with lower returns can be safely replaced by retaining the risky portfolio while setting aside a part of it as a reserve account.

Almost all retirees and soon-to-be retirees who need their financial assets to fund their remaining years would like a retirement plan that tells them how much they can draw safely every month without fear of running out. A common response is to shift their portfolios toward greater safety which is associated with lower returns. This article shows that there is a better way

Rationale of Portfolio Shifts to Lower Risk

The customary rationale is illustrated by the table below, which is drawn from Ibbotson and covers the period 1926-2012. As the share of common stock in the portfolio rises, the expected return rises but the worst-case return declines. (I define these as the median return and the lower 2% of returns, respectively).  The shorter the period covered, the larger the loss from the worst case.

Consider the retiree who currently has a portfolio of which 75% is in common stock.  The expected return of 9.5% would do very nicely but the worst-case return of -2.7%, if it occurred, would leave him destitute. While the probability of the worst case occurring is low. he doesn’t want to live with that risk. By shifting his portfolio to 25% stock, he reduces the expected return to 6.1% but he raises the worst-case return to 2.8%, which he considers to be manageable.

A Better Alternative: The Set-Aside Enhancer (SAE)

But there is another approach that allows him to capture some of the upside of the riskier portfolio while moderating its downside. The device, developed with my colleague Allan Redstone, we call a “set-aside.”  It can be viewed as a tpe of self-insurance. A set-aside is a part of the retiree’s asset portfolio that is not used in calculating the amount the retiree draws monthly from his assets. Its role, instead, is to offset the difference between the expected rate and the worst-case rate if and when such differences occur. If such differences do not occur, the set-aside becomes available for additional draws by the retiree.

For the set-aside approach to work, there must be a terminal date on the period during which it serves as a buffer. Since the date of the retiree’s death is not known, we use a deferred annuity for this purpose, with deferment periods ranging from one year to 25 years. I have found that a deferment period of 10 years works well, and I use it in my examples. The set-aside then guarantees that, even if the worst case materializes, payments to the retiree during the first 10 years can be based on the expected rate. At the end of the deferment period, the annuity kicks in seamlessly.

If the shortfalls don’t occur, which is very likely, the set-aside not used accumulates as a reserve that grows over time.  At any point, the retiree can use it to enlarge spendable fund draws. A convenient way to do this is to use the reserve to purchase a second annuity, in this case an immediate annuity.

Risk Reduction With a Set-Aside When the Worst Case Materializes

Here is an example covering a retiree with $1 million of financial assets who is choosing between a portfolio that is 25% common stock and one that is 75% stock. As shown in the table, the riskier portfolio has an expected rate of 9.5% and a worst-case rate of minus 2.7%. Using a 10-year deferment, the set-aside required to offset the worst-case return is $209,677. Spendable fund draws are all calculated to increase by 2% a year.

Chart 1 covers spendable funds in three worst cases. The larger drop during the deferment period applies to the risky portfolio without a set-aside, The smaller drop applies to the less-risky portfolio without a set-aside. The difference between these two declines in spendable funds in a worst case is the rationale for shifting retirees into the less risky portfolio.

The third line in Chart 1 is the risky portfolio with a set-aside. The set-aside eliminates the drastic drop in spendable funds during the 10-year deferment period, converting what could be an unmanageable risk into a manageable one. Note that payments on the set-aside connect seamlessly with the annuity at 10 years, where the dotted line connects to the solid line.

Capturing Part of the Upside of the Risky Portfolio When Expected Returns Materialize

The set-aside that reduces risk also reduces spendable fund draws based on expected rates. Yet if the funds set aside are not needed, which is highly likely, the retiree accumulates a reserve which can be used to increase spendable fund draws. The reserves can be drawn on a month-to-month basis, or they can be accumulated for a period and used to purchase an immediate annuity. The longer the wait, the larger the annuity.

The annuity purchase case is illustrated in Chart 2, which uses the low-risk portfolio as a point of comparison. At the outset, fund draws are higher on the low risk portfolio because of the set-aside on the risky portfolio. After 2 years, however, an immediate annuity based on the reserves make total fund draws higher than those on the low-risk portfolio. If the retiree waits for 6 years, the increase in fund draws is substantially larger.

Concluding Comment: Application to the Current Market

The current market is a worst case in fixed income securities, with interest rates at all-time lows. To implement a retirement plan that applies a set-aside to a risky portfolio, the fixed-income segment of the portfolio should be designed to generate rising rates as the market adjusts. The way to do that is to fund the conservative part of the portfolio with short-term assets on which the return would rise over time as market rates recovered.