(Retirees Can Shift To Higher Yielding Assets Without Increasing Risk)

December 9, 2020

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.

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__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.

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