How Will You Generate Income In Retirement?

By Macy Jae Moore on March 17, 2023

Written by: Zeke Anders

If you are close to retirement, or already in retirement, you may be wondering how you’ll turn your assets into cash flow to support your lifestyle. You may have questions about when to claim Social Security benefits, whether to take a pension or a lump sum, or how your portfolio will be used. Maybe you’ve heard of “bucketing” or the 4% rule but aren’t sure if they’re right for you. Two researchers, Alex Murguia and Wade Pfau, recently published a paper, ‘A Model Approach to Selecting a Personalized Retirement income Strategy’^[1], that found there are fundamental attributes of retirement income strategies: commitment versus optionality, and probability-based versus safety-first. There are many strategies for generating cash flow in retirement, and their research shows that people have innate preferences for one strategy over the others based on these attributes. In this piece, we’ll define those attributes and what strategies exemplify them.

Commitment versus optionality is the flexibility of a given solution. A diversified portfolio is flexible in that there are no barriers to changes or withdrawals. Assets can be bought, sold, or exchanged. In a commitment-oriented solution, assets are repositioned into a product that has some limits or consequences for withdrawals or changes, but generally offers a guarantee of some kind in return. Choosing a lifetime pension payment would be a commitment-type approach, whereas choosing a lump sum would be an optionality-based choice. The lump sum is flexible to be invested or held in a bank account, while the pension provides a guarantee from the company or government to provide an income stream for life.

Probability versus safety-first is about uncertainty. A diversified portfolio is based on probability, historical stock and bond returns, asset class correlations, and volatility to support retirement spending in a sustainable way and adjusting for the investor’s risk tolerance. While historical data might show that a given plan would work most of the time, there are no contractual guarantees and future results could be different than the past. The 4% rule^[2] is the classic example of a probability-based approach. 

A safety-first approach looks for guarantees and increased certainty. Some examples of safety-first solutions include delaying social security, building a bond ladder, or choosing a pension over a lump sum. A probability-based solution could provide more upside potential, but with downside risk as well. A safety-first solution could provide guaranteed income for a certain period or for life and possibly greater legacy too when someone lives a long life. 

Any retirement income strategy will sit on a matrix of commitment versus optionality and safety-first versus probability-based.

^[1] Murguia, Alejandro and Pfau, Wade D., A Model Approach to Selecting a Personalized Retirement Income Strategy (January 1, 2021). Available at SSRN: https://ssrn.com/abstract=3788232 or http://dx.doi.org/10.2139/ssrn.3788232

^[2] We discussed the 4% rule in the second paragraph of this piece, which, incidentally, also references research by Dr. Wade Pfau: https://twickenhamadvisors.com/blogs/unobstructed-thoughts/whole-life-insurance-as-a-buffer-asset  

As mentioned earlier, using a diversified portfolio is an example of a probability with optionality approach. An example of combining the safety-first with optionality attributes is using a “bucketing” approach to building a portfolio, where expenses are used to choose assets based on the time frame when they’ll be needed (also called asset-liability matching). The buckets are really a form of mental accounting. The assets remain flexible, but the contractual obligation of the bond issuer to pay interest and principal at maturity are a safety-first approach, particularly when low-default-risk assets like U.S. treasuries are used. Delaying social security and electing lifetime pension payments represent a safety-first with commitment approach, since those choices are not necessarily reversible.

This framework differs from risk tolerance in that it considers retiree preferences and risks beyond market risk. Risk tolerance refers to the magnitude of a decline investors are willing to endure in exchange for potentially higher returns. Professors Daniel Kahneman and Amos Tversky won a Nobel Prize for discovering “prospect theory”, which showed that most people experience more pain from a loss than they get pleasure from an equivalent gain. This concept has led to the creation of numerous tools to assess risk tolerance, which are then used to build portfolios of stocks, bonds, and other assets. Risk tolerance generally refers only to market risk, but retirees face other risks that are not traditionally factored into risk tolerance questionnaires. Some retirees are more concerned about outliving their assets and spending shocks such as long-term care than others. Someone concerned about outliving their assets or market risk might prefer a safety-first type of solution, even if historical market returns imply that a probability-based plan would work.

Another way to think of these styles is like love languages. Gary Chapman, in his book, The 5 Love Languages, found five “styles” of showing affection. In a couple where each member has a different style, they may be showing each other that they care in ways that the other doesn’t understand since they aren’t “speaking the same language”. Retirement income styles may be similar, in that if the retirement income strategy utilized doesn’t match someone’s innate preferences, they may never be truly comfortable with the plan. In a married couple, each spouse might have a different retirement income style, too. Understanding each spouse’s preference can help find a solution that bridges the gap.

Murguia and Pfau have created and tested the Retirement Income Style Awareness® Profile to help assess the different styles people possess along these attributes and found a healthy mix across them and found that the styles are persistent across time and different market environments. Ultimately, though, these styles are not meant to be utilized in complete isolation. Every retirement plan will likely include some elements of safety-first (most people are eligible for some social security benefits, for example) and even a fully safety-first with commitment strategy may use diversified investments with any assets not needed for essential spending. The goal is to look beyond one solution to find the combination of strategies that feel right to you.

If you’re interested in learning more about retirement income styles or discovering your own, please don’t hesitate to reach out.

Zeke Anders – Planning Specialist | zanders@twickenhamadvisors.com

Disclaimer

Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.