Thursday, March 20, 2014

Spend More Today vs. Spend More Tomorrow

My two previous blogs, The Downside of Upside and Diminishing Returns, initiated a fun conversation with Wade Pfau that he used yesterday to spur a discussion at Wade Pfau's Retirement Research Blog.

In those two posts, I expressed the opinion that investing in equities in order to increase a retiree's spending throughout retirement isn't terribly appealing because a) retirees typically — though not always — spend less as they get older and, b) by the time he earns the additional spending with stock market gains the retiree might well be too old to enjoy spending them.

Wade's response was, and I paraphrase here, "Well, yes, but retirees don't invest in equities to increase their spending if their portfolio grows."

Wade explained that he believes retirees are attracted to systematic withdrawal (SW) strategies primarily by the probability of greater spending than is attainable through investing in safer alternatives (albeit with risks of the opposite outcome). He believes that potentially increasing one's standard of living beyond the initial spending suggested by SW is merely a side-effect of the SW strategy, not a major consideration by retirees or one promoted by advisers.

I completely agree with the first part of that statement: the primary attraction of SW is the possibility of greater spending than with safer investment alternatives.

I argue, however, that it is not the only SW benefit marketed to retirees or expected by them. I believe there are three:
  • The potential to support more spending than with annuities or bond ladders
  • The potential to support the initial withdrawal amount annually for 30 years and leave a large legacy portfolio, and
  • The potential to improve one's standard of living throughout retirement if the portfolio grows.

The risk, of course, is that none of these potentials will be realized.

I would point out that with SW strategies, spending can increase over time, or decrease if the portfolio shrinks. As Michael Kitces pointed out in his critique of "The 4% Rule - At What Price?" by Scott, Watson and Sharpe, SW strategies are seldom implemented in the precise way depicted in that (and other) papers.

After portfolios grow significantly, advisers encourage retirees to spend more (increase their standard of living), according to Kitces, rather than stick with their initial withdrawal amount. I trust they would recommend the opposite should the portfolio contract significantly.

If this is truly the way SW is implemented, then the retiree would increase her spending contemporaneously with the growth of wealth (and decrease spending similarly if the portfolio contracted).

Wade and I actually disagree on very little here. We agree that increasing spending throughout retirement isn't the best reason to invest in equities after retiring. The question Wade and I are asking is this. Is the promise of continually improving your standard of living as retirement progresses a significant incentive for you to invest in equities after you retire?

We would both appreciate your thoughts below or at Wade's blog. And if you're an adviser, please let us know.


  1. Dirk
    for me the big issue is Long Term Care
    for various reasons (like most retirees) I am choosing to not take out LTC insurance. And even if i did it would be typically only pay out for 3 or so years.
    My goal would be to delay having to go onto Medicaid for as long as possible. No one knows how long they will need LTC. Except for the 5% richest of the population, everyone else has a chance (even those with LTCi )that they will ,for example ,get dementia and need nursing home care for so many years that they will eventually use up all their assets and have to go onto Medicaid.
    If I lock all money designated for LTC into very safe investments such as annuities, TIPS, short term bonds etc. I will be able to fund a set amount of LTC. However my LTC needs could well be more than that. If I invest the money in riskier assets, such as stocks, the odds are that I will have an upside, and so be able to delay Medicaid longer. Of course there is the chance that stocks will return less than a safe portfolio. If so, "oh well" I will have to go onto Medicaid sooner than I otherwise would have had to with safe assets. It will not be the end of the world. With safe assets there is no chance of an upside. For me, at 60, all my LTC "bucket" is in stocks. I will have other safe retirement savings at least until age 80 that could be used for LTC if I need LTC before 80. As I get closer to 80 when other assets may be running low, I will gradually reduce the risky allocation of the LTC "bucket" down to 20%
    You have alluded to LTC in your posts as a possible reason someone might consider higher equities, but for me, this should not be a passing minor consideration in retirement investing, but an extremely important one that should be central to this whole discussion. It the part of your previous 3 posts that I believe is missing in emphasis. Everyone needs a clear plan for how they will fund LTC, and asset allocation could well be affected by such choices.
    I find your blogs to be extremely helpful. Maybe you could do a post one day focussing on this issue of self funding LTC implications for portfolio allocation etc. It is not a topic that has had much discussion as far as I can tell.

  2. Derek, you raise a big, legitimate concern. I have actually written about LTC at

    For the majority of people who need LTC, it is not catastrophic. But it can be. LTC insurance would be nice, but it doesn't work.

    I would also point out that the two studies I have seen and referenced on retirement spending both say that even when there are high end-of-life health care costs, spending is typically lower than in early retirement.

    There isn't an obvious answer to this one unless you a) have a couple of million dollars or more and don't need LTC insurance or b) you can't afford the premiums and have no choice but to go the Medicaid route. If you're in the middle, I don't know of a great strategy to mitigate this risk.

    I wouldn't treat this as a retirement-income-portfolio allocation issue. If you are very concerned about this risk, as you appear to be, I would recommend setting up a separate portfolio targeted specifically at this liability.

  3. <>

    Dirk, why a separate portfolio? Would that be because you'd want a higher risk, higher return component, or some other reason?

  4. In a word, yes.

    The purpose of your spending portfolio is to mitigate longevity risk. Lifetime spending is a relatively well known amount and it is certain, in that you will certainly have bills to pay, though the length of your life is not.

    As my post on the topic shows, many people will have no LTC costs and many more will have manageable costs. A few will have catastrophic costs. It is not certain that you will have LTC costs at all and the range of possible costs is enormous.

    A single portfolio to address both risks (providing a lifetime of income AND saving a large pot of money in case you have large LTC costs) wouldn't address either very well.

    I'm not saying I think saving for an unlikely but potentially extremely large future liability is the best way to address the problem, but if I were going to do that, I would use a separate portfolio to match that liability.

    There seem to be a lot of basic questions. I'll try to post on the topic this week.

    Thanks for writing.