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What is Safety-First Retirement Planning?
- By Travis Echols
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- 11 Jun, 2020
| I just finished reading Dr. Wade Pfau’s 3rd book in a series of books on retirement planning, entitled Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. Let me try to summarize it for you and give you some of my thoughts at the end. The safety-first approach to retirement planning is differentiated from the more familiar probability-based models. His previous book on probability-based retirement planning is entitled How Much Can I spend in Retirement? A Guide to Investment-Based Retirement Income Strategies. Whereas probability-based models are based more on the growth and income from stocks and bonds, safety-first models are based more on risk-pooling. Note: In practice, both approaches typically use stocks, bonds and risk pooling (since Social Security is a form of risk pooling). It is more a matter of degree. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation. |
What is Risk Pooling?
What is risk pooling? Risk pooling is what a large entity like the government or insurance companies can do to spread risk over a large number of participants within the group. The two risks that are of greatest concern to retirees are sequence risk and longevity risk. Sequence risk (aka sequence-of-return risk) is the risk of a bear market early in retirement crippling your spending for life. Longevity risk is the risk of outliving your money. For more on sequence risk, see my PDF book "How to Invest in Stocks and Bonds in Retirement."
Safety-first planning attempts to shift or diversify more of this risk from retirees to an insurance company by using a guaranteed lifetime income annuity. Insurance companies can make the promise of a stable lifetime income knowing that some of their retirees will live longer than average and some will die at an earlier age. Risk pooling allows an averaging of these large numbers by the insurance company that individual retirees cannot do for themselves.
Notice Social Security’s life expectancy calculator gives average numbers, which may not be close to your actual life span. What if you live longer than average?
Income annuities are much like a traditional defined-benefit company pension plan or Social Security, allowing for lifetime retirement income rather than taking a chance on the markets and interest rates.
History of Safety-First Approach
The safety-first approach was originated in the 1920s in the research of people like Frank Ramsey and Irving Fisher. More recently, Nobel Prize winners such as Paul Samuelson, Robert Merton, Franco Modigliani, and William Sharpe have examined these models.
The safety-first approach is advocated by Professor Zvi Bodie from Boston University, who wrote popular books such as Worry-Free Investing and Risk Less and Prosper.
The method places a great emphasis on prioritizing your
goals and then matching those goals (liabilities) with your investments
(assets).
Prioritize Your Goals
The safety-first approach carefully prioritizes retirement goals and the investment strategy attempts to match the risk characteristics of your assets and goals.
In accord with this theory, Jason Branning and M. Ray Grubbs have delineated a funding priority for retiree liabilities. Essential needs are the top priority, then a contingency fund, then funds for discretionary expenses, and finally a legacy fund.
They illustrate their funding priorities with a pyramid. Notice it builds from the bottom to properly fund each goal before moving up to the next.
Figure 1. Modern Retirement Theory by Jason K. Brannon, CFP and M. Ray Grubbs, Ph. D. www.modernretirementtheory.com
Match Your Investments with Your Goals
If the purpose of saving and investing is to fund spending during retirement, then spending liabilities as described in the pyramid above must be properly matched.
The safety-first idea is that hedging and insurance should be used for the most basic needs. Hedging means holding individual bonds to maturity, and insurance means using income annuities as a solution for longevity and market risk.
Stocks can then be used to meet discretionary and legacy (i.e., inheritance) goals. Basically, assets are matched to goals so that the risk and cash flow characteristics are comparable.
For essential spending and contingency (i.e., emergency) funding at the bottom of the pyramid, the assets used should be “secure, stable, and sustainable.” Funding options can include Social Security, defined-benefit pensions, low-risk bond ladders, and guaranteed lifetime income annuities.
As Dr. Pfau words it,“The idea is to first build a floor of very low-risk guaranteed income sources to serve your basic spending needs in retirement (or, as Moshe Milevsky says, “pensionize your nest egg”). Once there is a sufficient floor in place, you can focus on upside potential. With any remaining assets, you can invest and spend as you wish. Since this extra spending (such as for nice restaurants, extra vacations, etc.) is discretionary, it won’t be the end of the world if you must reduce spending at some point. You still have your guaranteed income floor in place to meet your basic needs no matter what happens.”With the safety-first school of thought, income annuities are especially beneficial because of their ability to provide longevity protection through risk pooling. You don’t know the age of your death and there is a large distribution of actual lifespans around the average. As an individual retiree, you cannot self-insure to protect from longevity risk, and annuitization gives you a guaranteed income for what may be a long lifespan.
Because the annuity provider can pool the longevity risk over a large number of retirees, they can make payments at a higher rate, and especially in a low-interest-rate environment. Whereas a retiree seeking to self-annuitize should probably assume a time horizon extending well beyond the average life expectancy in case she lives much longer than the average. This worse-case longevity planning means the retiree must spend less than if they had shifted that risk by using a lifetime income annuity.
The strategy goes on to recommend that the portion of your retirement assets that are annuitized should be counted as part of your bond allocation. This allows you to invest more of your remaining retirement nest-egg in stocks for long-term growth. This guaranteed floor of income can allow the conservative retiree to not miss out on stock market growth while knowing he will not run out of money for essential needs.
Much more could be said, but this gives you the gist of the approach. Let me now give you some of my thoughts.
My Thoughts
- I agree that maintaining liquidity is vital so that unexpected spending shocks do not disturb the retirement income plan. A contingency fund should indeed be the next priority after essential needs are met.
- I agree that most retirees should have some income that is guaranteed for life (in the event of living a very long time).
- Most retirees have Social Security which is a guaranteed-for-life annuity with a cost-of-living adjustment. So Social Security can accomplish much, if not all, of what this safety-first approach aims for.
- Delaying Social Security for a higher lifetime income is another step in the safety-first direction.
- Many retirees have guaranteed lifetime pensions which also serve to mitigate longevity risk.
- Some retirees have rental income, which can also be considered a lifetime annuity -- with inflation protection--though not guaranteed.
- For those with essential spending needs above their Social Security income and company pensions, etc, it could make sense to carve out a portion of your retirement assets for a lifetime annuity. This could be especially appealing to cautious retirees who are concerned about longevity risk and stock market risk. Having a guaranteed income floor that meets essential spending needs could psychologically allow you the peace of mind to invest more of your remaining assets in long-term growth investments like stocks.
- Retirees should avoid simpleton advice that says all annuities are bad. Also avoid insurance salesmen who push annuities that make them a big commission from products that may not be best for you. The free dinner you get for attending one of their seminars could be the most expensive meal you have ever bought! See my paper, “Annuities: The Good, the Bad, and the Ugly”.
- If you consider a guaranteed lifetime income annuity, look at deferred, no-commission annuities, with no surrender charges, that allow a return of principal (minus fees and withdrawals). This is usually preferable to committing to a single premium immediate annuity (SPIA). By using a deferred, no-load, variable annuity with a guaranteed withdrawal benefit, you can lower your longevity risk without technically "annuitizing".
- Finally, you should consider other important factors such as inflation, taxes, RMDs, and inheritance goals.
Careful planning can help you balance your individual lifestyle, longevity, liquidity, and legacy goals. There is no one-size-fits-all approach. Speak to a fiduciary, fee-only, no-commission, financial advisor who specializes in retirement planning.
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- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
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Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
Protecting your lifetime retirement savings from excessive taxes is a crucial part of holistic financial planning. This involves protecting your IRA, 401k, lump sum pension rollover, Social Security, and any other type of retirement account or income stream from crushing tax rates.
So let's be sure to differentiate tax preparation
from tax planning
.
Tax preparation , also called tax return preparation, looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning on the other hand looks at taxes in the context of your overall financial picture. A tax planner not only looks in the rear-view mirror but will look forward 20 to 30 years at your projected tax liability and ask what can be done to lower your lifetime tax bill.
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Originally written on Aug 2, 2018 and updated for tax law changes.
If you are no longer working and have reached the age of 72,
you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution
(RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more,
but this requirement is the minimum
you must take or be severely penalized. Fortunately,
this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)
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If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.
Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo . There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)
However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA) , with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.
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The latest book I am reading is “ The Psychology of Money ” by Morgan Housel. Chapter 3 is entitled “Never Enough”. In this chapter, Housel talks about when rich people do crazy things. He tells stories of wealthy people who never had a sense of enough and wrecked their reputations, families, freedom, and happiness because of it. I have also talked to older couples who tell me they once had a much better retirement in view, but the quest for more led them to make unwise investment decisions that left them financially crippled in retirement. The importance of knowing when you have enough is not only vital to when you retire but also how you retire. It can affect how you invest, how you withdraw, and your overall satisfaction before and during retirement. Be sure to read to the end where I summarize a few key takeaways. Housel makes the four following observations in chapter 3 of his book. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Whether you do mini-Roth conversions over several years or big Roth conversions in a few strategic years, the Roth conversion strategy could save you tens if not hundreds of thousands of dollars over your retirement. This article will get deep into the issues of Roth conversions for retirees and the ten steps to take to be sure it is done properly. Be sure to scan or read to the end where I will give you the simple answer to getting your Roth conversion questions answered. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Making big financial decisions immediately following the death of a close family member can be dangerous. It is often best to allow some time before tackling big financial decisions. On the other hand, some people find getting immersed in the finances is helpful in coping with the loss. Whatever way is best for you, you will need to give it your
careful attention to avoid big financial mistakes. The different types of accounts have different rules. I'll address the most common types. In the case of the death of a parent or anyone other than your spouse in which you are a non-spouse beneficiary, there are many rules that you must know to make the best decision for you and your family. (In this article, I use the common parent-child inheritance, but the planning strategies can apply to other non-spouse situations.) Your decisions can have major tax and investment consequences, both now and in the future. And some of these decisions have time deadlines keyed to your parent’s date of death. Also, some of these decisions are irreversible. You can download my free Estate Planning Survivor Checklist here
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So, you don’t want to rush in and make decisions without knowing the rules, and you don’t want to wait too long and be stuck with fewer options. (In this article, I am not addressing estate taxes. As of 2021, only estates valued at $11.70 million or more are subject to federal estate tax. But there are plenty of other tax pitfalls to navigate around. I am also going to focus on liquid savings like investment and retirement accounts, versus real estate which will be for another time.) Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Delaying Social Security makes a lot of sense for many retirees; but there are common pitfalls that can cost you a bundle. As you know, the longer you delay your Social Security Retirement benefit, the higher your lifetime monthly payments are figured to be. This increase in delaying continues until age 70, after which there are no further increases for delaying. This increase for each month that you delay filing is not small, especially considering the current low interest rates. Even after full Social Security age, your payment goes up by 8% per year until age 70. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . Here are the five big mistakes of delaying your Social Security retirement benefit. |
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Are you wondering about the impact of the
2020 election results on your retirement? If so, you are not alone. The two political parties are greatly polarized. While the Democrat party has moved further toward ethno-centric socialism, the Republican party has moved further toward nationalistic populism. The difference in the two parties’ goals for our country is wider than ever. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . |
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
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