Total return decumulation
Total return decumulation is one of the ways that financial wealth can be turned into retirement income. Investors that have managed a stock-bond portfolio during asset accumulation, in the pre-retirement period, might be comfortable continuing with an approach that is familiar to them after retirement. The main difference, of course, is that withdrawals are now made to fund current living expenses. The decumulation strategy is called "total return" since portfolio withdrawals may consist of a combination of interest, dividends and principal.[1] This contrasts with "income investing" in which the retiree does not want to spend down the principal and is relying only on interest and dividends.
Who would choose this style?
Murguia and Pfau[2][3] have developed a four quadrant matrix of retirement income styles. "Total return" fits in the upper-right corner:
In the Total return quadrant, people have a preference for probability-based approaches and optionality. These two tendencies often go together: investors want to keep control of their portfolio (optionality), and they seek potentially higher returns through stock market participation (probability-based). Investors in the upper-right quadrant are more preoccupied than average with lifestyle goals, and less preoccupied than average with longevity goals.[3]
People in this quadrant are unlikely to consider life annuities attractive. They will continue to manage their portfolios of equities (stocks) and fixed income (bonds, GICs), as they were already doing during the accumulation phase, but now they are self-managing the drawdown (or having an advisor do it for them), and they might add some cash to the mix. When preparing for retirement, investors in this quadrant likely used Conventional retirement planning approaches, as opposed to Safety-first approaches.
Investors not fully comfortable with the total return strategy during retirement may look at the adjacent quadrants of the style matrix -- Bucketing and Risk wrap -- to see if they find a better fit there.
Direct access to the four strategy groups:
How it works
When choosing the details of a total return decumulation strategy, investors should think about some of the main risks during retirement:
- Longevity risk
- Investment risk and sequence of returns risk
- Sudden unforeseen expenses
- Inflation
The two main topics of debate among DIY investors and financial advisors in this quadrant are (i) asset allocation; (ii) withdrawal strategies. These topics are often treated separately but are ultimately linked: "the appropriate investment strategy will itself depend on the preferences of the retiree over the level and variability of income", which dictates the withdrawal strategy.[4] These topics are discussed below.
An investment policy statement is a useful document to have and update periodically, including during retirement. This document will contain, among other items, a target asset allocation and a rebalancing policy. During decumulation, it should also contain the withdrawal strategy.
Asset allocation
In general, asset allocation should be based on the investor’s ability, willingness, and need to take risk (invest in equities).[5][6][7] There are special considerations during retirement however, because (i) withdrawal rates are related with asset allocation; (ii) sequence of returns risk.
One way to illustrate these points is to use the constant real dollar withdrawal method, with a 4% initial withdrawal rate ("4% rule") and a 30 year planning horizon, for simplicity. In such studies, constant/static stock proportions between 50% and 90%, or even 100% (with the rest, if any, of the portfolio allocated to cash and fixed income), have the lowest failure rates, i.e. the best odds of succeeding, based on historical data and simulations.[8][9][10][note 1]
This shows that depending on which study one looks at, the required equity allocations to maximize the odds of success with a total return approach may be higher than some investors’ risk tolerances. Further, in simulations, the worst-case scenarios involve earlier failure for stock-heavy portfolios, as shown by the following figure which assumes a 4% rule, the percentage of equities shown, and the balance in fixed income:[11]
Notice how the range of outcomes dramatically widens as the equity portion is increased. But these studies are all based on the same withdrawal rule, which is the other big topic. Perhaps withdrawal rules other than the 4% rule can allow stock allocations below 50%, if this is what the retiree is comfortable with.
Sequence of returns risk is another consideration for retirees. If bad returns occur early in retirement and good returns later, the portfolio might be prematurely depleted, even if the average returns throughout the retirement period are not especially low. Higher fixed income allocations, especially at the beginning of retirement, can help attenuate this risk; the stock allocation can climb back higher later, if desired. This is known as a rising equity glide path[12] and contrasts with the traditional advice of declining or static equity allocations.
In summary, higher equity allocations, in general, can allow higher withdrawal rates, on average,[citation needed] but they also increase sequence of returns risk. Unsurprisingly, there is no consensus in the literature or on the Financial Wisdom Forum on the ‘best’ asset allocation, at retirement age and over time afterwards.
Withdrawal strategies
The choice of a suitable withdrawal strategy is a critical element of a retirement plan. On one hand, the retiree likely wants to ensure their yearly income supports their desired lifestyle. He/she might want to protect this income from the effects of inflation, and likely want this income to be as steady as possible. On the other hand, if portfolio withdrawals are too aggressive, the portfolio might be prematurely depleted, i.e. the retiree might run out of money, so the withdrawal method must minimize or eliminate the odds of that happening. This is a difficult problem to solve since the lifespan, future investment returns and rate of inflation are all unknown at the start of retirement.
A wide range of withdrawal strategies exist within a total return framework. This includes the constant real dollar method mentioned above (a.k.a. "sustainable withdrawal" or "4% rule"), and a number of more flexible spending strategies that adapt withdrawals to portfolio performance, including Variable percentage withdrawal. Generally, adapting withdrawals to portfolio performance is a more reliable approach in terms of avoiding depleting the portfolio, and might also allow higher initial withdrawals.[13][14]
Portfolio implementation
Once the overall asset allocation and withdrawal method have been decided, the strategy can be implemented. Many members of the Financial Wisdom Forum (FWF) use a discount broker to self-manage their portfolios during retirement, often within multiple account types such as non-registered, RRSPs (which become RRIFs), TFSAs, and so forth.
Investors can’t control what returns financial markets will produce, but they can control how much of these returns they keep for themselves. This means minimizing all costs: commissions, management expense ratios, withdrawal fees, etc. A reliable way to match the benchmark (market) returns as closely as possible is to use broadly diversified index (passively managed) exchange-traded funds (ETFs) or index funds to provide exposure to broad asset classes. These can be combined into simple index portfolios. Low-cost all-in-one solutions include asset allocation ETFs.
Portfolio rebalancing is an important way to manage risk by bringing the asset allocation back to target, for example once a year. When making withdrawals, the retiree can sell from the asset classes that are above target. This might not be enough to bring the portfolio completely back to target weights, in which case the rebalancing exercise will.
Another important consideration is investor behaviour. Market timing – buying and selling to try to anticipate market moves – can reduce returns if the timing is wrong and the investor misses the stock market recovery. If volatility is making the investor nervous, and the temptation to "sell everything before the crash" is getting strong, perhaps it is time to revisit the asset allocation and/or the withdrawal method. Watching the financial news less often might also help. Other considerations are presented in the article portfolio design and construction.
Pros and cons
The total return decumulation strategy has many nuances, but here is a general summary of the pros and cons:[15]
| Pros | Cons |
|---|---|
| The retiree keeps control of all financial assets * Change your mind later (optionality) * Can be used for sudden liquidity needs (although this will reduce the capital left to generate income) |
Longevity risk is not fully addressed: there are no guarantees that income will last a lifetime at a sufficiently high level to meet even your basic needs |
| Control over asset allocation and withdrawal methods | Multitude of withdrawal strategies available, none of which are perfect: * constant real dollar withdrawals provide steady income but expose the retiree to potential portfolio depletion (ruin) * more flexible strategies better protect the portfolio, but expose the retiree to income variations, including the risk that the income becomes insufficient |
| Potential for large legacy if the stock market collaborates and/or retirement is short | Decisions about portfolio management and withdrawals have to continue even in old age |
| Abundantly discussed on the FWF, where you can ask questions; similarly, this is what financial advisors are likely to offer, making the strategy easy to delegate |
Notes
- ^ One simulation-based study suggests that with a 4% withdrawal rate, the lowest failure rates are instead in the 20-65% equity range for a 30 year retirement. Source: Pfau W (undated) Guidelines for Withdrawal Rates and Portfolio Safety During Retirement, viewed February 18, 2024.
See also
References
- ^ Pfau W (2014) 2 Schools of Thought on Retirement Income, Journal of Financial Planning, April 2014 issue
- ^ Murguia A, Pfau WD (2021a) A Model Approach to Selecting a Personalized Retirement Income Strategy, working paper available on SSRN
- ^ a b Murguia A, Pfau WD (2021b) Selecting a personalized retirement income strategy. Retirement Management Journal 10:46-58, available on SSRN
- ^ Butt A, Khemka G, Lim W, Warren G (2023) Primer on Retirement Income Strategy Design and Evaluation. Society of Actuaries Research Institute, 104 p.
- ^ Swedroe, Larry, Asset Allocation Guide: How much risk should you take?, CBS Moneywatch, February 3, 2014.
- ^ Swedroe, Larry, Asset Allocation Guide: What is your risk tolerance?, CBS Moneywatch, February 12, 2014.
- ^ Swedroe, Larry, Asset Allocation Guide: How much risk do you need?, CBS Moneywatch, February 19, 2014.
- ^ Bengen WP (1994) Determining Withdrawal Rates Using Historical Data, Journal of Financial Planning, January 1994, p. 14-24
- ^ Estrada J (2019) The Bucket Approach for Retirement: A Suboptimal Behavioral Trick?, The Journal of Investing 28:54-68, preprint available here, viewed January 24, 2024.
- ^ Anarkulova A, Cederburg S, O'Doherty M (2023) Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice, available at SSRN, and discussed by Cederburg in the Rational Reminder podcast, episode 284; viewed January 24, 2024.
- ^ Finke M, Blanchett D (2016) An overview of retirement income strategies. Journal of Investment Consulting 17:22-30, available on SSRN.
- ^ Pfau WD, Kitces ME (2014) Reducing Retirement Risk with a Rising Equity Glide Path. Journal of Financial Planning, January 2014, viewed February 1, 2024.
- ^ Blanchett David, Maciej K, Peng C (2012) Optimal Withdrawal Strategy for Retirement-Income Portfolios. Morningstar
- ^ Pfau WD (2015) Making Sense Out of Variable Spending Strategies for Retirees. Journal of Financial Planning, October 2015, preprint available on SSRN
- ^ MacDonald B-J et al. (2013) Research and Reality: A Literature Review on Drawing Down Retirement Financial Savings. North American Actuarial Journal, v. 17, p. 181-215, preprint available from SSRN, viewed April 2, 2018.
