In Unraveling Retirement Strategies: Systematic Withdrawals, I set up a structure for comparing the various retirement funding strategies using eight criteria: primary advocates of the strategy, spending plan, investment strategy, liability-matching, longevity risk, spending floor and upside potential for standard of living.
In a second post, Unraveling Retirement Strategies: Life Annuities, I reviewed the strategy of purchasing a life annuity contract from an insurance company. Now, let's take a look at the floor-and-upside strategy.
Floor-and-upside is a strategy that locks in a secure stream of retirement income before investing any remaining retirement savings in a risky portfolio. It is sometimes referred to as “safety first” and derives from The Theory of Life-Cycle Saving and Investing. The Floor-and-upside strategy is championed by Retirement Income Industry Association founder, Francois Gadenne.
You could build a really simple floor-and-upside strategy by using part of your retirement savings to buy a life annuity to guarantee a certain amount of income for as long as you live and then investing whatever is left of your savings in an S&P 500 index fund.
Social Security retirement benefits and pensions also provide secure "flooring".
by Retirement Income Industry Association founder Francois Gadenne - See more at: http://www.walnuthilladvisorsllc.com/investing-101/investing/asset-allocation-theories/floor-upside-theory/#sthash.S4NvkPpC.dpuf
by Retirement Income Industry Association founder Francois Gadenne - See more at: http://www.walnuthilladvisorsllc.com/investing-101/investing/asset-allocation-theories/floor-upside-theory/#sthash.S4NvkPpC.dpuf
spoused by Retirement Income Industry Association founder Francois Gadenne and it follows a very BASIC premise, but one that after seeing the worry in the faces of many middle Americans, - See more at: http://www.walnuthilladvisorsllc.com/investing-101/investing/asset-allocation-theories/floor-upside-theory/#sthash.S4NvkPpC.dpuf
Compare floor-and-upside to the previously described strategies, systematic withdrawals and life annuities. Let's say you looked at the income range of the systematic withdrawal strategy, shown here from my previous blog, and thought, “I love the upside potential for my standard of living, but I'm really not feeling the downside.”
Next, you look at the chart from my annuities blog, shown below, and think, “OK, you took away the downside, but you took away the upside, too! Can't I get rid of the downside and keep a little upside?”
The answer is, “Yes, if you have enough money.”
And here's a tip. In personal finance, the answer is always, “Yes, if you have enough money.”
In this case, you can achieve the desired goal if you have enough money to buy secure income and have some left over to invest in a risky portfolio of stocks. But secure retirement income, or flooring, is expensive (which is another way of saying interest rates are very low), especially in early 2014. Purchasing $10,000 a year of real flooring for the next 30 years currently costs about a quarter million dollars.
So we can compare strategies, instead of starting from scratch to implement a floor-and-upside strategy, let's start with an optimized stock and bond portfolio to implement systematic withdrawals, as I described in the first post of this series. Assume you have $500,000 in retirement savings.
You choose a stock/bond allocation based on how much volatility you can tolerate (or, said differently, how big a loss you could stomach in a major bear market) with the systematic withdrawals strategy. A bond allocation of perhaps 40% to 50% of your portfolio would be typical, so assume you would invest $300,000 (60%) in bonds and $200,000 (40%) in stocks for systematic withdrawals.
To create a floor-and-upside strategy, let's take money from that bond allocation and dedicate it to purchasing secure income for the rest of your life. Perhaps you will invest that money in a TIPS bond ladder or purchase a life annuity. Either can provide you with pretty secure retirement income.
Also assume that your retirement shortfall, the amount of income you will need after Social Security benefits are considered, is $15,000. As I mentioned, $10,000 of secure flooring costs about $250,000 in early 2014, so the additional $15,000 you need will cost about $375,000 that you would use to purchase a TIPS ladder or a life annuity.
You can take $300,000 from the systematic withdrawals bond allocation to cover this, but you will also need to take $75,000 from the stock portion. The remaining $125,000 will remain in the stock portfolio to provide an increase in your standard of living if your investments perform well.
Note, however, that your portfolio allocation is now 75% bonds instead of 60%, so your optimal asset allocation for total portfolio return is no longer attainable. You'll have a safer, but lower return portfolio than you would have had with systematic withdrawals. As I mentioned, if you have lots of savings you can buy even more stocks after you build the floor, decreasing your bond allocation to the 60% that optimizes portfolio return.
Optimizing portfolio return at a given level of risk isn't a goal of the floor-and-upside strategy. It focuses on safety first. It is possible to create a floor-and-upside strategy and maintain your optimum MPT portfolio asset allocation, but only if you have enough money. For most households, the cost of flooring alone will exceed total savings and there will be no additional capital for a risky portfolio at all.
You trade more longevity risk and maximum upside spending potential with systematic withdrawals for less risk of outliving your money, less risk of a decline in your standard of living, but also less upside potential for spending with floor-and-upside strategies.
Following is a chart showing the potential range of annual incomes provided by a floor-and-upside strategy. There will be less upside income potential than the systematic withdrawals chart shows, but a firm floor. That's because increases in the value of the stock portfolio are switched out of stocks into lower returning bonds to secure more flooring.
If there are no remaining funds to purchase stocks after the floor is purchased, the upside curve simply goes away. The range of possible future annual spending with the floor-and-upside strategy will look something like this:
Compare this to the systematic withdrawals chart above. Also note that if you implement the floor with annuities instead of a TIPS ladder, the red line on the floor-and-upside chart would continue to the right for as long as you live, rather than being limited to the ladder length you choose.
Fixed annuities with inflation protection were recently paying out about 3.5%, so $10,000 of lifetime, inflation-protected annual income costs about $285,714 today. A 30-year TIPS ladder, according to a December 2013 study by Wade Pfau, would cost about $247,588 today to provide $10,000 of inflation-protected annual income for exactly 30 years. As interest rates rise in the future, both will become less expensive.
Floor-and-upside is my personal favorite retirement strategy for most people, even if they can only implement the flooring part. I prefer a TIPS ladder to annuities because I prefer to control my capital. I prefer the downside protection of floor-and-upside to systematic withdrawals, even with less upside potential, because I can't think of many financial outcomes worse than going broke in old age. I like to take that one off the table.
Floor-and-upside is a strategy more often embraced by economists. The investment strategy is split. The safe portfolio is invested in the safest possible investment, TIPS bonds, or annuities, while the risky portfolio is typically invested in stocks. The risky portfolio can be quite risky because living expenses are secured by the floor.
The spending strategy is also split. If your future stock investments perform poorly, your spending will be fixed when you purchase an annuity or fund a TIPS bond ladder. If your investments perform well, you may be able to increase spending over time by "raising the floor".
Assuming long term real TIPS returns of 2% (not achievable in today's capital market), a 30-year ladder will payout 4.46% of its initial value adjusted for inflation and deplete the ladder's value in exactly 30 years. A 30-year ladder purchased today would pay out about 4%, according to the Pfau analysis.
The floor is set by the payout of the bond ladder or annuity. The floor can increase over time if stocks perform well. The retiree controls his capital when he invests in a TIPS ladder, but loses control of capital to the extent that he purchases life annuities.
Floor-and-upside provides the highest level of liability-matching. Each year of the bond ladder is purchased to provide the income that will be needed for a specific future year of retirement income. In other words, every future year of retirement is considered a separate liability.
Only the life annuity strategy provides more longevity insurance than floor-and-upside. Flooring can be set up for any number of years expected in retirement, 30 years, 35 years, or more, but annuities will continue to pay no matter how old you become.
Who would prefer a floor-and-upside strategy? Primarily a retiree who is not content with the variable nature and downside potential of income with the systematic withdrawals strategy, or its weak longevity insurance. Someone who is attracted to the concept of knowing where the money is going to come from to fund each future year of retirement. Someone who believes that secure retirement income is worth giving up some of the opportunities of a possible huge bull market after they retire. Perhaps, someone who isn't willing to hand their life savings over to an insurance company.
But, as I said, the full advantages of floor-and-upside are only available if you have saved enough money to both purchase the floor and fund the risk portfolio. Otherwise, "floor-and-upside" becomes simply "floor", but it will still be more attractive to many retirees than a life annuity.
In my next post, I'll describe the remaining major category of retirement funding strategies, the “bucket”, or “time-segmentation” strategy.