Breaking Free from the Safe Withdrawal Rate Paradigm: Extending the Efficient Frontier for Retiremen

Combining stocks with single-premium immediate annuities (SPIAs) may be the way to optimize a retirement income portfolio for a robust set of circumstances.

That is the finding in my article from the February 2013 issue of the Journal of Financial Planning, A Broader Framework for Determining an Efficient Frontier for Retirement Income. I will provide an overview of that article and then delve deeper into some key assumptions and the implications of changing them.

Breaking free from the safe withdrawal rate paradigm

The traditional framework seeks to determine the highest possible inflation-adjusted withdrawal amount that can support a spending stream through a long retirement without any cutbacks. This is known as the safe withdrawal rate.

But this framework is insufficient for developing a retirement income strategy. It focuses only on whether or not financial assets deplete, without considering what other resources are available in the event of asset depletion. It also fails to track how long a client could maintain his or her lifestyle after retirement assets deplete. Lastly, it does not provide any way to incorporate partial annuitization strategies. Most practitioners of the safe withdrawal rate approach are also too wedded to U.S. historical data and too faithful to the idea that past experience is sufficiently representative of potential worst-case scenarios for retirees.

Practitioners must move away from the traditional approach and provide fixes for its limitations.

Based on pioneering work by Professor Moshe Milevsky of York University, I describe the efficient frontier framework for retirees to determine appropriate allocations of stocks, bonds, inflation-adjusted and fixed SPIAs and variable annuities with guaranteed living benefit riders (VA/GLWBs). The methodology is based on current market conditions.

Unlike the safe withdrawal rate framework, the efficient frontier does not solely focus on avoiding financial wealth depletion. Instead, there is a tradeoff between two objectives: supporting minimum spending needs and lifestyle spending goals, and maintaining a buffer of financial assets. This buffer could be for a legacy or to use as a reserve in the case of expensive health shocks, divorce, severe economic downturns or other emergency needs. Clients must determine how much they value each objective and choose the appropriate balance between them.

I plotted how 1,0011 different product allocations performed with respect to meeting the two objectives. Then, I identified the efficient frontier of product allocations. The product allocations represent ways to allocate assets at one’s retirement date among stocks, bonds, fixed SPIAs, inflation-adjusted SPIAs and variable annuities with guarantee riders. The assumptions I used in my analysis are documented in the appendix.

The resulting efficient frontier shows the allocations that support the largest buffer of remaining financial assets at death while still providing a given percentage of spending needs (or, alternatively, the highest percentage of spending needs that can be satisfied for a given reserve of financial assets). Any of the product allocations on the efficient frontier represent a potentially optimal point. Clients must make the final decision about which efficient allocation is most optimal for them.

The baseline case study

Results will differ for varying client circumstances. The basic case study I used is of a 65-year old couple with an inflation-adjusted lifestyle-spending goal of 6% of retirement date assets. They have Social Security benefits equal to 2% of their retirement-date assets. So to meet their lifestyle goal, they need to generate additional income equal to 4% of their retirement-date assets. The results for the baseline case appear in Figure 1.

Retirement Income Frontier for a 65-Year Old Couple

1. Mathematically, 1,001 is the number of possible combinations of five assets, where each asset can be held in 10-percentage-point increments from 0 to 100.