Congratulations. Throughout your career, you have worked hard, saved consistently and accumulated a significant sum of retirement assets. When it’s time to retire, though, you find that making a plan to finance the rest of your life is almost impossibly complex.
“You don’t know how long you’re going to live. You don’t know how long your spouse is going to live. You don’t know what the markets are going to do,” says Richard Thaler, a Nobel laureate, professor of business at the University of Chicago Booth School of Business and PIMCO senior advisor on retirement and behavioral economics. “It’s a problem that gives the best mathematicians big headaches.”
Worse, these known unknowns may encourage behavioral miscues that lead to suboptimal outcomes. Fear of outliving one’s assets, for instance, means most retirees leave this world without having spent – and enjoyed spending – the bulk of their savings. Fear of subpar returns can crush confidence in carefully crafted financial plans and cause investors instead to “go to cash.”
To counter these fears and ensuing misbehaviors, PIMCO believes that a retirement income plan must address these natural emotions and instill confidence in the investor. It needs to be intuitive and simple to implement and maintain. It should address the natural but conflicting human desires for both predictable income and long-term growth – without requiring individuals to give up control or the flexibility to change course. Flexibility, we believe, is a reasonable requirement in the face of inveterate uncertainty.
PIMCO’s Income to Outcome Framework™ is based on heavily researched investor behaviors and seeks to address three of their most common, and important, goals (see Figure 1):
- Financial peace of mind — The knowledge that, no matter their level of savings or what the markets may bring, they are unlikely to run out of money to support their lifestyle.
- Control of one’s assets – The ability to access all of their wealth whenever they see fit and adjust their plan if circumstances or objectives change – rather than cede ownership or administration of their assets (e.g., by purchasing an annuity), which could limit flexibility and the potential for future returns.
- Easy implementation – A decumulation strategy that is intuitive – simple to implement and adhere to.
TWO DEDICATED PORTFOLIOS
PIMCO’s Income to Outcome retirement framework uses insights from behavioral economics to help address these seemingly contradictory goals. Designed for financial advisors and their clients, it suggests that retirees consider separating their financial savings into two portfolios (see Figure 2).
One is a lower-risk bond portfolio – for example, a bond ladder that seeks to deliver a predictable income stream over a number of years (absent defaults). Cash flows generated by the portfolio, including interest income and the return of principal as bonds mature at regular intervals, seek to emulate the paycheck1 that the new retiree had long relied on.
The second portfolio is composed of long-horizon, higher-growth and higher-risk assets meant to address future (and often unforeseeable) spending needs, or to leave more for loved ones or charity. Importantly, growth assets also tend to be used to mitigate inflation risk.
The uncertainties of life and markets, of course, often stand in the way of realizing these desires.
Without doubt, we have control over some aspects of our lives, such as when we retire. Some individuals may wish to continue working and building savings – thus postponing the day when assets begin to be drawn down. Others may choose to retire early and live more thriftily. We also have significant control over how to organize and allocate our assets.
But unpredictable factors dominate (see Figure 3). No one knows if they or their spouse will remain healthy or succumb to illness – or, of course, the date of their demise.
The fate of markets – and thus one’s portfolio – also is uncertain. Over a period that may last decades, markets may rise or fall, often steeply. Return sequences may vary. Outcomes cannot be guaranteed.
And finally, while often overlooked, future tax rates and inflation are unknown. These may significantly erode the value of one’s wealth over time – shortening the spending horizon of the portfolio.
THE DECUMULATION DILEMMA
How can a single framework address these contrasting, even conflicting, desires amid uncertainty? How can a retirement plan give investors a clear shot at achieving both goals?
The two-portfolio framework applies the theory of goal-oriented investing, which is derived from mental accounting2 (a behavioral finance concept Richard Thaler introduced) to seek a more disciplined approach to decumulation – the drawdown of retirement assets. It aims to help set and automate regular withdrawals, protect against sequence-of-returns risk, provide flexibility around optimal strategies for claiming Social Security and seek long-term growth through a well-diversified but generally higher-risk (endowment-like) portfolio to support unforeseen expenditures and maximize potential for gifting and bequests.
As noted, our framework allocates the main components of most long-term portfolios – bonds and higher-growth-seeking assets – to distinct portfolios. Each serves a different purpose. Combined, they would approximate the allocation of a traditionally efficient portfolio. Separated, they create a behaviorally minded framework that may provide a solution for many investors who desire greater certainty around the timing and sources of future cash flows without sacrificing the potential for growth (see Figure 4).
The bond ladder seeks to provide, over the near term (say, five to seven years), a stream of consistent income and the return of par value when bonds of varying duration reach maturity (absent defaults). Bonds maturing at regular intervals over a period of years seek to emulate the “predictable paycheck”1 individuals relied on during their working years.
Securing a potential income stream, in turn, may pay numerous dividends.
For one, it may help provide retirees more flexibility in claiming Social Security at a more advantageous time. Having set up a bond ladder that seeks to provide income for several years of spending, retirees may be more inclined to let the clock run on their Social Security strategy (see Figure 5).
PIMCO research shows that deferring Social Security benefits increases the real benefit payout by an average of about 7.3% per year relative to taking benefits at age 62, the earliest age to claim benefits. Nonetheless, retirees frequently take benefits3 early or, most commonly, within a few months of retirement. Only about 4% wait to age 704 and receive the maximum benefit.5
RECOVERING FROM AN UNTIMELY RETIREMENT
The psychological benefits of the framework may be even more significant. Consider that for many individuals the start of retirement is a scary time. Having a better idea as to when, and how much, income they will likely receive may help
That, in turn, can deliver a key behavioral benefit. It may help individuals keep their hands off equities and other higher-volatility assets that compose the growth portfolio. These assets may then have more time to realize their potential for appreciation – and, crucially, avoid the crystallization of losses by helping retirees to reduce the temptation to liquidate their portfolio when markets fall.
This can be a major risk. Consider a retiree who got spooked when U.S. stocks began to slide in October 2007. For many, the loss in portfolio value was compounded by untimely, fear-driven de-risking (achieved by reducing equity exposure or moving to cash outright) that prevented the investor from recouping the losses when the market eventually rebounded. PIMCO’s Income to Outcome framework may make retirees less susceptible to this type of counterproductive behavior.
OUT OF SEQUENCE
Mistiming the outset of retirement can cripple an investor’s ability to achieve their goals. But time can also be a balm and an ally — so long as the investor leaves enough time, and enough wealth in their portfolio, (ideally unburdened by spending), to potentially recover.
That’s the essential function of the growth portfolio, endowment-like in both allocation and purpose. Excess returns from the growth portfolio could be used to prolong (or “reload”) the bond ladder and the income it generates.6 (Depending on one’s circumstances, the initial bond ladder may stretch over five, seven or more years.)
By timely reloading of the bond ladder – extending the ladder by a year or more after a prolonged market rise, for instance – investors may be able to take advantage of equity reversion, transforming sequence risk into a tailwind.
Recall that during the great financial crisis, the S&P 500 plunged by 57% over 17 months through March, 2009. But it recouped these losses by 2014 and has nearly doubled since then (remember, markets are unpredictable and the next downturn may not behave the same). It’s another example of the flexibility of the Income to Outcome approach, which allows advisors wide latitude to deal with inevitable market dips and rallies.
Investors may stand to benefit from the tailwinds provided by the growth portfolio, as their total net worth climbs into “surplus,” above that required to support the paycheck portfolio. Their margin of safety becomes the measure of their ability to begin considering other uses for those funds (see Figure 6).
Some may ask: What about longevity insurance – i.e., annuities? We believe they may play a role for some investors. However, the calculus is different. We typically insure against risk when the risk becomes relevant. Longevity risk is a good example: It’s most significant when assets are depleted or age mounts, typically later in the retirement journey (although purchasing such insurance earlier may offer some value).
Again, life is uncertain. Overcommitting to longevity insurance at the start can shift precious capital away from other potential uses, limiting flexibility, compromising control, and reducing the potential for investment gains. (Of course, each investor must weigh their own circumstances and should speak with a financial professional about their unique financial situation and needs.)
THE BENEFITS OF BIASES
Behavioral biases and the inherent uncertainties of life make retirement income planning an imperfect art, even more so because it’s human nature to want things that conflict – in this case, the desire for predictable income and the potential for growth. The Income to Outcome framework seeks to thread this needle for those with sufficient means. It aims to make behavioral biases work for, not against, the retiree and provide a structure for a sound allocation of assets that is intuitive and easy to administer.
For more on our new Income to Outcome retirement framework, click here.