Summary and Rationale for Retirement Planning Using Annual Available Spend

There have been many attempts to create a science of retirement planning.  The premise of this article is that no effective formulaic approach exists.  Instead of relying on such techniques, it is incumbent upon us to thoroughly understand our present financial position and then evaluate how we will manage our finances given a range of possible future outcomes

It is, of course, possible to determine odds of success if we assume that one's investments will exactly follow the past.  Although we can learn from the past, "scientific" reliance on the past has been demonstrated to be wrong.  For example, few if any people actually believe the 10% equity returns of the past will be repeated.  The types of market declines and inflation of the past are a rough guide for the future, but we should not place meaningful reliance on them.

Perhaps the most common ''science" is safe withdrawal rates, SWR.  In the past it was widely accepted that the Trinity Study proved that a 4% withdrawal rate was safe.  Today with the advancement of the SWR science, we deal with a range of <2% to >5%.  With this broad range, and the many alternative methods of implementation, SWR is of questionable value.  Having said that, SWR can be a useful tool for those who want ballpark future planning, e.g., if I save 1m, I will have about 30 or 40k of cash flow when I retire.

The objective of SWR is to determine the amount of annual spending that is "safe".  If safety is the goal, there are methodologies that can be used.  Life-cycle investing and Liability Matching Portfolios (using, for example, TIPS ladders) are used to eliminate or minimize market and inflation risk.  These approaches are the best means of achieving safety, but at a very substantial cost.  Some individuals do not have a large enough portfolio to live off the low returns generated by this approach.  Those who do must sacrifice a great deal of upside potential.  Not using such safe approach does not mean the alternative is unsafe.  Instead it will mean accepting a small possibility of some (acceptable) reduction in retirement spending in exchange for a much larger likelihood of increases in available retirement spending.

Monte Carlo Simulation is a popular scientific approach that is used to evaluate the variability of future returns.  MCS is used to estimate probabilities of success of reaching one's retirement goals based upon 1000's of computed iterations.  The outputs from MCS are, of course, only as good as the assumptions that are input.  Faulty inputs, often using historical facts, have resulted in corresponding false probabilities of success.  Although good inputs can result in a meaningful evaluation of odds of success with respect to sequencing of returns, MCS fails to deal with Nassim Taleb's Black Swans or deal with Bill Bernstein's caveat " any estimate of long-term financial success greater than about 80% is meaningless".  Inclusion of outliers in MCS defeats the purpose of the science.

Some financial planners prescribe safe approaches such as life-cycle or liability matching portfolio methodologies, but at the cost of very low returns. The majority of financial planners use one or more formulaic approaches discussed above, which are regularly revised and expanded with the ever changing "science".  The quest for certainty by advisors and their clients is understandable, but no formula can provide that certainty. 

Because there is no effective scientific approach to retirement financial planning, it is incumbent upon us to thoroughly understand our present financial position and then evaluate how we will manage our finances given a range of possible future outcomes.  The methodology described in this paper is limited to establishing these fundamental facts and analyses.

  

The first year law student is told that the most important factor in earning credit on exam questions is to demonstrate an understanding of the relevant and material facts.  That is the best advice for anyone who is attempting to analyze and solve problems where there is no certainty.  When I began my own retirement planning, I researched the subject thoroughly.  I could do a reasonable job of estimating my range of spending needs in retirement, but I realized that nowhere did the retirement literature deal with my most basic question:  How much will I have available to spend each year for the rest of my life?  Of course, given the uncertainty, there is no precise answer to this question, but it is possible to determine a reasonable range for retirement financial planning.

This article explains the methodology for assembling the relevant and material facts necessary for effective retirement financial planning.  It does not pretend to assess the probabilities of various worst case scenarios.  It does not attempt to evaluate the risk inherent in various investment portfolios.  Instead, it provides those facts, specific to the individual, that are essential to set the stage for effective retirement planning by the retiree or his advisor.