In the debate over whether it is better to base a retirement income withdrawal rate on predictable historical returns or one that focuses on basic retirement needs, it appears that the jury is still out.
“Do you want to focus on the probability of failure or the magnitude of failure?” said Wade Pfau, associate professor of economics at the National Graduate Institute for Policy Studies.
Mr. Pfau, who has championed the conversation over new ways to manage a retirement income portfolio, presented his food for thought yesterday in Chicago at the InvestmentNews Retirement Income Summit.
The two schools of thought, as he explained them, include a “probability-based” approach of establishing a 4% withdrawal rate, and the “safety-first” approach that involves taking defensive measures to ensure that basic retirement needs are met.
The investment approach for the probability-based approach, for example, relies on systematic withdrawals and typically applies a total-return perspective.
In the safety-first approach, by contrast, the portfolio assets are matched to goals, and lifetime spending potential is the focus, as opposed to maximizing wealth.
In a model arranged as a pyramid, the bottom layer in the safety-first approach is dedicated to essential needs, followed by a contingency-fund layer, discretionary-expenses layer and finally a legacy fund at the top.
“Volatile assets are not appropriate for basic needs,” Mr. Pfau said. “You think of essential versus discretionary.”
The fact that Mr. Pfau would not commit to one approach over the other underscores the need for flexibility and open-mindedness on the part of financial advisers.
“Risk is not whether a portfolio goes up or down in value; it's the risk to one's lifestyle that matters,” he said. “The risk is that events will take place that would force someone's lifestyle or consumption to divert from where they want to be.”
Part of the argument for a safety-first approach, he explained, is that in the current low-interest-rate environment, a 4% withdrawal rate could challenge a lot of portfolios, which could result in more risk than some clients can stomach.
“There's a lot more to retirement income than just the 4% rule, especially in a time like this when interest rates are so low and we have an overvalued stock market,” he said. “I think it's important to think more holistically about retirement income, and I'm trying to be agnostic about these two different schools.”