Eight Core Ideas to Guide Retirement Income Planning
by Wade D. Pfau, 2/15/16
Eight key messages and themes have underscored my writing and research. Those guidelines serve as a manifesto for my approach to retirement income planning:
Play the long game. A retirement income plan should be based on planning to live, rather than planning to die. A long life will be expensive to support, and it should be the focus. Fight the impatience that would lead one to choose short-term expediencies carrying greater long-term cost. This does not mean, however, that one sacrifices short-term satisfactions to plan for the long-term. There are many efficiencies that can be gained from a long-term focus that can support a higher sustained standard of living for as long as one lives. One still has to plan for a long life, even when rejecting strategies that only help in the event of a long life. Remember, planning to live to life expectancy is quite risky; half of the population will live longer than this. Planning to live longer means spending less than otherwise. Developing a plan that incorporates efficiencies that will not be realized until later can allow for more spending today in anticipation of those efficiencies. Not taking such long-term efficiency-improving actions will lead to a permanently reduced standard of living. The implication is more conservative lifetime spending in order to preserve assets for the long-term as a fix for the planning inefficiencies.
Some strategies I have discussed that focus on building a long-term plan over accepting short-term expediencies include the following: delaying the start of Social Security benefits, purchasing a single-premium immediate annuity (SPIA), paying a bit more taxes today in order to enjoy more substantial tax reductions in the future, making home renovations and living arrangements with the idea of supporting aging in place, setting up a plan that accounts for the risk of later cognitive decline that makes it harder to manage one’s finances with age and opening a line of credit on a reverse mortgage. These strategies may not make much sense if the planning horizon is only a couple of years, but they make a great deal of sense for someone building a sustainable long-term retirement income plan.
Do not leave money on the table. The holy grail of retirement income planning is finding strategies that enhance retirement efficiency. I define efficiency such that if one strategy simultaneously allows for more lifetime spending and/or a greater legacy value for assets relative to another strategy, then it is more efficient. Efficiency does have to be defined from the perspective of how long one lives. Related to point (1), there can be a number of strategies that enhance efficiency over the long-term (but not necessarily over the short term) with more spending and more legacy. One simple example for tax planning is taking IRA distributions or harvesting capital gains to the point that the marginal tax rate leaves the 0% tax bracket could help to reduce future taxes without any present cost.
Use reasonable expectations for portfolio returns. A key lesson for long-term financial planning is that you should not expect to earn the average historical market returns for your portfolio. The average is just that; half the time it is more and half the time less. Beyond this, we have been experiencing a period of historically low interest rates, which unfortunately provides a clear suggestion that at least bond returns are going to be lower in the future. This has important implications for those who have retired (these implications are relevant for those far from retirement as well, but the harm of ignoring them is less than for retirees). At the very least, dismiss any retirement projection based on 8% or 12% returns, as the reality is likely much less when we account for portfolio volatility, inflation, a desire to develop a plan that will work more than half the time and today’s low interest rates. As a corollary to this point, while low interest rates generally make retirement more expensive, there are some strategies that are made more attractive by low interest rates, such as delaying Social Security or opening a reverse mortgage.