Benchmarking Your Retirement Portfolio With a Risk-Free Strategy

Making the savings from 35 or 40 years of work pay for a retirement of the same length is a real challenge – something that our forebears didn’t have to worry about, because they rarely lived past 80, much less to 100 or 105.  At a zero real rate of return, you would have to save half of your income to enjoy a retirement that long without taking a cut in your living standard.

There is, of course, a better way – judicious use of TIPS and annuities.  A riskless strategy using those asset classes can safeguard one’s retirement assets and can serve as a benchmark against which riskier portfolios can be measured.

Few live to 105, but some do, and they will probably run out of money using conventional investment strategies.  Annuities enable those who die younger to help pay benefits to those who survive – but most investors are loath to transfer control of their portfolio to an annuity provider in exchange for a lifetime stream of income. 

The better strategy takes advantage of the longevity-risk-pooling features of annuities without relying on them exclusively.  A number of advisors, academics, and investment managers have been pursuing parallel paths toward such a solution. 

Joe Tomlinson described one such effort in a March 6 Advisor Perspectives article.  Tomlinson suggested holding a conventional investment portfolio (either riskless or risky) to fund the first part of one’s retirement, and a deferred income annuity (DIA) to fund the latter part.1

Let’s look at a recent research paper that supports Tomlinson’s position, and then show how those findings can be used to compare an equity-oriented retirement portfolio to a passive and riskless retirement benchmark.

Using TIPS and DIAs to define a decumulation benchmark

A recent Financial Analysts Journal article by Stephen Sexauer, Michael Peskin and Daniel Cassidy extends Tomlinson’s logic to arrive at a slightly different goal – an investable benchmark for asset decumulation in retirement.  The benchmark portfolio consists of about 88% in a laddered TIPS portfolio, providing income to the investor for the first 20 years – that is, from age 65 to 85 – and 12% in a DIA, providing income for the rest of the investor’s life.  The 88-12 portfolio is a benchmark, in that investors can either hold it directly (akin to indexing) to avoid market risk entirely, or try to beat it by blending risky assets into the mix. In the latter case, the benchmark serves as a measuring stick for the success of the investor’s risk-taking.

Because, in this strategy, annuity payments start at age 85, the likelihood is high that the investor will live to collect only a few of them.  Thus the deferred annuity is priced cheaply.  It is so cheap that a mere 12% allocation to this asset class produces an income in year 21 (the first year of payout) that is equal in real terms to the annual income produced by the TIPS ladder; hence the 88/12 split.  In other words, the investor does not take a pay cut, even when the last TIPS bond is redeemed.  Unfortunately, there are no real (inflation-adjusted) DIAs available currently, so the income remains level in nominal terms after that time – but most investors won’t care, since expenses (other than those related to health care) tend to tail off after age 85.  (When using this strategy, it’s prudent to maintain a separate reserve or insurance policy for nursing care and/or in-home health care; unlike ordinary living expenses and travel-and-leisure expenses, these tend to shoot upward near the end of life.)

1. For an academic’s take on this question, see Shankar, S. Gowri, “A new strategy to guarantee retirement income using TIPS and longevity insurance,” Financial Services Review, vol. 18 (2009), pp. 53–68.