Latest from Graham Westmacott and Susan Daley

More from Graham Westmacott and Susan Daley / All columnists


Integrated Case Study

We use the ideas developed above to compare the fortunes of two couples, Jacques and Karine and Claire and David, who retire prior to the Great Recession.

The year is 2007. Both couples are age 65 and looking forward to their first year of retirement. Both have $1,000,000 of investment capital.

Jacques and Karine have a portfolio of 60% equities, 40% fixed income and have been advised that the popular 4% withdrawal rule will allow them to withdraw 4% of their initial capital, indexed to inflation at 2%, without running out of money. Thus they expect $40,000 in the first year, rising with inflation. Their advisor had them complete a risk questionnaire that showed they were tolerant of the risk associated with the price fluctuations of a 60% equity portfolio.

Claire and David had a different advisor who listened to the importance they attached to income stability. They also wanted to withdraw $40,000 annually, indexed to inflation, and wanted to make sure that this could be done for 15 years from the start of retirement. Every year as they progressed through retirement, and should circumstances allow, they wanted to maintain that 15-year horizon of secure income.

Fast-forward to February 2009. Jacques and Karine’s portfolio is depicted in the chart below. They have received their monthly payout but their portfolio has suffered badly from the financial crisis and is only worth $670,000, a 33% decline in just over two years. They are facing the real prospect of running out of money. To make their 2009 withdrawal of $42,085 (inflation-indexed) would mean withdrawing 6.3% of the portfolio. They consider some combination of giving themselves a pay cut or reducing their equity exposure to preserve their remaining capital. Getting a part-time job to provide additional income didn’t seem an option in the prevailing economic climate.

Source: PWL Capital calculation based on monthly performance data from Dimensional Fund Advisors

Claire and David have also received the same monthly payout as Jacques and Karine and are also seeing their capital eroded, but to a much lesser extent (their portfolio is worth $838,000, a 16% decline).  The chart below shows Claire and David’s portfolio with Jacques and Karine’s as a blue line for comparison. Claire and David are reassured that their payouts are protected for the next 15 years and they can afford to take a long-term view.

Source: PWL Capital calculation based on monthly performance data from Dimensional Fund Advisors

The process used by Claire and David can be summarised as follows:

  • The lump sum required to generate 15 years of $40,000 annually, increasing with inflation, is calculated using 2007 interest rates. The result, which is allocated to the Security Portfolio, is $520,000.
  • The Security Portfolio allocation is used to purchase a series of bonds which, through their maturity and interest payments, pay $40,000 annually.
  • The remaining $480,000 is used to purchase a long-term Growth Portfolio. In this case we chose a globally diversified 60% equity, 40% bond allocation.
  • The Security Portfolio provides all the income. Each year the Security Portfolio allocation is recalculated using prevailing interest rates, taking into account the payout, investment returns and any changes in inflation. The calculation also accounts for the possibility of Claire and David dying. Since this probability increases with age, all other things being equal, the Security Portfolio allocation declines in real terms.
  • The portfolio is rebalanced every year between the Security Portfolio and the Growth Portfolio, so the Security Portfolio always provides a 15-year horizon of secure income. Every year they check, using the ARVA method, whether their total portfolio is sufficient to generate an annual real income of at least $40,000 over their expected lifespan. This ensures that they always retain sufficient assets to generate $40,000 in real income not just for the next 15 years but for their expected lifespans.

At the start of 2007, the asset allocation for Claire and David’s total portfolio was 73% bonds, 27% equities. It is easy, with hindsight, to see the wisdom of this choice and why it fared better in the 2008 recession.

However, Claire and David made their choice, not because they could forecast the pending market decline, but because they wanted to protect their income in retirement. Had Claire and David been 30 years old and had no need for income they could have adopted the same portfolio as Jacques and Karine and would have been content to hold out for the market recovery. The key message here is that, for retirees, risk no longer means price volatility but income volatility. Designing a portfolio with the wrong objectives can lead to poor outcomes.

In our example, Jacques and Karine cut back on their income and cashed out most of their equity investments. If they had the stomach to persevere, we know, again with hindsight, that their portfolio would have recovered. In the figure below we plot the recovery for both couple’s portfolios, assuming both portfolios continued to make annual inflation adjusted withdrawals of $40,000. By the end of 2014 both portfolios have similar value, but Claire and David’s is much less volatile.

Source: PWL Capital

To summarize, this example uses liability matching to provide a 15-year horizon of secure income. The ARVA spending rule was used as a check to ensure that Claire and David never reduced their portfolio below what could sustain a real income of $40,000 for their expected lifespan.

Concluding remarks

Investments are accumulated to be depleted, usually by the same household as part of retirement funding. The financial industry is always exhorting Canadians to save more, but on the topic of depletion strategies it isn’t so vocal. Simple spending rules that ignore longevity and market risk aren’t efficient in using a retiree’s assets for their intended purpose: consumption.

We started with funded status as an overall assessment of whether assets matched spending liabilities. ARVA was introduced as a dynamic spending rule that considered life expectancy, market performance and interest rates. Complete hedging of retirement risks are seldom affordable and often not realizable, but partial hedges are better than none. Given the challenge, already noted, of building a ladder of real return bonds, using nominal bonds or nominal bond ETFs is a more practical alternative for the Security Portfolio. In the event of unexpectedly high inflation, the retiree is then exposed to the risk of diminishing purchasing power from the Security Portfolio. Studies of retirees spending patterns in developed countries (e.g. The Real Retirement, by Fred Vettese and Bill Morneau) indicate spending tends to reduce after the mid-70s, so a decline in real income may mirror a decline in real spending.

Longevity risk can’t be pooled without using commercial annuities, but the risk can be capped by differentiating between essential consumption, as represented by the Security Portfolio, and discretionary consumption, sourced from a Growth Portfolio.

The term structure of the Security Portfolio was introduced to provide a dynamic duration match between the assets and liabilities throughout retirement and to reduce interest rate risk.

Retirees have differing consumption profiles and have different abilities and needs to take risks to achieve their consumption. The methods outlined show how retirees can be more deliberate in assessing trade-offs between income volatility, maximizing income and hedging longevity risk. In doing so, they are more likely to enjoy a higher and more certain level of income in retirement.

Next steps

Graham Westmacott and Susan Daley Graham Westmacott, is a portfolio manager at PWL Capital, and Susan Daley, is an investment advisor at PWL Capital
Originally published on
See all comments Recent Comments

alan morris

Great insight

Thursday, Oct 12, 2017 at 10:33 am Reply

Vevencia L De Vera

Alan and Betsy are on the safe side of their retirement income because the graph shows that they still have a surplus. The statement says the $40,000 per year is as long as they live and their fund status is greater than one.

Saturday, Sep 30, 2017 at 9:20 am Reply

Add a comment

Have your say on this topic! Comments are moderated and may be edited or removed by
site admin as per our Comment Policy. Thanks!