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Many retirees face a daunting challenge: converting lump sums of cash into a reliable, inflation-protected income stream that will last the rest of their lives. For clients who work for governments, unions and companies with defined benefit pensions, this is not an issue; taxpayers and employers are ultimately responsible for this liability.

Clients with employer-sponsored defined contribution pensions and those who don’t have pensions at all must pull off this difficult feat themselves. That’s why decumulation, the drawdown of savings accumulated over one’s working years, has been described as the “meanest, nastiest problem in finance” by Nobel laureate William Sharpe.

Decumulation is “mean” because the stakes are high. A 2017 Allianz Life study found that 63% of those approaching or in retirement (aged 44 to 74) are more afraid of running out of money than they are of dying. And decumulation is “nasty” because the solutions must be customized to each client’s life circumstances.

The meanest

A 2016 Broadbent Institute study found that the number of Canadian seniors living in poverty tripled from 3.1% in 1976 to 10.7% in 2015. For single women, the rate is a concerning 28%. Poverty is defined as after-tax income below half the country’s median income of $57,000.

Further, many seniors have not saved enough for retirement. The same Broadbent Institute study found that nearly half of Canadians aged 55 to 64 have no employer pension benefits and have median retirement assets of just over $3,000 (see Table 1).

The nastiest

Life’s complexities expand geometrically through family formation and into retirement. In a 2017 interview with Barry Ritholtz for Bloomberg, Sharpe identified six main factors: actuarial, capital markets, inflation, treasury inflation-protected securities (TIPS), social security choices and the utility of income in each subsequent year. Financial planners understand that these variables require multi-stage stochastic programming to address possible multi-period variations. Sharpe suggests that there are 100,000 possible outcomes for capital market returns and another 100,000 outcomes for TIPS, demonstrating the multifaceted problem advisors must consider in combination with iterations of other factors.

Abandoned by advisors?

The changing economics of advice have led to rising minimums that disqualify more and more baby boomers. Advisors are largely compensated for growing assets, not for overseeing their erosion, and face fee compression and increasing regulatory constraints.

Ironically, today’s financial services industry was built to serve baby boomers, yet few post-work products or solutions exist. Annuities provide the reliable stream of income that retirees want and need, but restricted access to capital, high cost and low interest rates make them unpopular.

Thanks in part to compliance constraints, portfolios are often parked in conservative, 40-60 balanced funds, leaving investors exposed to market and related risks. In fall 2017, I co-authored a paper in the Journal of Retirement with colleague Ioulia Tretiakova that found such a conservative investor would have a 22.9% probability of running out of money before dying by withdrawing 4% of initial capital every year. The analysis adjusted for inflation on a joint and last-survivor basis.

4% safe withdrawal not safe

The person to propose the 4% withdrawal rule was William Bengen, back in 1994. At the time, Bengen calculated a person’s retirement funds would last forever with a 4% withdrawal rate if invested in a 50% equities, 50% intermediate treasuries portfolio.

Things have changed dramatically since 1994. Bengen’s 4% rule has been widely debated and is considered too high in the current low-interest-rate environment. In a low-to-rising interest rate environment, a 4% withdrawal rate on a 50% equity, 50% bond portfolio has a 17.6% probability of ruin.

In the Journal of Retirement paper, we propose a way to manage assets in retirement that could boost payouts significantly without increasing the risk of running out of money before dying. The main considerations when investing in retirement are to minimize exposure to volatility while maintaining a growth component to offset both inflation and longevity risk. We will examine this approach in a future article.

Table 1: Retirement savings for Canadians aged 55-64 without employer pension plans (rounded)
Family income range (2011) Overall Under $25,000 $25,000 to $50,000 $50,000 to $100,000 Over $100,000
Average family income $64,000 $12,000 $38,000 $71,000 $199,000
Median retirement assets $3,000 $0 $250 $21,000 $160,000

Source: Richard Shillington, An Analysis of the Economic Circumstances of Canadian Seniors, for the Broadbent Institute

Mark Yamada is President of PÜR Investing Inc., a software development firm. Disclosure: PÜR Investing Inc. provides risk-based model portfolios to Horizons ETFs.