Managing Investment and idiosyncratic longevity risks for retirees

1. Managing Investment and idiosyncratic longevity risks for retirees • Michael S. Finke, Ph.D., CFP® • Professor & • Director Retirement Planning & Living • Department of Personal Financial Planning • Texas Tech University

2. Congratulations! You’re a pension manager!

3. Pension Managers What do they worry most about? 1) Asset Return Risk 2) Longevity Risk

4. Individual Pensions are Harder • Asset Return • Pension Manager – Pool returns across generations • Advisor – One whack at the cat • Longevity Risk • Pension Manager – systemic increases in longevity • Advisor – Idiosyncratic longevity risk

5. Systematic Longevity Risk Source: Robine, 2012

6. Wealthier Live Longer Source: SSA, 2008

7. Idiosyncratic Longevity Risk Source: Frank, 2013

8. Idiosyncratic Longevity Risk • How do you deal with idiosyncratic risk? 1) Diversification (pool it) 2) Retain it • Avoiding running out of money by spending less and accepting portfolio risk • Live it up and accept greater risk of running out of money

9. Turning Retirement Assets into Income

10. The 4% Rule (William Bengen, 1994) • Safe Withdrawal Rates (1920s - present)

11. Philosophy of the 4% Rule • Retirees have a lifestyle goal and not meeting that goal indicates failure • Failure = inability to spend lifestyle goal for 30 years • Portfolio risk increases likelihood of meeting spending goal • Use prior returns to establish safe withdrawal rate

12. Historical Random Returns 8.99% -10.1% 3.0% 13.7% 23.5% -38.5% 31.0% 20.3% 34.1% -1.5% 7.1% 4.5% 26.3% -6.6% 27.3% 12.4%

13. Asset Pricing 101 pt = Εt[β * u’(ct+1)/u’(ct) * xt+1] Price at time t (now) = Expectation (now) Of β(how much we discount the future) * Marginal utility tomorrow Marginal utility today *Expected payout tomorrow

14. What This Means

15. What’s Affecting Asset Prices? How Much Do Global Investors Value the Future?

16. Capital Market is Global

17. Global Real Interest Rates

18. Importance of 1st Decade Source: Milevsky and Abaimova, 2005

19. Monte Carlo Failure Rates • Historical Real Returns: Stocks 8.6%, Bonds 2.6% Stock Allocation: 30%50%70% Failure Rates 6% 6% 6% • Slightly more realistic: Stocks 5.5%, Bonds 1.75% Failure Rates 24% 24% 27% • A little better than today’s rates: Stocks 6%, Bonds 0% Failure Rates 47% 33% 28% • Early 2013 Rates: Stocks 4.6%, Bonds -1.4% Failure Rates 77% 57% 46% Source: Blanchett, Finke and Pfau, 2013

20. What if Rates Revert in 5 Years? • Start out at current rates (Stocks 4.6%, Bonds -1.4%) • Revert to Stocks 8.6%, Bonds 2.6% Stock Allocation: 30%50%70% Failure Rates22% 18% 18% • What if Rates Revert after 10 years? Failure Rates43% 32% 38%

21. Other Problems with the 4% Rule Source: Blanchett and Finke, 1% fee

22. No Risk Tolerance, No Optimization Source: Finke, Pfau and Williams, 2011

23. Value of a Dynamic Approach Source: Blanchett, 2013

24. Illustration of Dynamic Source: Pfau, 2013

25. Assumes Historical Equity Premium

26. S&P Dividend Yields

27. What Does Current P/E Imply? Source: Asness, 2012

28. Requires Managing Assets in Old Age

29. Literacy and Confidence

30. A Better Approach • Prioritize spending categories (basic needs, discretionary expenses, legacy) • Employ risk when a retiree is willing to accept possibility of a loss • Deal efficiently with idiosyncratic risk • Simplicity - make sure real people can handle it, use research to create defaults • Be realistic about future asset returns

31. Questions/Comments • Michael S. Finke, Ph.D., CFP® • Professor, Ph.D. Program Director • Director Retirement Planning and Living • Department of Personal Financial Planning • Texas Tech University • Michael.Finke@ttu.edu