Wade D. Pfau, Ph.D., CFA, is a professor of retirement
income at The American College and a principal at McLean Asset Management. He is
a two-time recipient of the Journal’s Montgomery-Warschauer Award and host
of the Retirement Researcher website RetirementResearcher.com.
How should a retiree choose
an initial spending rate and asset allocation for retirement? These are key
questions facing advisers when working with clients approaching retirement. But
answering these questions is complex and relates to multiple factors. I have
tried to summarize the important factors into something I call the Retirement
CARE AnalysisTM. CARE stands for Capacities,
Aspirations, Returns, and Emotional considerations.
Advisers should consider these factors, as follows, when
deciding on the aggressiveness of both spending and asset allocation within a
retirement income plan:
Reliable income. What
proportion of the client’s spending goals are covered through reliable income
sources from outside the investment portfolio that will not be diminished by
Spending flexibility. Is
it possible to reduce portfolio distributions by making simple lifestyle
adjustments without significantly harming your client’s standard of living?
Funded ratio. Are there
sufficient assets to meet retirement goals without taking market risk? Is there
excess discretionary wealth, or is the client underfunded with respect to
Availability of reserves and
exposures to spending shocks. How much exposure is there to large and
uncertain expenses? What insurance policies or other reserves are available to
manage these shocks? Are there buffer assets? How is home equity used within the
Lifestyle. What is the
retirement budget? How does it change over time? How closely connected is it to
consumer price inflation?
Legacy. What are the
legacy goals? How important is legacy relative to other goals?
expectations. What are reasonable market return assumptions for different
asset classes and inflation to guide simulation of the retirement income plan?
How are returns impacted by investor behavior, fees, taxes, inflation, and
investment vehicle choices?
Emotional Comfort (Constraints)
Traditional risk aversion.
How much short-term portfolio volatility can your client stomach before it
affects his or her sleep and leads to panic and changing course if markets are
Longevity risk aversion.
How fearful is your client about outliving his or her investment portfolio?
Greater concern means more longevity risk aversion, implying that the adviser
should build in a higher planning age.
Financial tool aversion.
Is the client (and adviser) willing to consider different types of retirement
tools, such as annuities and reverse mortgages, or are some tools simply
nonstarters for the discussion?
Susceptibility to behavioral
mistakes. When it comes to investing and long-term planning for complex
situations, how prone is the client to making a variety of behavioral mistakes?
Will the client be able to stick to his or her financial plan? Does the adviser
have the capacity to provide advice and support late into the client’s
Financial plan complexity.
What is the acceptable degree of complexity and involvement needed to manage the
client’s finances? Do they enjoy the planning process, or would they prefer to
outsource much of management to others? Would they prefer simpler
set-it-and-forget-it types of solutions?
Financial savvy of all household
members. How is financial planning knowledge and savvy distributed among
household members? What is the degree of vulnerability of others in the
household if the more financially savvy member experiences cognitive decline or
an unexpected death?
In answering these Retirement CARE questions, a more
conservative client will experience some of the following characteristics:
- Fewer reliable income sources outside of the investment
portfolio to help cushion the impact of market volatility on lifestyle;
- Less flexibility to make spending reductions because
spending goals are fixed and adjust with inflation;
- Fewer reserves, buffer assets, or insurance policies to
help cushion spending shocks;
- A greater desire to build in a margin of safety for the
- Greater worry and stress about short-term market
- Greater worry and stress about outliving his or her
Meanwhile, a more aggressive retiree will tend to fall in
the opposite direction on these matters, highlighting the highly personal and
complex nature of these decisions. It is only after thinking about these
different types of questions and assessing assets and liabilities on the
retirement balance sheet that clients are able to fully determine their
appropriate asset allocation and withdrawal rate decisions.