Rethinking portfolio analysis to reduce living-standard risk

Avoiding an abrupt drop in living standard after retirement is a major risk for retirement plan participants and all other investors. Depending on spending and investment decisions over time, participants, particularly defined contribution participants, can reduce living-standard risk based on a lifecycle planning framework.

Investing and spending are not independent decisions. Spending too aggressively when young can be as risky, if not far more risky, as investing aggressively in determining where your living standard ends up in retirement. For this reason, spending and investing decisions are most sensibly considered together over time. However, investment advice based on conventional financial planning models assumes, in effect, that you've already made all your saving decisions. Consequently, your only task is to decide how to invest your savings and spend whatever you have earned at the end of the investment period, i.e., during retirement. In this framework, investors will enjoy a comfortable retirement if returns turn out well but will be disappointed if returns are small. This static, one-shot investment model dates to the 1950s. Although it provides many useful insights, it is disconnected from reality in many important ways.

Importantly, participants don't spend years doing nothing but saving, then spend years doing nothing but investing, and then spend years doing nothing but spending. Participants make saving, spending and investing decisions simultaneously each and every year. And the decisions they make now affect what decisions they can make in the future. The more participants spend now and the more aggressively they invest now, the greater the chance of spending far less in future years. This dynamic analysis of interconnected spending and investing decisions is the hallmark of modern lifecycle portfolio theory and provides a powerful framework.

This framework has practical implications for all retirement plan executives and participants, as well as financial planners. In particular, it supports a conservative spending profile over time to build sufficient savings, which would be consistent with higher contribution levels when young. Sponsors now have a useful framework to assess if the plan replaces sufficient income at retirement to prevent a sudden drop in the living standard of plan participants. In this way, sponsors can use the tool to judge if policy changes in the plan can help smooth the living standard of participants over their lifetimes.

Financial planners can also use the lifecycle planning framework to show plan participants their dynamic living standard risk-reward trade-off. Specifically, they have a framework to show their clients that saving more now will let them invest more aggressively without unduly raising the risk of a far lower living standard in retirement.

In sum, while traditional financial planning and portfolio management tools yield important investment insights, they generally focus on the trade-off between expected return and volatility at a single point in time. A lifecycle planning framework can guide plan executives, participants and financial planners in forming optimal spending, saving and investing decisions.

A participant's living standard will change through time as he or she invests in risky assets. For retirement plan participants, the framework provides a new way to plan saving, spending and investment decisions over time that produce a higher average living standard with less downside living-standard risk. A lifecycle financial planning approach can quantify and distinguish the impact of aggressive spending decisions and inadequate portfolio diversification on living-standard risk.

For example, beginning at age 45, a participant who is an aggressive spender initially has higher spending compared to a cautious spender, but faces greater living-standard risk in retirement years as the cautious spender benefits from greater accumulated assets. The framework allows participants to quantify the living-standard risk of spending agressively given different assumptions about lifetime investment returns. A participant who is a cautious spender could have a living standard at age 85 roughly two times greater than a participant who is an aggressive spender.

Retirement plan sponsors can use such a framework to assess if the plan provides sufficient income at retirement to gauge the living-standard risk of the typical participant. With a framework, sponsors can help guide participants to develop better spending, saving and investment decisions that, over time, can support the achievement of their ultimate goal: a desired living standard in retirement.

Laurence Kotlikoff is a professor of economics at Boston University and president of Economic Security Planning Inc., a Boston-based company specializing in financial planning software, Todd Mattina is the chief economist and strategist of the asset allocation team at Mackenzie Investments Corp., Toronto.