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The Retirement Income Assumption That Can Lead to Suboptimal Portfolios

Retirement Income

David BlanchettFinancial planning tools and retirement research predominately assume that retirement spending is effectively static, where the annual spending amount increases annually with inflation, regardless of portfolio performance. This simplifying assumption is clearly unrealistic and can result in incredibly flawed guidance on optimal portfolios for clients.

In some recent research, we explored how incorporating flexible spending in retirement modeling can impact the definition of the optimal retirement portfolio. First, we split the retiree income goal into two types of expenditures: “needs” and “wants.” Needs are relatively inflexible spending that the retiree can’t live without—things like housing and healthcare costs. Needs spending is sometimes called essential or nondiscretionary spending. Think of wants as more flexible spending that the retiree would like to have but is willing to adjust as situations warrant, like travel or entertainment. Adjustments may include both increases, if the portfolio does well, as well as decreases, if the portfolio does poorly.

Most models treat retirement spending entirely as needs, which assumes retirees are unwilling and unable to cut back over time. This is just not realistic. While some portion of every retiree’s income goal is likely going to be for essentials (we estimate about two-thirds on average), this is going to vary by retiree. For example, the percentage of the total retirement income goal that is considered needs tends to decline at higher income levels.

When determining optimal portfolio allocations, it’s important to think more holistically about client assets and liabilities (as well as income goals) to ensure risk levels are appropriate. Retiree assets under consideration should include guaranteed income and savings, as well as anything else the retiree has to fund spending. The liability needs to be broken out into perceived flexibility, such as needs and wants, or potentially even further, into needs, wants, and wishes.

For many retirees needs spending may be covered by existing sources of guaranteed income, such as Social Security retirement benefits or a pension. This leaves the retirement portfolio (whether it be a 401(k), 403(b), IRA, etc.) to cover remaining needs spending and wants spending.

A retirement portfolio focused on funding wants spending can typically be more aggressive than a portfolio focused on needs, especially for a younger retiree (e.g., someone who is 60 versus 75). A retiree focused on covering needs spending with their retirement portfolio is going to typically have a greater focus on consistency and therefore may prefer slightly less risk, on average. A retiree who is investing the portfolio to cover wants spending (because the needs is covered through guaranteed income) is likely going to be willing to take on more risk, on average, because the potential pain of shortfall isn’t as great and is offset by the expectation of higher returns.

There are other important portfolio considerations when thinking about needs and wants as well. For example, real assets, which includes asset classes like TIPS, real estate, commodities, infrastructure, etc., are typically going to play a larger role in a retiree needs portfolio, compared to a wants portfolio, which may look more similar to traditional accumulation-focused portfolios.

In summary, assuming that a retiree’s spending goal is static doesn’t track with reality and may lead to portfolio recommendations that are notably different than if a more realistic model is considered.

David Blanchett is Head of Retirement Research for PGIM DC Solutions. PGIM is the global investment management business of Prudential Financial, Inc. David is also currently an Adjunct Professor of Wealth Management at The American College of Financial Services and Research Fellow for the Alliance for Lifetime Income.

 

This material is for informational, illustrative and educational purposes only, and is not intended as investment advice and is not a recommendation about managing or investing retirement savings.

©2022, PGIM. Used with Permission.

 

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