With the decline of traditional pensions, many older workers and retirees face a “do it yourself” retirement: You’re on your own to figure out how to make your retirement savings last for the rest of your life. With retirements that can extend 20 to 30 years or more, this is indeed a daunting challenge for those who are fortunate enough to accumulate significant savings by the time they retire.
To address this challenge, different thinking and new language is needed to transition from a mindset concerned with accumulating assets for retirement to a mindset concerned with generating income in retirement.
To help with this mindset transition, you can apply portfolio concepts that people have successfully used to accumulate assets in building a portfolio of retirement income. You’ll gain valuable insights about this strategy from a recent major study that’s a collaboration between the Stanford Center on Longevity (SCL) and the Society of Actuaries (SOA). (Full disclosure: I was a co-author of this study, along with Wade Pfau and Joe Tomlinson.)
When you’re saving for retirement, classic investment portfolio theory advocates that you allocate your savings among different types of asset classes, each having distinct characteristics and each expected to perform differently in up vs. down markets. This is called the “asset allocation decision.” Applying this theory to asset accumulation means many retirement portfolios have a mix of stocks, bonds and cash investments. This is the common definition of “portfolio diversification.”
When you’re accumulating assets, investment risk is expressed as the possibility that your portfolio might lose money or not keep up with inflation. The goal of asset allocation is to minimize the odds of these undesirable outcomes over the time horizon that applies to you (typically until the age when you expect to retire).
But things get more complicated when you retire and need to use your savings to generate income for the rest of your life. To help meet your new goals, you can apply portfolio thinking by diversifying your sources of income among different types of retirement income generators (RIGs). You then allocate your retirement income among RIGs that not only perform differently in up vs. down markets but also have different characteristics when it comes to how long your income might last. They may also have other desirable features to meet different life circumstances. This is the “retirement income allocation decision.”