Determine sustainable spending from the investment portfolio in retirement



Determining the sustainable spending rate from a diversified investment portfolio in retirement requires making decisions about longevity and market returns. the last word section during this chapter provides an opportunity to integrate this discussion so on get a far better sense about sustainable distributions from an investment portfolio in retirement.

Rather than blindly applying something rather like the 4 percent rule-of-thumb for portfolio distributions, we are able to create a more realistic analysis using the tactic described during this section. This process provides sustainable portfolio distributions that are calibrated to the retiree’s longevity risk aversion and accepted risk for outliving the investment portfolio.

Looking ahead, we also seek to develop market return assumptions which can be applied to the pricing of annuities, with regard to the bond yield curve, fees, and other related assumptions, so we are able to compare investments and annuities on an equal footing.

Exhibit 1.1 brings together the factors that determine portfolio return assumptions as outlined during this chapter. To derive generalized stock and bond returns, we start with the components of portfolio returns: inflation, real bond yield, and a risk premium for stocks relative to bonds. First, the inflation assumption is 2 percent, which relies on the present break-even inflation rates between traditional Treasuries and TIPS as was shown in “The Yield Curve And Break-Even Inflation”.

Next, the assumed real bond yield and return is 1 percent. this can be supported the present TIPS yield curve also seen in “The Yield Curve And Break-Even Inflation”. When building a bond ladder for retiree income, the typical yield for the ladder matches closely to the long-term TIPS rates, which are approximately 1 percent. Sustainable spending is approximated quite well by assuming a flat yield curve at the long-term rate of interest as compared to pricing a bond ladder supported the whole yield curve. As our focus is on comparing the chance premium to risk pooling, we simplify the analysis for bonds by assuming a flat yield curve with a 1 percent real yield. When inflation is included, the yield curve is flat with a 3 percent nominal yield. These two values become the assumed gross arithmetic returns for bonds.

Next, the assumed real bond yield and return is 1 percent. this can be supported the present TIPS yield curve also seen in “The Yield Curve And Break-Even Inflation”. When building a bond ladder for retiree income, the typical yield for the ladder matches closely to the long-term TIPS rates, which are approximately 1 percent. Sustainable spending is approximated quite well by assuming a flat yield curve at the long-term rate of interest as compared to pricing a bond ladder supported the whole yield curve. As our focus is on comparing the chance premium to risk pooling, we simplify the analysis for bonds by assuming a flat yield curve with a 1 percent real yield. When inflation is included, the yield curve is flat with a 3 percent nominal yield. These two values become the assumed gross arithmetic returns for bonds.

Exhibit 1.1 The Building Blocks of Portfolio Returns



This is an excerpt from Wade Pfau’s book, “Planning for Retirement First in Safety: An Integrated Approach to Retirement Without Worries” (Retirement Researcher's Guide Series), now available on Amazon