This is the second Post on why a greater focus should be placed on generating a level of Income in retirement as an investment goal. The first Post outlines why income matters as an investment goal.
This Post covers why variability of retirement income is a better measure of risk rather than variability of capital.
A greater focus on Income is different to the current industry approach, where accumulation of wealth has a higher priority. This is important of course. Yet a greater focus on generating Income as an investment goal is not that radical. It is consistent with the age of the Defined Benefit investment solution. Therefore, it is not a new concept.
The inspiration and material for these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Nobel Prize winner Professor Robert Merton. The Podcast is 90 minutes in length and full of great conversation about retirement income. Well worth listening to.
To set the scene Merton discusses the difference between the high and low in longer term interest rates in the United States in the last 10 years, if you retired … with a given pot of money, if you retired and you got an income of a hundred, whatever that means, at the peak of interest rates, when they’re high, you get a hundred. At the trough, at the low end of interest rate, the same amount of money, you’d only get 74.
As he says, in other words your income will be 26% lower. “Think about that, 26% less of income, that’s a big hit especially for working middle class people but for any of us.”
You may well argue, that the last 10 years was an extraordinary period of time and corresponding fall in interest rates. Which would be correct.
Nevertheless, this does not detract from the point being made, how can we determine if a pot of money is enough to retire on? This can only be known by focusing on income generated from that pot of money.
Importantly, if you don’t monitor this risk, generating a stable level of income in retirement, you cannot manage it. And I would argue, such a focus will lead to you making better informed investment decisions that will likely result in a more stable and secure income in retirement.
This could well mean that as interest rates rise, you need a smaller pot and don’t need to take on as much risk as thought to support your life style in retirement.
Back to Merton, he uses another example, and highlights a number of times, the industry focuses on the wrong metric, the value of the pot (accumulated value).
If the value of the pot rises, we are happy, if the value declines, ‘you’re frowning’!
But, that’s not reality and in most cases it is not telling how you are going to go in retirement because you really want to know what income you are going to get in retirement.
Therefore, you should not be worried about the value of your pot, but what income the pot can generate in retirement.
That is the goal, and we should measure ourselves relative to that goal.
Defining risk around the risk of not being able to achieve income
Merton uses the following thought piece:
You’re 62, you’ve done well in your retirement account and I say to you, “Hey, you’ve got enough money to basically lock in your goal. I can buy you inflation protect, US Treasuries with funding that will take care of you throughout retirement guaranteed full faith and credit, the government protected for inflation at this level income, that’s your goal. Then I say, “You do want to increase your goal?” You said, “No, I’m happy with that, that’s my lifestyle. If I have some extra money, I’ll do something with it but basically, I’m happy with that. That’s what I want to live on and the safety and security, that is what matters to me.”
As Merton argues, in this situation the rationale thing to do would be to implement such an investment strategy. (This is Liability Driven Investing, or Goal Based Investing. Such investment approaches can be implemented now. Such approaches are aligned with how Insurance Companies and some Pension Funds implement.)
Such strategies as outlined above will closely match a desired level of income (subject to availability of appropriate securities – which is an area Government Policy could help in securing better retirement outcomes).
Under such an investment strategy retirement income is safe and largely predicable – reflecting the use of Government securities that are linked to inflation.
Nevertheless, while Income is stable, the value of the portfolio of fixed interest securities is not stable.
As interest rates rise, the price of bonds, fixed interest securities such as Government Bonds, fall.
However the Income from the bond does not change.
Using Merton’s example:
“Income is absolutely stable in a bond. Its value will fluctuate with interest rate. If interest rates, especially long-term bonds, which is what you would need for retirement, if the interest rates go up and let’s say your bonds go from 100 to 85 and I send you or put it on your account that your account has gone down 15% and you’re 62, you see that, you’ll go berserk. You’re going to say, “You told me you’re being safe for me and I’ve lost 15% of my retirement.”
“In fact, that’s not correct statement. Your retirement is defined by how much income you get for life. That hasn’t changed. The value of that has, that example is the problem at the core. It’s misinformation because we show them the wrong number”.
As Merton notes, investors get happy when the value of their portfolio goes up, but they are not actually better off if interest rates have fallen (meaning the price of a bond goes up).
Under this scenario buying new bonds will mean a lower level of income in the future.
This highlights that we focus on volatility of a capital as risk, the changing value in the pot of money, rather than volatility of future income.
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