Michael S. Finke, Ph.D., CFP ® Professor & Director Retirement Planning & Living Department of Personal Financial Planning T EXAS T ECH U NIVERSITY M ANAGING I NVESTMENT AND IDIOSYNCRATIC LONGEVITY RISKS FOR RETIREES

Congratulations! You’re a pension manager!

Pension Managers What do they worry most about? 1) Asset Return Risk 2) Longevity Risk

Individual Pensions are Harder Asset Return  Pension Manager – Pool returns across generations  Advisor – One whack at the cat Longevity Risk  Pension Manager – systemic increases in longevity  Advisor – Idiosyncratic longevity risk

Systematic Longevity Risk Source: Robine, 2012

Wealthier Live Longer Source: SSA, 2008

Idiosyncratic Longevity Risk Source: Frank, 2013

Idiosyncratic Longevity Risk How do you deal with idiosyncratic risk? 1) Diversification (pool it) 2) Retain it  Avoiding running out of money by spending less and accepting portfolio risk  Live it up and accept greater risk of running out of money

Turning Retirement Assets into Income

The 4% Rule (William Bengen, 1994) Safe Withdrawal Rates (1920s - present)

Philosophy of the 4% Rule Retirees have a lifestyle goal and not meeting that goal indicates failure Failure = inability to spend lifestyle goal for 30 years Portfolio risk increases likelihood of meeting spending goal Use prior returns to establish safe withdrawal rate

Historical Random Returns 13.7% 23.5% 20.3% -1.5% -10.1% 31.0% 8.99% 34.1% -6.6% -38.5% 3.0% 4.5% 12.4% 7.1% 26.3% 27.3%

Asset Pricing 101 p t = Ε t [β * u ’ (c t+1 )/u ’ (c t ) * x t+1 ] Price at time t (now) = Expectation (now) Of β (how much we discount the future) * Marginal utility tomorrow Marginal utility today *Expected payout tomorrow

What This Means Demand for Consuming Now Decreases Asset Prices Demand for Consuming in Future Increases Asset Prices

What’s Affecting Asset Prices? How Much Do Global Investors Value the Future?

Capital Market is Global

Global Real Interest Rates

Importance of 1 st Decade Source: Milevsky and Abaimova, 2005

Monte Carlo Failure Rates Historical Real Returns: Stocks 8.6%, Bonds 2.6% Stock Allocation: 30% 50% 70% Failure Rates 6%6%6% Slightly more realistic: Stocks 5.5%, Bonds 1.75% Failure Rates24%24%27% A little better than today’s rates: Stocks 6%, Bonds 0% Failure Rates47%33%28% Early 2013 Rates:Stocks 4.6%, Bonds -1.4% Failure Rates77%57%46% Source: Blanchett, Finke and Pfau, 2013

What if Rates Revert in 5 Years? Start out at current rates (Stocks 4.6%, Bonds -1.4%) Revert to Stocks 8.6%, Bonds 2.6% Stock Allocation: 30% 50% 70% Failure Rates 22%18%18% What if Rates Revert after 10 years ? Failure Rates 43%32%38%

Other Problems with the 4% Rule Source: Blanchett and Finke, 1% fee

No Risk Tolerance, No Optimization Source: Finke, Pfau and Williams, 2011

Value of a Dynamic Approach Source: Blanchett, 2013

Illustration of Dynamic Source: Pfau, 2013

Assumes Historical Equity Premium

S&P Dividend Yields

What Does Current P/E Imply? Source: Asness, 2012

Requires Managing Assets in Old Age

Literacy and Confidence

A Better Approach Prioritize spending categories (basic needs, discretionary expenses, legacy) Employ risk when a retiree is willing to accept possibility of a loss Deal efficiently with idiosyncratic risk Simplicity - make sure real people can handle it, use research to create defaults Be realistic about future asset returns

Michael S. Finke, Ph.D., CFP ® Professor, Ph.D. Program Director Director Retirement Planning and Living Department of Personal Financial Planning T EXAS T ECH U Q UESTIONS /C OMMENTS