Evaluation of Retirement Strategies - CFA Institute€¦ · CFA Cape Town May/22/2018 Johannesburg May/24/2018 Final Thoughts It is critically important for retirees to implement

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EvaluationofRetirementStrategies

JavierEstradaIESEBusinessSchool– Barcelona

1.RetirementStrategies• Key variables• Key questions

2.EvaluationofRetirementStrategies• Approaches proposed• Pros, cons, and evidence

3.ConcludingThoughts

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA

Cape TownMay/22/2018

JohannesburgMay/24/2018

Research

2

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



TheBasicsExogenous (given) variables Size of the retirement portfolio• Usually a round amount easy to scale up or down

Endogenous (decision) variables Asset allocation• Usually, but not exclusively, stocks and bonds

Withdrawal rate• The initialwithdrawal rate plays a key role

Main uncertainties Length of the retirement period Portfolio returns* Both have exogenous and endogenous components

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



AssetAllocation(AA)Basic trade-off Aggressive AA• High growth, high standard of living, high uncertainty

Conservative AA• Low growth, low standard of living, low uncertainty

Key questions Should the AA be static or dynamic?• If static, aggressive or conservative?

* A lot could be said in favor of very aggressive AAs

• If dynamic, predetermined or tactical? If predetermined, DEG or REG?

If tactical, depending on what variables?

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



WithdrawalRateBasic trade-off: Spending ... too much and running out of money early too little and lowering the standard of living

(And leaving an unintended bequest)

Key questions Should periodic withdrawals be fixed or variable?• If fixed, amount or percentage? (Why not percentage) If amount, nominal or real? (Why not nominal)

› If real, at what level?

* Quirk: Initial WR + Inflation-adjusted withdrawals

• If variable, depending on what variables?

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



WithdrawalRateThe beginning Bengen (JFP, 1994)• The4%Rule: An initial withdrawal rate (IWR) of 4%,

with subsequent annual withdrawals adjusted by inflation, never depleted a portfolio before 30 years Lower IWRs unnecessarily lower a retiree’s standard of

living (At 3% portfolios last over 50 years)Higher IWRs are risky (At 5% portfolios often fail to last

at least 30 years) Therefore, 4% is a safe IWR

Tricky issues: Results depend on ...• country considered (Bengen: USA)• asset allocation considered (Bengen: 50-50)• assets considered (Bengen: Stocks and bonds)• the definition of an acceptable failure rate

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



EvaluationKey questionWhatisanoptimalAAandWR?• This is where most of my research comes in* This is also an issue during the accumulation period

Proposals Failure rate Bequest Success-to-variability ratioMaximum withdrawal rate Shortfallyears(SY) Risk‐adjustedsuccess(RAS) Downsiderisk‐adjustedsuccess(D‐RAS) Utility‐basedapproach

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



TheFailureRateThe basics Definition• Fraction of retirement periods considered in which a

strategy failed (Frequency) Calculation• Based on historical or simulated retirement periods

(Usually 30-year retirement periods)Motivation• Proxy for the probability of failure

Shortcomings• Two strategies may have the same failure rate but

may have left very different bequests• Measures howoften a strategy failed but not byhowmuch it failed

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



TheFailureRate– Evidence

4%IWR

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



TheFailureRate– Evidence

60‐40

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



TheFailureRate– Shortcoming1Two strategies may have the same failure rate but

may have left very different bequests

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



TheFailureRate– Shortcoming2Measures howoften a strategy failed but not byhowmuch it failed

60‐40

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



ShortfallYears(SY)Measures the average number of years a strategy

fell short, across all the periods in which it failed

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



Risk‐AdjustedSuccess(RAS)

Evaluation S1 vs S3 ⇒ S1 (Same F but lower SY) S1 vs S2 ⇒ S1 (Same SY but lower F)* Note that neither variable is useful in isolation

But what about S3 vs S4? F and SY point in opposite directions

(100 retirement periods / No bequest)

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



Risk‐AdjustedSuccess(RAS)RAS is similar to a Sharpe ratio but applied to the

evaluation of retirement strategies

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



Risk‐AdjustedSuccess(RAS)

S3 vs S4 ⇒ S4 Same E(YS) Lower SD(YS) HigherRAS

(100 retirement periods / No bequest)

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



TwoMoreIdeasThe comparison between S3 and S4 suggested

two additional insightsWhat if the risk of YS were measured not with its

standard deviation but with its semideviation? If different individuals make different choices, then

the utility they get from S3 and S4 may be different

These insights were developed into two more analytical frameworks to evaluate retirement strategies Downside risk-adjusted success (D-RAS) A utility-based approach

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



DownsideRAS(D‐RAS)D-RAS is similar to a Sortino ratio but applied to

the evaluation of retirement strategies It basically aims to avoid penalizing strategies that

leave large bequests

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



DownsideRAS(D‐RAS)D-RAS does not penalize aggressive strategies

that leave large bequests For this reason, it typically selects more aggressive

strategies than RAS

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



AUtility‐BasedApproachThis approach involves defining a new variable,

the coverageratio (C), and then calculating … C for each retirement period considered the utility of each C the expected (mean) utility of the strategy

Define Yt : Number of years of inflation-adjusted

withdrawals sustained by a strategy Ct =Yt/L : Coverageratio in retirement period t

Note that, … if a strategy fails, then C < 1 if a strategy leaves a bequest, then C > 1 C contains all the information in F, SY, and YS

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



AUtility‐BasedApproachThis approach involves a kinked utility function

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



AUtility‐BasedApproach

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JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



Evaluation– TheBigPicture

JavierEstrada

IESEBusinessSchool

BarcelonaSpain

CFA



FinalThoughts It is critically important for retirees to implement

a ‘good’ retirement strategy But what is a ‘good’ (or better, or optimal) strategy?• This is where evaluation approaches come in

Many different approaches have been proposed to evaluate retirement strategies They all have pros and cons• But some are more comprehensive than others

My (probably biased) take on this line of research The failure rate is incomplete but here to stay I like the coverage ratio (My co-author’s idea)• It can be used to build risk-adjusted success measures• It can be used within a utility-based approach

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EvaluationofRetirementStrategies

Thankyou

JavierEstradaIESEBusinessSchool– Barcelona

Documents

Evaluation of Retirement Strategies - CFA Institute€¦ · CFA Cape Town May/22/2018 Johannesburg May/24/2018 Final Thoughts It is critically important for retirees to implement