Life Cycle Investing "then" (2013) and now

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AlwaysLearningMore
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Life Cycle Investing "then" (2013) and now

Post by AlwaysLearningMore »

This is an excellent post from 2013, and it's interesting to think about how the current rising interest rate environment juxtaposes to ZIRE.
bobcat2 wrote: Mon May 27, 2013 7:37 pm Life-cycle saving and investing (LCSI) is the economics approach to personal finance. It is the only approach to personal finance consistent with economic and financial theory. The life-cycle model developed by Robert Merton in 1971 shows that the rational household will plan for both a floor and aspirational level of future retirement income. (See chapter 2 of Michael Zwecher's book for more on these points.) That hasn't changed over time. It is not something that economists such as Zwecher, Zvi Bodie, Laurence Kotlikoff and others have only recently been advocating, but instead comes directly from Merton's work of over 40 years ago. So Bodie and Merton in particular, who have been collaborating on LCSI research since the early 70s, have been in agreement on the importance of meeting both floor and aspirational retirement income goals for about 40 years.

The above means that there is only one portfolio in life-cycle investing, but there are two retirement income strategies. One is matching for the floor and the other is a diversified strategy to get from the floor income to the aspirational level of income. This distinction between strategies and portfolios is important, because typically if the diversified portion of the portfolio does well one raises the safe floor nearer to the aspirational income level. One does not keep the floor and redefine the aspirational level up. Conversely, if the diversified portion of the portfolio does poorly, you keep the safe floor but choose some combination of the following options with regard to the diversified portion - save more, retire later, take more risk, or lower the aspirational retirement income goal. Unfortunately, each of these four options has a downside, which is a key reason you want a truly safe floor strategy in addition to the diversified assets in the portfolio.

In an operational setting what this is saying is that when you are roughly 25 years from your expected retirement date you should estimate the floor level of safe income you want in retirement above SS payments. Price out how much a real annuity would cost at your retirement age for that amount of retirement income. Put some of your retirement assets into safe assets now and plan on saving enough in additional safe assets between now and retirement to have the level of safe assets at retirement that's sufficient to buy the annuity. You would re-evaluate periodically to make sure you are staying on course. Keeping in mind that the amount needed to purchase that annuity will change over time for several reasons, but primarily because of changes in real interest rates and longevity.

The above is not the same thing as investing only in safe assets until some portfolio level is hit. You are instead simply making sure that a portion of your portfolio at retirement will be invested in enough safe assets to support the floor income, but you do not need to invest only in those safe assets first.

Finally, you don't have to buy only an annuity at retirement, but the amount of safe assets set aside at retirement should in some manner provide safe income in retirement. For example, the safe assets at retirement could consist of part annuitized income and part TIPS and I-bonds.

BobK
Retirement is best when you have a lot to live on, and a lot to live for. * None of what I post is investment advice.* | FIRE'd July 2023
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