By Philip Murphy
In a previous blog post, I described some benefits of having an income goal and a method of estimating one's retirement income liability. I reviewed a hypothetical example to illustrate steps 1-2 from the list of benefits below, and I calculated a net estimated retirement liability (the portion of retirement income one must fund with personal savings). This post will focus on the remaining steps, 3-5.
- Income levels are intuitive because they provide built-in budgeting guidelines.
- Estimating required future income can be tailored to individual circumstances and does not require specialized financial knowledge.
- Estimating a future income level (that would be attained upon conversion of one's savings into income risk hedging assets) does not require guesstimating future market returns the way that estimating one's future wealth level would.
- As a result of step 3, there can be more certainty about one's future income than about one's future wealth as long as some of one's assets are managed to hedge income risk and more savings are devoted to those assets over time.
- Once a desired future income level has been attained through the allocation to income risk hedging assets (essentially locking in future income), if other capital is available it can remain invested for long-term growth without great risk of income impairment during market downturns.
The reason step 3 is true is that a future income level is a future stream of cash flows, and we can find the present value of future cash flows with certainty by using the current, observable yield curve. Related to its S&P STRIDE Indices, each month, S&P DJI publishes the present value of specific inflation-adjusted cash flows (called "Income Cost"), commencing at particular points in the future. The cash flows begin at target years spaced over five-year increments from 2005 to 2060, and each one lasts 25 years from its respective target year. For example, the 2035 cash flow starts in January 2035 and continues until 2060. These hypothetical cash flow streams are designed to represent inflation-adjusted retirement income.
Using the Income Cost for 2035 (assuming that is when I want to retire), and continuing the example from my last post, if I have to fund $58,000 in annual spending, then I can measure the current value of income-hedging assets that would be required to lock in that cash flow in real terms, beginning in January 2035:
$58,000 X $19.29 (cost of 2035 income as of April 2018) = $1,118,670
If I invested $1.12 million in a portfolio of income-hedging assets, I would essentially lock in my inflation-adjusted retirement cash flow over a period of 25 years - which is the reason step 4 is true. The more of my assets that I dedicate to income risk hedging assets, the more certain I can be of my future cash flows. The opportunity cost of doing so is that those assets cannot be invested for growth. However, the benefit is lowering risk to future income.
Finally, step 5 flows from step 4. Once I have an amount invested in income-hedging assets that, given the current income cost, secures future cash flows sufficient to meet my net estimated retirement liability, then any remaining assets can be invested for growth without risk to income. In other words, I can sleep soundly without worrying about market risk. Where does one find income-hedging assets? S&P STRIDE Indices incorporate income-hedging into their framework by allocating index weight to S&P U.S. TIPS sub-indices designed to hedge income risk.
Putting steps 1-5 into practice allows one to periodically check progress toward an income goal. In other words, you can measure your funded status, the currently funded portion of your net estimated retirement liability. A funded ratio, expressed as a percentage, assuming you have $500,000 of income-hedging assets, would be calculated as:
$500,000 ÷ $1,118,670 = 44.7%
Now that you can measure your funded status, it can be utilized to adjust current spending, saving, and portfolio allocations in order to manage future income risk. If you periodically add income-hedging assets, your funded ratio will grow over time. When it gets close to 100%, you have effectively hedged income risk over a period of 25 years, commencing at retirement.