Route 4: Exploring Retirement Finance

Show Chapters

Save and invest         

F 01 Why save at all?

F 02 10-30-60: the huge multiplier effect of investing

F 03 Investing is only a means to an end

F 04 Facing the future (and older and happier) you


Investing as you accumulate

F 11 Glide from youth into life after work

F 12 Target date funds and how to improve them

F 13 Two other considerations: buying a home, and life insurance


How far have you come?

F 21 What does spending money do for you?

F 22 A budget doesn’t have to be detailed to be useful

F 23 Your personal funded ratio

F 24 Inheritances and bequests

F 25 How to use the personal funded ratio calculator

F 26 An example of the use of the personal funded ratio calculator

F 27 Variations on a theme

F 28 Wealth zones: essentials, lifestyle, bequests, endowed

F 31 Financial stages in planning for life after full-time work


Clear thinking about creating lifetime income from your assets

F 41 An overview of this section of the route

F 42 Risk: the rubber meets the road

F 43 Happiness comes from certainty about not outliving your income

F 44 Safety and growth as investment goals

F 45 With two extreme philosophies, either/or is a bad way to frame the choice

F 46 Three goals, three instruments


A little reality

F 51 A liquidity reservoir creates flexibility

F 52 Three things that could derail your plan (long life, illness, cognitive decline)

F 53 When the time comes to make decisions


Investing as you decumulate

F 61 Four ways to generate sustainable income

F 62 Buy an immediate lifetime income annuity

F 63 Each year’s drawdown is based on your future longevity

F 64 A drawdown plus longevity insurance

F 65 A sustainable drawdown until some advanced age

F 71 A case study on the investment glide path after work

F 72 Is your home part of your portfolio for life after work?


On the trail for enthusiasts

T 10 Equities in the retirement glide path: a tough issue (increasing, decreasing or level exposure to growth assets?)

T 11 The role of an annuity in a sensible retirement portfolio

T 12 Measuring what matters most



Where the route takes us

Remember that we saw in the Prologue that we need to set aside money while we’re working if we want to draw on it later so that we don’t have to work forever. This stage picks up on that idea, and explores how much we need to save, as well as what our choices are if we don’t save as much as we need to.


Why do we bother to save at all?

Well, if we have enough money, we really don’t need to save. So we save if we feel that we’re going to need money at a time when we won’t have enough.

Typically there are two types of occasions.

One is emergencies, meaning something we don’t contemplate as a regular occurrence, and so it doesn’t come out of the normal paycheck. Some of us think of anticipated vacations or gifts that way, in fact, and we set aside money for them separately. But here, when I refer to emergencies, I’m thinking simply of unexpected events. Talking to financial professionals, I’ve heard advice that recommends that, during your working years, you should accumulate up to six months of spending in a bank account that you keep just for emergencies – possibly even unemployment.

Apart from that, the main goal of saving is to give ourselves the gift of being able to retire – to have money available for regular spending, without the need to keep working forever.


Let’s do a little arithmetic to see how much saving we need to do for that goal.

I’m going to show you a simple example. And I’m going to make some assumptions, to keep the calculations easy. There’s a very important point that follows.

I’m going to deal with someone who is now 25 years old and hopes to stop working at the age of 65. This person, whom I’ll call X (a nice, mysterious name), is planning to start saving right away, and intends to save for the full 40 years until reaching age 65.

Let’s assume X is given pay increases in line with inflation, and saves 10 per cent of that pay each year. I know that’s more than most people actually save. Don’t take any of these numbers seriously – they’re just used as an example.

X invests those savings safely, earning a return in line with inflation but nothing more: a 0 per cent “real” return (rather like the Treasury bills in Stage I 21).

Because of those assumptions, we can ignore inflation in our calculations, since every year, everything automatically matches inflation.

OK, let’s see what happens to the savings.

After 40 years, X will have 40 times 10%, or 400%, of pay accumulated. In other words, at 65, X will have a pension pot that has a lump sum in it, equal to 4 years of annual pay.

How much money can X withdraw every year after age 65?

That depends, of course, on how long X will live. On Route 3 I explained longevity. For this example, let’s make an assumption that X plans to have enough to last until age 90. So that’s 25 years of withdrawals required.

X continues to invest safely, earning a return that matches inflation each year. For a constant drawdown each year, X can withdraw 400% divided by 25, or 16%, each year; and that will last for 25 years.


There endeth the example. The benefit of X’s saving 10% of pay each year is to be able to withdraw 16% of pay each year, when working stops. (Note, by the way, that the actual amount available for spending is probably somewhat lower, because typically the drawdown is taxable.)

To this, of course, X will add whatever is available from the Pillar 1 pension in that country (as mentioned in P2 in the Prologue).

I think I can guess what your reaction is, because I hear it every time I show this calculation.

Hey, 16% plus Pillar 1 isn’t nearly enough to maintain my standard of living! And that’s if I save for 40 years – and I haven’t actually been saving for 40 years – and I’m not actually saving 10% every year. There must be something wrong!

No, there isn’t anything wrong. The arithmetic is simple and impeccable. That’s the point I want to make – that if we save over a whole working lifetime, even as much as 10% of pay each year, and invest it safely, the chances are that we aren’t going to have enough money to match our retirement ambitions.


OK, what are our choices, then? This is the point I want to make. I think in terms of a dashboard with three dials that we can turn.

The first dial is to save more, or longer. Meaning, we can save more than 10% of pay. Or we can start before age 25. Or we can work until after age 65. Actually, postponing retirement is doubly valuable, because not only does it increase the accumulation period, it also reduces the post-work drawdown period.

The second dial we can turn is to scale down our post-work ambitions. We don’t like to do that. But it’s a possibility that is realistic for most of us, so let’s at least bear it in mind, even though it’s not a choice we would make willingly.

The third dial we can turn is the investment risk dial. By that I mean that we can try to earn an investment return that exceeds inflation. And that means we have to invest, not in something safe, but in something risky, and hope that taking investment risk will be rewarded (rather like the equities in Stage I 21), and we’ll end up with a lump sum much in excess of 4 years of ending annual pay.


That’s in fact what we tend to do. In the investment part of the tour (Route 2) we looked at different types of investment and different amounts of risk, and saw that it’s reasonable to expect a higher return if we take higher risk – though of course it’s also not certain, because that’s the essence of risk.

But for this stage, I just want to make the point that our retirement ambitions tend to greatly outstrip our willingness to save enough, and that, because of that, we are forced into the situation of taking investment risk.



We need to save because otherwise we won’t have enough money to last the rest of our lives. Our retirement ambitions are typically such that we need not only to save, but also to take investment risk in the hope of adding to our savings.





Where the route takes us

People don’t realize what a huge impact it has when we add investment returns to our savings over a lifetime, or how important it is to keep the investment effort going after retirement. In this stage we’ll look at some numbers and come up with a simple rule of thumb — even if it’s just a very approximate one.


In Stage I 21 I showed that it’s not unreasonable to expect a higher return (the so-called “risk premium”) if we take higher risk. In this stage I want to give you a rough idea of how much our lifetime savings can be multiplied if the risk premium that we hope for, comes through.

Some years ago three of us published a book about saving for retirement[1] from which (we were told) the most surprising take-away was what we called the 10-30-60 rule. Based on assumptions that seemed reasonable before the global financial crisis, we estimated that, if an individual saved over a lifetime (specifically, from age 25 to 65) and gradually drew down the pension pot in retirement (specifically, from age 65 to 90), roughly 10 cents of every post-retirement dollar came from money that was saved each year, roughly 30 cents came from investment returns in the pre-retirement accumulation period, and roughly 60 cents came from investment returns in the post-retirement decumulation period.

Let’s be explicit about interpreting two aspects of that result.

The first is that, if 10 cents saved ultimately creates a dollar of withdrawals, overall that’s a multiplier effect that gives the original savings 10 times as much power by investing them.

The second is that the aggregate investment return after retirement contributes twice as much as the aggregate return before retirement: 60 cents versus 30 cents.

No wonder people found those conclusions memorable!


Of course it’s possible to quibble about every one of our inputs. You wouldn’t expect to earn the same return today. You wouldn’t maintain the same asset allocation throughout the accumulation and decumulation periods. Who knows what the individual’s pay path would look like? Or life expectancy. True, true, true, true.

So there’s a simple challenge to any critic. Put in your own assumptions. If you re-do the calculations, two conclusions will still emerge:

  • Investment returns create a huge multiplier effect on the amounts actually set aside as retirement savings. (It doesn’t matter whether or not the multiplier is 10.)
  • A large proportion of the overall investment return actually accrues after retirement. (It doesn’t matter whether or not it’s twice as large as the amount that accrues before retirement.)

You may think the investment job is done once you retire. It isn’t. There’s probably as much to be done after retirement as there was before.


Sure enough, the 10-30-60 rule has been challenged and reassessed.

For example, Dr David Knox reworked the numbers in 2018, using inputs that he considered more suitable for the then current Australian environment.[2] His result can be summed up as 15-30-55. There you are: the two conclusions stand.

When I published 10-30-60 on my website, reader Aaron Minney criticized the “money illusion,” the fact that a dollar at age 65 is surely worth much less than a dollar contributed at age 25, so they shouldn’t be counted equally. Surely I ought to have shown the calculation in “real,” that is, after-inflation terms, so that the rule would be adjusted to preserve purchasing power.

Quite right. We had no idea, when we first enunciated the rule, that it would be taken so very seriously, or we would probably have done the calculations in real terms.

What, then, did Minney come up with? He said his results would be more like 2-3-4. Not as memorable, perhaps – but nevertheless, check those two big conclusions again. They still hold. A multiplier effect ($2 of contributions give you $9 of post-retirement purchasing power). Most of the return accrues after retirement ($4 after retirement for every $3 before retirement).

That’s my point.


Just for fun, Table F 02.1 shows the numbers (underlying 10-30-60, that is), based on a first-year contribution of 1,000, and aggregated into 5-year periods.

Notice how:

  • The contributions grow gradually, as the pay increases gradually.
  • The investment return starts off absolutely tiny. It takes more than 10 years before the returns exceed the contributions.
  • But after that the investment returns accelerate noticeably. This is often called “the magic of compound interest.”
  • After retirement, withdrawals start.
  • Even after withdrawals start, the investment return on the remaining assets is large for a long time. That’s because the assets remaining stay large. This is why the aggregate post-retirement investment return is so big – and so important.


Table F 02.1: The Multiplier Effect

Partici-pant’s Age at Start of Year Accumulated Assets at Start of 5-Year Period Total 5-Year Contributions Made (increasing at 4.75% a year) Total 5-Year Withdrawals (increasing at 3% a year) Total 5-Year Investment Return (at 7.5% a year)


lated Assets at End of 5-Year Period
25-29 0 5,498 1,084 6,582
30-34 6,582 6,934 4,234 17,750
35-39 17,750 8,745 9,458 35,953
40-44 35,953 11,029 17,838 64,820
45-49 64,820 13,910 30,979 109,709
50-54 109,709 17,541 51,251 178,501
55-59 178,501 22,123 82,121 282,745
60-64 282,745 27,900 128,672 439,317
65-69 439,317 154,057 160,550 445,810
70-74 445,810 178,594 158,470 425,686
75-79 425,686 207,040 144,010 362,656
80-84 362,656 240,015 109,956 232,597
85-89 232,597 278,244 45,647 0
TOTAL 0 113,680 1,057,950 944,270 0



By the end, of the 1,057,950 withdrawn, only 113,680 (between 10% and 11%) came from contributions and 944,270 (between 89% and 90%) came from investment returns. If you do the addition, of the investment returns 325,637 (just under 31% of the withdrawals) accrued before retirement and 618,633 (a bit more than 58% of the withdrawals) accrued after retirement.

To remember it conveniently, we called it 10-30-60.

The main lesson is simple. The investment job is less than half done at retirement.



Over time, investment returns multiply our savings greatly. And much of that effect takes place after retirement, so continuing to focus on our investments after retirement is vital.





Where the route takes us

OK, we know that investing is important. But let’s place it in perspective. This stage explains that money is important if it helps us to achieve something that makes us happy.


Why do we invest?

It’s not a natural thing to do. Investment is postponed consumption. And our brains are hard-wired for current consumption. Anything that gives pleasure today has a natural advantage. The anticipation of the pleasure from current consumption registers in our brain’s instantaneous emotional limbic system. The benefit of postponed consumption is evaluated in the rational neocortex, which kicks in more slowly. And the cost-benefit analysis of postponement also takes place in the neocortex. No contest: as Dr Daniel Kahneman and others have shown, emotion trumps rationality. It takes a big conscious effort to reverse that dominance. And so investment requires a big conscious effort.

We make that effort only if we believe that it will bring much bigger benefits in the future: the ability to consume even more than we could today, or the ability to consume in the future without having to work for it. It’s the fulfillment of that sort of goal that we invest for. Investment is therefore not an end in itself, but an instrument, a means to an end. We need some goal that gives us fulfillment or happiness.


I realised this powerfully when I joined the investment committee of a charitable foundation. Each meeting was combined with an encounter with one of the beneficiary organizations (a “grantee”). That encounter was invariably a very moving experience. It showed how much good charitable grants can achieve. Without investing the foundation’s assets, the good work would continue, but with a limited lifespan. Investing created a multiplier effect, a postponement of the limited lifespan of the assets, possibly forever. Investing didn’t do good by itself; it extended the time horizon for doing good – a means to an end.

We saw this in Stage F 02, where the multiplier effect was applied in enabling savings to achieve much more in creating retirement income. Yes, it’s a very powerful means.

My point, though, is that post-work spending is the goal, not investing. Investing is the means to get there. Freedom from the daily routine of working, freedom to indulge ourselves by doing the things we choose to do, the things that bring us happiness – even freedom to continue working part-time, if we enjoy it (graduation from full-time work, as I have called it) – that’s the goal.

Of course, there are some people for whom investing is so enjoyable, or so ego-fulfilling, that keeping score competitively is an end in itself. But I’d guess that these people are a small minority – and I’d argue once again that investing, for them, is a means to the goal of ego satisfaction. (More about this in Stage F 21.)


So what? Does it matter that investing is (only) a means to an end? I think it does matter, in a number of ways. Let’s apply it to the context of investing for retirement.

If the goal is to free ourselves from having to keep working forever, to create however much replacement of working income we need for our desired post-retirement consumption, then a number of investment consequences flow.

First, the measure of success. It isn’t the investment return earned – which is actually something we have essentially no control over, anyway. It isn’t whether or not the investments outperformed some benchmark over the short term. It’s how much of our income we’re on track to replace.

In fact, if we have a specific replacement goal, we should measure how much of that goal we’re on track to achieve. 100%? More? Less? This is exactly what actuaries do for defined benefit pension schemes. They calculate the so-called “funded ratio.” Depending on whether it’s higher or lower than 100% (and all too often it’s lower), there are actions that can be taken, in time to affect the outcome. One’s “personal funded ratio” (as I call it, for my wife and me) gives exactly the same insights, and potentially the same sort of call to action. We’ll look at that in Stage F 23.

Second, the investor’s risk tolerance. There’s no natural measure of investment risk tolerance. How do we arrive at a measure like “a maximum of 50% in equities” or “an annual standard deviation of 8%”? The only natural measure is our tolerance for giving up some aspect of our desired lifestyle. And from the cost of the given-up aspect, we can derive some measure of tolerable investment downside. But again, the goal comes first – life comes first – and investing is the method of getting there.

So, if and when your investment professional asks you about your risk tolerance, remember to say that it’s the impact on the income from your pension pot that’s the relevant measure.



Investment returns are only a means to an end, the goal being to replace as much pre-retirement income as we need.





Where the route takes us

Still not convinced that you want to save? Some behavioral economists have experimented and found an emotional approach that people find convincing.


We know we should save for retirement. And we really want to. But typically we procrastinate, we never get around to doing it, for two reasons. One (as discussed in Stage F 03) is that we’re hard-wired to think of today rather than tomorrow (let alone the distant future). The other is what behavioral economists call “status quo bias,” meaning that we’re inclined to leave things the way they are unless there’s a very powerful incentive to change them. Two of them, Drs Richard Thaler and Shlomo Benartzi, figured out a way to make inertia our friend rather than our enemy.[3] They launched a program called SMarT™ (for Save More Tomorrow), and it has been hugely successful.

It is characterized by first making participation in a workplace savings plan the default option (from which you have to take action to override it and stay out of the plan) – this is often called automatic enrolment – together with (this is the SMarT part) a pre-commitment to increase the contribution rate with every increase in pay. Very clever: it’s easy to commit to something today that doesn’t take effect until later, and the status quo changes from non-participation to participation. What’s more, the future contribution increase won’t feel like a cut in pay because there’ll still be some net increase in pay.

This is now pretty much the standard approach in most places to get high rates of participation.

One negative aspect of automatic enrolment is that typically the default contribution rate is very low. Hence the focus on automatic future increases in contributions (until some pre-set maximum is reached).

I hope that the use of the personal funded ratio calculator (see Stages F 23 and F 25) will prompt you to get quickly to whatever contribution rate is appropriate for you, at a time when it’s appropriate (see Stage F 31).


Meanwhile there’s another angle being studied, and I’ll describe it here even though there isn’t yet an approach that’s readily available to implement it. It’s based on the notion that our neglect of the welfare of our future self may happen because of our failure of imagination, or some false belief. When we’re young it’s tough to imagine retirement – I remember myself describing it as “life on a different planet.” (Today I realize it’s more like life in a new land – but a desirable land, of personal freedom!) And we also find it tough to relate to our future selves – again, I remember thinking that I didn’t want to make a sacrifice today for the benefit of some old geezer (me as a retiree) I didn’t know. Ah, I perfectly epitomized the problem!

Enter another bunch of behavioral economists.[4] They wondered if people might identify better with their future selves if they could see, through virtual reality, an image of themselves as they might appear in the future – older and greyer. Lots of experiments followed, with a dramatic result: yes, this tended to increase retirement saving by about 50%.

Then they went further. They showed each participant an image of himself or herself today, along an image of the future self. They showed what percentage of pay each of those selves would live on, if there was no saving for retirement. These images were shown smiling (for the current self) and frowning (for the future self) – smiling because the current self has a current standard of living, and frowning because Pillar 1 plus welfare is all that the future self will have, in the absence of retirement saving. A slider permitted the proposed rate of saving to increase from zero, and as the proposed rate increased, the smile on the current self gradually reduced (because the saving ate into the current standard of living), and the frown on the future self gradually reduced as the future self would have an improving standard of living.

When the two selves would have identical standards of living, both faces were neutral, neither smiling nor frowning. And if the saving went even higher, the current face started frowning and the future face started smiling.

Participants could stop at any rate of saving they felt comfortable with. Amazingly, they actually went past neutrality, and were willing to live with a slightly frowning current face and a slightly smiling future face. Such is the power of conveying information about the impact of saving. Without some mechanism of this sort, we tend to underestimate how valuable saving can be: this is the false belief referred to above. (Not a total surprise to me: I know that most people are totally unaware of the power of 10-30-60, described in Stage F 02.)

I don’t know if and when a tool will become available to young workers, to give them this sort of dramatic virtual reality experience. I’m certain that the funded ratio tool won’t do it!

Meanwhile, the mere fact that you’re reading this gives me hope that you and the future (and older and happier) you will connect.



We can focus on saving in two ways. One is emotional, visualizing our future selves. The other is rational, calculating how much we need to save in order to retire comfortably.





This is Walk 20 in Life Two.






Where the route takes us

A glide path that is based on assumptions about the average saver is a great start as a default option. That doesn’t mean it can’t be improved. This stage describes ways in which it can be customized to better fit each saver’s characteristics.


In Stage F 11 we saw that a glide path makes sense in accumulation, meaning that the investment of savings for retirement should start with a high growth exposure, which in turn should decline as you approach retirement. The reason is actually that a constant allocation to growth makes sense, when you add together the sum of invested financial assets and future human capital; but if one considers future human capital as a non-growth asset, then the accumulated financial assets themselves should have a declining growth exposure.

Declining from what initial level? Start declining after how long? At what pace? The glide path concept gives no answer to these questions. It simply says that a decline makes sense. In fact, when it comes right down to it, the glide path notion makes only one claim: that it’s superior to a level growth exposure for accumulated assets throughout the accumulation period. (And this can be proved mathematically.)


Not surprisingly, the investment industry found a simple way to implement the idea. What else in a saver’s life changes over time? The saver’s age, of course. So, if we can find a target date for retirement, we can construct a schedule of growth exposures that decline with age as the retirement target date approaches. Make some reasonable assumptions about the saver’s goals and risk tolerance and probable contributions throughout the working years, and it’s then possible to calculate the glide path precisely.

This became known as the target date approach. Everyone with the same target date goes into a fund (called, naturally, a target date fund: for example, the 2035 fund for those planning to retire in 2035) and the growth exposure in the fund is automatically adjusted downward every year.

Of course, the devil is in the details. And anyone who dislikes any one of the details in any one approach seems today tempted to condemn the entire approach. And so it seems to have become the norm to attribute increasingly exaggerated shortcomings to target date funds.


Let me mention some ways in which today’s state of the art can be improved. In fact, there are really only three broad categories of improvement.

  • Customize the glide path. Remember those assumptions I mentioned? Whenever possible, don’t use generic assumptions: customize them for the individual saver. HR departments know much more than a worker’s age. They know the current pay, the pay history (making it easier to project the Pillar 1 pension that the pension pot will supplement), whether there’s an existing defined benefit entitlement, whether the worker has committed to increasing future contributions. All these can easily be taken into account to create a customized glide path. Asking specific questions can improve the customization: when do you hope to retire, do you have an income replacement goal, and so on.
  • Recalibrate the glide path periodically (for example, annually). It’s based on investment return assumptions, and of course life always deviates from the assumptions. So too does the pay scale. It’s also possible that the worker’s goals or risk tolerance may have changed. Recalculating the glide path to take account of these changes is not a big mathematical problem. Adapting the path to changing circumstances is always superior to a “set it and forget it” approach.
  • Implement it inexpensively. Investment charges are notoriously high. Studies invariably show that higher charges are not correlated with higher returns. Perhaps, then, take the certain improvement of outcome that comes from low fees, in preference to the uncertain hope of superior performance. (See Stages I 41 to I 44 for discussions of the active/passive issue.)


Those are improvements that are feasible, without in any way contradicting the superiority of glide paths over constant allocations. But critics attack the entire notion rather than a specific aspect of it.

It’s perfectly legitimate to attack employers who buy a target date approach from an investment vendor without understanding the underlying assumptions or whether they fit the workforce. That’s irresponsible. But critics don’t stop there.

Suppose, as a critic, that you don’t like high-fee funds. Then say so, explicitly. Don’t condemn the entire target date approach. High-fee funds are not a necessary part of the concept. They also occur with overwhelming frequency in programs that don’t offer target date funds. Bringing in target date funds would actually be an improvement. Of course, using low-fee funds would create a second level of improvement. But abusing the target date concept itself as the product of “some kind of marketing genius” because “all you’re getting is that glide path, a gradually declining allocation to the stock market,” and meanwhile savers “are getting ripped off”[5] is (to say the least) misdirected.

But my favorite criticism comes from an Australian forum at which “target date funds … were roundly criticized by academics”[6] as being “not a good idea” because all they provide is “time diversification” (nice phrase, and accurate) but “they do not seem to achieve any worthwhile purpose” – because Australian law doesn’t permit you to use your “balance towards a first mortgage”! (Yes, that’s my exclamation point at the end.) So, these academics should campaign to change that law. What on earth has that got to do with target date funds? But they have become the whipping boy for too many faults.

I’m still waiting for target date funds to become the scapegoat for not curing poverty worldwide or not guaranteeing happiness in retirement or … no, never mind, you can’t print that.



A typical glide path can be improved by customizing it to the investor’s circumstances and goals, recalibrating it periodically, and focusing on inexpensive investments.





Where the route takes us

We’ve discussed retirement saving at some length. But when we’re young, we have other long-term financial goals too. Where do buying a home and insuring one’s life fit in?


Typically we have so many demands on our resources that it’s very difficult to find additional money to save for retirement. Two of the most fundamental demands come from the desire to own a home, and to buy life insurance so that our dependents aren’t left in the lurch if we pass away at a relatively young age. In this stage let’s (briefly) discuss both of those competing desires.

First, buying a home. Typically that requires a lump sum as a down payment, plus taking out a loan (called a mortgage) for the rest of the cost of the home. That loan in turn requires monthly payments to pay it off along with the interest charged on it. Is it worthwhile? More worthwhile than saving for retirement? Those are questions to which the answers are personal rather than absolutely right or wrong.

I’ve seen a quotation to the effect that we’re born short a home, implying that we don’t feel complete until we own the roof over our head (though if we buy more than one, any additional real estate is just another investment rather than bringing emotional satisfaction). Whether the quotation is accurate or not, it reflects a strong emotional need, and for many people that’s a good enough reason to place buying a home at the top of the list.

Emotional fulfillment is a valid reason for spending, as we’ll see in Stage F 21. The thing is to pay a rational price for the home, rather than one inflated by our emotional satisfaction.

A home is usually considered a growth asset, rather than a safety-oriented one. We didn’t explore real estate as an asset class in Stage I 21, but it isn’t difficult to see that it isn’t a form of fixed income asset, since it doesn’t come with a series of pre-specified income payments that we receive. Rather, it’s a kind of asset that we hope will grow in value as our economy grows. But we shouldn’t expect its growth to be commensurate with the long-term return on equities, because a home effectively pays us dividends by saving us rental payments, and it’s the total real estate return (growth in property value plus rent saved) that would be more comparable with equity returns.

Two more comments on your home as an asset.

One is that it isn’t a diversified asset, like an equity index. It’s one very specific holding in your portfolio. So it’s not unreasonable to expect its investment performance to vary widely from that of a diversified equity index or even a diversified portfolio of real estate holdings.

The other is that, regardless of any emotional fulfillment it may bring you, your home is also an expensive asset, and if (as it typically does) it reduces your ability to contribute to your pension pot, it may be an asset that you need to sell in order to be able to stop working. If so, it does double duty, as part of your pension pot too. We’ll examine your options at that time in Stage F 72.

Now let’s look at life insurance. Why would you need it? In fact, why would you need any form of insurance at all? (Your home, your car, your life, whatever.) It’s because the future is uncertain, and there are some outcomes that can leave us (or our survivors) financially badly off; and even if we can’t completely avoid those uncertainties, we’d like to do something about the negative financial impact if one of those bad events occurs.

There’s a quick commonsense sort of way to think about such events, shown in Figure F 13.1. This considers future risks in two ways. One way is: how likely is the risk to happen? Is there a high probability that it will occur, or is the probability low? The other way is: how big a financial impact will it have, if it occurs? A high or a low impact?


Figure F 13.1 Risks and financial impacts


High probability Low probability
High impact Budget for the expense Pool risk; buy insurance
Low impact Budget for the expense Accept disruption


Here’s what the figure suggests. If there’s a good chance (a high probability) that the event will happen, build the impact into your budget. Don’t let it surprise you. After all, it is likely to happen. In the unlikely event that it doesn’t happen, that’ll be a pleasant financial surprise for you.

How about an event that’s unlikely to happen, but if it does, the impact will be small? Typically, that’s not worth bothering about. Even if it does happen, it won’t disrupt your financial situation much. You may even have a small reserve for these unexpected events. You’ll remember from Stage F 01 that financial professionals advise keeping a cash reserve of six months’ spending in case of emergencies.

Now look at that box that represents something unlikely to happen, but if it does, it’ll have a big impact. That’s the situation you want to avoid, and that’s when insurance is typically indicated. Techies will tell you that that’s when risk pooling is indicated. But even if you’ve never heard that, risk pooling is something you probably already do, whether you realize it or not.

For example, fire insurance for our homes. According to statistics available on the internet, the chance that a person’s home will catch fire in any given year is far less than 1%. But if there is a fire, it can do enormous damage. So we pool our risk exposure with others by buying a fire insurance policy. The premium (apart from the insurance company’s loadings) is essentially the product of the probability of occurrence and the likely financial impact. And commonly, the product is a small number. So the premium tends to be small and acceptable, and if we don’t have a claim, that’s just fine.

Now apply that principle to your life. The chance of passing away in any given year is small, while we’re working: it doesn’t reach 1% until we’re close to retirement. But if we have dependents, the loss of working income if we do pass away can be devastating. So a logical step would be to consider buying term insurance that replaces the lost income, the term ending when work is projected to end. And since the lost income declines by one year’s worth every year, a logical consideration might be what’s called a “decreasing term insurance,” where the amount paid on passing away is very large if that event happens when we’re young and declines to zero at the projected retirement age.

Of course there are many other considerations involving life insurance, which potentially has uses beyond the replacement of working income. But I’ll leave those for the experts to explain, particularly since some considerations depend on taxation, which varies from one country to another.



A home, if bought at a rational price, satisfies many potential needs: a roof over your head, emotional fulfillment, retirement savings. Decreasing term insurance can inexpensively hedge the chance that an early passing away deprives your dependents of the work income you would otherwise have earned.






Where the route takes us

In the same way that we observed that there’s more to life than money, so too there’s more to spending money than obtaining something that’s useful to us. Here are some emotional benefits.


Dr Meir Statman wrote something profound.[7] We all know that we make investments in the hope of financial gain. Financial economists have proclaimed that for generations. But Dr Statman observed people and said that we make investments for two other reasons, sometimes. Both of these reasons are emotional rather than financial. One points inwards (it makes us feel good about ourselves), the other points outwards (it expresses something about ourselves to others). He called these utilitarian, emotional and expressive benefits. And he said that they’re all valid, indeed perfectly normal, reasons for investing.

For example, buying a car has the utilitarian benefit of giving us the means of getting from one place to another. Buying a fund that invests in environmentally friendly companies makes us feel good about ourselves. Buying a Bentley or a hedge fund proclaims something about us to others.

When I first saw this, I thought (and I still think) it was profound. Indeed, like the very best ideas, they feel like common sense – but not until someone else has expressed them. Until then we may have a vague intuitive notion about them, but it takes a brilliant mind to express them simply and powerfully. I also remember thinking that I now understood myself better, because I now understood my own motivations better. I felt that I became a wiser, better, less anxious investor as a result.


Dr Statman is one of the founders of behavioral finance, the branch that goes beyond economic theory (“this is what totally rational people do”) to explaining what normal human beings do. (Dr Richard Thaler won the 2017 Nobel Prize for Economics for his outstanding contributions to this very field. And while I’m thinking of the leaders in the field, let me mention Dr Hersh Shefrin too.) Lo and behold, a few years later Dr Statman published a book that he called “Finance for normal people.”[8] And along the way he extended his three motivations for investing as being equally applicable to spending.

At which point I thought again: yes, that’s obvious! (And again: why didn’t it occur to me before he said so?) The only difference between spending and investing is the time period in which the benefit is expected. Spending refers to an outlay for which the benefit occurs quickly. Investing refers to an outlay for which the benefit is expected at some time in the future. So yes, it makes sense that utilitarian, emotional and expressive motivations exist for spending too.

A consequence of all of this is that, since people are different, spending that brings some form of benefit to some people will not work for other people. Things that some people consider essential to their lives and happiness will be unimportant for others. And Dr Statman tells us: that’s OK. These are not absolute values, these are personal values. And we should be grateful for his capturing these ideas for us and making them feel like common sense.

He doesn’t say that everything we do is therefore sensible, just because we do it. Oh no. He tells us that, in addition to being normal-knowledgeable, we can also be normal-ignorant and normal-wrong. (Too bad – for a moment I was hoping that everything is OK. No such luck.)

For example, buying a dream with a lottery ticket brings an emotional benefit, even if it’s temporary. But if we buy the lottery ticket because we over-estimate our chance of winning, that’s ignorance. Wanting a thrill is one thing; overestimating our ability as, let’s say, the driver of a car is ignorance. Dividing our money mentally into different buckets for different purposes can make sense because our tolerance for not achieving the various goals may be different. But kidding ourselves with the benefit of hindsight that we knew in advance which of several possible outcomes of an event would occur is wrong and could cause unnecessary misjudgment in the future. You get the idea. The three motivations make sense; our actions may not.

Anyway, my purpose here is just to assure you that you’re the only person who can decide what you are motivated to do with your money. Other people’s “shoulds” can be relevant as inputs into your thinking, rather than as forcing your decisions.



We get three kinds of benefits when we spend money. There’s the utilitarian benefit that something is useful to us. There’s the emotional benefit that something makes us feel good. There’s the expressive benefit that our purchase says something we consider positive about ourselves to others. They’re all valid reasons for decision-making.







This is Walk 12 in Life Two.







Where the route takes us

There’s a simple concept that is extremely useful. Just compare how much you’ve got with how much you need! Here’s how to apply that concept to see how far you’ve come.


For some reason mathematical calculations involving retirement have appealed to me for a long time. I mentioned in Stage F 22 that I developed a simple tool that I called the STAR analysis (for Saving To Afford Retirement). It estimated for Canadians roughly what level percentage of pay needed to be saved in order to continue one’s lifestyle from age 65. It took into account Canadian income taxes and the amounts of saving and current consumption that would stop some time before retirement (such as mortgage payments, retirement contributions and children’s education). I had no idea at the time that the same technique would prove to be useful decades later; all I knew was that I was hopeless at turning it into a source of income for me!

Someone who reported to me when I joined Russell Investments some years later, and who became a good friend, in time rose to a very senior position. He remembered STAR from our conversations, and called me shortly after my 60th birthday. He suggested that, if I ever thought about my own retirement and came up with some ideas, please let him know anything that wasn’t intensely personal, because he was sure there’d be ideas that Russell could use. I wasn’t thinking at all about retirement, but his suggestion launched a train of thought, and over the next couple of years I asked myself a number of questions and wrote a series of notes to myself, some of which have led to stages on this tour. (And yes, some ideas were incorporated into Russell thinking, I’m proud to say.)


One fundamental question was simple. When can we afford to retire? When our personal funded ratio exceeds 100%. That’s a concept that comes straight out of the defined benefit world. It’s the one thing every trustee of a defined benefit plan learns very early. They may know nothing about pensions or investing when they’re appointed. But in no time they know the funded ratio (the ratio of assets to liabilities): it’s 86%, or whatever. They may even remember the next decimal place, even though these calculations are only very approximate. And they know that a funded ratio over 100% is rare and means you have more money than you need, and under 100% means you’re under stress and have to add extra money to the pot.

Well, exactly the same thing applies to an individual or a couple. You have a lifestyle. Express it in terms of an annual budget. Subtract whatever you’ll get from your country’s Pillar 1 pension (and any Pillar 2 defined benefit you may have accrued). The balance is the amount that you need to generate each year from your pension pot. Calculate how large a lump sum you need in order to generate that annual amount for a period equal to your future life expectancy.

Think of that lump sum as the value of your desired or target liability from your pension pot. How does that compare with your pension pot? Or, in the case of my wife and myself when we first did the calculation, we used only our liquid assets: we didn’t include our home because at this stage we didn’t want to contemplate selling it or getting a reverse mortgage. We wanted to keep that as a safety margin against continuing bad economic circumstances or higher personal taxes, or to leave to our children. So the ratio of our liquid assets to our desired liabilities was the relevant ratio. Yes, we had become a two-person pension plan!

(In fact, from that time onward every idea I’ve had about retirement finance for individuals comes from the transformation of established pension fund notions to an individual or couple. It really is that simple.)

When I’ve explained the notion, some people say they prefer to call these amounts resources and claims, rather than assets and liabilities. That’s good. But no matter – whatever terminology works for you. I’ll use them interchangeably. The basic idea is to see how much of what you need is covered by what you have. That’s your funded ratio.

Actually, in practice I re-define the funded ratio slightly. Here I’ve explained it as a comparison of your pension pot’s resources and claims. In practice I add back the Pillar 1 and Pillar 2 amounts to both resources and claims, so that what we’re measuring is the extent to which your desired lifestyle is funded. That’s a bit more intuitive than the ratio of pension pot resources and claims.

And now it’s obvious that a funded ratio higher than 100% is good, and a funded ratio lower than 100% requires you to think about taking action. And I think of the action as turning a dial.


There are four dials you can turn (as you’ll remember from Stage F 01): save more; retire later; lower your ambition as regards desired lifestyle; or take more investment risk in the hope that the risk will be rewarded and will bridge the gap to 100%. Of course, after retirement only the last two dials are available.


You may remember (from P4 in the Prologue) the definition of “rich” as implying that your personal funded ratio exceeds 100%. Well, the explanation in this stage is where that notion came from.

You’ll have guessed that you can use two numbers for the assets. One is your total assets, including illiquid assets such as your home. The other is your liquid assets, meaning the assets you can convert to cash easily. I find it useful to calculate our funded ratio in both ways. One tells me if our lifestyle is supportable by our liquid assets, which would be a good outcome; the other tells me if we need to liquidate our home at some stage (in which case Stage F 72 becomes relevant).

I’ve also found it useful to calculate the target liability in two ways. One way is to estimate how much it would cost to buy an annuity that would lock in the required annual income for the rest of our lives. That’s essentially the way in which actuaries calculate the funded ratio for defined benefits. But since I’m taking investment risk, I also want to know whether, if the risk creates the investment reward I’m hoping for, our funded ratio would rise past 100%. So that gives me two estimates of the amount I’m targeting: a safety-oriented estimate of how much I can lock in (from the annuity calculation) and a hoped-for best estimate (the number that results from taking advance credit for the investment reward).

If you do this, you can them compare both the target liabilities with both the asset values, coming up with four funded ratios, in this order:

  • If liquid assets exceed the safety-oriented target liability, this is your best outcome, because it means that you’re in a position to lock in all of your future lifestyle for all of your future life, without the need to create liquidity from your illiquid assets.
  • If liquid assets exceed the best estimate target liability, this says that it’s reasonable to expect (but not certain) that you’ll live your desired lifestyle, without the need to create liquidity from your illiquid assets.
  • If your total pension pot exceeds the safety-oriented target liability, it means that if you’re willing to convert your illiquid assets to liquid form, you’ll then be in a position to lock in all of your future lifestyle for all of your future life.
  • If your total pension pot exceeds the best estimate hoped-for target liability, this says that it’s reasonable (but not certain) that you’ll live your desired lifestyle, but to do so you’ll have to convert your illiquid assets to liquid form.

And if none of the funded ratios reaches 100%? You really should think seriously about turning at least one of those dials.

This possibility leads me to make one more suggestion. It’s for you to make a rough division of your budget between essentials (“must have”) and discretionary spending (“nice to have”). Don’t worry about what others consider essential. Personalize it. It’s the answer to the question: “If I had to turn down the spending dial, what are the things I simply can’t imagine giving up?” Those are your essentials. We’ve already seen (in Stage F 21) that your evaluation is the only one that counts. Beyond your essentials, everything else is, in a sense, discretionary. We’ll see (in Stage F 28, where we consider what I call “wealth zones”) how to find out how securely you have financed your essential spending and how securely you have financed your discretionary spending. For this stage, introducing you to the notion of those two categories is enough.


Let me add some thoughts on what that set of four ratios should do for you.

My purpose is to give you an initial impression of where you stand today.

It is not to suggest any precision in the numbers. The ratios are valid to the extent that the assumptions made in calculating them actually work out. Nobody can predict the future – that’s why the ratios are offered as orders of magnitude, initial estimates, rather than predictions. Beware of attaching too much significance to them.

Are they then worthwhile at all? Good heavens, yes! Think of what you were aware of before calculating them, perhaps even before being aware of the concept. Would you have known whether one of those four ratios was closer to 50%, to 100% or to 150%? Most people I’ve asked have said: no, they have no idea at all. Would it make a difference if they had an idea? Well, yes, of course it would. Their financial attitude to retirement would be vastly different if they thought their ratio was 150%, but it actually turned out to be 50% – or vice versa.

Similarly, would you have guessed, before making the calculation, how much of your desired future lifestyle is likely to be covered by Pillars 1 and 2, how much by your past accumulation, how much by your future savings, and how much by the hoped-for reward from investment risk-taking? Of course not. Those insights come from making the calculations.

Watch how the ratios evolve over time. That will actually be your best learning tool – seeing the progress of the numbers over time; whether there are trends; whether or not the numbers are volatile. Those learnings will greatly influence your attitude towards the financial aspects of retirement.

Others have potentially better tools to offer you, taking into account things like taxation, contributions that are an increasing percentage of pay, whether your proposed retirement is gradual or total, converting a level Pillar 2 pension into an inflation-equivalent one, integrating cash flows that start at different times, even the annual probability of survival of you and your partner. I encourage you to try them out. My purpose is simply to start you on this path, not to pretend that my personal funded ratio concept and calculator are all you’ll ever need.



Your personal funded ratio measures how much money you already have, and are likely to have after your future savings, relative to the amount you’ll need to support your post-retirement ambitions. Over 100% is good, under 100% suggests that you ought to think about doing something about it.



Where the route takes us

In practice we may add to our savings if we receive an inheritance, and we may want to leave bequests in addition to providing for life after full-time work. In this stage we look at how to accommodate those aspects.


There’s a potentially large source of assets for retirement that I haven’t mentioned yet. It’s inheritances. There’s a reason why. But first, let me give you some American statistics I found, to demonstrate their relevance.[9] They apply specifically to the “baby boom” generation (those born between 1946 and 1964), but the amounts involved are about the same order of magnitude (after adjusting for inflation) as the amounts received by the preceding 1927-1945 generation, so the Boomers are not an unusual generation in this regard.

The headline number sounds huge: American Boomers will inherit over $8 trillion. But the aggregate is meaningless on its own. It tells you nothing about the impact. Here’s the impact. It’s estimated that two-thirds of all Boomer households will receive something. The higher a household’s income, the more likely they are to receive an inheritance, but even among the Boomers with the lowest income, more than 50% will inherit something.

The study says: “Most Boomers will receive their inheritances in middle age, reflecting a pattern in which wealth passes from parents to children on the death of the surviving parent.” Most inheritances are received from parents, with grandparents as the second most common source. Some transfers do occur, however, while the older generations are still alive. Dr Statman[10] uses the lovely phrase “It is better to give with a warm hand than with a cold one,” pointing out that waiting until death deprives the giver of the joy of giving.

The lower the income, the bigger the impact the inheritance is likely to have. The Boomers with the highest income will receive the most, but they already have their own wealth, and their inheritances add proportionately less than the inheritances of the lower earners. For low earners, the average inheritance of $27,000 will mean much more, representing roughly two-thirds of their wealth.


If it’s that significant, why haven’t I mentioned it yet? For the same reason that the study’s authors add this warning: “Regardless of the anticipated amount, any prospective inheritance is uncertain. Parents or grandparents who expect to leave a bequest may revise their plans based on fluctuations in their asset values. Or they may exhaust their wealth as a result of medical costs or long lifespans. In short, Boomer households should not count on an anticipated inheritance to eliminate the need for increased retirement saving.”

Nevertheless, if you want, you can use the personal funded ratio calculator to make your own estimate of the impact an inheritance of whatever amount, to be received on whatever future date, would make to your funded ratio. Or get an expert to do the calculations. Either way, just remember the warning.


Now let’s think about the possibility of your own giving: your planned, or hoped-for, bequests, whether to your family or as philanthropy. Regardless of whether they are given with a warm hand or a cold one, the amounts involved won’t play a part in your own retirement finance. I’ll let you think through what your plans are. Right now the down-to-earth question is: what effect will this giving have on your funded ratio?

I’ll deal broadly with three financial situations. If your plans are more detailed, an expert can help you take the nuances into account in calculating your funded ratio.

  • Suppose you want to leave “whatever is left after we pass.” Well, that’s the easiest to take into account. You simply ignore it, because your own lifestyle comes first and is unaffected by your bequests.
  • Suppose you want to leave a specific asset that you own today, together with any accumulation that it generates. That too is easy to take into account. Simply leave it out of the assets that you consider in your personal funded ratio calculations. In effect, you’re saying this isn’t really part of your assets. It’s as if you’re giving it away today. (In which case you might consider Dr Statman’s warm/cold hand thoughts.)
  • A tougher situation to deal with accurately is if you want to leave a specific amount on passing, and you have no idea how much it’s worth today, given the uncertainty surrounding the time of your passing. One logical but unorthodox way to deal with it is to take out a second-to-die insurance policy, which pays the exact amount on the second passing of a couple. That solves the bequest issue, and the expense of the premium becomes part of your spending pattern while you’re around.

Beyond those three situations I have no general rules, and suggest that you find appropriate expertise to take your desires into account.



Inheritances are likely to play an important part in every generation’s retirement funding. But they come from other people’s desires, so it’s difficult, if not unwise, to take them into account explicitly in planning for your retirement. Bequests, on the other hand, arise from your own desires, and there are ways of accommodating them in your financial planning.




Where the route takes us

In this stage I explain how to use the Personal Funded Ratio calculator that’s on the website: the principles it’s based on, the questions it can answer, the information you need to provide, where and how I’ve imposed limitations on its flexibility – that sort of thing.


My purpose in this stage is to show you how the Personal Funded Ratio (or PFR, from now on) calculator works, and how you can use it to answer a number of questions – or at least get initial orders of magnitude, always subject to the imprecision of making any sort of estimates about the future, as explained near the end of Stage F 23. I assume explicitly, in fact, that before you use the calculator you have first read that stage.

Here’s the basis of how the calculator can be turned to multiple uses.


Three things are always intertwined. You put money into your pension pot, you invest it to make it grow, and there’s something available at the end. Common sense, right? What’s fundamental is how those three elements are connected. If you know what goes in and how much it’ll grow, that’ll tell you how much will be available. But also, if you know what goes in and how much you’d like to have available, that will tell you how much growth is necessary. Or, if you have some rate of growth in mind and know how much you’d like to have available at the end, that will tell you how much you have to put in. You see how the three things tie together?

The website calculator gives you all three options.

To me, the first one is the natural starting point. I asked friends which of the three unknowns they’d most like to start finding out about, and they all had essentially the same answer. “First I want to know whether I’ll have as much money as I need. That’s where I want to start. After that it might be interesting to see how the answers change if I change my savings rate or my future investment return, but start me off with my PFR.”

So that’s the first of your three choices: calculating your PFR. You can select two other options if you want to work backwards from a desired funded ratio to the savings or the investment return required to get there.


Some inputs are the same, no matter which aspect you’re looking at. For example, your personal details and your current position. So those inputs stay the same for all the output screens.

All the calculations are done on the website. There’s nothing to download. And the website saves nothing. So, if you want a record of any calculation, you need to print it. Once you erase it, the record is gone. So, right at the start, I give you a spot to name a particular calculation, to enable you to identify it (the “version name”) if you end up doing multiple calculations.

OK, let’s go with the instructions.

Oh, one more thing. In Stages F 26 and F 27 I’ll go through an example of a couple actually going through the calculations. So you’ll be able to see how they comply with the instructions and fill in the required boxes. I hope that’ll help you with your own inputs.


First, the common inputs.

Your name, age, gender. If the calculations involve two of you, then add your partner’s name, age, gender.

How far in the future you’re planning to retire.

Together these tell you what your ages will be at your planned retirement date.

Now you have some work to do. Go to (or whatever longevity tables you find most useful) and find two estimates. One is the 50% estimate of survival in years (for you alone, or for your partner and you, depending on your calculation). Enter that number in the “locked-in basis” for “Years of post-retirement income needed.” The other one is the 25% or the 10% survival in years, depending on your degree of caution. (I have a personal preference for the 25% number. I explained why in Stage L 21.) That number of years goes into the “best estimate basis.”

Next enter your current (combined, if that’s relevant) annual gross income.

Next enter the required gross (that is, pre-tax) annual income that’s your target. This target income will be assumed to increase every year with inflation, to preserve your purchasing power. The calculator tells you how it relates to your current gross annual income, as an interesting comparison.

Next we take into account what annual amount you’re likely to receive from your country’s Pillar 1 pension (such as US Social Security, or the UK state pension, or C/QPP and OAS in Canada). I can’t help you here. You need to find out about this yourself or from the national agency or an expert or friend – whatever.

You’ll also need to find out about any Pillar 2 pension you may have, that is, a defined or target benefit plan offered by your employer or union. (This is NOT a defined contribution plan for which you receive periodic statements about how much money you have accumulated.). Though in many countries this annual amount, once it starts, does not get increased with inflation, nevertheless enter the projected starting annual amount in the relevant box. (The absence of inflationary increases results in an inaccuracy in the calculator’s analysis, which is too complicated for me to make good. Sorry. More advanced calculators may be able to do adjust your fixed Pillar 2 pension to an equivalent inflation-adjusted basis.)

The calculator now tells you the balance of your target annual income required to be met by your personal assets, after the Pillar 1 and Pillar 2 pensions have been taken into account.

And finally, where do you stand today? Input your current liquid assets and your current illiquid assets.

All of those inputs are common to all three sets of calculations.


OK, now we come to the choices regarding the output screens.

The first choice is focused on calculating your personal funded ratio.

This requires two further sets of inputs.

The first relates to how much more money you are planning to save. Enter the annual amount that will go into your pension pot in the relevant box. Your contribution and your partner’s contribution are both relevant here. So too are any contributions made by your employer, your union, the government – whoever. Add them all up, and the total goes in here. (Of course, this does NOT take account of anything going to Pillar 1 or Pillar 2, which are implicitly taken into account earlier.)

The second relates to your projected average annual investment returns. As you might guess, these are all returns after inflation (often called “real returns”). And (sorry, but this is necessary) there are four relevant inputs here.

Two relate to the locked-in basis. Actually, I give you no choice here. The calculator uses 0% annually for these returns. These are safety-oriented returns, designed to be relevant for safety-oriented investing, which is what underlies the attempt to lock in a cash flow.

The other two relate to the best estimate basis. There’s an annual real return to be estimated before retirement, and another one after retirement. Why the difference? Because most people tend to take less risk after they retire, in which case their reasonable expected reward should also be lower after retirement. (And of course, these inputs cannot be 0%, since here you are inserting the reward you expect for the risk you are willing to take.)

Done! Finally, you can look at the results! Hit “Calculate.”


Remember, all the results are shown in terms of today’s currency (dollars, euros, pounds, whatever), so that you’ll have an immediate idea of what you can purchase with the output.

The first set of results shows how much money your target income will require you to accumulate by retirement. The locked-in basis is an approximation of what it would cost to buy a lifetime income annuity at retirement, guaranteeing you the required income for life. (Information for the techies: I’ve assumed a 20% loading for the insurance company.) The best estimate basis is the projected amount your own pot will need to reach, to provide your target income for the number of years you input earlier.

OK, those are the targets. What are the projected amounts you’ll have available?

The amounts available are shown, item by item, from your current liquid assets, from your current illiquid assets, and from your future savings. And they are shown separately for the locked-in basis and for the best estimate basis.

In turn, those amounts lead to the components of your personal funded ratio. You can see the funded ratio if you attempt to lock everything in, and you can see the funded ratio that’s your best estimate if the reward comes from the investment risk you will be taking. And you can see how much of your funded ratio comes from Pillar 1, from Pillar 2, from your current liquid assets, from your current illiquid assets, and from your future savings.



Take some time to absorb those results. See whether they make you feel comfortable or anxious. See if they give you any insight into what you might like to change: your future annual savings, your best estimate annual investment return, or your target post-retirement income.

(You might want to name this set of calculations and print out these results, regardless.)

You can go back to the top of the screen and edit your inputs, if you’d like to test different inputs.


Often, instead of changing the planned savings or assumed investment returns, people often prefer to ask: what do those need to be, for me to get to 100% of my target? That’s when you need to go back to the initial page, and select a different calculator.

You can retain, or change, your inputs shown above the calculator choice.

To calculate the required annual savings, you have of course to input the investment returns.

And you have a choice of which ratio you would like to set at 100%: the locked-in or the best estimate ratio, excluding or including illiquid assets.

Hit “Calculate,” and there you are. Right at the end, you will see your required annual future savings.


Similarly, if you want to calculate the annual real returns required to reach your target, that’s the calculator you select.

And this time, of course, you have to specify your planned future annual savings, and identify which ratio you would like to set at 100%. Naturally, if you’re searching for an unknown rate of return, that implies it’s not a locked-in funded ratio that’s relevant; it can only be a best estimate ratio. Whether to exclude or include illiquid assets is always relevant.

You’ll notice, after you hit “Calculate” and look at the results, that you’ll see required returns both before and after retirement – and in particular you’ll notice that the return before retirement is three times as high as the return after retirement.

That’s deliberate on my part. It’s an arbitrary relationship, I admit, but I had to make a choice here to limit the complexity in the calculator, and I thought it would be useful to show what both returns need to be, if there’s to be the usual risk-reduction after retirement.


I hope that’s useful. Already I can imagine the more numerate among you finding ways to use the three calculator choices to answer even more complex questions. If that’s you, I’m delighted, because it means I’ve piqued your interest and you’re taking it further – yes, I’ve created a teachable moment!


One last thing. If you use someone else’s calculator and get a substantially different outcome, please let me know. I’ll try to see why the difference, and if this indicates that something in my calculator is worth changing.



You should now be ready to use the calculator to help you find out what point you’ve reached, as far as retirement finances are concerned.







Where the route takes us

It’s time to assemble the facts required for a funded ratio calculation. If you’ve never done it before, gathering the information is not always easy. Here’s how one couple did their best, even though it was far from perfect.


Let’s follow Alain and Amélie (both now 40 years old) as they have a go at calculating their personal funded ratio. They both work, and together they earn $115,000 a year. They’re a long way from retirement (they think perhaps 25 years), and they’re pretty sure that they’re far short of 100%, particularly if they exclude their home, but just for fun they’re going to calculate all the ratios set out in Stage F 23.

It has been tough just getting to the starting line.

They started with longevity estimates and found that, at their ages (65 and 65) at projected retirement, their 50% and 25% estimated “joint and last survivor” life expectancies are 27 years and 32 years respectively. In other words, of couples like them, half expect that at least one of the couple will still be around after 27 years, and a quarter of such couples will still have at least one partner around after 32 years. Those are the numbers they’re using for their calculations.


They haven’t a clue as to what their post-retirement income target should be. Living expenses, the mortgage payments and their retirement contributions eat up their net pay. No children, and none planned. They don’t keep track of their expenses and don’t have a budget. In despair, they decided to use 70% of their gross pay as an initial target, a number they got from a friend, as a sort of default option. That gets them to $80,500 a year. They round it to $80,000 for their selected target. (And they resolve, before recalibrating next year, to see how much money they actually spend, and get expert help to gross that up to a post-retirement income target.)

What will their Pillar 1 pensions give them? Again, not a clue. The same friend said it might be $30,000.

They have no Pillar 2 pensions, unfortunately.

That means their combined pension pot needs to provide the $50,000 a year remaining from their $80,000 initial target. (Further note to themselves: find out about their Pillar 1 entitlements.)


What are their current assets?

They have both assiduously contributed to their workplace defined contribution plans. With excellent equity returns, their combined tax-deferred assets are now an amazing $150,000. They have no after-tax savings worth including in the calculation, just a small amount for emergencies. They own a home but even though its value has climbed to an estimated $300,000, their mortgage is $250,000, so there’s only net equity of $50,000 there. No other significant debt.

Wait a minute! They’ve just realized that by retirement their home mortgage will have been paid off, and their net worth will reflect the full value of their home, not just their current equity. Good heavens, it’s the mortgage payments that eat so heavily into their current standard of living – and that’s a form of saving for retirement that wouldn’t otherwise be taken into account. So (quite correctly) they change their starting illiquid assets position to reflect the full value of their home. And so, while their liquid assets stay at $150,000, they change their illiquid assets to $300,000. Whew, that’s better!

They choose to calculate their personal funded ratios.


Between them and their employers, total contributions amounting to 8% of their combined current pay are going into their pension pots. That’s $9,200 a year.

They have one more set of inputs to insert.

At this point they feel exhausted, but they’re nearly there, so they don’t give up! They realize that once they have all the inputs, the calculator does all the remaining work for them.

For their best estimate annual real return before retirement, they guess that they’ll need to take a lot of risk to reach their target income level.

For the liquid assets and their future savings, given that they won’t touch them for 25 years, they’re going for growth. They won’t have 100% in growth throughout, but they’ll have 100% for a long time. Assuming 4% (real) a year for growth investments, they decide to use an average real return of 3.5% a year over the next 25 years.

The calculator uses the same number for their illiquid assets too (their home), for convenience. A more sophisticated calculator might use a different number.

Through the drawdown period after retirement, they expect to take much less risk. So they don’t want to use the same 3.5% number. They think it likely that, over the whole post-retirement period (which, remember, is being planned as 32 years), they’ll average perhaps a quarter of their assets in seeking growth. So they use 1% as their input here.

(By the way, you recognize, of course, that these numbers are not meant to have any significance at all, as far as your own decisions are concerned. They’re not benchmarks to compare yourself with. They’re purely what I attribute to Alain and Amélie for illustrative purposes.)

OK, finally they can hit “Calculate”! Let’s look at their results.


Their interpretation of the results

The first thing they notice, with relief, is that the final funded ratio number is 103%. Yes, it exceeds 100%! They’re excited!

Not so fast, though.

Of that 103%, 32% comes from their illiquid assets (their home). Without their home, the rest only adds up to 71%. That tells them that they’ll have to find a way to monetize their home – an uncomfortable feeling.

Of course, they were just guessing at their target 70% requirement. This makes them realize how very important it is to see how much they’re actually spending right now, so they won’t have to make a wild 70% guess again next year. The good news is that their mortgage payments take up a good chunk of their take-home pay, and so their spending isn’t really related to their gross income, it’s more a function of income minus mortgage payments. Their post-retirement need, to maintain their current spending, won’t have to be large enough to meet mortgage payments too.

And in fact, once the mortgage is paid off, they’ll be able to save much more of that cash flow towards retirement, improving their funded ratio. This calculator doesn’t take that into account.

The biggest chunk of their funded ratio comes from their Pillar 1 pension. Remember, that too was a piece of guesswork, made by their friend. Again, this is clearly a significant number, and therefore one to be researched before next year’s recalibration.

As for accumulated liquid assets and future savings, together they generate 18% on a locked-in basis and 33% on a best estimate basis. That tells them that the difference (33% – 18% = 15%) comes from hoped-for growth in their growth-seeking assets. That disappoints them, as they remembered the 10-30-60 stage (Stage F 02).

(My explanation, which they weren’t aware of: there are two factors. One is that, when expressed in real terms, that is, in terms of today’s purchasing power, the investment multiplier effect isn’t as great as 10-30-60 suggests. The other is that they are now 40 years old, and have fewer years in the future than 10-30-60 involved. In fact, their past investment returns have been extremely high.)

Regardless, they really do need that growth to get to 100%. Another memo to themselves: talk to an expert (whether at work or outside their work environment) about what is required to make this a reasonable outcome – and also what are the risks involved, and what might happen if the risks result in some shrinkage rather than growth. (A horrible thought, but a necessary one.)


All in all, the only firm conclusion that they come to is that some form of lifestyle continuation is feasible after retirement. There’s a lot more to investigate before they feel knowledgeable about interpreting the results, let alone confident about their future.

No, they realize they can go further. That’s not the only firm conclusion. There’s another really important firm conclusion. It’s a psychological one. They realize that they’re no longer totally ignorant about where they stand. They’re no longer scared stiff. They’ve taken the big first step, just by doing this rough calculation. They’ve escaped from their previous world of unknown monsters, and moved to a new world of research and discussion. It’s as if they were totally lost, and now know where they are; and they own a compass, indicating directions. They have a framework for looking at the future, financially. They feel, for the first time, a little bit more in control. Talk about a teachable moment!

Well done, guys!



Even without precision, using the calculator represents a psychological step forward, indicating areas that need further investigation. Having a framework is a big first step.






Where the route takes us

Our exemplary couple decide that they want to play with the numbers a little bit.


Remember that Alain and Amélie felt that they were no longer totally lost, but now knew where they were and felt that they owned a compass? It was irresistible to probe further and draw the outline of a map; in other words, try to find out how far they were from relative safety, as they followed the compass in different directions. And that meant using the PFR calculator with variations in their inputs, to get a feeling for what would be the effect of turning various dials (to use the language of Stage F 23).


Given that even their best estimate funded ratio was (at 103%) barely higher than 100%, they wanted to know what changes might give them a greater feeling of safety and comfort.

The first variation they tested was one they were told would probably make a big difference, even though they weren’t exactly thrilled at the prospect of having to put it into practice. And that was to see how much the PFR increased if they were to retire at 70 instead of 65.

So they went back to the calculator and made the requisite changes.

  • They changed their years to retirement, from 25 to 30.
  • Since they would each be 70 at retirement, they went back to their longevity tables and discovered that their post-retirement years decreased. Instead of 27 and 32, they were now 22 and 27.
  • Postponing their Pillar 1 pension, their friend told them, would increase it from $30,000 to roughly $40,000 a year. (My note to you, the reader: when you make this estimate for yourself, be sure to reflect it in purchasing-power terms, not nominal terms. For example, if the nominal increase for a five-year postponement is 40%, inflation at 3% a year would reduce it to about 34%. I’m not sure if the friend realized this, in making the $40,000 estimate.)

The changes in their PFR were stunning.

Their locked-in ratio increased from 70% to 92%.And their best estimate ratio increased from 103% to 142% – very comfortable.

How on earth did this happen?

Essentially, two things caused it.

One was that five additional years of saving and five additional years of investment returns increased their projected assets at retirement.

The other was that they needed less money to fund a retirement that would be five years shorter than initially projected.

Put them together, and the difference was enormous.

When they looked at the numbers more closely, they realized that it might not be essential to monetize their home. Without that illiquid asset, their best estimate PFR reached 98% – temptingly close to 100%, and certainly within the margin of error of all their approximations. Memo to themselves: yes, really check on their budget and on their Pillar 1 pensions – suddenly these had become important focal points.

All of a sudden, delaying retirement until 70 no longer felt quite as unhappy a prospect. And they resolved to re-calibrate their PFR every year from now on.


But wait – what if, instead, they increased their contributions? That took them to a different calculator.

Now they went back to their initial inputs. They kept everything else unchanged (meaning those initial retirement-at-65 numbers), and tested how large their future annual savings needed to be, for their best estimate to reach 100%, excluding illiquid assets.

Answer: the current $9,200 annual savings needed to increase to $25,312.

Oh dear. Not a chance.

What if they used the retirement-at-70 inputs instead? Then the $9,200 increased to $9,921. Oh, of course, that made sense. They were already at 98% if they saved $9,200, so it didn’t need much of an increase to get to 100%.

(And they realized that they were getting a feel for the numbers.)


Finally, what if they took more investment risk and hoped thereby to get a higher average return in the future? Risky, yes – but this was now just for curiosity.

So they went to that calculator.

First, they tested what real returns would be required if they wanted to reach 100% without their home. Yes, they realized this would be a pie-in-the-sky calculation, but at this point they were starting to become familiar with the calculator and playing with it had developed its own appeal.

Sure enough, the answer came back: 6.13% a year real before retirement, combined with 2.04% a year real after retirement. Not in this world.

How about getting to 100% using their illiquid assets? Presumably the required returns would not be far different from the 3.5% and 1% that they used in their very first calculations, because that got them to 103%.

Right. The calculator said: 3.27% a year real before retirement, combined with 1.09% a year real after retirement. Close enough. This simply confirmed that they were indeed starting to get a feel for the numbers.

That’s where they stopped, at least for the moment. There were really no further insights to be gained from playing with the calculator, until their investigations produced better inputs. That’s when they would go back.

To their surprise, they were now eager (though still a bit afraid) to examine those inputs. They hoped their investigations would lead to more comforting outputs.

Regardless, what a change! This had become territory they could explore, rather than a map with “here be dragons” covering a part of it, the way maps sometimes showed unknown territory in centuries past.



Using all the possible calculators allows you to see which changes have a big impact and which ones a small impact, as well as which changes might be feasible and which really aren’t possible to implement.





Where the route takes us

So now, through the personal funded ratio calculation, you have an idea of where you are, relative to your target. What if you’re above your target? Or below? How does that affect your lifestyle options?


Once I got used to the idea of a personal funded ratio, it seemed natural to interpret it, to give an intuitive idea of what the funded ratio could achieve for someone. In time I developed a framework that mentally divides wealth into four pots; but as the concept of pots is already established, I changed the framework to that of a building with many levels.[11]  If you have no ability to earn income from work, then the levels in the building define where you are now. If you have some years to go before your work income ceases, then you have the opportunity to rise in the building.


Figure F 28.1 Wealth Zones


Start with the basement. Most people have some pre-annuitized wealth, by which I mean wealth that already comes packages as lifetime income: a national Pillar 1 pension plan (such as America’s Social Security or the Canada and Quebec Pension Plans or the UK state pension), some form of national protection against medical costs, perhaps a defined benefit plan, a lifetime annuity, or whatever income source lasts for life. Some of it may be inflation-proofed, some of it may not be. This is wealth we tend not to count explicitly, because it is difficult to estimate its present value. But it is very important. In many countries, this already-annuitized wealth accounts for the bulk of post-retirement income for large segments of the population.

I place it in the building’s basement precisely because it isn’t visible, yet it’s the foundation of our retirement wealth.

Next, the wealth that’s visible, the amounts we took into account in calculating our personal funded ratio in Stage F 23.

Remember the target lump sum we need to fund, that will enable us to continue our desired lifestyle for as long as we live? I divide this into two parts. One is the target lump sum for the bare essentials of life. The other is the remainder of the target, the portion necessary to preserve our full desired lifestyle.

The ground floor of the building, which I call the Essentials Zone, has a ceiling at the point where there’s enough to lock in that essentials-maintaining target.

And the next floor up is the Lifestyle Zone, and its ceiling is at the point where there’s enough to lock in the full desired lifestyle target.

Another way to express the height of these ceilings is that they’re the wealth levels at which the essentials of life are 100% locked-in funded and at which the full desired lifestyle is 100% locked-in funded.

Let’s think about the choices that people have in these zones, and the zones I’ll define above them.

Essentials Zone

For those who live in the Essentials Zone, they don’t have enough money for the essentials. It’s likely (and sensible) that they hold an emergency cash reserve before thinking of anything else. And then they will rely on some form of social assistance. Sadly, in this zone, the residents don’t have the luxury of choice.

Lifestyle Zone

In the Lifestyle Zone you have enough for essentials but not enough for your full desired lifestyle. Yet that means you do have some flexibility. And you have a choice: you can buy a lifetime income annuity to lock in the highest level of lifestyle possible, even though it isn’t as high as you desire; or you can forgo longevity protection and take investment risk, in the hope that the resulting return will grant you a better lifestyle. There’s no right or wrong choice (except in retrospect!): it’s just a matter of your approach to risk tolerance.

What about bequests, if you’re in the Lifestyle Zone? That depends on your priorities. Remember the three approaches we discussed in Stage F 24? You can ignore bequests during your lifetime. If there’s anything left after your “estate event,” that forms the basis for the bequests mentioned in your will. If not, there are no bequests. Or second, set aside a specific amount now, that you want to ensure is available for bequests. (This may, for example, be your home.) Or third, it may be possible for you to buy a life insurance policy (a second-to-die policy, if there are two of you), the proceeds from which will go to your choice of beneficiary. In this case, the premiums for the policy become part of your essentials or your lifestyle (depending on the priority you assign to it), and will influence your target.

Notice that in the second and third ways you still have room for bequests; in the second way you sacrifice a lump sum, in the third way you sacrifice income.

All in all, in the Lifestyle Zone you have choices – indeed, you have more choices than in any other zone – but they’re all difficult choices because every choice you make in favor of one goal necessarily moves you away from another goal. There just isn’t enough wealth to do it all.

Bequest Zone

Above the Lifestyle Zone you have, or are likely to eventually have, a surplus of wealth relative to your lifestyle, and you’re in what I call the Bequest Zone. At first I thought of it as the “investment and risk zone,” because that’s what enables the owner to maintain a full investment portfolio, and of course it’s always subject to investment risk. But my wife reminded me that if we get there, it’s really the “kids’ zone,” because after we’ve gone that’s what the kids will inherit. We like our kids. Very much. And we want to leave them a legacy, if we’re in this zone. The psychological difference in the labeling came when I realized that we’d be playing with those assets in making investment choices. It’s their risk and their reward, and so we want to consult them if we get there.

Oh yes, just to formalize it, I generalized the name and now think of it as the Bequest Zone.

One consideration that is likely to be relevant is the impact of taxes when your estate event occurs. Laws vary around the world, and in some jurisdictions there are no taxes triggered by the estate event. But where there are such taxes, often they differ according to the form in which the assets are held (for instance, in the form of the proceeds of an insurance policy). It’s as if the state says, “We’ll tax assets in your right-hand pocket differently from assets in your left-hand pocket.” Clearly it makes sense, in some circumstances, to transfer assets from one pocket to another. That’s another area in which a financial professional can help.

Endowed Zone

I deliberately place a ceiling on the Bequest Zone, or perhaps it’s more accurate to call it a floor for the Endowed Zone. That’s the point at which you can live on the investment return alone, so you never actually decumulate. You continue to accumulate forever. You don’t have to do anything different with money in the Endowed Zone, relative to the uses to which you put the money in the Bequest Zone. It’s just a conceptual difference: in the Bequest Zone you are actually decumulating, even though you won’t run out of money before you run out of life, whereas in the Endowed Zone you don’t decumulate at all.


Statman’s categorization of wealth zones

Dr Statman[12] has a fascinating way to describe the position in which you find yourself. It’s a little different from mine, but it’s broadly consistent with what I’ve just defined, and he goes further in explaining some of the paths that people may have followed in getting to their post-retirement financial positions. Here’s what he says.

He starts with the top. He calls them simply the wealthy. They earn more than adequate incomes during their working years, and their accumulated savings are large enough to assure no retirement worries. Below them come the steady middle. They earn adequate incomes steadily throughout their working years and save enough for adequate retirement spending. Indeed, many among the wealthy and the steady middle are members of the “millionaire next door” group, frugal people earning steady incomes who believe that financial independence made possible by savings is more important than lavish spending. Below them are the precarious middle. They consist of two segments, the low-earners and the high-spenders. The low-earners strive to save from their low earnings during their working years but their meager savings place them precariously close to poverty and inadequate retirement spending. High-spenders spend their adequate incomes during their working years, failing to save enough for adequate retirement spending. And finally there are the poor. They earn inadequate income throughout their working years, rendering them unable to save much for adequate retirement spending.

I think that corresponds roughly with my Endowed Zone, Bequest Zone, Lifestyle Zone and Essentials Zone citizens.


Final thoughts

Since the options and choices are so different in the four zones, it makes sense to establish as early as possible which one you’re currently in, so that you can get used to the choices you face, and you have longer to think about how you want to make those choices. Or, of course, that you can revel as early as possible in the freedom that comes from being above the Lifestyle Zone. And it really is a joy to get that sense of freedom.

As anecdotal evidence, I once explained the zones (actually, in those early days I referred to four buckets of money rather than four zones) as a guest speaker at a financial professional’s “client appreciation night.” A lady approached me afterwards and thanked me, saying it was the first time she had been out since her husband’s death, and she was afraid that it might be depressing to talk about planning for late in life, but she enjoyed the talk. The next day I visited the professional, and lo, there was the lady again, having consulted her professional first thing in the morning. A huge smile appeared on her face when she saw me, and she said: “I just had to find out. I have four buckets!” Yes, the realization is a pleasure, at any level of wealth.

Note also that, just as your personal funded ratio will change periodically as markets move and as your circumstances change, it’s also possible that the wealth zone you’re in will change. Of course, it’s terrific to rise up a zone. But the one thing you want to be aware of is if you actually fall down a zone, say from the Bequest Zone into the Lifestyle Zone, or worse, from the Lifestyle Zone into the Essentials Zone. Either would constitute a wake-up call (P7 in the Prologue).

So remember to recalibrate periodically.



It’s useful to find out which “wealth zone” you’re in, because your practical choices vary a lot from one zone to another. So the earlier you know, the more time you have available to think about your choices.





This is Walk 11 in Life Two.





Where the route takes us

Let’s pause, take a breath, and start to focus on using the accumulated assets to generate income for the rest of our lives. We’ll start by identifying clearly the principles involved.


It doesn’t hurt to pause now and then. Route 4 is the longest, and since it puts together stuff we’ve covered on the other three routes, it covers the most complex territory. And already on this route we’ve looked at saving and investing, at the principles of accumulation, and assessing how far you’ve come on the total journey.

Now we’ve reached what really constitutes the ultimate purpose of the journey: the use of the assets you’re accumulating. So an overview, at this point, of what is yet to come might be useful, and might help you focus on it.

My main purpose here is to draw out some simple but very important principles. All too often, I’ve found, these principles are buried under a mass of detail, rather than identified separately and explicitly. If you master them, your conversations with financial professionals will be much more rewarding – and perhaps you’ll encourage them to make the principles part of their discussions with their other clients.


We’ll start by gathering together a lot of the thoughts about risk that we’ve come across gradually. And we’ll do that by identifying the three goals that retirees have. Risk is then, quite naturally, the chance that those goals will not be fulfilled.

One of those goals has to do with longevity: retirees are scared of outliving their assets. The other two goals have to do with investments: retirees want their investments to give them both safety and ongoing growth.

We’ll find that sometimes financial professionals – sometimes even academics – want to push you towards one of those investment goals, to the virtual exclusion of the other one. They think in terms of “either/or.” That’s not healthy. It’s much healthier to think in terms of “and,” adopting both goals rather than just one.

And we’ll end these principles by discovering a simple but obvious truth: that if you have three goals, you ought ideally to have at least three different instruments to achieve them.



In this section of the tour we’ll see that retirees generally have three financial goals. They should identify and accept them all, and use at least three instruments to achieve them.






Where the route takes us

We’ve talked a lot about risk, particularly the impact of uncertainty in investment returns, all the way through. Here we’ll gather together a lot of those thoughts, give them names, and set them out in a way that gives you a framework for the sequence in which you can make risk decisions.


If you wanted to, you could spend a lifetime thinking and reading and learning about risk. You may also be asked by your financial professional to complete a risk profile, to assess various aspects of risk as they relate to you. So it’s surely useful to simplify the subject for you. Dr John Grable is co-author of a brief piece[13] that defines many of the abstruse terms in use (risk tolerance, risk capacity, risk composure, and so on — seven such terms, in all) and I leave it to the enthusiasts among you to read it as an introduction and pursue the subject, if you so desire. But in this stage I’ll simply visit the few essential angles that you’ll need.

Four, in all. Two are reasonably objective. Two are purely psychological.


Start with what’s called needed risk. As its name implies, this is a measure of how much risk you need to take (if indeed you need to take some risk). Why would you need to take any risk at all? The reason is simple. You might need to take some investment risk if you don’t already have enough money to do what you want to do. In other words, when you calculate your personal funded ratio (Stage F 23) it comes to something less than 100%. You have less than 100% of the amount you need to achieve your goal. Taking investment risk is one way to try to get there.

The more risk you take, the better your expected outcome. Of course, along with that is the unwelcome news that risk may also make your position worse than it currently is. (And it’s essential, as we’ve seen in the past and indeed will see again in this stage, to estimate how much worse things could get if the outcome of taking risk is a bad one.) But how much risk you need in order to get your expected outcome to a funded ratio of 100%: that’s what “needed risk” measures. The immediate measure is how large a return you need. That then translates into what proportion of your assets need to be invested to seek growth. That’s pretty objective. Yes, it’s dependent on numerical definitions of your goal and your assets and the length of your time horizon and the return you expect from your growth assets. But all of those things can be quantified, and none of them depend on whether you feel good or bad about them.

The second objective measure is called your risk capacity. This tells you how much risk you can afford to take. How much money could you lose, and still achieve your goals? Or still find the loss acceptable? Again, you can quantify these amounts, without lamenting about how badly you feel if the loss happens.

Those may well be two measures that your financial professional will calculate for you.

And then your emotions take center stage. Remember (Stage I 32), this is really the more important angle. And so now we come to the aspects that involve your feelings.

The first of those (and the third of the four angles I promised) is your risk tolerance. This is not the same as your risk capacity. You may be financially capable of withstanding a loss of (let’s say) $50,000 in the value of your assets, or (let’s say) a drop of $5,000 a year in your annual income after work. But you may not be willing to contemplate losing that amount of money. In that case, your risk tolerance is less than your risk capacity. “I don’t care if I could still survive after losing $50,000 or $5,000, I just don’t want to lose that much, and that’s all there is to it!” You can imagine how two people with the same calculated risk capacity may have very different risk tolerances, in that one may be willing to contemplate losing more money than the other, even if their financial situations and goals are identical. That’s why risk tolerance isn’t an objective measure. It’s very much a subjective measure.

We haven’t finished. There’s one more aspect to look at. And that’s the aspect of comparing what you say you can tolerate with your actual behavior if that loss really materializes. Let’s suppose, for example, that you say you can still live your life (not as happily, of course, but still get by) if you lose a maximum of $25,000 in asset value or its equivalent as a drop in annual income. And then, horror of horrors, it actually happens. Many people (probably most people) will be worse than horrified. They’ll be heartbroken. They will have discovered (Stage H 22) the phrase my friend John Gillies coined, that Risk has a friend called Pain. In assessing their risk tolerance, they considered risk as best they could; they imagined how they’d feel; and they came up with $25,000 as the limit of their tolerance. And now they have actually experienced it, and what hits them is not the abstract concept of losing $25,000, but the real feeling of pain now that it’s gone. For most people, experiencing the pain is far worse than contemplating the theoretical risk, no matter how much they try to imagine (in advance) how they’ll feel.

That’s where the expression risk composure is relevant. Risk composure is revealed when someone’s reaction to the actual pain is pretty much the same as the imagined (in advance) reaction to the possible loss. So it’s something revealed after the event. Obviously, if you have risk composure, you become a much more reliable person in discussing risk. And it’s not a precise measure, of course. It’s a sort of general assessment. It’s along the lines of “X is very/reasonably/not at all composed in his or her reaction to pain.”

The only way to assess your risk composure is to see how you’ve behaved in the past when outcomes were bad. That becomes an input to your risk profile, when your financial professional tries to help you to decide how much future risk you ought to take.


So here’s the sequence.

You and your financial professional do some initial calculations. Your professional tells you that you need some specific amount of risk, otherwise it isn’t reasonable to expect to achieve your goals. Associated with that amount of risk, if things go wrong, you could lose some specific amount of money (which might be measured in terms of assets or in terms of income to live on). If this is within your risk capacity, fine. If it isn’t, you really ought to seriously consider taking less risk, because frankly your goal is unreasonable, given your circumstances.

Either way, you move forward with either the original or a reduced amount of risk to take.

Then you think: never mind my objective risk capacity, how do I think I’d actually feel if that risk really materialized and I suffered the loss? Do I think I could actually live with it?

And if you’ve been through this sort of situation before, you and your financial professional can add: “Remember when we actually went through this? We discovered that the initial feeling of tolerance was (or was not) accurate … ”

And you amend, or go ahead with, your financial plan.



In practice you can estimate, reasonably objectively, how much risk you need to take in pursuit of a goal, and whether you have the financial capacity to withstand the consequences if things turn out badly. But you also need to think about how you’ll feel if things turn out badly, and remind yourself whether, in the past, your feelings were a good predictor of how you actually behaved when bad things happened.






Where the route takes us

What’s the relationship between happiness and money? When we understand that, we can understand what retirees say scares them the most.


We saw, in Stage H 02, why we’re hard-wired to feel happiest in our later life – that’s the U-curve of happiness. It’s because of brain chemistry. It’s not explicitly connected with giving up full-time work. It’s just a (happy) coincidence that those years are naturally our happiest time. And if we take advantage of the opportunities that that transition brings, we can enhance that happiness.

My theme in this stage is to echo the medical profession’s mantra: first, do no harm. In other words, let’s do all we can to leave the post-work happiness level high, and not pull it down. Which raises the obvious question: what is it that is most likely to pull it down? And the answer is: uncertainty that causes anxiety. In particular, anxiety about money, anxiety about outliving our assets.

Surveys in North America pretty consistently highlight this as the biggest worry for retirees and near retirees. For example, The Motley Fool cites (in reverse order, for suspense) the three biggest fears facing would-be retirees[14]: #3 Social Security’s demise; #2 declining health leading to long-term care; and #1 (ta-da!) outliving retirement savings. USA Today headlines[15]: “Big retirement fear: Outliving your savings,” saying that 46% of investors are worried about this (36% of retired investors and 50% of investors who aren’t retired). In the UK, where in April 2015 the law was changed so that retirees were no longer forced to buy a lifetime income annuity with their tax-favored savings, The Telegraph ran an article titled “How to build a pension pot that can outlive you.”[16]

What, then, is the relationship between happiness and money?[17]


It turns out that money and happiness are pretty much the same thing throughout life, when you’re very poor. It’s pretty much a straight line – more money means more happiness – until income reaches subsistence levels. After that, yes, more money does generally mean more happiness, but it’s far from a straight line. Technically, it’s a logarithmic curve. What that means, in plain language, is that it takes a lot more money to buy a little more happiness.

That’s because, once we’re OK with surviving, we start to think about thriving. And we compare ourselves with people we admire, or want to emulate, or envy. Happiness is no longer something that’s absolute, it becomes relative; the measuring stick becomes a comparison with others. That’s why we see a glass half empty rather than a glass half full. And that’s also one of the reasons why poor people can feel happier than wealthier people. So much depends on our expectations and wants, rather than our needs – our lifestyle desires, rather than our survival essentials.


What about certainty? Again, we can look to the brain for this angle.

In general, the brain doesn’t have a location for various feelings. For example, there’s no happiness center. (Too bad, it would be nice if we could trigger the happiness center any time we wanted!) There’s one exception. And that’s an area (actually, two areas, one in each side of our brain) called the amygdala. (That’s the Latin word for “almond,” which is how it’s shaped.) Social scientists call that the “fight-or-flight” center. Whenever we instinctively feel alarmed or anxious, the amygdala is triggered, and in turn it instinctively triggers an emotional reaction that directs us either to fight what we’re facing or to flee from it. Either aggression or panic.

Certainty makes us feel good, precisely because uncertainty triggers the amygdala, and that makes us nervous and unhappy. There’s no time for happiness when the survival instinct is triggered, and that’s what uncertainty does. That’s why we crave certainty. This too is deep in our psyche; this too is what’s hard-wired into our brains.


For example, one of the strongest influences on happiness in mid-life is the status of employment. If you go from employed to unemployed, your happiness level falls a huge amount. Examined by age, it’s still a U-curve. But the U-curve for the unemployed is much below the U-curve for the employed. Why is that? Because all the certainty that the regular paycheck brought has gone. And instinctively, we’re afraid we may have to go into survival mode.

This fear goes a long way back. Today it’s unemployment that triggers it. That reflects the modern world. Go way back, before the modern world, to when agriculture was what we depended on. What was the big fear then? Where’s the rain? In all the systems of gods that human beings imagined in the old days, there was the chief god, and the next most important typically was the rain god, if in fact the chief god wasn’t also the rain god. For the Greeks, Zeus was both the supreme god and the rain god. The same for Jupiter, in Roman mythology. Indra, the Hindu rain god, is the leader of their gods. Even in the modern world, in a financial context, we still call some people rain-makers. When we need something, we’re very anxious until it arrives.

Yes, the certainty of the next check is vital.


In a post-work context, it’s helpful if you already know how much income you’ll need, to support your lifestyle. Then it’s possible to calculate how much you need in assets, to support that spending for a lifetime. See, for example, Stage F 28 on the subject of wealth zones. And that’s also why, in Someday Rich,[18] Noonan and Smith define being rich as having enough money to do whatever you want to do, and define financial security as being in that position all the time. Certainty! Happy? You bet!

Unfortunately, most people aren’t in this fortunate position. Typically they have enough for the essentials of life, but not enough to live their full desired lifestyle. And so they have to make some difficult choices, to balance the desire to make their assets grow with the desire to create certainty with at least some future income. We’ll explore the issues and the choices, starting in Stage F 46, where we’ll identify their three goals: safety of income, growth of assets and protection against the financial effects of living a long life.

Those are the three characteristics of happy income.



The biggest fear retirees have is outliving their income. And it’s a fear that’s virtually hard-wired into us. The safer your income and the higher the likelihood it’ll outlive you (rather than the other way around), the happier you’ll be.






Where the route takes us

Here’s a clarification of the goals of safety and growth.


In Stage I 31 I said that we have two investment goals, safety and growth, that they’re at opposite ends of the spectrum, that they’re both sensible, that we tend to place ourselves somewhere between the two ends, and that they’re psychologically equivalent to a desire to sleep well or to eat well.

All of that may have sounded like common sense to you. I hope it did. But it’s surprising how often ordinary people and professionals are confused in the way they use those ideas. Some professionals act as if eating well is the only thing to focus on, others as if sleeping well is the only thing, and the ordinary person is often ignorant of the consequences of how different the two approaches are: “Hey, these guys are professionals, they must know what they’re doing, and I place myself in their hands.”

That may be OK. But first, let me explain to you some of the principles that follow from my simple assertion in Stage I 31. Then, if you so choose, you can challenge your expert if he or she appears to go against the principles.

I’ll refer to the principles in several stages later in the tour. That’s why I want to gather them here.


Safety essentially means that you don’t want to suffer the financial effects of bad stuff happening to you. I’m talking purely about financial bad stuff, of course.

There are two possible ways to arrange to meet this goal. One is to avoid the bad stuff itself. The other is to arrange for compensation to mitigate the effects of bad stuff happening. Either way, you’re left whole, financially.

Arranging for compensation is insurance. Again, this can be achieved in two ways. One is to pool your risk exposure with others, for example by buying an insurance policy. The other is to self-insure, to make arrangements all by yourself so that your goal of avoiding the bad financial outcome is achieved.

Growth essentially means that you want good financial stuff to occur. Good stuff is never certain; but you do have to give it the opportunity to occur. (There’s the story of the guy who complained to the Lord that his dream of winning the lottery had never been fulfilled. To which the Lord very properly replied, “I keep telling you: first you have to buy a ticket.”)

Also, when you create the conditions for good stuff to occur, you invariably also create the conditions for some form of bad stuff to occur. In other words, you forsake safety and expose yourself to risk. Opportunity is always linked to risk.

Safety always involves a cost. This might be indirect, like forsaking the opportunity for growth. Or it may be direct: the explicit (and certain) cost of adopting a safe position.

Growth always involves a risk exposure.

All of that is why growth and safety are at opposite ends of the risk spectrum.


It’s rare for us to want to be exclusively at one end of the safety-growth spectrum. Not that there’s anything wrong with being at one end, obviously. As long as it’s a thoughtful choice, it’s perfectly OK.

But most of us place ourselves somewhere in between. I’ve already explained, in Stages I 31 and I 32, how to consider the financial and psychological angles before deciding on our stance. The thoughtful conclusion tends to take the form: “As long as I have X, I’m happy to go for growth with the rest of my pot.” Of course, it’s typically a difficult decision, to specify what X is. And X could be a number, or it could be an outcome we specify. There are many varieties of safety, and we think of it differently.

But that’s the principle we tend to use: safety first; then the rest follows. First we survive; then we can seek to thrive.



If we understand safety and growth as being at opposite ends of a spectrum, we can decide where on that spectrum to place ourselves.





Where the route takes us

This stage expands on the notion of philosophies that embrace only the safety or only the growth end of the spectrum along which goals are placed.


Among the things that surprise me is when academics suggest that only one philosophy makes sense, in retirement finance. I’m less surprised financial professionals may split into groups that specialize in either insurance or investment; sometimes that may be the result of qualifications required in a country to practice in either field.

Let me use this stage to summarize for you the debates that sometimes take place about what is an appropriate philosophy for retirement’s financial goals and the related investments. What has materialized from very erudite and thoughtful discussions is that there are essentially two diametrically opposed philosophies. I have seen them described as safety-based and stretch-seeking (think of my “safety” and “growth”), and also as insurance-based and probability-based. You get the idea, I hope.

What is also emerging from the discussions is that preaching either approach to the exclusion of the other is not helpful to those of us who are planning or living our post-work lives. And yet, as far as I can discover, the idea of “some of each” is a relatively recent one, entering the technical literature following a paper by Drs Peng Chen and Moshe Milevsky.[19]

I think that framing it as “either one or the other” is counter-productive. I don’t mean that it’s unreasonable to place yourself at one of the extremes. That’s fine when it results from an informed choice. All I’m saying is that it should surely make sense to allow some people to say “I’ll have some aspects of both, please and thank you.”

I’m going to base my summary on written pieces by Dr Wade Pfau and Jeremy Cooper.[20] Among other virtues, they came up with the brilliant notion of referring to the extremes as “the yin and yang of retirement income philosophies.” This is a reference to the Chinese names for opposites that are also inseparable, and when they come together they complement each other and form a whole that is greater than the sum of the parts. Perfect!


First, the safety-based approach.

People with this approach are particularly fearful of the chance of something going wrong, and therefore prize predictability and guarantees above all else. That gives them peace of mind and the ability to enjoy the life that results, even if that life is less than they might originally have hoped for. That’s OK, they feel, if we make the best of what’s feasible, that’ll be pretty good, and at this stage of life we’re very happy to be able to feel that way. No worries!

Since the biggest fear that retirees have is outliving their money (Stage F 43), predictable income guaranteed to last for life is a fundamental goal. Lifetime income annuities play a large part in the resulting asset portfolio, where they are available. Low-risk fixed-income investments are there for the same reason, probably tailored to match the need for income at predictable times. If a bequest is also an important goal, paying premiums towards an insurance policy is an obvious solution.

Their spending is itself probably prioritized, with a distinction between essentials and “nice to have” things, the former being fully covered by guaranteed income and the latter coming after unforeseen contingencies have been looked after or allowed for via a separate reserve.

All in all, I suspect that most of us subscribe to a lot of this philosophy, and some of us endorse all of it.


Where’s the room, then, for stretch-seeking? What’s the point?

That arises for people who feel: “Hey, if it doesn’t place too much of the future at risk, it would be really great to be able to add to the ‘nice to have’ list, particularly at a time of life we’ve been looking forward to so much. We’ve accumulated our retirement assets, and now is the time to use the freedom it gives us. Surely we shouldn’t say, ‘I don’t care how small the risk is, zero risk is the only amount I’m willing to contemplate.’” (You recognize, of course, that I’m exaggerating for effect, because even safety-first people realize that in life there’s no such thing as zero risk, no matter how much we may strive to achieve it via our lives and our investments.)

OK, then, a crucial aspect is: how much risk is too much, and how likely is it that that amount of risk will result in a bad outcome, and what will I have to cut out if a bad outcome happens? Easy questions to frame, but impossible to answer simply. That’s what retirement planning is all about. So in effect the stretch-seeking people should be into making estimates of probabilities and amounts at risk. That’s the approach that’s logical for them.

Typically, then, their goal is a lifestyle, and it probably isn’t separated into essentials and nice-to-haves. They find a way to estimate how large an annual or monthly or weekly withdrawal from their assets is likely to be sustainable, if investments (which will focus on growth-seeking types) have a reasonable return in the future. In making these estimates, they will (probably through a professional) consider what is “reasonable,” how much disappointment there might be in what actually happens, how those disappointing returns will affect their lives, and how long they are likely to live. All probability-based and risk-conscious. Almost certainly they will err on the side of caution in making their estimates, because they have no recourse if things go bad, and they’ll adjust their lifestyle if circumstances require it; but there’s a world of difference between informed caution and zero risk.

That’s the essence of their philosophy and approach.

And I’m sure that most of us subscribe to many elements of this philosophy, and for some of us it’s the only way to think.


But gosh, isn’t it OK to include elements of both philosophies?

Like something along these lines: “I’d like to lock in some things, yes. But I’m also willing to leave some things uncertain, particularly if that gives me the possibility to do things I’m dreaming of.”

If you say something along those lines, your philosophy and goals will be somewhere in between the two extremes. Your portfolio will reflect elements of both sets of asset choices. How close you are to one extreme or the other is entirely up to you, and where you place yourself on the opportunity-plus-risk spectrum. As you can see, an informed choice is the only way to go, and there’s no “right” answer in the sense that only that answer is sensible and everything else is stupid.

The only thing to avoid is placing yourself is the hands of an expert who reflects just one of the two extremes, someone who goes solely with insurance-type solutions or someone who is purely investment-focused and won’t consider products with guarantees. That way you pre-empt the discussions that lead to an informed choice.



Beware of finding yourself in a situation in which your financial professional only uses insurance instruments or only focuses on investments.






Where the route takes us

This stage looks at the main kinds of financial goals we have for retirement, and why each goal needs its own financial instrument.


Putting it all together, we have identified three potential financial goals in connection with retirement finance. (Obviously I’m ignoring the bequest motive, taxation, and so on.)  Two of them concern investment, one of them concerns longevity. Roughly speaking, they sound like this:

  • The investment goal of safety: arrange my assets so that they give me the amount of money I need, at the time I need it.
  • The investment goal of growth: arrange my assets so that they continue to grow.
  • The longevity goal of not outliving assets: stretch my assets to ensure that they don’t run out while I’m still alive.

These are separate goals. We’ve seen in many stages that investment safety and growth are at opposite ends of the spectrum. It’s obvious that the longevity goal is also separate, because it isn’t in fact an investment goal at all. It’s totally compatible with either growth or safety or both. You can go for growth, you can go for safety, and the investment instruments involved never ask you “How old are you?”


There are many forms of investment instruments available. Some are focused exclusively on safety; some are focused exclusively on growth potential. Think of those as basic or pure instruments. Some combine the two, influencing a mixture of growth and safety; think of them as combination instruments.

In Stage F 44 I invoked one particular philosophy with the words: “As long as I have X, I’m happy to go for growth with the rest of my pot.” Here X could be a number, or it could be an outcome you specify.

In principle, it makes sense to start by considering the basic instruments, the ones at the ends of the spectrum. That makes it easier to match your choice of X, by fitting the proportions of the two sets, also called the allocation across them. And if, later, circumstances change and you want to tweak either X itself or the allocation to the basic safety and growth instruments, you (or your professional) can do so directly.

It may happen that it’s more economical to use a combination instrument, perhaps because that instrument is more readily available or more easily traded. So you include a combination instrument that gives you some safety and some growth. But it may be tough to use it, all by itself, to get either as much safety as you seek, or as much growth. And it may be that the combination instrument can’t move enough towards the safety end or the growth end of the spectrum, if and when you desire a tweak.

For example, a combination instrument may be essentially a mixture of one-third safety and two-thirds growth. By changing the allocation to the combination instrument, you can move towards safety or towards growth; but there’s some level of safety below which you can never go, and some level of growth above which you can never go, as long as that’s the only instrument you use.

So, while the combination instrument may be useful and have other attractive characteristics, it may be desirable to have some element of pure safety and some element of pure growth, the allocations to which can be separately dialed to give you the X that you desire.

That, by the way, is the common sense explanation of Nobel Prize winner Jan Tinbergen’s dictum that the number of instruments you use should be at least equal to the number of goals you have.


Sidebar: I know that most people have never heard of Tinbergen, so let me tell you why he’s a giant.

Nobel Prizes started in 1901. Except, that is, for the Economics Prize, which started in 1969. So, when the first Economics award was made in 1969, every living economist was eligible. When I mention this to American audiences, I compare it to the start of the Baseball Hall of Fame. The first intake, in 1936, included the ultimate baseball giants, the greatest in history: Ty Cobb, Walter Johnson, Christy Mathewson, Babe Ruth, Honus Wagner. Well, in 1969 it wasn’t Samuelson or Kuznets or Hayek or Friedman or other famous names who got the first Economics award. They got their awards later. One of the two people honored in 1969 was Jan Tinbergen.

His work was in macroeconomics. But along the way he enunciated a principle which, like the best of insights, seems like common sense – once you hear it. Someone has to say it, first. Only then is it obvious. Here’s what he said (though it seems impossible to get an exact quote):

Achieving a number of economic targets requires the use of at least an equal number of instruments.


Now, here’s how to apply Tinbergen’s principle to retirees. They have three financial goals, as we’ve seen on numerous occasions. And at the risk of overkill, I’ll explain them again.

One is longevity protection. Quite simply, they don’t want to outlive their money.

Another is growth. For most retirees, their ambitions are less than 100% funded, and they therefore need to take some investment risk (Stage F 28).

Third – ironically, as has been pointed out – they’re very risk-averse. In particular, they don’t want to be suddenly told, “Oops, too bad, last year the markets didn’t perform, this year you’ll have to turn down the spending dial.” No! They realise that growth-seeking is risky, but they want some advance warning of the need to turn down the spending dial.

And Tinbergen reminds us that, if we have three goals, we need (at least) three instruments.

We’ve already discussed accommodating safety and growth by using at least two investment instruments.

The longevity goal isn’t an investment goal. A direct application, then, of Tinbergen’s principle is that you shouldn’t try to solve the longevity problem via an investment instrument. Not that you can’t do it, but it’s very expensive and therefore inefficient to try to do so, as I discuss in T 07, on the trail for enthusiasts.


One final consequence that I want to mention relates to measuring outcomes or performance.

Again, it’s common sense that is often ignored.

Suppose you desire safety and organize a portion of your retirement pot to give you safety. For example, you get a portfolio of index-linked instruments, or perhaps bank instruments, because X, the definition of safety, is for you to have certain amounts of cash flow on certain dates.

The measure of success is whether or not this actually achieves the safety you specified. It’s almost a “yes or no” question. If it achieves X for you, it worked. If not, it didn’t, even though it may have come close.

If there are many possible arrangements, all of which achieve X for you, then it makes sense to select the one with the smallest cost. It may even be that some arrangements give you a positive investment return. Great! But that’s a side effect, not your main goal.

What doesn’t make sense is to measure the return that your safety-oriented arrangement gives you, and integrate it into the return that you achieve with your growth-seeking portfolio, and say “That’s the total return from my pension pot,” and compare it with the total return from someone else’s pension pot.

That’s because you’ve really divided your pot into two parts, each with a different goal (safety and growth). You can sensibly measure whether the safety part achieved X, and at what cost, and what the return is on the growth part. But it doesn’t make sense to add in the growth return when you measure the success of the safety part, and it doesn’t make sense to reduce the growth return by the cost of the safety measures, when you measure the success of the growth part.

It’s amazing how often this simple piece of common sense is ignored in practice, not just by financial professionals but sometimes even by academics, when they say that dividing your overall pot into different buckets doesn’t affect the overall return. It’s true mathematically, but the overall return is irrelevant when you have different goals you’re trying to achieve with different portions of your pot.



Typically you’ll have three goals: investment safety, investment growth and some form of protection against the financial impact of a long life. This suggests the use of three different instruments, one for each goal.






Where the route takes us

If it’s possible, it helps a lot to have some money set aside for emergencies. In fact, as we’ll see in this stage, a bit of cash also helps enormously to smooth out the impact of investment fluctuations.


You may remember from Stage F 01 that financial professionals often recommend that you hold a few months’ worth of spare cash in case of emergencies. That way if something unexpected happens you can cope with it right away and don’t have to change your other plans.

In this stage I’m going to expand on that idea, in the particular context of being able to create a barrier between investment value fluctuations and being forced to make your spending plans fluctuate in response. In Stage F 43 we talked about the way in which certainty creates happiness. Well, to the extent you can insulate your lifestyle from the inevitable ups and downs in the value of your pension pot, that will create great happiness.


In theory, what you do is to periodically (weekly, monthly, yearly, whatever) cash out a sufficient amount from your pension pot to cover your spending until the next withdrawal (or “drawdown,” as it’s often called). But fluctuations in your pot’s value cause a problem. Here’s why.

If your rule is to cash out a fixed proportion each time, then fluctuations in the pot’s value will cause your drawdowns to fluctuate. And that means your spending will need to fluctuate in the same way. Bad news! “Last month the market really dropped. This month you need to really drop your spending.” Not made for happiness!

If instead your rule is to cash out a fixed spending amount each time, then you are subject to what the techies call “sequence of returns risk.” In a nutshell, here’s how it happens. Suppose you get a very low return in the first year, followed by a very high return in the second year. On average, looking solely at your returns, you’ll have achieved an average return over the two years. Satisfactory, you may think at first. But looking at your returns turns out not to be useful. That’s because, during the first year’s low return, you have to cash out a bigger-than-expected proportion of your pot in order to generate your spending. That leaves a smaller amount in the pot than expected. And though in the next year we’re assuming a high return, there’s less money for it to work on, and so you don’t make up the shortfall. In fact, if there are low returns for a few years at the start, your pot may shrink very rapidly, and you may never recover. Again, not a formula for happiness.

So the ability to insulate yourself from the effects of those fluctuations becomes particularly important in the drawdown phase of life. And that’s where the notion of a liquidity reservoir comes in.


In investment terms, liquidity refers to assets that are already in cash, or can be converted to cash quickly and at virtually no cost. For example, a bank checking account is liquid. A one-year bank term deposit is slightly less so, because typically it involves a small penalty to convert it to cash.

Publicly traded equity investments are technically thought of as liquid, because they can be quickly converted to cash with a very small transaction cost. But for retirees they have a very negative feature, which is that equity value fluctuations mean that the amount available to you fluctuates too. If you own $10,000 worth of equities that you are considering cashing in, and a few months later they have fallen in value to $9,000, it’s not much consolation to be told that you can now get that $9,000 converted to cash quickly. You feel as though the cost of cashing out is $1,000.

It’s even worse if you needed that $10,000 for a particular set of expenditures, because now you feel the panic of having to rearrange your plans suddenly. And that’s why retirees typically don’t go directly from assets to spending. They create a liquidity reservoir in between.


Here’s what I mean.

They create and maintain a pool, a reservoir, of liquid assets: cash or a bank checking account. This holds more than they plan to spend in the near future. Periodically they draw down some of their pension pot and put the proceeds in the reservoir. And then they take money out of the reservoir for spending.

Why do they do this? Because they don’t want asset value volatility to have an immediate impact on spending. Forced volatility in their spending is something they fear. And so the reservoir gives them a sort of cushion, smoothing out the spending. Even if the drawdown is somewhat volatile, spending itself doesn’t have to be volatile. Spending volatility should be much less than drawdown volatility.

In effect, by creating a reservoir they have given themselves a bit of insurance against being forced to cash out at a bad time.

It’s even better, in the sense of enabling you to sleep better at night, free from worry, if the drawdown amount is itself less volatile than the value of your pension pot. In other words, whatever the fluctuation in asset values, the drawdown shouldn’t be forced to be equally volatile.


Let’s put this together and understand it well, because it’s a fundamental driving force, as far as the psychology of money is concerned.

It’s acceptable for the pension pot to be volatile, provided we can find a way to insulate the drawdown from at least some of that volatility. And then we can further insulate the actual spending from the drawdown’s volatility, via the creation of a liquidity reservoir.

So …

  • The pension pot’s value can be volatile;
  • The volatility of the drawdown can be made less volatile;
  • And the volatility of spending can be made still less volatile.

Or, in terms of smoothness:

  • Spending is smoother than drawdowns;
  • And drawdowns are smoother than pension pot asset values.


Don’t misunderstand me. Ultimately, if there are low returns for a prolonged period, there’s no way to insulate yourself from their impact on your lifestyle. What the liquidity reservoir achieves is to give your investments time to recover from the typical short-term fluctuations that investments go through. But they do need a recovery; if none arrives, ultimately we all have to face the music. Another way of saying this is that the reservoir gives us protection against shallow risk, but not against deep risk (in the language of Stage T 01 on the trail for enthusiasts).

In passing, let me say that it strikes me as unhelpful, if not downright bizarre, that the current state of the art with many financial professionals is to try to assess a retiree’s tolerance for asset volatility when, as we’ve just seen, asset volatility is hardly relevant, given the ability to reduce its impact on spending. It’s spending volatility that’s relevant, but risk profile questionnaires don’t typically get into that angle.

One final observation about the liquidity reservoir. Typically its purpose goes beyond reducing spending volatility. The money in the reservoir can be used for any purpose. In particular, it also serves as that emergency fund that we started this stage with. So any form of emergency spending typically comes out of the reservoir. And, since retirees are typically wealthier than their children, or at least have a bigger emergency reservoir, it sometimes also gets used for children and grandchildren. This emergency purpose is another reason why a reservoir is such a good idea.



A pool of cash can fulfill many purposes, from being a source of emergency funds to being a way to insulate your lifestyle spending plans to some extent from the inevitable fluctuations in the value of your pension pot.





Where the route takes us

There are things that we should be aware of, that could upset our post-work lives from evolving as we hope. Here’s what we can consider, in case one of them appears in our path.


I came across this Irish blessing on a greeting card: “As you slide down the banister of life, may the splinters never point the wrong way.” And it occurred to me that, at least as far as the post-work years are concerned, there are three splinters to be feared: outliving our assets; the expense of becoming very sick; and dementia, or some other form of cognitive impairment, meaning we’ve outlived our ability to think clearly.


We’ll spend a number of stages on this tour discussing how not to outlive our pension pot. Indeed, that’s the main focus of this tour topic. So I’ll say no more about it here.


As far as the expense of becoming very sick is concerned, it’s possible to find numbers for different countries. I haven’t cited any here. That’s because the numbers are just averages; they’re far from conclusive evidence of needs. Averages disguise the fact that some retirees never reach the stage of having very large medical expenses, while others do – and the average covers both groups, and therefore isn’t indicative of the cost for those who face those expenses.

Also, different countries have very different healthcare systems. Some cover most expenses, some cover some expenses, some cover none. Because of these significant differences, as I mentioned in P6 in the Prologue, I have nothing generic to say except that it’s probably worthwhile to find out (from a financial professional if necessary) the answers to a number of questions. It may still be difficult to decide which approach suits you best, but at least it’ll be an informed decision, whatever you choose.


In Stage H 73 we discussed talking to your adult children about this phase of life. It’s best to do it, of course, before cognitive decline sets in.

My insights into this aspect come partly from reading and partly from life.

The reading started with a paper co-authored by one of my favorite economists, Harvard’s Dr David Laibson, called “The age of reason.”[21] Cut a long story short. The authors investigated how the way average people deal with simple financial tasks, like home equity loans and credit cards, varies with their age. They found that experience gained with ageing helps people to make more sensible decisions – but only up to a point. Beyond that point, a gradual loss of cognitive capability starts to outweigh experience. What’s the age at which that happens? Looking at the evidence, they said: roughly age 53. (Except that, as these are economists using regression techniques, they couldn’t resist quantifying it as 53.3!)

You’re doing your own calculations? For me that was many, many years ago. I remember thinking, when I first read the paper, that when I was 53 I was on a three-year ex-pat assignment in London at the time, so none of my North American colleagues knew me at my peak! (Just kidding, of course. They probably thought I was already long past my peak.)

When I recounted this episode to the clients of my firm, I told them that I was sure that the peak age was likely to be higher for all present, because their experience and wisdom come in a more complex field of finance, where they keep learning for much longer. That’s why I thought their learning peak would come later, and so my guess was that their performance decline would start later. Regardless of that, I told them, we will decline, if we haven’t already started.


In my family, my dad showed signs of losing it as he approached his 90s. My mother had Alzheimer’s for many years before she passed away. My wife’s dad died of Alzheimer’s. And both of us come from long-lived families. I think there’s more than a fair chance that one or both of us will lose cognitive capability some time before our estate events.

That’s what prompted us to write the “Goals and Plans” document mentioned in Stage H 73.

It was partly so that they’ll know about things in much more detail than in Dad’s Decumulation Talk, and partly an appeal to them, that as we update it periodically, as soon as they see incipient signs of my losing it in particular, they’ll feel confident enough to say, “You know, Mom, Dad doesn’t sound right; he’s always said … etc.”

I want them to be confident that they know the plans well enough to quote them at me, when the time comes, and carry them out. I am totally confident that they’ll recognize when the time comes, because they already warn me about it constantly, although up to now I think it’s in jest. I’m the slow one in the family, the figure of fun there, so I expect that. But the Goals and Plans document is serious.



Be aware of three things that could derail your plans: outliving your assets; becoming very sick; and dementia. The first one is dealt with throughout the tour; the second one has a cost that varies with a country’s healthcare systems; the third one suggests that you should make decisions early in your retirement and inform your adult children about them.





Where the route takes us

This tale by a master story-teller is scary. It reminds us that we should think about those potential disruptive things before they’re upon us. This stage also explains why we prefer to postpone tough decisions.


We don’t want to outlive our pension pot. That requires decisions from us, some of them hard decisions. Sometimes we’re willing to make them; sometimes we tell ourselves that those decisions can wait for tomorrow. Let me entertain you in this stage with a story from a master story-teller, and then draw an important lesson from it. My connection with the story goes back a long way.

When you hold a hammer, as the saying goes, everything you see begins to look like a nail. That’s how I felt when I first became an actuarial student; everything I encountered took on an actuarial tinge. That’s when I first read “The Lotus Eater,” a short story by Somerset Maugham.[22] At the time I considered it my very first actuarial story – you’ll see why in a moment. Today I recall it for its poignant ending – one I want to avoid personally. Enough commentary; let me relate the story, quickly. It starts a few years before the First World War.


Maugham visits a friend in Capri, and through the friend he meets Thomas Wilson, a perfectly ordinary person conducting what Maugham considers a bold experiment. Wilson tells of how he came to Capri for a summer holiday, and fell in love with everything – the place, the views, the sunsets, the people – and wondered why he should go back to life in London as a bank manager. But he did go back.

Yet he couldn’t get Capri out of his mind. He was an only child, and his wife and daughter had both died tragically. He was 34 years old. His lump sum gratuity from the bank after 17 years of working there (not a life pension: that required 30 years of service), combined with his savings and the proceeds from selling his house, weren’t enough to buy him a life annuity. But he could buy a 25-year annuity to provide the modest income he would need to live happily in Capri.

So he returned to Capri, ready for his 25 years of happiness. His philosophy was: “I wanted to live the perfect life while I still had the energy and the spirit to make the most of it.” The annuity would take him to age 60. “No man can be certain of living longer than that, a lot of men die in their fifties, and by the time a man’s sixty he’s had the best of life.” (My observation: How things have changed since those days! Thank goodness!)

Had Wilson ever regretted his decision? “Never. I’ve had my money’s worth already.” (This was 15 years into the planned 25, when Maugham met him.)  “And I’ve got ten years more. Don’t you think after twenty-five years of perfect happiness one ought to be satisfied to call it a day?”

What would Wilson do after the 25 years were over? Maugham says cautiously: “He did not say in so many words what he would do then, but his intention was clear.” Maugham says that a shiver ran down his spine. “The odd thing about him was that he was so immensely commonplace. I should never have given him a second thought but for what I knew, that on a certain day, ten years from then, unless a chance illness cut the threads before, he must deliberately take leave of the world he loved so well.”

Move forward, not ten years, but thirteen. The First World War has taken place, life has changed, Maugham has forgotten about Wilson. Then Maugham returns to Capri. His old friend is still there – now living in a different house. It’s Wilson’s house. And so of course Maugham wants to know what has happened to Wilson.

No, he didn’t commit suicide. “It had never occurred to him that after twenty-five years of complete happiness, his character would gradually lose its strength.” Wilson had had no need to exercise discipline, and found that he had lost the ability to do so. He put off the contemplated deed from day to day. His landlord threw him out. He fell ill, had an accident (possibly a weak attempt to end it all, Maugham speculates) and slowly lost his mind. He found a ramshackle bed and survived on scraps of charity. It was six years later that he finally died.


Well, it’s obvious why I considered this a story with an actuarial basis. And that’s why I remembered it, years later when I started thinking about longevity from a personal perspective. But it also triggered a line of thought, which needed investigation. How would I behave, if I made a commitment to be carried out many years later (even if the commitment wasn’t quite as final as literally pulling a trigger!)? Would I be like Thomas Wilson? Or is that a trait everybody shares? Sure enough, there has been research on the matter. Not specifically about pulling a trigger, but about how much easier it is to make a future commitment than to actually keep it.

Let me take you quickly through some of the research. Today we know that Maugham didn’t have the explanation. Today we know that we all find it easier to make commitments that are to be carried out in the future than to make commitments that must be carried out today.

One study is called “Estimating discount functions with consumption choices over the lifecycle.”[23] What a wonderfully academic title! But the idea is simple, and we can relate it to Thomas Wilson. Wilson made the so-called “consumption choice” to enjoy life today in preference to a deferred enjoyment of life in 25 years’ time. Of course, his was an extreme choice, because he needed to reduce his deferred enjoyment to precisely zero. All of us prefer immediate enjoyment to future enjoyment. In fact we demand compensation for deferring current consumption, in the form of some enhancement of our future ability to consume. Think of the enhancement as a rate of interest. We won’t postpone enjoyment unless we earn interest that enables us to consume even more in the future. (I use the words “consumption” and “enjoyment” interchangeably.)

One obvious question is: what is this rate of interest? Well, we have lots of observations in the investment field about how large a risk-free return society seeks, and how the expected return varies with risk. But another question is: do we have consistent time-preferences? In other words, if we require x% to postpone current consumption by a year today, would we require the same x% to postpone 25th year consumption to year 26?

And the answer is: no. We are grossly inconsistent. We hugely favor the present. We hate putting off consumption until next year. But we think it’ll be easy to put off consumption from year 25 to year 26. Well, that’s exactly what Thomas Wilson thought! He loved immediate enjoyment, and made an apparently easy decision to cut short – literally cut short – future enjoyment in 25 years’ time. When the 25 years passed, and the future became the present, he found he had grossly underestimated the psychological cost of forgoing future enjoyment.

Behavioral economists call this “time-inconsistent preferences.” Maugham thought of it as a decay of self-discipline. It turns out Maugham was wrong in thinking that Wilson’s character had decayed and lost its strength because for 25 years he hadn’t needed to exercise self-discipline. It wasn’t Wilson. It was all of us. But also, it wasn’t a character deficiency, rectifiable by the constant exercise of normal self-discipline. It was something that we all suffer from, a common tendency to think sacrifices will be easier to make in the future than today. (We saw this in Stages F 03 and F 04, in the context of current versus deferred consumption, and the fact that we’re hard-wired to prefer the present to the future.) Of course Maugham was a master story-teller rather than a behavioral economist, and I have no doubt he gave more pleasure to millions by writing his story than the behavioral economists do in saying that we’re all prey to Wilson’s shortcoming. But we should all be aware that we too easily make commitments about the future which, when the time comes, will prove to be much more difficult to keep than we imagine today.


As an aside, how do economists measure these tendencies? The authors of the study I mentioned begin by observing that Americans simultaneously act patiently and impatiently. Households accumulate substantial illiquid retirement wealth at real interest rates of about 5% (the data relate to the late 1990s), yet the very same households also borrow regularly on credit cards at real interest rates of about 12%. Is there a single lifetime-constant interest rate that is consistent both with the data and with a life-cycle “buffer stock” spending and investment model? In a word, no. Then the authors test a model in which households have both a short-run and a long-run interest rate, the short-run rate gradually giving way to the long-run rate as the distance of the decision horizon expands. Now they find they can explain the data, if the short-run interest rate is about 40% per annum and the long-run rate about 4%.

In other words, when they look forward, let’s say, 40 years, Americans will save rather than consume if they can earn 4% for postponing consumption by a year. But to settle for a reward tomorrow rather than today, they are much more impatient and demand compensation at an annualized interest rate of 40%.

(And by the way, it’s not just Americans who behave this way. We all do. It’s just that American data got studied.)

That’s an examination of time-preferences for treats. How about time-preferences for chores? Suppose we have something unpleasant to do today but can postpone it by a day if we can pay for the postponement. Will we be willing to make the same payment to put off the chore from day 14 to day 15? No, we wouldn’t; we wouldn’t pay nearly as much to buy a day’s respite in two weeks’ time. So the same principle applies to chores as to treats. We substantially favor gratification today over gratification later. Yet when that “later” day arrives, it becomes “today” and we find we’ve substantially underpriced our future preference.


Thomas Schelling shared the 2005 Nobel Prize for Economics for his work on related aspects. He is famous for his work on conflicts between nations, particularly where nuclear weapons are involved. He analyzes pre-commitment, in which a nation makes a commitment that reduces or even eliminates its future flexibility, because it realizes that it is much easier to make a future commitment today than to trigger it when the need arises in the future. An example is an army burning its bridges to make retreat impossible. Or a country passing a law that binds it to defend another country if the second country is attacked. This reduces future flexibility, but the existence of the law also reduces the threat to the second country.

Schelling’s famous work is actually based on earlier work in which he examined individuals’ behavior. He described what he called an “intimate contest for self-control,” in which people act as if two different selves take turns to run the show. We all seem to suffer from split personalities. One part of us desperately wants to lose weight or stop smoking or rise early to work. Another part of us wants dessert or a cigarette or sleep. The noble self tries to make long-term plans, but the self-indulgent one tries to take over short-term planning.

Of course these behavioral economists are interested in solutions, but before we get to the solutions, let’s remind ourselves that they’re describing Maugham’s subject Thomas Wilson. In fact they’re describing the Thomas Wilson in all of us. And so my recollection of Maugham’s story started a line of thought that has been well worth pursuing.



If you push crucial decisions into the future, you may well find it very difficult to face them when the time comes.






This is Walk 21 in Life Two.






Where the route takes us

Let’s examine the mechanics of generating income via an immediate annuity, and look at its pros and cons.


This is, in principle, the simplest and most certain way to solve the typical retiree’s most worrisome problem, of outliving the available assets. The mechanics are straightforward, in countries in which immediate lifetime income annuities are available. Go to a financial professional and get quotations from several insurance companies, and select one. The resulting contract will guarantee an income for life. It may have additional features, such as some minimum period of payment regardless of survival; it may be based on more than one life; and so on. And of course this guarantee is subject to the insurance company’s survival and reinsurance arrangements and matters of that nature. But in practice it tends to be the most certain form of lifetime income available.

Yet, unless it is the only form of decumulation permitted by law (as it was, for example, in the UK until 2015, for tax-deferred savings), it is not a popular voluntary approach in any country – with the exception of Chile, where two-thirds of all retirees select it. Dr Moshe Milevsky[24] believes the reasons behind the Chilean phenomenon are that the retirement advisers are independent and commission-neutral; retirees must be shown illustrations that demonstrate that, without it, a volatile and possibly declining income stream may otherwise result; all life annuities are indexed to inflation; this is the basic Pillar 1 pension (so most Chileans have no other retirement income); and the Chilean government explicitly offers some backing if insurance companies become insolvent.

The advantages of a lifetime income annuity are simply that the income lasts for life, regardless of how long that may be, and that (until longevity pools are available – see Stage T 05) there is unlikely to be a cheaper way to guarantee any level of income for life.

Why then do most people shun it? (So much so that even the name “annuity” has become a negative word and other names, emphasizing the lifetime income aspect, are being tried.) Let me suggest some reasons.

One is that people instinctively compare the lump sum with the annual income. Dr Meir Statman eloquently recounts the regret of an annuity-purchasing friend, quoting him as saying, “Yesterday I was a millionaire. Today I’m living on $79,700 a year”[25] – and that was in the good old days of high interest rates.

A second reason is loss of control. The lump sum is gone and the deal is irreversible. Your portfolio flexibility has gone with it.

A third reason is that, in effect, an annuity is effectively a fixed income investment: pure safety. The ability to take some growth risk vanishes. (But there have been attempts to design new contracts that permit a growth feature, such as Guaranteed Lifetime Withdrawal Benefits or GLWB contracts.)

And a fourth reason is that it may feel like a gamble: early death causes a huge loss. (This is why we will see, in Stage T 09, that a deferred annuity may be a more palatable option.)

So, as in many instances in life, and particularly in finance, there are trade-offs to be considered, and the cheapest and most certain way of creating income for life will appeal to some and not to others.



Among the characteristics of an immediate annuity are that it is typically the cheapest way to guarantee an income for life, but it is inflexible and may feel like a gamble.





Where the route takes us

Here’s an approach that’s used in the US to calculate the minimum drawdown required for tax purposes each year. Regardless of whether or not you use this approach (particularly if you don’t live in the US), it’s instructive to consider its pros and cons.


This is a straightforward concept.

Suppose you have $200,000 in your pension pot, and your future longevity is 16.2 years. Divide the $200,000 by 16.2, and you get $12,346 (approximately). That’s how much you draw down in the coming year.

The idea is simple.

  • If you live exactly as long as your future expectancy, and earn no investment return, the $200,000 will last exactly the right length of time. Problem solved.
  • In fact, you can invest the money any way you like, with whatever combination of safety and growth you feel comfortable with. Since your drawdown left some balance ($187,654, if you withdrew the amount on the first day of the year), there will be some pension pot (the balance adjusted by the investment return) remaining at the end of the year, if you are still alive. Let’s say the new balance is $190,000.
  • At the start of the next year you are one year older. You still have a future life expectancy, though it’s a now little bit shorter than 16.2 years. Let say it’s 15.5 years. Divide the $190,000 by 15.5, and withdraw $12,258.
  • And so on.

There is always some balance in the pension pot. It never declines to zero. There is always some future life expectancy as long as you’re alive. And so the process continues.

In fact this is essentially the process used by the US government to define the minimum you must withdraw from your tax-deferred savings once you reach age 70½. They specify the life expectancy table you must use. (They insist on some withdrawal, otherwise they never get to tax the pension pot; so they define the minimum that you must withdraw, and it becomes taxable income.)

The advantages of this approach are that it guarantees some income for life, and it permits whatever approach to asset allocation you are comfortable with.

The main disadvantage is that the amount of income is both variable and uncertain, because there is no certainty to the future investment return that the pension pot will earn.

If the returns in the early years are high, it is likely that the annual drawdown will increase, rather than the decrease shown in my numerical example. If I had shown a pension pot of $195,000 at the end of the first year the next year’s drawdown would have been $12,580, higher than the first year’s.

It’s easy to calculate what rate of return is required to restore the end-of-year pension pot to the amount at the start of the year. In my example, since $12,346 was withdrawn, a return of $12,346 will restore the initial $200,000. On the balance of $187,654, a return of $12,346 represents about 6.5%. In later years, though, as future life expectancy decreases, the proportion of the pension pot withdrawn becomes large, and therefore it requires a much larger return to preserve the pot’s value. This tends to result in drawdowns that become much smaller, later in life.

That’s a second disadvantage of this approach.

For some retirees, the prospect of declining drawdowns late in life may not feel too troublesome (at any rate, until that late stage in life is reached!). Nevertheless, there are some who would prefer a slower decline, and there is a method designed to achieve this.

It consists of adding some number (like 6 years) to the future expectancy, and then applying exactly the approach described here.

So, in the first year, add 6 to 16.2, and that gives you 22.2. Divide the $200,000 by 22.3 and withdraw $9,009. In the second year, add 6 to 15.5, and that gives you 21.5. Divide the $190,000 by 21.5 and withdraw $8,837. And so on.

Of course the drawdowns are smaller, but the decline later is not nearly as rapid.

Remember, by the way, that when I refer to your pension pot, I’m referring to all the assets you intend to use in retirement, not just the tax-deferred assets. You can use the slower drawdown “life expectancy plus 6” formula for all your assets. But if, in the US, you only have tax-deferred assets, you will be forced to draw down the government’s formula amount, in which case there isn’t a way to avoid the decline in the later years.

Again, some advantages and some disadvantages to this approach, whether or not you add something to the future expectancy.



The longevity drawdown guarantees some income for life, and permits flexibility in asset allocation. But the drawdown is uncertain and variable, and tends to decline later in life.





Where the route takes us

Here we buy, not an immediate annuity, but a deferred annuity, and we have to make the rest of our money last until the contract’s income kicks in. Again, let’s consider the pros and cons of this approach.


You’ll see in Stage T 09 why a deferred annuity (also called longevity insurance) is usually preferable to an immediate annuity. A big problem is that in most countries such a product simply isn’t available from insurance companies. But if it is, or if a longevity pool offers it, then this approach becomes feasible.

The concept, as always, is simple. You pay a lump sum to purchase longevity insurance, which is an income for the balance of your life (or perhaps also for the balance of your partner’s life), commencing on some future date (the deferred date) if you are still alive then. For example: you’re 65 and pay a lump sum that guarantees that, if you reach age 85, from then onward you’ll get an income for as long as you live.

All sorts of variations are feasible. One is that there might be some form of death benefit if you die before the deferred date. But in that case you’re not pooling much of your longevity risk, so the terms of purchase won’t be nearly as favorable as if there’s no benefit on death before the deferred date. Another variation might be that you choose not to buy the entire longevity insurance on one date (age 65 in my example above), but choose instead to spread the purchase over many years, perhaps buying pieces of it every year from age 55 onward. In that way your terms of purchase will change to reflect your current age every year, but (perhaps more importantly) will also reflect the interest rate regime that exists each year, so you get to spread your exposure to interest rates over a long period rather than have it all depend on interest rates in force on one date.

Anyway, regardless of which variation you choose, you have longevity insurance that kicks in from the deferred date. The balance of your pension pot then only has to last until that deferred date. The financial impact of your longevity uncertainty has gone, and you have the simpler task of drawing down some regular amount from the pot until the deferred date.

A complication that arises in practice is that the longevity insurance income is fixed at the time of purchase, whereas your drawdowns from the balance of the pension pot will inevitably be somewhat variable. So there’s likely to be a discontinuity between the last drawdown and the first longevity insurance payment. I don’t know of any way to avoid that, because even if you make your best estimate to equate the purchased longevity insurance payments with your probable sustainable drawdown, an estimate is necessarily only an estimate, and life is not known to follow anyone’s estimate exactly.

That still leaves the question of how to calculate the drawdown level that is probably sustainable for the fixed period until the deferred date. That problem is solved in Stage F 65. True, Stage F 65 in its purest form deals with a very long period because the aim is to self-insure longevity. But that doesn’t matter at all. It deals with a fixed period, and that’s all you need in order to apply the principle explained in that stage.

The main benefit of this approach is that you pay relatively little for longevity protection, while preserving the control, the flexibility and the liquidity of maintaining the rest of your pension pot for drawdowns.

A disadvantage relative to buying an immediate annuity is that you implicitly pay more for your longevity protection, because the amount you contribute to the insurance company’s longevity pool is equal to the amount of the lump sum premium, which is very much smaller for longevity insurance than for an immediate annuity.

Also, as with any approach where you maintain control of your pension pot, your drawdown will be variable and depends on the extent to which you seek growth for your pot’s assets, since growth is inevitably uncertain and variable.



With the drawdown-plus-longevity insurance approach, you pay relatively little for longevity protection, while preserving control, flexibility and liquidity in the rest of your pension pot. But implicitly you pay more for longevity protection than with an immediate annuity, and your drawdown until the deferred date will be variable.





Where the route takes us

Here we’re self-insuring our longevity, by aiming to make our assets last until a ripe old age. Like the other approaches, this one too has pros and cons.


In this approach you’re self-insuring your longevity risk. By that I mean that you aren’t going into any pooled arrangement, whether a longevity pool or some form of immediate or deferred annuity contract. So the biggest financial uncertainty you face (see Stage T 04) comes from uncertainty about how long you’ll live. And if, like most people, your greatest financial fear in retirement is outliving your assets, you’ll make arrangements to draw down an amount each month or year that is likely to be sustainable until some advanced age, much beyond the average future life expectancy for people of your age.

How much longer? That’s up to you. To help you pick a number, the longevity table (see Stage L 11) shows, for any age or combination of ages for partners, not only the average future life expectancy, but also the future number of years that only 25% of people like you are likely to live to, and the 10% number. In other words, if you choose the 10% number and you’re in average health, there’s only a 10% chance that you’ll outlive your assets. (And if you start to approach that point, there are ways to extend the horizon further, such as the “expectancy plus 6 years” approach described in Stage F 63. Or you can buy an immediate annuity at an advanced age – but that’s beyond the scope of this book.)

OK, now you’ve selected a horizon. (Or, if you’ve adopted the “drawdown plus longevity insurance” approach of Stage F 64, you already have a natural horizon, going up to the deferred date.)

All that’s left is to calculate how large a monthly or annual drawdown is likely to be sustainable until the horizon is reached.

This requires (as it did in Stage F 64) that you specify your risk tolerance (with all the attendant problems that typical risk tolerance questionnaires create). The case study in the next stage (F 71) is how one couple reacted when considering whether their equity exposure should increase, decrease or stay level after retirement. The issue is discussed in some depth in Stage T 10.

This approach has the benefit of preserving control, flexibility and liquidity in your pension pot. The main disadvantage is that it’s the most expensive way to deal with longevity uncertainty, as explained in Stage T 14. It’s like arranging to have sufficient assets to replace your home and its contents in the event of a fire, rather than paying an insurance premium. And, as we’ve seen in earlier stages, the drawdown is variable.



The drawdown-until-an-advanced-age approach preserves control, flexibility and liquidity in your pension pot. But it’s the most expensive way to deal with longevity uncertainty, and the drawdown is variable.




Where the route takes us

The experts make assumptions about our attitude to financial risk in our retirement years. Here’s a case study that suggests that psychology plays a considerable role, regardless of finances.


In the previous stage I mentioned a case study in deciding whether an increasing, level or decreasing equity exposure should apply after work.

Let’s start with some background on the couple involved.

They think of themselves as being in the Lifestyle Zone (see Stage F 28). Their pension pot isn’t large enough to buy an immediate inflation-linked annuity that will provide for their desired lifestyle for as long as they both shall live (as the saying goes). Or maybe it is. If they include their home, then yes it is. But they want to leave that to their children, and meanwhile it gives them a cushion. It would be hugely disruptive psychologically if they had to sell it. So they ignore it in their assessment, knowing it’s their Plan B; meanwhile they’re focused on their liquid assets only.

They understand clearly that they have three different goals: safety, growth and longevity insurance. There are no longevity insurance policies available in their country, so to deal with it they have to take the expensive route of providing for possible survival to old age. In their case, they have ascertained that, for couples of their age, there’s a 10% chance that at least one will still be alive after 30 years. If they approach that time, they’ll make adjustments; meanwhile, that’s the period over which they’re planning their drawdowns.

To provide for that, and in the hope of increasing their sustainable drawdown, they know they need to take some investment risk, and therefore there are no guarantees.

Behavioral economists sometimes jokingly refer to two kinds of people: Econs (the non-existent theoretical folk who are always totally rational about their behavior) and Humans (the rest of us, for whom emotion invariably plays a part). The couple in our case study are trying to anticipate (as Econs) what their psychological (Human) reactions will be. There’s no guarantee that they’ll actually react as they hope to, when they discover the fact that risk (as anticipated by Econs) has a friend called pain (as experienced by Humans). (That’s one of the reasons I included the topic of happiness and psychology early in this tour, to help couples such as them.)

Before they retired, they were advised by experts who assumed that their risk tolerance would be based on asset volatility and that it would remain constant over time, in absolute terms. The experts therefore recommended an increasing equity exposure over time. The couple’s actual experience of retirement has caused them to reject those notions.

It’s now clear that what affects them is not asset volatility but spending volatility. Why is that?

It’s because, like most retirees, they create and maintain a pool, a reservoir, of liquid assets, like cash or a bank current account (as discussed in Stage F 51). This holds more than they need to spend in the near future. Periodically they draw down some of their pension pot and put the proceeds in the reservoir. And then they take money out of the reservoir for spending.

In this way, asset volatility doesn’t have an immediate impact on spending. Forced volatility in their spending is something they fear. Asset volatility causes fluctuations in the drawdown amounts; but the reservoir gives them a cushion against reducing spending. Even if the drawdown is somewhat volatile, spending itself doesn’t have to be nearly so volatile.

And therefore there’s no need for very high risk aversion with its consequent very low equity exposure at the start of their retirement.

There’s another reason why they don’t want an increasing equity exposure over time.

They think that their psychological attitude towards risk will change over time, as their desired lifestyle settles down, from the go-go early years to the slow-go settled-down sequel that typifies many retirements. They therefore want as much safety as possible in their investments by the time the older one’s age reaches – oh, pick a number – let’s say 80. It doesn’t matter if, financially, they can afford to take a lot more risk. In addition, they don’t want their adult children to worry about them or their finances, and the children will be easier in their minds if they know that their ageing parents have looked after themselves. That suggests a target of 100% in safety-oriented investments, kicking in after the couple’s “autumn crescendo” is over, as Dr Laura Carstensen beautifully describes the early stage of life after work.

Now let’s think about their other goal: growth. Where will the desired growth come from? From a high initial equity exposure. But that’s dangerous! If they have no significant ceiling on their equity exposure in the early retirement years, then they are particularly exposed to “sequence of returns risk,” meaning that a few years of bad equity returns in the early part of retirement could condemn them to permanent regret and a permanently much-lower-than-desired lifestyle forever after.

So to enable them to focus on growth, they also want a ladder of safety, a tranche of safe investments initially from which they’ll make their drawdowns in the early retirement years. This is very important psychologically, even though they realise that it makes no financial difference to divide their pot conceptually into drawdown and growth segments: ultimately they have an overall asset allocation and that’s what determines the outcomes.

They hope they can re-extend the ladder periodically, so that it’ll always be available as a safety measure. Warning: dangerous! Yes, they realise that, and what they’re betting on is “mean reversion,” the notion that governments or central banks will manage to intervene and prevent a prolonged equity market downturn. If that doesn’t happen, then their risk will indeed turn to pain. They also realise that governments are notoriously inclined to increase their borrowing to help with the current crisis, then not fully repay the borrowing when good times come back, so each time governments have less and less ability to deal with the next crisis.

The couple are being as realistic as they can be, given the fact that they’re consciously taking risk. (Discussing the dangers is beyond the scope of this book.)

It turns out that the combined notions of a specific overall horizon (30 years), a specific time at which all assets should decline to safety (10 years from now) and a specific length of ladder (they’ve chosen 5 years of spending) are enough to determine a customised glide path for the growth/safety exposures as well as an estimate of sustainable annual drawdown. The couple are pleasantly surprised and relieved that they don’t need to understand the intricacies of investing, and don’t have to respond to artificial questions such as how they might feel when their assets fall 10% in value (which most people have no clue about, and simply make up guessed answers).

They also like the fact that this approach doesn’t treat all couples of the same ages and assets identically. It doesn’t assign them identical asset allocations and drawdowns, ignoring how different their feelings about the future may be.

And they remind themselves of their cushions against forced spending volatility: the liquidity reservoir, the safety ladder, full safety (to the extent such a thing exists) in 10 years, the reduced need for income after the first partner passes away, and ultimately their home. They’re lucky.



In this case study, a couple prefers a falling glide path, for purely psychological reasons. They’re willing to take their highest risk in the early retirement years (provided they have a ladder that enables them to climb to safety over the short term), and rely on safe investments as their lifestyles settle down and they become older.





Where the route takes us

Wouldn’t it be great if we had enough money to create a lifetime income stream, and could live forever in the home we own? Sure! But all too often we need to use our home to help generate that income stream. This stage explains four ways to do so.


Every December my generation of my family watches “It’s a Wonderful Life.” Among the heartwarming scenes is one where the townsfolk show their gratitude to the hero, who has been operating the mortgage company that enabled them to buy their homes. It’s a lovely way of showing how important it is psychologically to most of us to own a home. In Stage F 13 we noted the feeling that we’re born short a home, meaning that we don’t feel complete and secure until we own one. There are studies showing that homeowners behave better in society than renters. Governments often encourage home ownership. And so on.

We also noted that a home is not only a roof over our head, it’s also an investment. Typically we need to borrow money in order to buy it, at a time when we’re asset poor but cash-flow rich. Then we pay off the mortgage debt gradually from our income. Meanwhile the home tends to appreciate in value over the long term, and though we have to pay for repairs and property taxes, it saves us from having to pay rent.

I’m not saying that home ownership is always a good investment. Sometimes it’s cheaper to own, at other times it’s cheaper to rent. I’m simply mentioning the emotional connection.

For most homeowners, their home is often the single largest asset they possess. And so it plays a large role in the finances of retirement.

The fortunate ones have enough other sources of retirement income that they don’t need to monetize their homes. They can then consider leaving it to their children, or whoever. But for most, at this stage of their lives they are now asset rich and cash-flow poor, and so they need to convert their home into a source of retirement income. (See Stage F 23 on your personal funded ratio, where there’s a distinction between liquid and total assets in the pension pot.) They have essentially four options.

The first is to sell it, and rent an apartment or a house. This is often a psychologically wrenching decision. It’s not just that change is unsettling. It’s also that the home is a huge source of loving and happy memories. In principle the memories remain after a move, but in practice it’s tougher to remember them when in different surroundings. That’s why so many people, even in the final stages of life, hate to move (or worse, be moved).

From an investment perspective, though, a sale generates liquid capital, which can then be added to other liquid assets and invested to become a source of drawdown income. Of course, rent now has to be paid, but the former owner can now afford to do so – for some period of time, at any rate. And from a strictly financial perspective, the former owner now has the typical retirement issues of uncertain longevity and determining what is a sustainable drawdown, and so on, uncomplicated by home ownership.

The second option is just a variation on the theme of selling. It’s to downsize. In other words, sell, but buy another smaller, less expensive home than the previous one. It matches the middle of three stages of retirement that studies categorise: an early stage characterised by throwing off the shackles of work and a release of suppressed urges and energy, often involving travel; a middle stage in which the lifestyle is downsized, and for which a downsizing of the home may be an appropriate accompaniment; and a potential final stage of impaired health. (You’ll remember these as go-go, slow-go and no-go. See Stage H 61.)

The third and fourth options are for those who don’t want to sell at all – they want to stay put – but they also want to find a way to use the home as an asset to generate cash flow. The obvious way is to rent out some space to a tenant, thus generating cash flow. A friend suggested that I include the notion that if you’re going to rent out a room in your home, making it a B&B could add purpose and joy to your retirement.

But if you don’t want to share your space, you need a fourth way.

The finance industry has come up with a way, typically called a reverse mortgage. The homeowner borrows a lump sum, or takes out a line of credit, or even borrows a cash flow stream (for example, every month or every year) against the security of the home. Aha, you say, but what about paying interest on the loans – doesn’t that reduce the available cash flow? And how does the aggregate loan get paid off, if the home isn’t sold?

In fact, those are exactly the questions you need to ask before considering a reverse mortgage.

The interest is never paid. In effect, each unpaid amount of interest is added to the loan. So, as you can imagine, the aggregate loan grows pretty fast. That’s why the amounts that lenders are willing to advance are relatively small (for example, in most countries advances stop when the aggregate reaches perhaps 50% to 60% of the home’s value). And those advances are made only to borrowers who initially are at or near what the community considers normal retirement age. Critics point to fees that are added to the loan value, potential penalties, high interest rates and other negative features, so a reverse mortgage is something that needs to be studied carefully and not entered into lightly.

The homeowner retains title to the home and therefore remains responsible for its upkeep and property taxes. The lender gets repaid when the owner sells the home, moves out of it or dies. In some places the repayment is limited to the actual value of the home at the time of repayment.

So there they are – four options if your home needs to be called upon to assist your retirement finances, none of them entirely happy.



There are four ways to use your home to generate income after you retire: sell, downsize, rent it out or take out a reverse mortgage.

[1] Ezra et al (2009).

[2] Knox (2018).

[3] Thaler et al (2004).

[4] Hershfield et al (2011).

[5] Baldwin (2013).

[6] Bright (2016).

[7] Statman (2010).

[8] Statman (2017a).

[9] Munnell et al (2010).

[10] Statman (2017a).

[11] Ezra et al (2009).

[12] Statman (2017a).

[13] Nobre et al (2015).

[14] See

[15] See USA Today, September 24, 2014.

[16] See, March 4, 2016.

[17] See Ezra (2014), Chapter 14.

[18] Noonan et al (2011).

[19] Chen et al (2003). See also Chen et al (2006).

[20] Pfau et al (2014b).

[21] Agarwal et al (2009).

[22] Maugham (1940).

[23]  Laibson et al (2004).

[24] Milevsky (2015).

[25] Statman (2007).