Modern Portfolio Decumulation: A New Strategy for Managing Retirement Income

Longevity Risk and Retirement Income Planning

“…In contrast to Babbel and Merrill (2007), Fullmer (2007) espouses a topdown approach, where the option to annuitize is a last-resort safety measure. Fullmer asserts that systematic withdrawal plans must often reduce future spending following a bear market.…”

“…The case for retirement income portfolios is unlike the modern portfolio theory approach to asset accumulation, where the investor is concerned with terminal wealth and where standard deviation of wealth is an appropriate risk metric. Rather, according to Fullmer (2007), a more appropriate risk measure is the sustainability of income sufficient to support a threshold standard of living. Shortfall risk, relative to this threshold standard, is a more meaningful risk metric to the investor.…”

“…By exercising the option only when it is necessary to ensure a threshold standard of living, the investor takes full advantage of the time value of the annuitization option. Fullmer (2007) writes: "The key for leveraging this optionality is setting the projected cost to annuitize the investor's desired lifetime income stream as a wealth goal in the objective function. Doing so effectively transforms longevity risk into investment risk, because now it is the portfolio's job to preserve the ability to annuitize the desired lifetime income stream.…”

“…This logic leads directly to a recommendation for "a dynamic allocation strategy" (p. 9). Fullmer (2007) asserts, "When substantial cash flow risk is present, the objective function begins to take on more of the characteristics of a cash flow matching model" (p. 9). The risk management approach mirrors the hurdle race problem in which the "provision" must exceed the cost of securing the threshold living standard through annuitization.…”

“…The decision becomes how much of the portfolio surplus to put at risk before exercising the option to annuitize. Fullmer (2007) also provides a refreshing counterpoint to the conventional wisdom that suggests a retiree with dwindling resources must assume more risk in the hope that the portfolio will bounce back from bear market declines.…”