Potential Risks When Constructing a Sustainable Lifetime Income

In retirement, financial ruin is taken to mean when one’s savings have been depleted before one passes away.  If one’s savings are invested in a diversified portfolio, financial ruin is taken to mean the combined effects of withdrawals and adverse market conditions that can potentially deplete the portfolio before one’s passing.

Financial ruin to one’s portfolio can stem from three specific drivers:

  1. Longevity: The longer one lives, the greater the burden on the funding portfolio;
  2. Random market conditions: Market returns are not uniformly distributed, and thus some retirees may experience more adverse conditions than others; and
  3. Withdrawals: If the initial distribution from the funding portfolio were excessive, it would accelerate the depletion of the portfolio in the event that the portfolio went through unfavorable market conditions.

To be able to see potential ruin to one’s portfolio over the long-term horizon would bring great insight to one’s financial well-being.  The notion of a coverage ratio, defined as the proportion of available assets to the annual spending gap, can be a handy tool.  The annual spending gap is defined as the spending needs required after taking into account all sources of dependable income, such as social security benefits, pensions, and income and dividends from one’s investments.  Thus, if one’s annual spending gap is USD 40,000 a year, and one’s available assets are USD 1,000,000, then one’s coverage ratio equals 25.

A more sophisticated way of measuring the probability of ruin was presented in a 2004 paper entitled “Ruined Moments in Your Life: How Good are the Approximations?”[1] written by a trio of professors at York University.  They determined that a coverage ratio (or margin of safety) of roughly 30 for a balanced fund would have a 95% chance of success (i.e., sustainable lifetime income).  The flip side of this 95% chance of success is equal to a 5% chance of lifetime ruin probability.

If retirees can maintain their lifetime ruin probability at 5% by making changes to their withdrawal strategy as needed, they should be in good shape for their retirement.

[1]   Huang, H, M.A. Milevsky, and J. Wang (2004), Ruined Moments in Your Life: How Good are the Approximations? Insurance: Mathematics and Economics, Vol. 34, pg. 421-227.

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