For decades, modern portfolio theory (MPT) has guided the investment decisions of pension funds and other large financial services institutions.

But clients aren’t pension funds. Clients don’t simply want to grow their portfolios forever; they are looking for ways to turn their assets into a steady income in retirement, maintains Sherrie Grabot, CEO of GuidedChoice Inc., a San Diego-based provider of managed-account services for defined-contribution retirement plans.

Could something like MPT help make sense of the income side of the retirement equation? The short answer is yes, she says, in a recent paper entitled Financial Guidance Theory: A Rational Approach to the Uncertainties of Retirement Income.

The goal of the traditional investor is simple: maximize the potential gains for a given degree of risk. For clients facing retirement, however, it’s really the inverse: minimize the risk to attain a given investment goal. A solution to this problem is at the heart of what Grabot has dubbed “financial guidance theory” (FGT), an offshoot of MPT.

As with any financial planning, modelling income starts with setting goals. What kind of specific results would represent the optimal retirement income?

In FGT, the “outcome” isn’t a fixed dollar amount per month or year, nor is it a percentage drawdown. Rather, it’s a total amount of money distributed in a somewhat variable manner over the whole period of retirement.

Rather than set a fixed rule, FGT establishes the spread between the minimum necessary income and the desired, best-case income. FGT also allows the income projections to float between the two through a process of adjustments that Grabot calls “consumption smoothing.”

A consumption-smoothing framework focuses on probable spending and saving needs over time, accounting for things such as a changing household structure or an increase in travel.

Once goals have been defined, an income model must identify the investment policy that’s most likely to keep the retiree as close as possible to his or her maximum income with an acceptable degree of risk. This extrapolation would look at the decisions available to the retiree: how to invest the portfolio among asset classes over time, and how much money to take out of it at regular intervals.

At the same time, because client lifespans are impossible to predict, the model uses standard actuarial mortality figures, then adds 10 years to provide a margin of safety.

Then, following the client’s stated income needs, the model generates a “consumption history” for each investment result, attaching a score that describes how successful each is in producing income by focusing on the size of the retirement paycheque throughout each history.

That score, when plotted on a graph with all possible outcomes of a given policy, produces the same curve found in MPT’s “efficient frontier” illustrations.

The curve drops off rapidly where scores represent a minimum retirement income or less, Grabot says, because a less than minimum income is unacceptable. And the curve tapers off gradually as scores approach the maximum, because exceeding the maximum delivers little or no real value.

In other words, money the client can’t spend is better left
invested. IE