What’s Your Retirement Income Style?

“It’s a style box for retirees!”

That was my reaction as I read about the Retirement Income Style Awareness matrix in Professor Wade Pfau’s excellent Retirement Planning Guidebook.

Forget bickering about “the best” solution for generating retirement cash flows, whether bucketing or annuities. They’re both valid—for certain people. The key is getting to the bottom of each retiree’s specific preferences: how much of a priority guaranteed income is, for example, and whether the retiree is seeking a permanent solution for retirement income or wants to be able to change up the strategy as the years go by.

The RISA assessment aims to help us discern those attitudes and then maps us to a specific box on the four-box matrix—a style box for retirees. Each of those four boxes, in turn, is associated with a specific retirement income solution that jibes with our preferences. Professor Pfau and Alex Murguia, CEO of Retirement Researcher, developed the RISA questionnaire and matrix after surveying scores of retirees about their preferences.

If you’re formulating or assessing your retirement plan, it’s clarifying to at least think through your attitudes toward the two key elements of the RISA matrix: whether you have an optionality or commitment orientation (I’ll explain) and more intuitively, whether you prioritize a safe, guaranteed stream of income or portfolio growth. Knowing those preferences can help you arrive at a retirement strategy you can live with.

Safety First Versus a Probability Outlook

This is the easy-to-understand aspect of the RISA matrix. Are you seeking a turnkey “paycheck replacement” for your retirement, or are you OK sourcing your own cash flows from a total return portfolio even if that might entail some variability in your paydays? Ponying up for a fixed annuity on Day One of retirement—or perhaps staking the entire portfolio in a laddered portfolio of Treasury Inflation-Protected Securities—would be at the extreme “safety first” edge of the RISA matrix. (The former strategy is simpler but courts inflation and insurance-company risk while the latter avoids them.)

Meanwhile, a probability-based approach would entail investing your retirement assets in investments that have the potential to grow and periodically digging into those funds for retirement cash flows. You’re banking on the likelihood that your portfolio will grow and that whatever withdrawal system you’re using will be maintainable.

From a practical standpoint, most retirees are receiving some form of consistent cash flows from a pension, Social Security, or both. That baseline of income might enhance their comfort with sourcing at least some of their cash flow needs from a total return portfolio. On the other hand, if those nonportfolio income sources (Social Security, a pension) aren’t enough to cover core living expenses, generating some additional guaranteed income through an annuity might appeal.

Optionality Versus Commitment Orientation

The second major factor in the RISA matrix gauges preretirees’ comfort level with committing to a specific strategy and sticking with it through retirement. Here again, purchasing an immediate fixed annuity exemplifies an extreme commitment orientation: Such a purchase is all but irrevocable, and the insurance company is legally obligated to deliver your cash flows in accordance with your contract. In other words, you’re both committed. The laddered TIPS strategy is similarly anchored in commitments: The US government is on the hook for paying you interest plus inflation, and you could lose money if you need to sell a bond prior to its maturity.

Choosing to source cash flows from a total return portfolio epitomizes an optionality orientation. You’re allowed to change up your investments any time you see fit, take more from your portfolio in some years and less in others, and prioritize a legacy for children or charity at the end of your life. As humans, we like options, which is likely one of the chief reasons that most people don’t buy annuities for their retirements but exercise control over and draw cash flows from their portfolios instead.

4 Quadrants, 4 Styles

Pfau and Murguia’s research notes that people with a safety-first outlook will also tend to be more comfortable with commitment—in other words, they want guaranteed income for their retirements and they don’t mind committing to it. They may even see committing to a very specific income-generating strategy as a positive, in that it’s one less thing they need to worry about and it’s also a safeguard in case of cognitive decline. The probability-based mindset, on the other hand, is closely correlated with optionality.

But not everyone with a safety-first mindset needs commitment, and not all of the probability-based total return investors are commitment-phobes. Hence, Pfau and Murguia’s matrix has four quadrants, each associated with a specific retirement-income approach.

Safety-First Outlook, Commitment Orientation (Income Protection): As discussed above, a retiree with these preferences would tend to prefer guaranteed income for life via an annuity. But as Pfau notes in his book, it’s not all or nothing. A retiree with these preferences might choose to match fixed, nondiscretionary expenses to guaranteed income sources (Social Security plus perhaps an additional annuity purchase) and maintain an investment portfolio to meet discretionary outlays.

Safety-First Outlook, Optionality Orientation (Time Segmentation): This is what Pfau calls “a hybrid case.” People with these preferences prize stable cash flows and safety but don’t want or need contractual guarantees. Hence, someone with these preferences would be a good fit for a time segmentation approach—also known as bucketing. That means the retiree might organize their portfolio to include very safe investments (cash) for near-term cash flow needs, moderately safe investments for intermediate-term spending, and aggressive assets for long-term growth and spending. I’ve written extensively about this approach and developed model Bucket portfolios to demonstrate how it works.

Probability-Based Outlook, Optionality Orientation (Total Return): This is the retirement strategy that underpins most of the retirement-spending research that you see, including our now-annual research on safe spending rates in retirement. People with these preferences will tend to favor a total return portfolio with periodic withdrawals. The portfolio will gyrate periodically, as it includes higher-risk assets like stocks, and ideally the retiree will adjust spending in line with those fluctuations. My anecdotal observation is that most Morningstar.com readers—and most Bogleheads—are using some variation of this approach to manage their retirement portfolios.

Probability-Based Outlook, Commitment Orientation (Risk Wrap): Retirees with these “hybrid” preferences want to maintain exposure to risk assets but also seek downside protection and a structured income stream. Variable and indexed annuities are the most common expression of a “risk wrap” strategy; they provide some degree of market exposure and may offer some level of control over how those assets are invested, but also offer lifetime income (at a price).