The financial services industry has struggled to develop inno- vative retirement-income solutions. Such solutions are elusive because providers suffer from behavioral biases that blind
them to post-retirement changes in risk and psychology, trapping
themselves in habitual modes of thought that strangle the imagination needed to see new solutions. This paper reviews the changes in
post-retirement risk and psychology that demand new approaches,
offers a critique of existing retirement-income solutions, and
presents an alternate model called “adaptive distribution theory.”
Retirees have a small margin for error and may be hypersensitive
to losses, so they need approaches that focus on downside risk and
adapt as goals, risks, biases, wants, and markets change over time.
Innovation is desirable in business, but behavioral biases make it
difficult for solution providers to see past old ways, lead them to
focus on the wrong things, and cause organizations to reject creative
ideas. Adaptive distribution theory for retirement-income portfolios
redefines risk and captures investor psychology by incorporating
key features of prospect theory. Risk and cash flow are addressed by
managing the portfolio using acceptable annualized erosion rates
and building a buffer of earnings. The ability to see the obvious is a
recurring theme and the key to retirement-income solutions.
New Problems Call for New Solutions
There is a saying that, if after thirty minutes in a poker game you
cannot tell which player is the patsy, it’s you. Like poker, retirement
income requires a thorough understanding of both risk and
psychology, or players risk losing their shirts. All patsies, poker or
otherwise, are blind to their blindness. Risk and psychology change
after retirement in ways that require new solutions. Investment
advisors and retirees alike need to be aware of these changes.
Do Not Over-Focus on Inflation Risk
When accumulating wealth, inflation rate is synonymous with
standard of living, so most investment strategies seek to earn a
targeted rate of return that will keep pace with if not beat inflation.
But decreased consumption post-retirement offsets price increases,
so inflation rate is no longer synonymous with standard of living.
Yet much of the industry research about retirement income incorporates (usually) a 3-percent inflation factor, which significantly
overstates inflation risk for retirees.
The drop in consumption post-retirement has been documented
in multiple studies,
1 can be observed anecdotally among senior
citizens, and is presented graphically in figure 1. Table 1 shows that,
on average and across all percentiles, spending drops about 20 percent from age 50–64 to 65–79, another 22 percent as you move to
age 80–89, and an additional 12 percent after age 90.2 Blanchett
(2013) found that retiree spending does not increase at the rate
of inflation or any other predetermined rate—and certainly not
by 100 percent, which is what would be expected if spending
increases matched a 3-percent inflation rate over a period of
To summarize: Because consumption drops with age, a retiree’s
standard of living is no longer synonymous with the inflation rate.
Yet most retirement-income research and calculators mistakenly
assume that it is and in doing so significantly overstate inflation
risk. This leads to the flawed assumption that retirees must earn a
targeted rate of return over inflation.
Adaptive Distribution Theory
By James B. Sandidge, JD
Figure 1: Spending by Age Group
Source: Employee Benefit Research Institute
Table 1: Average Change in Spending
Age Change in Spending
Age 50–64 to 65–79 −20%
Age 65–79 to 80–89 −22%
Age 80–89 to 90+ −12%
Distribution of Household Expenditures by Percentile,
2003–2011, for Different Age Groups (2013 $s)
25th Pct Median 75th Pct 90th Pct 95th Pct
50-64 65-79 80-89 90+