Saving strategies in old age should also play a role in asset accumulation. But what should you consider if you want to retire earlier? What portfolio withdrawal strategies are there anyway? And where are the pitfalls? I talk about this in the new podcast episode with Professor Dr. Philipp Schreiber.
Overview Interview Prof. Dr. Philipp Schreiber
I have Professor Dr. Philipp Schreiber as my guest today. He is a professor of investment and finance at Esslingen University of Applied Sciences. His research focuses on retirement and desaving strategies in old age. Together with Professor Dr. Martin Weber from the University of Mannheim, he has written a research volume on this.
In the next hour, we will talk about the questions I should ask myself as an investor, lifecycle models, what desaving strategies there are and where the pitfalls lie.
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Summary of the interview
You are a professor of business administration with a focus on investment and financing at Esslingen University of Applied Sciences. What do you mean by this focus?
It’s about investing itself, but with a focus on companies. In English, this focus is called “corporate finance”. The core questions there are: What do I do with the capital in the company, also to increase it? And in the case of financing: Where does my capital actually come from?
Examples of investments made by a company are a new production facility, new software or a production robot. This is then in turn financed through loans, bonds or shares.
You were previously a member of the Behavioral Finance Team at the University of Mannheim – together with Professor Martin Weber and Professor Christine Laudenbach, whom I also had as a guest on the podcast. Are you still involved in investor psychology today?
Yes! Together with Christoph Merkel, I published a paper this year on the psychological aspects of the retirement decision.
Your research topics are retirement and desaving strategies in old age. Have you become more involved with this privately, or how did you come across it?
That I came to this niche and did my doctorate on it was purely by chance. Originally I wanted to look into credit derivatives. Then my PhD father, Martin Weber, gave me a paper that talked about why people choose the lump-sum option or the annuity when it comes to pension insurance. Here’s how that started.
So what are the psychological anchors around annuities?
First and foremost, time preferences. That sounds complicated at first, but it’s quite simple. It’s about how I value time and how I value a payment today, tomorrow or 10 years from now.
We have recognized that young people underestimate when they want to retire. So statistically, people do very often want to retire before the statutory retirement age.
In addition, young people statistically overestimate their life expectancy by 7 years.
Taken together, these two aspects show that it is better to plan your pension early.
Together with Prof. Weber, you published the research report “Entsparen im Alter Portfolioentnahmeestrategien in der Rentenphase” and updated it in February 2022. To what extent was the update necessary? Were there any new findings?
We published a book in 2020, “The Ingeniously Simple Wealth Strategy.” In that book, we added a few more aspects that weren’t in the research report, so the research report was updated to include those aspects.
The update included a new sample portfolio, historical capital market data (5 years more data than 2017) and minor corrections.
Desavings strategies play a critical role, especially in light of steadily declining bond yields. So what questions do I need to ask myself as an investor in advance, and what metrics matter?
These questions relate to the savings phase and the deconsolidation phase. The earlier I want to save, the larger the portfolio should be.
Then there is the question of how much should be saved each month. If the assets are to last exactly until the end of one’s life, one’s own life expectancy must be estimated. Another approach is to close only the consumption gap created by consumer spending and payments from the state pension or the company pension plan.
More concerning the accumulation phase are questions about portfolio composition and investment horizon. But it also directly affects the withdrawal phase. Because if the portfolio generates more, I can also withdraw more.
What is behind the life cycle model?
The life cycle model is about the distribution of total lifetime income over a lifetime.
The underlying assumption here is that people tend to be risk-averse, so more money is better than less money. However, money also has a marginal utility, so each additional euro brings less than the previous one.
With this assumption underlying, it comes out that lifetime income is smoothed as much as possible over the lifetime.
This is a theoretical model and practice shows that people do not really live by it. But it can help people rethink their own consumption and savings behavior and make better decisions.
Why does it not make sense to take one of the prefabricated insurance products that are often sold to older people, but to implement it yourself?
Basically, both have their advantages and nand everyone should know that for themselves.
I see 3 important advantages if you do the retirement planning yourself:
- Low costs: the management of the investments by the insurance companies must of course be paid. When doing it yourself, there are almost no costs.
- Flexibility: The insurances have restrictions concerning the investments, for example to reach a certain guaranteed interest rate. You can invest as not so risky.
It is also less flexible when it comes to payouts. With my own portfolio, I might want to spend more the first 10 years of retirement because I’m still fit and want to go on vacation a lot. With insurance, I have a fixed amount per month.
- Control: I keep track of my finances myself, I know where my money goes, what I can afford and I actively deal with the issue.
So how do I calculate my consumption and investment/spending decisions?
These can be calculated using the life cycle model and a spreadsheet program (such as Excel or Google Sheets).
The input values are:
- Today’s income,
- Trend in income (estimate),
- Value for inflation,
- Value for return earned on investment.
Someone starts working at 25, works 40 years, retires at 65, and then lives until he is 95.
The average net income in Germany is about 2,000 euros (source: Statista). 2,000 euros is therefore the starting value or 24,000 euros in the first year. We assume that one’s income grows as the average income has grown in the past: 2% per year.
For inflation, I also take the value of the last years, namely 1.8%.
We assume that we manage to generate 5% return from the portfolio after expenses and taxes. That’s not super aggressive, but it’s not easy either.
How much would I then need to save each month if I wanted to keep my real consumption constant after inflation over my entire life?
The result: a savings rate of 20% of income. So in the first year 400 Euro monthly, with increasing income the monthly amount also grows. This would cover me until the age of 95 without additional pension payments. In this respect, this 20% is a kind of upper limit, because in practice most people do receive some pension payments from the statutory or company pension.
Calculate it yourself? Here is the Entspar calculator from the Behavioural Finance portal of the University of Mannheim.
One factor I can’t influence is life expectancy. How did you calculate this variable?
30 years after retirement is, of course, a highly simplified model. I could also take the stochastic approach and look at the life expectancy tables. But calculating that exactly is very complex and probably wouldn’t add that much to the understanding.
30 years after retirement is optimistic and therefore conservative. Unfortunately, according to current mortality tables, most people will not reach that.
There is an online calculator to calculate life expectancy. There you can enter your lifestyle and previous illnesses from your family and calculate your statistical life expectancy. You can see what influence smoking and sports have, for example, and then you can optimize that if you want.
What removal strategies are there?
There are basically two categories here:
- Constant withdrawal – the 4% rule: This strategy stands for constant, inflation-adjusted consumption. I can take 4% out of the portfolio starting in the first year and then it should last for 30 years. 4% is more than 1/30, so it only works if the money that remains in the portfolio also increases over the years. Furthermore, this model is based on the assumption that the markets develop as they did in the past.
An alternative to the 4% rule would be to keep your assets relatively risk-free (bank account, bonds) and pay out 1/30th every year.
- Dynamic withdrawal: in this strategy, consumption does not stay the same, but is dynamic. So I look at how the portfolio has performed and adjust the withdrawal. If things are going well, I can afford more. If things are going less well, I consume less.
What are the risks?
With the 4% rule, on the one hand there is the risk of going “broke,” meaning that you have nothing left before the 30 years are up. As well as the risk of an unplanned inheritance if the portfolio performs better than expected.
The risk of dynamic development is that one is not prepared to reduce one’s standard of living again if things go worse on the stock market again.
Inflation is currently higher than it has been in 30 years. How can I plan for such risks?
Inflation has to be priced in, of course. Let’s assume inflation is 1.8% and the standard of living is currently 2000 euros a month. Then I will need about twice that in 30 years to maintain my standard of living. This calculation is relatively simple, because the inflation figures are calculated and published annually. At this rate, I have to increase the withdrawal.
What role does asset allocation play in making the portfolio last over 40 years?
Our model portfolio is 60% stocks and 40% bonds. This has worked well over the last 50-60 years and provides a mix that offers good diversification while providing attractive returns.
If I am now at the beginning of retirement, I can invest what I don’t need for 20-30 years in a riskier way than what I want to consume in the next few years.
One could also proceed in such a way that one consumes the bond portion first and then the share portion. The equity portion has a higher risk. If you let it run longer, there is a realistic chance of a high return. The less volatile portion (bonds) is consumed at the beginning.
You ran a Monte Carlo simulation and evaluated withdrawal strategies. How did you proceed and what were the specific results?
Monte Carlo is a method from probability theory. It involves drawing random samples from a distribution and then looking to see what distribution comes out.
The method measures the probability of certain events, d
he calculation would be too complex numerically. Probabilities for dice can be calculated numerically. For portfolio questions, a simulation is the better way to calculate probabilities
Example – Probability of success of the 4% rule
Question wording: How likely is it that the 4% rule works over 30 years of retirement (=no bankruptcy occurs)?
Approach: Several MSCI World monthly returns are plugged into a…
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