This proved a dangerous assumption. While theory suggests there should be a long-term risk premium, there is nothing in securities markets that assures a risk premium. In this new, projected lower-return world, stock yields are less than 2% and bond and cash yields are well below historic norms, as are US Treasury inflation-protection securities (TIPS) and almost any other market you care to mention.

What should institutional investors do? For example, the average corporate pension fund continues to use a return assumption of over 8% in their earning statements. To bridge the difference between real and assumed yield, should they pursue substantial risk premiums with the enhanced awareness provided by recent painful events that higher-risk investments do in fact sometimes result in lower returns?

Or should they commit to a spending stream that can be assuredly earned and enjoy the fortuitous times when they actually occur? At the very least, corporate pension funds should acknowledge that such variable real yields mean that they cannot expect to replace pension contributions with pension fund returns, as happened in the 1990s.

Sustainable spending is also a powerful concept for individuals who, due to the worldwide move away from defined benefit to defined contribution (DC) plans, are assuming more responsibility for funding their own retirement. Demographic developments are also placing state social security systems under increasing stress. Future retirees will likely find that their 401(k) or DC plans will become a primary source of retirement income to fund their lifestyles rather than simply a supplementary income source.

Funding a retirement lifestyle is a financial liability in real terms. That is, individuals enter a period when they no longer have income based on their human capital and need to live off their accumulated assets. A DC plan should support the individual by maximizing and enhancing purchasing power over the accumulation phase of their life so they can achieve sufficient post-retirement income after accounting for the effects of inflation.

One of the first to articulate the notion of sustainable spending was Robert Arnott in a 2004 article in the Financial Analysts Journal.* He wrote, “Sustainable spending typically starts with sustaining the real value of the assets. This step requires realistic return assumptions. … We need to know how much we can spend on a nearly risk-free basis if we want to identify how much of our intended spending is coming from wishful thinking, from mere hope. This knowledge sets the stage for a reasoned, risk-controlled quest for the incremental returns that we hope to achieve.”

There are several ways to construct sustainable spending solutions to provide real appreciation potential. However, the core assets must meaningfully hedge inflation to achieve an income stream that sustains purchasing power in real terms.

For individuals, it is critical that they not only define their ideal retirement income, but also their retirement income floor. This is the point below which income cannot fall without reducing them to discomfort or old-age poverty. A sustainable spending strategy will aim to ensure income in excess of this by providing varying degrees of risk profiles. However, the objective is to ensure at least this minimum is achieved through prudent investments that prevent an unrecoverable loss in purchasing power occurring throughout their life cycle.

Approaching decumulation, today’s retirees enjoy a longer and more active lifestyle than any preceding generation. This means investors will need an investing strategy with the potential to sustain their spending – in “real” or after-inflation terms – for some 20 years or even more. To maintain a lifestyle costing $40,000 a year, adjusted for inflation, for a life expectancy of 25 years, this means $1 million (assuming a realistic after tax-return on a portfolio of roughly zero).

Unfortunately, many investors will fall short of such security. The sustainable spending concept is a strategy that enables retirees to arrive at retirement with the purchasing power of accumulated assets intact. It does not mean that they will have sufficient assets in retirement. That depends on contributions made during the accumulation phase and actual spending in retirement, which is in their hands.

It is true that current plan provision has little connection between financial life-cycle stages (accumulation and decumulation). As potential pension plan members become more aware of the issues, the resources required and risks involved in delivering an adequate income in retirement, innovative, integrated retirement plan designs will be demanded.

The creation of such prudent, responsible solutions for the entire financial life cycle involving investment management integrating longevity insurance will require cooperation across investment disciplines. We are on the cusp of seeing such solutions emerge, but capital restrictions and laws plus the high cost of guarantees mean creating them is currently easier said than done.

* Rob Arnott and his firm Research Associates serve as a subadvisor to PIMCO on a real-return-based asset allocation product. He also co-authored a chapter on portable alpha and sustainable spending in Portable Alpha Theory and Practice (Wiley Finance, 2008) with Brent Harris.

Published by PROJECT M in September 2009