Optimal Investment Strategy for Retirement Using the Coverage Ratio

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Beliavsky
Posts: 932
Joined: Sun Jun 29, 2014 10:21 am

Optimal Investment Strategy for Retirement Using the Coverage Ratio

Post by Beliavsky » Fri Jan 11, 2019 4:03 pm

I think the utility of the coverage ratio, as defined in this paper, is a better metric than the commonly-used failure rate, but the paper
assumes a constant inflation-adjusted spending regardless of portfolio performance and that the number of years in retirement is
known. It would be good to relax those assumptions.

Toward Determining the Optimal Investment Strategy for Retirement
JAVIER ESTRADA, IESE Business School
MARK KRITZMAN, Windham Capital Management
Investors who are about to retire are first and foremost concerned
with supporting their spending needs throughout retirement. But they
also derive satisfaction from growing their wealth beyond what is
needed to support consumption in order to leave a bequest to their
heirs or chosen charities. The predominant metric for evaluating
retirement investment strategies is the failure rate. However, it
fails to distinguish between strategies that fail early in retirement
from those that fail near the end of retirement. Moreover, it fails to
account for potential bequests. To overcome these shortcomings we
propose a new metric, the coverage ratio, which is more comprehensive
and informative than the failure rate. In addition, we propose a
utility function to evaluate the coverage ratio, which penalizes
shortfalls more than it rewards surpluses. Finally, we use the
framework we propose to determine the optimal allocation to stocks and
bonds using both historical and simulated returns.

From the paper:

A critical issue for retirees and advisors is to determine whether a retirement investment
strategy is better than another, and ultimately which is the best one. The predominant metric for
such evaluation is the failure rate, which measures how frequently a strategy failed to sustain a
withdrawal plan over all the (historical or simulated) retirement periods considered. This failure
rate has at least two critical shortcomings. First, it fails to distinguish failures that occur near the
beginning of retirement from those that occur near the end. Second, it fails to account for
surpluses that could be left as a bequest.

To overcome these limitations of the failure rate, we propose a new metric for evaluating
retirement investment strategies called the coverage ratio, which measures the number of years
of withdrawals (during and after retirement) supported by a strategy, relative to the length of the
retirement period considered. In addition, we recognize that investors are more averse to failures
than they are attracted to surpluses. We, therefore, propose a particular utility function for
evaluating the coverage ratio which penalizes failures more than it rewards surpluses. Finally, we
apply our approach to evaluate static investment strategies based on both historical and
simulated returns.

RadAudit
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Re: Optimal Investment Strategy for Retirement Using the Coverage Ratio

Post by RadAudit » Fri Jan 11, 2019 5:12 pm

Beliavsky wrote:
Fri Jan 11, 2019 4:03 pm
the paper
assumes a constant inflation-adjusted spending regardless of portfolio performance and that the number of years in retirement is
known. It would be good to relax those assumptions.

Isn't this similar to a liability matching portfolio with a 4% SWR? Probably missed something.
FI is the best revenge. LBYM. Invest the rest. Stay the course. - PS: The cavalry isn't coming, kids. You are on your own.

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Horton
Posts: 371
Joined: Mon Jan 21, 2008 3:53 pm

Re: Optimal Investment Strategy for Retirement Using the Coverage Ratio

Post by Horton » Sat Jan 12, 2019 9:07 am

RadAudit wrote:
Fri Jan 11, 2019 5:12 pm
Beliavsky wrote:
Fri Jan 11, 2019 4:03 pm
the paper
assumes a constant inflation-adjusted spending regardless of portfolio performance and that the number of years in retirement is
known. It would be good to relax those assumptions.

Isn't this similar to a liability matching portfolio with a 4% SWR? Probably missed something.
As far as I can tell, the OP and the paper referenced are in no way discussing liability matching portfolios.

I believe the comment you quoted was a critique of the paper. The OP frames the coverage ratio as a better metric than failure rate to determine a SWR, but notes that it still uses a fixed stream of real cash flows, rather than a variable withdrawal method.
🏃 since 2005

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ResearchMed
Posts: 9271
Joined: Fri Dec 26, 2008 11:25 pm

Re: Optimal Investment Strategy for Retirement Using the Coverage Ratio

Post by ResearchMed » Sat Jan 12, 2019 9:58 am

Beliavsky wrote:
Fri Jan 11, 2019 4:03 pm
I think the utility of the coverage ratio, as defined in this paper, is a better metric than the commonly-used failure rate, but the paper
assumes a constant inflation-adjusted spending regardless of portfolio performance and that the number of years in retirement is
known. It would be good to relax those assumptions.

Toward Determining the Optimal Investment Strategy for Retirement
JAVIER ESTRADA, IESE Business School
MARK KRITZMAN, Windham Capital Management
Investors who are about to retire are first and foremost concerned
with supporting their spending needs throughout retirement. But they
also derive satisfaction from growing their wealth beyond what is
needed to support consumption in order to leave a bequest to their
heirs or chosen charities. The predominant metric for evaluating
retirement investment strategies is the failure rate. However, it
fails to distinguish between strategies that fail early in retirement
from those that fail near the end of retirement. Moreover, it fails to
account for potential bequests. To overcome these shortcomings we
propose a new metric, the coverage ratio, which is more comprehensive
and informative than the failure rate. In addition, we propose a
utility function to evaluate the coverage ratio, which penalizes
shortfalls more than it rewards surpluses. Finally, we use the
framework we propose to determine the optimal allocation to stocks and
bonds using both historical and simulated returns.

From the paper:

A critical issue for retirees and advisors is to determine whether a retirement investment
strategy is better than another, and ultimately which is the best one. The predominant metric for
such evaluation is the failure rate, which measures how frequently a strategy failed to sustain a
withdrawal plan over all the (historical or simulated) retirement periods considered. This failure
rate has at least two critical shortcomings. First, it fails to distinguish failures that occur near the
beginning of retirement from those that occur near the end. Second, it fails to account for
surpluses that could be left as a bequest.

To overcome these limitations of the failure rate, we propose a new metric for evaluating
retirement investment strategies called the coverage ratio, which measures the number of years
of withdrawals (during and after retirement) supported by a strategy, relative to the length of the
retirement period considered. In addition, we recognize that investors are more averse to failures
than they are attracted to surpluses. We, therefore, propose a particular utility function for
evaluating the coverage ratio which penalizes failures more than it rewards surpluses. Finally, we
apply our approach to evaluate static investment strategies based on both historical and
simulated returns.
With an assumption that "the number of years in retirement is known" ... is this even worth reading?

If we *knew* the number of years, most of the fancy modeling wouldn't be necessary in the first place, no?

RM
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Topic Author
Beliavsky
Posts: 932
Joined: Sun Jun 29, 2014 10:21 am

Re: Optimal Investment Strategy for Retirement Using the Coverage Ratio

Post by Beliavsky » Sat Jan 12, 2019 2:23 pm

ResearchMed wrote:
Sat Jan 12, 2019 9:58 am
With an assumption that "the number of years in retirement is known" ... is this even worth reading?

If we *knew* the number of years, most of the fancy modeling wouldn't be necessary in the first place, no?
Much of the literature on investment strategies in retirement assumes that the time horizon is known.
This paper uses a better criterion than previous work using the failure rate. Even the fixed-horizon
problem is not so simple, since there is a trade-off between higher average wealth and
consumption with a stock-heavy portfolio and a lower chance of destitution with a bond-heavy portfolio.

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