Portfolio Design: A Modern Approach to Asset Allocation

BASELINE CASE: CAN TWO LIVE MORE CHEAPLY THAN ONE?

We begin with two sets of simulations that will investigate differences between spending rules for single individuals and married couples. The first simulation will be for a 62 year-old man who has just retired. The second simulation will be for a 62 year-old married couple also newly retired.

At retirement, the 62 year-old man is assumed to choose a spending rule that is to rise with inflation. For example, a 5 percent spending rule for a retiree with $1 million will permit the retiree to spend $50,000 (before tax) the first year. With a 2.5 percent inflation rate, spending will rise to $51,250 the second year, and so on. Later simulations will allow part of the spending to fluctuate with the size of the portfolio rather than being a set dollar amount (adjusted for inflation).

The 62 year old is assumed to want to use his wealth to support his retirement. That is, he has no plans to leave a bequest, so his wealth can be used up during his lifetime. This will allow him to raise his rate of spending higher than in the case where his aim is to keep a given wealth level intact. Later simulations will allow for a specific bequest. Of course, he does not know his age of death ahead of time, so the challenge will be to adopt a spending rule that will keep his wealth positive throughout the remainder of his life.

The retiree must choose a spending rule low enough so that he does not run out of money before death. In the presence of uncertainty, ...