Chapter 12. Asset Allocation: The Long View

laurence booth

Retirement problems are all about saving and spending. How much money must be saved each year so that in retirement the wealth can be drawn down and spent? Both sides of the issue—saving and distribution—involve the same challenges: how to deal with uncertainty in the personal circumstances of the individual, such as death and disability, and how to deal with uncertainty in investment returns. This chapter focuses on the investment uncertainties that must be addressed in planning retirement income and shows how the three iron laws of finance—the laws of time, tax, and risk—can help in structuring the solution.

The three iron laws tell us that there is a time value of money, a tax value of money, and a risk value of money. The first two concepts are relatively straightforward, but dealing with the risk value of money—that riskier securities, such as common equities, tend to generate higher rates of return—is tricky, to say the least. But probability targets can be introduced into retirement-income planning. It is commonly said that the target for income replacement in retirement should be something like "70@65," meaning retirees should aim for 70 percent income replacement at age 65. However, given the uncertainty of investment returns, a more reasonable retirement target would be something like "70 percent of 70@65," meaning a 70 percent probability of achieving 70 percent income replacement at age 65. Of course, some planners ...

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