Individuals below the critical path face the unpleasant task of deciding how to cover the difference between the lifetime income they can generate and their expenses. To do this, they can either seek supplemental income from outside sources, now or in the future, or they can reduce their standard of living below what they currently call "acceptable."
A retiree on or below the critical path can also modify what she considers to be absolutely necessary objectives (such as living expenses that are non-negotiable). If, by making this change, she moves above the critical path, then she would be able to invest in nonguaranteed investment vehicles and seek the higher returns available in traditional investments (and also take on their inherent risks). This could have the benefit of increasing her retirement income.
Those who sit above the critical path can use no guaranteed investments and rely entirely on their portfolios to generate annual income, which they would gather from sources such as dividends, nonguaranteed interest and capital appreciation, as well as through their consumption of capital. They should design investment and withdrawal strategies that always keep them above the critical path. Should their investments underperform and their objectives be endangered, they would need to change their strategies to reflect those of somebody sitting on or below the critical path. They would need to purchase investment and insurance products to lock in their positions and receive guaranteed income to cover their essential expenses. They do not have the option of saying, "I will wait. The market will recover. It always has." The threat that they will need to convert to riskless or guaranteed investments should be a strong incentive to keep them on a more conservative path.
Even so, individuals above the critical path may still want to make a portion of their income guaranteed. They could develop a plan to cover all or a portion of their living costs from guaranteed sources and then supplement those with the income of dividends, interest, etc. In doing so, they have, in effect, lowered their critical path. With a portion of their income guaranteed, the rest of their portfolios can be more aggressive to seek higher returns.
The Risks Retirees Face
People in retirement face a number of threats:
Higher-than-expected living expenses (typically inflation)
Unexpected expenses to cover long-term health care
Less-than-expected investment returns
The possibility of living longer than expected and depleting resources
With these problems looming in front of them, guaranteed products offer retirees the closest thing to riskless returns. Of course, there are no riskless investments. Guarantees by high-quality third parties such as bond issuers or insurance companies promising future payouts are the closest thing. And there are big differences among these groups in the quality of their promises.
Laddered TIPS, immediate annuities with inflation riders and longevity insurance are all logical choices for retirees seeking guaranteed income. Deferred annuities with living benefits are another option, but they are hard to understand and have high expenses. Presumably, investors go to these third parties because they have little or no risk of defaulting on their promises. But at a time when even the creditworthiness of governments and insurance companies has been cast in doubt, clearly no organization is 100% safe.
Traditional open-end mutual funds that hold bonds do not qualify as a guaranteed investment vehicle, even though the bonds themselves may guarantee a future payment. The funds are actively managed for objectives such as current income or total return and do not offer guaranteed future payments for retirees.
The Conservative View Of Risk
In their book Risk Less and Prosper: Your Guide to Safer Investing, authors Zvi Bodie and Rachelle Taqqu argue that most individuals, including retirees, should invest most of their portfolios in conservative investments, particularly TIPS. After enough is put away to take care of basic needs, they write, the surplus can be invested in risky assets such as stocks.
This is a bold challenge to the investment practices used by the majority of advisors and supported by the majority of the investment community-the traditional approach of modern portfolio theory, which says that including some risky assets increases expected risk-adjusted returns. Advisors typically use these techniques for managing investors' portfolios regardless of whether they are above or below the critical path. Bodie and Taqqu say that most investors can't take this risk. In other words, they say most investors really sit below the critical path.