A practical way to locate retirees on the path is through a "decumulation benchmark."

This benchmark was proposed by authors Stephen Sexauer, Michael Peskin and Daniel Cassidy in the January/February 2012 issue of Financial Analysts Journal. (They call it a "defined contribution-decumulation benchmark.") It's a portfolio composed of laddered TIPS for the first 20 years of a person's retirement and a deferred life annuity (longevity insurance) to cover expenses after 20 years-for as long as the person lives. These products combined offer guaranteed lifetime income.

The benchmark is useful because investors can use it to calculate how much capital they would need for a particular level of guaranteed lifetime income. It is made up of nearly riskless investments, so it is a useful reference for comparing other strategies that don't offer guaranteed lifetime income. And what's more, plotting the results over time approximates the location of the critical path.

For the "decumulation" benchmark, the investor purchases both laddered TIPS and longevity insurance initially. The TIPS purchases are laddered to provide constant, inflation-adjusted returns for 20 years. The longevity insurance also purchased at the beginning offers lifetime income after 20 years. This product, however, is not available with an inflation rider, so after 20 years the income is not adjusted for inflation. Since the authors published their paper, the government has started to sell 30-year TIPS, which for some people may negate the need for longevity insurance.
Sexauer, Peskin and Cassidy compare this strategy to purchasing an immediate annuity with an inflation rider. The laddered TIPS and longevity insurance offer very similar cash flows for the same invested dollars for the first 20 years. But after 20 years, the immediate annuity keeps offering increases to offset inflation, while the TIPS and insurance do not.

Still, say the authors, most retirees would prefer the laddered TIPS and insurance because they could still access the remaining investment in the TIPS during the first 20 years, whereas they could recover none of the original investment in the immediate annuity after it's purchased. On day one, the market value of the TIPS is 88% of the total investment, a desirable benefit for someone who might change his or her mind, while the cost of the deferred life annuity is 12%.

The critical path can be thought of as the dividing line between those who argue for conservative portfolios like these, and those who argue for the use of strategies entailing some risk, typically based on modern portfolio theory.

Not Always Applicable?

In some situations, the critical path may not apply.

Obviously, if you have college bills to pay in six months and you have no alternative options, the assets should be invested in a riskless manner. The individual would have no alternative options if the assets lost value.

During longer periods of time, investors may have additional flexibility to meet or even modify their objectives; for example, they could choose a college with lower costs, tap funds from other sources or even defer their college start date. In those cases, they would not need to use the critical path.