Originally Posted by from The Ages of the Investor: A Critical Look at Life-cycle Investing (Investing for Adults) by William J Bernstein
...illustrate how the Liability Matching Portfolio and the Risk Portfolio fit together (assuming that a retiree is lucky enough to have both), let’s consider four fictional cousins from the Frick family who demonstrate how the choices in this table play out in the real world.
The first, Fenwick, has just retired at age 62 from his school superintendent position in rural Kansas. He has a superb health-care package to supplement his Medicare coverage and $850,000 in an IRA rollover from his 403(b) plan. He has also made nearly the maximum in Social Security contributions. His house is paid for, and he and his wife enjoy a secure but spare lifestyle. Current living expenses, including taxes, amount to just $36,000 per year.
Next, consider his twin brother Frank, who also wound up a school superintendent, but in California’s Sonoma Valley. His rollover IRA size*and Social Security and health-benefit profile are identical to Fenwick’s, and he is just as frugal. But, fortunately or unfortunately, depending on your perspective, he lives in Northern California, with its much higher living expenses, of $56,000 per year. He, too, would be a fool to refuse the cheap, but partial, longevity insurance offered him by Uncle Sam. So like brother Fenwick, Frank elects to start the full $36,000 annual Social Security “benefit” at age 70.
Frasier struck it rich with his robotics company, which was bought by a larger firm, a purchase that left him with a lump sum, after taxes, of $10,000,000. Consequently, he has no sheltered assets. It is not being too flip to say that Frasier really doesn’t need much of an investment or retirement strategy. Although TIPS ladders are a good way, in general, of protecting against inflation, they are problematic in a taxable account. The gain in the inflation component of the price is taxable each year, which is a real accounting headache. Almost any prudent mix of indexed global stocks and, on the bond side, short-term Treasuries, munis, and CDs will last Frasier nearly forever.
Fritz also succeeded, after a fashion, but not as well as Frasier. The sale of his Internet startup netted him “only” $4,000,000 after taxes. Clearly, Fritz has a problem. Even if he completely annuitizes his new $4,000,000 nest egg at age 62, he’ll only receive about $142,000 per year in inflation-adjusted annual income. To the extent that he employs any of the strategies considered by his cousin Frank involving TIPS and deferred annuities, he’ll have even less annual income, albeit with more control and perhaps greater safety of his money. The optimal solution for Fritz, alas, likely involves some combination of fixed annuities purchased somewhat later in life, part-time work to supplement his income, and a reduction in his standard of living.