Modern Portfolio Theory Is Not for Retirement Income Planning: New Paper

Upside-down piggy bank with dollars bills falling out

What You Need to Know

Retirement researchers Alex Murguia and Wade Pfau have published a series of new white papers on retirement income planning.
The latest paper in the series identifies the limitations of standard risk tolerance questionnaires when it comes to retirement income.
Murguia and Pfau argue a framework called retirement income style awareness provides a superior starting point for income planning.

The investment management framework used by most advisors, based on Modern Portfolio Theory, is well-suited to asset accumulation but fails to address some important needs of investors who are retired and drawing down their portfolios, Alex Murguia and Wade Pfau argue in a recent paper.

Murguia and Pfau, the co-founders of the Retirement Income Style Awareness assessment program and well-known authorities on retirement income planning, have published a series of detailed white papers in collaboration with the Retirement Income Institute of the Alliance for Lifetime Income.

In the words of Pfau and Murguia, the three-part research series seeks to “change the conversation” about retirement income strategies by focusing on the consumer and their preferences, rather than putting the emphasis on specific products and solutions.

The first paper, published in October 2022, quantifies retirement income beliefs and preferences to help individuals determine a retirement income style. The second paper, published in November, explores the ways these retirement income preferences can inform retirement income approaches.

Now, the third paper in the series has been released, with a focus on identifying the standard limitations of risk tolerance questionnaires when it comes to addressing retirement income concerns. The paper asks how effective common risk tolerance questionnaires are when it comes to addressing the concerns that individuals have in retirement, and whether the common focus on market volatility in these questionnaires misleads investors about the potential role of income guarantees.

Why Risk Questionnaires Can Fall Short

As Murguia and Pfau write, the financial services profession has mostly evolved around meeting the needs of pre-retirees, whose focus is set squarely on the question of asset accumulation.

The investment management framework offered by the vast majority of advisors is based on Modern Portfolio Theory, which uses portfolio diversification to seek the highest risk-adjusted returns for portfolio growth over a single period. The MPT approach further assumes there are no liabilities to be funded by the investment portfolio.

According to Murguia and Pfau, this approach successfully guides the wealth accumulation effort, allowing investors to build portfolios to seek the highest expected returns for an accepted level of volatility. As such, the advisory profession has developed accumulation-focused risk questionnaires to determine the level of short-term volatility an investor can stomach as they attempt to grow their wealth over a lengthy career.

However, while MPT may provide a reasonable approximation for the pre-retirement accumulation problem, maximizing risk-adjusted returns is typically not the direct goal for most retirees, Murguia and Pfau said. Instead, retirees use their assets from an investment portfolio and other sources to fund their living expenses and other financial goals over an unknown time period.

Moving to a More Sophisticated Approach

According to Murguia and Pfau, many “naïve” industry professionals who lack income planning expertise simply extend their accumulation-focused risk questionnaire approach to the post-retirement investing problem.

“We say naïve because in 1991, Harry Markowitz surmised that his MPT was not equipped to fully handle the household investing problem,” Murguia and Pfau write. “In MPT, cash flows are ignored, and the investment horizon is limited to a single, lengthy period.”

Murguia and Pfau suggest investment risk simply behaves differently when spending from assets in retirement in a manner not accounted for by the assets-only assumptions of MPT. That is, while market downturns can happen during the accumulation years, individuals are still earning a living and can continue to draw from their human capital to cover expenses, while the portfolio remains invested.

“If anything, a market downturn allows savers an opportunity to buy more shares with their new savings,” Murguia and Pfau write. “Human capital is funding the daily spending needs, creating a significant degree of separation from the investment portfolio during the accumulation phase.”