Friday, October 19, 2018

HITBLITS: Charles Barkley and Saving for Retirement

"I'm a HITBLIT", Charles Barkley, in the waning days of his NBA career, told his interviewer.

"A HITBLIT?" the reporter asked.

"Yes, that stands for had it. . . but lost it", the aging Round Mound of Rebound explained with a laugh.

Having it and losing it seems to be heavy on the minds of many near-retirees who see record equity prices and who have lived long enough to know that bull markets don't last forever. They can end very badly. Severe bear markets near a retirement date can delay retirement plans and even permanently lower a standard of living in retirement.

Robert Powell recently wrote at The Street[1] regarding a subscriber who asked, "What is the best thing to do with a 401(k) if the market keeps crashing or we go into another recession when I only have a few more years to go before retiring? I need to minimize losses at this point."

Two things we can be relatively sure about are that the market will keep crashing and that there will be another recession. Bear markets often overlap with recessions but not always, as the following chart from Capital Economics[4] shows.

Powell responded to the question with answers from a number of retirement advisers (including yours truly). It's a nice piece and you can read it at the link below but I can distill the essence of the advice.

Don't gamble more than you can afford to lose.

"Once you win the game, stop playing", William Bernstein advised about saving for retirement. I don't believe, as some have suggested, that he means that you should stop investing in stocks once you've funded retirement. I think he's making a more subtle point about utility, a measure of the satisfaction we receive from consuming goods and services.

If you have an income of $1,000 and you receive an additional $100, the additional consumption that a hundred bucks enables would probably make you happy. It would probably make you much happier than if you had an income of $100,000 and received an extra $100. The "utility" of an extra $100 becomes less as income grows.

There is a similar utility issue when we consider how much to invest in the stock market as we approach retirement because investing more means we might earn more but also that we might lose precious capital. For most of us, losing capital after we have "won the game" would generate a lot more pain than increasing our savings by that same amount would generate happiness.

Earlier in our careers, the scenario is reversed. We don't have much financial capital to lose and we have decades to make up for any losses. We have lots of "human capital", the ability to earn money from our labor. The losses are less painful because we expect to win in the long run and we don't need the money for decades. We can better afford losses because we have lots of two key ingredients: time and the ability to work. Both diminish with age.

The solution is to gradually shift the game away from growth of capital and toward preservation of capital, though not entirely. We'll probably still need some growth. After decades of saving for retirement, many of us have difficulty making that shift from accumulation to spending. It's a different game.

Sadly, I have much more experience with HITBLITS than most. During the Tech Crash, I personally knew dozens of 20- and 30-somethings who had amassed 5 or 10 millions dollars or more in tech stock options but refused to sell them and rode them all the way back to zero. It happened quickly. From zero to millions to HITBLIT in about ten years. The crash was over in months.

A close friend in his early 60s sat atop $4M of vested MCI stock options only to see his boss, Bernie Ebbers, convicted of the largest accounting fraud in U.S. history, at least until a different Bernie stole that record. At least the 30-somethings had a few decades to recover, though they were very unlikely to see such wealth again as they once had. My friend had a handful of working years left and a bankrupt employer.

Just after the Great Recession, the national press was replete with stories of near-retirees who were looking at postponing retirement for years in hopes of getting back to where they were in early 2007 with no certainty of ever reattaining that level of wealth. They had simply had too much equity exposure.

These experiences probably left me with a different perspective than most have regarding the need to protect your savings when you have little time left to recover from losing them.

HITBLITS: Charles Barkley and saving for retirement.
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Why not just accept bear market losses with the confidence that a higher equity allocation will help you recover quickly? That works fine in early stages of the accumulation phase but the calculus is quite different as one approaches retirement.

Younger households still have careers that let them buy more equities at bargain prices after a crash. As a result, their portfolios will recover even faster than the market. Near-retirees, on the other hand, have far less time to recover and most of their wealth growth comes from their base of capital and not new savings.

Not long ago, a reader pointed out to me that when dividends are included, the U.S. market recovered from the Great Depression relatively quickly. There are some markets that have never recovered, though, and Japan's recovery has exceeded 20 years and counting.

But, my reply to the reader was "you are not that guy." Someone beginning a career right after the Great Depression would probably have had little to lose in the market crash but years to work and save money to invest in a recovering market. By investing periodically in stocks, his portfolio would have grown even faster than the market.

For someone retiring around the time of the Great Depression, however, the crash would have devastated her savings just when she needed to begin spending them. Instead of adding new investments like the early-career guy, she would be spending from a depleted portfolio. Her portfolio would recover much more slowly than the market and, in fact, would likely never recover. Large market losses in our youth are far less dangerous than losses when we approach retirement.

I often receive comments saying something like, "but the market recovered in just 5 years after the Great Recession!" True, but if you were paying bills for those 5 years by selling investments, your portfolio didn't.

I think anxiety is an excellent metric for asset allocation. Bernstein agrees. In The Intelligent Asset Allocator[2], he recommends first allocating one's portfolio between stocks and bonds based on the greatest bear market loss we believe we could stomach without being tempted to bail out at market-bottom prices.

There are other factors to consider beyond the equity allocation of our portfolio, including total wealth and our floor of safe (not market-based) investments.

Very wealthy households may spend only a small percentage from their portfolios each year. They can afford to take more equity risk with limited risk to their standard of living. They have the luxury of riding out market declines and waiting for the recovery. If you only spend a percent or so of your investment portfolio each year, a bear market shouldn't bring on an anxiety attack.

Households without large savings but with significant safe income from Social Security benefits, annuities and pensions also have a more secure standard of living. I've helped clients whose safe income could completely cover their standard of living. They, too, have the luxury of riding out market declines and waiting for the recovery.

Retirees and near-retirees who lose sleep over the next bear market are likely to be largely dependent upon market returns to fund their desired standard of living. The problem may not be their portfolio's exposure to equity risk but a lack of income from non-market sources.

For these households, purchasing annuities can ensure more of their standard of living and allow them to take more risk — and potentially enjoy more gains — with a smaller equity portfolio.

Sleep loss and anxiety attacks aren't the only symptoms of a retirement plan that might not be right for you. Frequently checking your portfolio balance or regularly checking market levels can also be a red flag.

I check my portfolio balance (or more often my net worth) once or twice a year. I have felt the need to rebalance perhaps three times in thirteen years of retirement. Admittedly, I check more often in a severe bear market (I'm not immune to anxiety) and I suspect most retirees check more frequently than I do. Nonetheless, if you feel the need to check on your stocks more than monthly (or anxiously await your daily dose of Mad Money), it's probably worthwhile asking yourself why.

If your current retirement plan has you on edge like The Street subscriber, then your concern is likely more about losing your standard of living than seeing your savings balance abruptly (and hopefully temporarily) decline. Maybe you have too much equity exposure for your risk tolerance and risk capacity but maybe your plan is too dependent on market returns.

One of my favorite quotes about retirement planning is a comment from Michael Finke to financial advisors:
"Your goal is to make [clients] as happy as they can be in retirement and it may make them happier to have less anxiety about their investment portfolio.[3]
If your retirement plan makes you overly anxious about bear markets, maybe you need a plan that makes you happier.


[1] What to Do With Your Retirement Portfolio in This Volatile Market, The Street.

[2] The Intelligent Asset Allocator, William F. Bernstein, Chapter 8.

[3] What Makes Us Happy, The Retirement Cafe.

[4] Bear Markets and Recessions, Capital Economics via Business Insider.

Wednesday, September 12, 2018

Two Tweets and a Comment: Spending in Retirement

The inspirations for this week’s post are two tweets and a reader comment, which could be the title of a movie about retirement planning if anyone were ever desperate enough to film one.

Retirement planner and researcher, Larry Frank[1] tweeted a link from a Wall Street Journal article by Dan Ariely, a professor of psychology and behavioral economics. The article, entitled “How Much Money Will You Really Spend in Retirement? Probably a Lot More than you Think[2] suggests that the conventional wisdom that we will need to replace 70% to 80% of our pre-retirement income may be vastly optimistic and the real number could be as high as 130%. That will require workers to save twice as much as they expect, according to Ariely.

Before you throw up your hands and give up on ever saving enough, let me explain that these two numbers, 70% and 130%, don’t measure the same thing.

The leader in estimating “replacement ratios”, the income needed for the first year of retirement as a percent of the income needed to buy the same standard of living as the year before retirement, is AON Consulting.[3] AON doesn’t calculate a single replacement ratio but notes, for example, that it is higher for lower-income households than higher-income households. Over time, “conventional wisdom” settled on about 70% for a replacement ratio no matter what your circumstances, which is obviously a poor rule of thumb, however widely accepted.

Beware the Ides of March and rules of thumb.

For my two cents, from some unrelated research I'm doing using the Health and Retirement Survey data from 1992 to 2014, I find that about 550 one-person, retired households experienced a median replacement ratio of about 107% and about 850 two-person households experienced a replacement ratio of about 112%. I don't yet know how long those increases continued. As I mentioned, replacement ratios are about the first year of retirement. Furthermore, these are medians — your mileage may vary.

To be perfectly clear, I'm not a fan of replacement ratios as a planning device.

Two Tweets and a Comment: Spending in Retirement.
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Ariely’s calculations are the results of an experiment in which people were asked what they hope to do after they retire. Of course, many would hope to travel the world, eat all their meals in fancy restaurants, take the grandchildren to Disney World annually or retire to a golf resort. That will cost a bit more than simply staying home from the office, living in the same place and doing the same things as before without the commute, which is closer to the AON calculations.

The important points I learned from the Ariely column were more behavioral than economic. Here's one. I’ll bet if you ask most workers whether retirement will cost more or less than pre-retirement, most would answer, “Less, of course!” Ariely shows that really depends on what you plan to do after retirement and where you plan to do it.

The WSJ column provides a link[4] to Ariely's spreadsheet to calculate replacement costs based on your own retirement dreams. If you calculate that replacement ratio and then compare it to the AON Consulting replacement ratios specific to your financial circumstances, you may find numbers that differ significantly from 70%. Both numbers may help your planning by providing a range of estimated spending and they might also provide a warning flag that your expectations of what you can afford in retirement may be overly optimistic.

I found the behavioral aspects of the column more compelling than the economic perspective. First, replacement ratios compare costs for the first year of retirement to the year before. Hopefully, your retirement will last longer than a year and it is unlikely that if you decide to travel the world at age 65, for example, you will still be flying at 85. (Airlines statistics show that retirees tend to stop traveling internationally in their 70s.)

Even if the retirement you envision requires a 130% replacement ratio, that increase won’t last forever and probably won’t require doubling your pre-retirement savings target, though it will increase it. If an early-retirement spending increase were to actually be sustained for your entire retirement then your savings needs might double but I doubt that it will.

Ariely states that in retirement "Every day becomes just like the weekend. And on the weekend, we have all kinds of time and opportunities to spend money. We shop, travel, buy tickets for events and eat out." As a retiree of 13 years, I don't know any retirees who would agree that retirement is like that, at least not moreso than when we worked, and I will repeat my assertion that we need more researchers with retirement experience (a personal peeve).

My second inspiration was a tweet from a financial planner who didn’t understand why estimating retirement spending is difficult. He suggested basing it on the past four months of current expenses. Calculating current spending is indeed relatively simple and estimating spending for the first few years of retirement isn’t a stretch; the challenge is estimating spending 10, 20 or 30 years into the future.

Will your retirement spending go up or down after you retire? I think the best research on this question comes from David Blanchett[5] and Sudipto Banerjee[6]. Blanchett concludes that a household’s spending trajectory is a function of the ratio of retirement savings to the desired standard of living or said differently, a function of whether the retired household has saved appropriately for the desired standard of living, under-saved, or over-saved.

Blanchett found that households with appropriate savings tend to see a 1.5% to 2% annual reduction in the cost of retirement (spending), though it isn’t a smooth decline. He found that households that “over-save” tend to realize they can spend more after a few years and do. At the other extreme, households that haven’t saved enough tend to notice their savings are declining too fast and reduce spending.

Some have interpreted Blanchett’s findings to suggest that spending declines for the "first half" of retirement and increases for the second half. That’s really only true if you live to 100 or so. Most households won’t and their spending trajectory will look a lot like Banerjee’s chart, which is to say that spending will tend to decline throughout retirement and even large end-of-life costs will likely be smaller on an inflation-adjusted basis than first-year spending.

Which direction your spending will head is unknowable. It’s important to understand that these projections are made for the population of retirees and there is no way of knowing if your household's unique retirement spending will be like any of these averages. Your retirement spending will be determined not only by your wealth and income but also by how much life decides to charge you and for how long.

My final inspiration was a reader asking how much money she will need to spend annually throughout retirement. You can see my response in the comments section at The Critical Factors of Portfolio Ruin Aren't Predictable but there is one inescapable reality — no one can predict how much wealth and income an individual household will have or how much it will need with any accuracy for more than a few years.

To summarize this information about retirement spending, I would say we have some good research on population averages but they can’t predict the future of a single household. Ariely tells us that the retirement we want might be more expensive than the one we can afford and perhaps more expensive than our pre-retirement standard of living. Blanchett and Banerjee tell us that retirees who have saved enough and those who have saved too little tend to experience spending declines throughout retirement. The airlines tell us that we become less adventurous in our 70s.

No one can tell you how much your household will need to spend or be able to spend for more than a few future years. The only realistic solution is to plan for the long term but adjust often.

Retirement finance has no cruise control.


[1] You can follow Larry Frank on Twitter at @LarryFrankSr and you can follow me at @Retirement_Cafe.

[2] How Much Money Will You Really Spend in Retirement? Probably a Lot More than you Think, Wall Street Journal.

(I frequently have problems with the WSJ paywall but you should be able to read this by clicking "sign in" if you don't subscribe. If not, I found that I could read it by Googling "How Much Money Will You Really Spend in Retirement? Probably a Lot More Than You Think" and clicking the link on the Google search page.)

[3] AON Consulting Replacement Ratio study, AON Consulting.

[4] Retirement Spending spreadsheet, Dan Ariely.

[5] The True Cost of Retirement, David Blanchett.

[6] Expenditure Patterns of Older Americans, 2001-2009, Sudipto Banerjee.