Friday, November 20, 2015

Uncertainty Denial

Joe Tomlinson wrote an excellent piece at Advisor Perspectives last week entitled, “The Most Critical Planning Assumption – and How to Choose It.” The piece is primarily a warning to advisers who rely on a single estimate of future market returns for retirement plans, or who use planning software that limits them to a single estimate, but there is a lot of good insight in the piece for all of us.

The assumption Joe has in mind is the equity risk premium, or ERP, but to simplify the explanation, I’ll substitute a related and more familiar term, the expected market return.

We need to estimate future market returns and volatility to make a number of calculations, including how much we need to save, how much we can spend each year, and what an ideal asset allocation would be. We may also use this estimate of future returns and volatility to determine how much to allocate to a floor portfolio. If we think future equity returns will be quite high, we’ll probably feel less need for a large floor portfolio and vice versa.

Since so many plan parameters are dependent upon this estimate of market returns and volatility, Joe rightly calls it the most critical assumption. (I think there's a strong argument that life expectancy is the most critical assumption, but I'm sure Joe and I agree it's best to assume a long life.)

The issue Joe describes is that there isn’t a single spending rate, savings rate, asset allocation and floor allocation that are optimal across the broad range of possible returns suggested by such a mean and standard deviation. Picking the optimal parameters from the average (and most likely) scenario may be wildly incorrect if your retirement ends up significantly better or worse than the average case you predicted.

Plan results are very sensitive to the market return and volatility assumptions. A small change in a plan's market return assumption can make a large difference in what we calculate as optimal spending rates and asset allocations. The error in our estimate of future market returns gets magnified.

"Pretending we can accurately predict a critical assumption like future market returns is dangerous overconfidence. "
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Tomlinson provides an example using Professor Aswath Damodaran’s estimated ERP of 6.25% with a standard error of 2.32% for the period 1928-2014. He assumes a 65-year old retiree with a 4% spending rate and $1M savings portfolio at retirement. He finds that depending upon where the returns actually fall within that broad range of potential outcomes, a retiree would have a portfolio failure rate ranging from 2% to 42%, a median bequest of $127,000 to $2M, and an optimal stock allocation ranging from 10% to 90%.

I ran those estimates through Moshe Milevsky's formula for lifetime probability of ruin (download PDF) and found 95th percentile sustainable withdrawal rates ranging from 2.35% to 8.5%. Here's a chart with data from the Tomlinson piece and my own SWR calculations.

Source: data from the Tomlinson post plus author's calculations.
To quote Joe's post, a completely forthcoming (though, likely unacceptable) discussion with a client should go something like this:
Your results will be heavily dependent on the extra return of stocks over bonds. Unfortunately, we have limited statistical evidence and don’t know what to expect. The best I can do is tell you that I’m 95% confident that you can expect a bequest in the $100,000 to $2 million range and that the probability of plan failure is somewhere between 2% and 40%. For an asset allocation recommendation, it could be anything from 10% to 90% stocks.
I actually believe Joe is optimistic about our prospects here because even if we could accurately predict future returns with a relatively small variance (we can’t) we need to consider sequence of returns risk when we save to or spend from a volatile portfolio. Sequence risk is unpredictable and an unfortunate sequence of returns can ruin even a good average return. We need to know the return, the variance and the sequence of those returns.

The gist of Joe's post is that retirement plans entail a great deal of uncertainty and that pretending we can accurately predict a critical assumption like future market returns is dangerous overconfidence. (Please read his column – I don't do it justice.)

We tend to think that the estimates of our optimal asset allocation, floor allocation, safe spending rate and required savings can only be as good as our estimate of future market returns. I think it's correct that they won't be more predictable. The problem is that our plans are highly sensitive to market return assumptions, so those optimal parameter estimates can actually be a lot less predictable than our market return estimate.

Generally speaking, I think most of us understand that retirement finance, and investing in particular, is risky, but I also think we are overconfident in our ability to manage that risk. We pretend that we can accurately (or accurately enough) predict future market returns. Many of us seem to believe we know whether we will live long lives. We believe we can identify a precise sustainable withdrawal rate when that rate is a function of both the rate of return we can't predict and how long we will live, also unpredictable. We believe we can avoid stock market risk by simply holding stocks a very long time.

This is overconfidence. There are ways to manage this financial risk but even if we do the best job possible there will still be much uncertainty.

You're likely overconfident when you think, "I'm really not sure what my investments will return in the future, but I probably oughta' tweak my asset allocation by 5%."

Next post, I'll suggest an approach to accept and plan for this uncertainty.