Friday, February 1, 2013

Your Retirement Savings: WIll You Take the Bet?


Yesterday, I spoke at length with a very nice lady in her mid-fifties who is wondering if she will be able to retire at age 62. After discussing her financial situation for about an hour, I told her that if the stock market is kind to her for the next few years, her chances of retiring at age 62 and maintaining her pre-retirement standard of living look quite good. (Her finances would, however, look even better if she delayed retirement a few years, but 62 appears doable.)

Her response was that she invests with a credible wealth manager who ran sophisticated software that said if she retired at age 62 she would have a relatively high probability of running out of money before she died.

Am I right, or is her wealth manager?

Actually, we both are.

Her wealth manager is saying that if she retires at age 62 and invests her retirement savings in the stock market, there is a good chance that her portfolio won’t earn enough to fund retirement if she lives a very long time, say into her nineties. And I completely agree with that.

I’m saying that if she retires at age 62 and uses her savings to purchase a life annuity or a ladder of U.S. government TIPS bonds, that she can almost certainly fund a long retirement that begins at age 62.

Her wealth manager would argue that by purchasing TIPS or annuities when she retires she gives up the opportunity to improve her standard of living if her retirement future holds a roaring bull market. I agree with that, too.

He would also probably agree with me that the opportunity for improving her standard of living brings with it an opportunity for lowering it substantially.

The decision comes down to this: Are you willing to risk losing your retirement standard of living in exchange for a chance to improve it?

There are two schools of retirement finance strategies. The first, advocated by a long string of Nobel laureates, says to create a “floor” of retirement income that is as certain as possible by purchasing lifetime annuities or investing in government bonds. Then, you can invest any assets you have left over in the market to create upside potential. 

(A large majority of Americans today don’t have enough savings to guarantee the floor of their pre-retirement standard of living, let alone surplus savings to invest for upside.)

The second school, advocated by the investment industry, suggests that investing in the stock market is always more profitable in the long run than government bonds and annuity payouts (it is — because it’s riskier). Sure, stock investing is risky, but they believe (incorrectly) that stock investing gets safer the longer you hold the equities, so you can manage that risk (you can’t).

I find that people feel very strongly about their preference. I recommend the “floor and upside” approach because the stock market-only strategy entails far more risk in retirement than I consider acceptable. 

Many prefer the stock market-only approach because they can accept the risk, or more likely because they don’t really understand that risk. The market-only approach also includes a wonderful possible outcome (retiring into a roaring bull market), unlikely though it may be.

Regardless, my discussion yesterday exemplifies a choice that anyone with substantial retirement savings will have to make when they leave the workforce. 

Do we maintain our current standard of living as best we can, or risk making it worse for an opportunity to make it better?

4 comments:

  1. Hi Dirk, Really good post. Hey Wade you are here that's good too.
    Annuity types

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  2. This comment has been removed by the author.

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    1. For some people, selling a home is a very emotional issue. My father-in-law is 95 and still lives in the house he bought when he was married around 1950. Selling never occurred to him.

      If you're OK with selling, doing so can reduce your maintenance workload significantly. I'm starting to think about downsizing, too.

      From a purely financial perspective, selling may improve or worsen your standard of living, depending on your individual circumstances. The best way to look at that, in my opinion, is with consumption smoothing. There is a free tool at http://basic.esplanner.com/ that will calculate your standard of living in both scenarios.

      Even if not selling generates more spendable cash, though, not having to rake, mow, paint and chlorinate the pool becomes more and more attractive, I agree.

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