Friday, October 25, 2013

A Retirement Plan Begins at the End

A lot of retirement planning revolves around your expectations for the end of retirement.

You need to begin with the end in mind, as they say.

There are two basic schools of thought regarding retirement financing. The first, explained by Zvi Bodie in The Theory of Life-Cycle Saving and Investing, is often referred to as the life-cycle approach, or sometimes the "safety first" approach. It is based on the principle that you should first secure your minimum acceptable lifestyle by investing in safe bonds, life annuities and the like, and only then risk what's left of your savings in the stock market in hopes of improving your lot.

The other school is represented by Safe Withdrawal Rates (SWR) and refinements of that strategy and is predicated on making a stock portfolio "safe enough" to minimize the chances that you will go broke late in life. No one, including SWR advocates, will tell you that this strategy will work 100% of the time. In fact, they shoot for about 95%.

So, the bulk of retirement planning revolves around how important it is to you and your spouse to be financially secure if one or both of you live long lives.

For retirees like me who want as close to a zero percent probability of going broke in their nineties as they can possibly arrange, betting on how long we will live or counting on a wonderful next thirty years of market returns isn't good enough. We know that we might live to 95 or 100 and that the market might not bail us out.

But not everyone feels that way. Some feel that a 5% chance of running out of money is an acceptable risk for the opportunity to improve their standard of living. Or maybe they're convinced that longevity isn't their fate.

Neither of us is right or wrong. We safety-first people are simply less willing to take that risk than are the SWR crowd.

The group that worries me are retirees who believe they can have both a perfectly safe retirement and invest the bulk of their savings in the stock market. They hope to find a magic withdrawal rate, buy equity-indexed annuities that promise stock market returns with no downside, or some other such "spending strategy".

You can't have both. If you choose the stock market route, understand that you risk suffering a permanent reduction in your standard of living. If you opt for the safety-first route and the market goes straight up for the next 30 years, understand that you risk missing out on a huge, long-term bull market.

With either choice, in the worst case outcome you'll need to feel good about saying, "I knew the risk. It was a wise decision. I'd do it again." If you don't think you would be able to say that, you're probably making the wrong choice.

My personal feeling is that I would be happier with my current standard of living and missing out on a grand bull market than going broke late in life. Thinking that probably won't happen doesn't work for me. But, that's a personal decision.

Knowing which school of thought suits you can be a huge help when you begin planning retirement. If you're a safety-first kind of person, your plan will include strategies like saving a lot for retirement, spending less after you retire, claiming Social Security benefits as late as possible, buying TIPS bond ladders and maybe even fixed annuities.

A safety-first retiree ignores life expectancy and plans for the worst-case financial outcome living a long time and going broke.

If you're willing to risk financial safety in your later years, your available strategies will include stock and bond portfolios, perhaps saving less and spending more, maybe claiming Social Security benefits sooner. Perhaps you consider the probability of living a very long time an acceptable risk. You may do better or worse than the safety-first strategies and you might go broke. That's the risk.

Most of the clients I work with spend the bulk of our time together struggling with the risks and rewards of these two approaches, generally trying to convince themselves that there is some way to have both maximum financial security in old age and the maximum opportunities possible with stock investments.

There isn't a way to have both, but I'm not sure I have ever completely convinced a client of that.


  1. "Therefore, since the world has still
    Much good, but much less good than ill,
    And while the sun and moon endure
    Luck's a chance, but trouble's sure,
    I'd face it as a wise man would,
    And train for ill and not for good."
    A.E. Housman - LXII A Shropshire Lad