Tuesday, November 12, 2013

Deep Risk: Wealth versus Standard of Living

Standard of living and wealth are closely related but they aren’t exactly the same thing.

You can buy the same standard of living at dramatically different prices, for example, depending on which city you choose to live in. Your current standard of living in Manhattan would cost you less in San Francisco, much less in Wichita.

Even if you retire in place, you will no longer pay FICA taxes or need to save for retirement, so you can have exactly the same standard of living at a significantly lower cost without even relocating.

If you play around with consumption smoothing at E$Planner.com, you begin to see a number of things that can raise or lower your standard of living (discretionary spending) with a given level of wealth. You can delay Social Security benefits, for example, or pay off your mortgage and perhaps be able to spend more with the same amount of wealth.

That’s the benefit of consumption smoothing, arranging all your assets, borrowing power, and income streams to provide the highest consistent discretionary spending level, though these might not be the optimum strategies to maximize your portfolio value.

Consumption smoothing has convinced me that standard of living is a better metric for retirement planning than wealth. That thought hit home as I was reading William Bernstein’s new e-book, Deep Risk: How History Informs Portfolio Design (Investing for Adults).

(If you want to understand retirement finance, read this book. Then read the rest of Bernstein’s books, magazine articles and his posts from long ago at http://www.efficientfrontier.com. When you finish, you will know more about the subject than 99% of the population. Heck, you’ll know more than 99% of financial planners.)

Bernstein distinguishes between “shallow risk” and “deep risk” based on the amount of the potential loss and its duration, or how long it would take the investor to recover that loss. Normal portfolio variance is shallow risk, for example, and a major depression would be a deep risk.

I think of it a little differently. I think of shallow risk as financial risk that won’t impact my long-term standard of living, while deep risk can.

Bernstein identifies four major types of deep risk: long-term inflation, deflation, confiscation and destruction. He notes that deflation is actually a symptom of economic depression and not the disease. A year or two of deflation probably won’t destroy you, but long term deflation associated with an economic collapse (think Japan) might well do the trick.

Confiscation refers to the government seizing your assets. While taxation always does this to some extent, Bernstein is thinking more along the lines of Russia and Argentina. Massive confiscation is pretty unlikely in a developed nation like the U.S. and as Bernstein points out, it’s difficult, expensive and perhaps felonious to protect yourself against it.

Destruction is loss due to a war or a natural disaster and again, there is no reasonable way to protect yourself, unless you are ridiculously wealthy.

(I’m not sure where Bernie Madoff fits among the four horsemen, but theft and fraud have cost more retiree’s their life savings in the U.S. over the past 75 years than deflation, confiscation and destruction combined. Not covered in Deep Risk, it certainly warrants your consideration as a major risk to your standard of living.)

If you're a long-time reader of Bernstein, you know that he believes a retiree can't expect more than an 80% probability of successfully funding retirement. That's not because he thinks the safe withdrawal rates math is wrong, but because he thinks there are larger risks, like these four, that may render the withdrawal rate moot.

What actionable information did I take away from Deep Risk?  Perhaps not a lot, but then I was pretty much a Bernstein guy to begin with.

Perhaps I feel a little better knowing that, while I have done nothing to protect myself against destruction and confiscation, there is little I could do. Stashing gold bars in various banks around the world or buying real estate in those places probably isn’t in the cards for me. These are highly unlikely events in the U.S., anyway.

Since most countries moved away from the gold standard, instances of deflation around the world have greatly diminished. Still, deflation in the U.S. is possible and far more likely than losses due to war or a cataclysmic natural disaster.

The problem with protecting against deflation risk, as Bernstein explains, is that the solution (long term bonds) is a really bad one if we experience inflation, instead, and that is a far more likely possibility. Bernstein estimates that the likelihood of destructive, pervasive inflation is an order of magnitude greater than that of a depression.

That leaves inflation as the most likely of the four risks and not the 3% or 4% we typically see, but a long, grinding period like we experienced in the seventies. Deep Risk suggests two solutions, depending on whether you’re trying to protect yourself for the next 10 to 20 years, or the next 20 to 30. TIPs work better for the former, but Bernstein believes a globally diversified stock portfolio better protects us against inflation for money we probably won’t need in the next two decades.

Bernstein also writes that shallow portfolio risk can turn into deep risk if an investor chooses (or is forced) to sell assets at low prices during a market crash. In fact, he believes it is the most common way that people experience a real loss of standard of living.

And that brings me back to my initial thought about a standard of living metric. Bernstein often suggests two retirement portfolios, along the lines of Life Cycle Finance Theory, with one to provide the income we need to maintain our standard of living (he refers to this as a “liability matching portfolio”) and the remainder of our assets, if we are so fortunate to have any, allowed to grow in a risky portfolio.

This approach secures your standard of living while perhaps giving up some potential to grow your overall wealth. In essence, you have a “standard of living” portfolio that you don’t put at risk and a “wealth” portfolio in which major losses won’t impact your standard of living.

And, here’s the actionable information I gleaned from Deep Risk. Instead of thinking of my retirement assets as two portfolios, I’ll think of three. My risky portfolio will remain the same, but I may start thinking of my 20-30 year standard-of-living liabilities as being met by a larger stock allocation to mitigate the risk of a long bout of inflation and as a better solution than long bonds.

Thinking of wealth and standard of living as two separate but closely related financial metrics brings me greater clarity when I think about retirement planning.

So does reading Bernstein.


  1. Thanks Dirk. I wonder if you would comment on what you recommend for the near-term retirement portfolio, and what stock allocation you're thinking of for the 20-30 year portfolio. Also, at what age would you suggest someone put in place these 2 or 3 'portfolios' , i.e. how many years prior to retirement? Currently I'm basically in the market with a 50/50 allocation. Really enjoy your posts.

    1. Honestly, I don't think there is a good answer today for the near-term retirement portfolio, but I think short bonds and cash are the best of a sorry lot while we wait for the Fed to let rates rise. Rates have to rise from here at some point, so long bonds will lose value as will intermediates to a lesser extent. We're due a setback in equities. My plan is to invest safely and wait it out. There are worse things than a zero return on TIPs, like a negative return on equities.

      Regarding the age to put the portfolios in place, please look at my column "Sequence of Return Risk or Something Else" at http://theretirementcafe.blogspot.com/2013/09/sequence-of-returns-risk-or-something.html. The biggest market risk to your standard of living occurs in the decade before and the decade after retiring. I like the work by Pfau and Kitces cited in that column that says you should reduce your stock exposure significantly then.

      I've just started thinking about the 20-30 year portfolio, but my initial thoughts are that I would hold mostly equities at the beginning, selling a portion of those positions to build a TIPs ladder rung every year until after ten years I would hold only bonds in that portfolio for the last 20 years of retirement.

      Thanks for the compliment, and thanks for reading.