Tuesday, March 11, 2014

Diminishing Returns

My major goal in writing this blog is to explain retirement finance to people who aren't economists or financial planners. Based on the responses from some of my readers to The Upside of Downside, I failed miserably with that particular effort. If you're one of those readers who felt like he had just swallowed a jawbreaker whole after reading it, here's a do-over.

The question I want to consider is "what are the chances that you can increase your spending at age 95 by investing in stocks after retirement and do you really care?"

The Upside of Downside may have seemed overwhelming to some because I tied together several different observations to reach a conclusion. The conclusion is that betting some of your secure retirement income in an effort to improve your standard of living as retirement progresses may not pay off as often as you think and, when it does, the increased spending will likely arrive later than you'd like to have it.

The observations were:
  • You can lose your standard of living with systematic withdrawal strategies as easily as you can increase it. SW suggests that you will avoid ruin about 95% of the time, not that your portfolio will continue to grow after you retire 95% of the time. More often than not, based on historical market returns, your portfolio would have declined in real value from its initial balance after 30 years.
  • Most retirees spend more early in retirement than they do later. A typical retiree's spending is highest when she retires and it declines constantly throughout retirement at about 2.3% a year. 
  • When it works well, given time and compound growth, SW generates the most wealth when you have the least need for spending (late retirement) and the least wealth when you need it most (early retirement).
  • It takes about 10 years to reliably grow a portfolio 20% or more. So when you're 65, for example, you're investing to increase spending when you turn 75.
  • By the time you're about 80, you will be less active and more consumption will be less attractive.
  • You're a lot more likely to still be living during the first half of a long retirement than the second half. Beware retirement strategies that are back-end loaded. Not all of us see the second half.
The easiest way to see the implications is to begin at the end.

Let's say you're 95 years old and have just enough money to invest in Treasury bonds and CDs to generate all the income you need for 5 to 10 more years. A financial planner knocks on your door and suggests that you take some of that Treasury bond money and invest it in the stock market so you can maybe have even more money to spend when you reach 105. There's about a 45% probability that your spending will increase significantly and a 22% chance it will decline significantly over the next ten years with this strategy.

You explain to him that your chances of living to 105 seem extremely slim, maybe 2%, that you're not planning any European vacations, that you don't play much golf, anymore, and that you can't think of anything you would buy if you had more money to spend. Then you chase him through the living room and back out the front door waving your cane at his head. He's amazed you can still run this fast.

Now, let's back up to your 85th birthday. You have just enough money to invest in Treasury bonds and CDs to generate all the income you need for 15 to 20 more years. A financial planner knocks on your door and suggests that you take some of that Treasury bond money and invest it in the stock market so you can maybe have even more money to spend when you reach 95. There's a 45% chance that your spending will increase by at least 20% ten years from now, but a 22% chance that it will decline by at least 20%.

You ask him if he is aware that a man your age only has a 14% chance of living ten more years to even begin to spend that extra money. He shrugs. At 85, you're not planning any European vacations, you don't play much golf, anymore, and that you can't think of anything you would buy if you had more money to spend if and when you're 95. Then you chase him through the living room and back out the front door waving your cane at his head. He's amazed you can run this fast.

Back at age 75 now, you have just enough money to invest in Treasury bonds and CDs to generate all the income you need for 20 to 25 more years. A financial planner who may continue to annoy you for decades knocks on your door and suggests that you take some of that Treasury bond money and invest it in the stock market so you can maybe have even more money to spend when you reach 85.

You ask him if he is aware that a man your age only has a 50/50 chance of living ten more years to spend that extra money. He shrugs. You're still fairly active at 75, but doubt you will be as energetic at 85. But he's not promising more money to spend now, he's promising it when you reach 85, which you find less appealing. And it's not really a promise. It's a 45% chance. And maybe your wealth will decline. It certainly isn't attractive enough to bet some of your current, adequate income. You point him back toward the front door and bid him good day.

One more leap in the time machine takes us back to retirement day at age 65. (Was that Mr. Peabody at the controls? He hasn't retired??)

You think you have enough savings to last 30 years, but that's a very long time and you're certainly not sure. A financial planner you will one day regret ever letting into your home knocks on your door and suggests that you take some of that money and invest it in the stock market so you can maybe have even more money to spend when you reach 75. There's an 80% chance that a man your age will reach 75 to spend some extra money and you should still be active then. There's a 45% chance you'll be able to spend more, but a 22% chance that your spending will decline.

Maybe risking a little of your secure future income in hopes of spending more at age 75, ten years from now, has some appeal. Maybe not.

As you can see, the deal looks somewhat interesting at age 65, but as you age, it loses its appeal. You need less money as you get older, you're less likely to live long enough to spend additional money, or to be active enough, and risking some of what you have for certain to maybe spend more ten years down the road makes less and less sense as time passes.

This scenario isn't limited to systematic withdrawal strategies. In fact, unless you're quite wealthy, you are likely to have less money to invest in stocks with a floor-and-upside strategy than with SW and, therefore, to have even less potential to increase spending.

If you do decide to make the bet at 65, you may want to change your strategy more toward a floor around age 70 or 75.

The downside of the bet to generate upside spending potential is that you may not be healthy enough  or even around enough   to enjoy the increased spending even if you win the bet.

And, that's most of what I tried to get across in The Downside of Upside.

11 comments:

  1. Hi Dirk, I like the first one, and this one. Don't think I'm willing to take the risk for additional income for all the reasons you stated at any age. It took too long and too much effort to risk it now. Enjoy the humor in all your blogs. Brad

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  2. Dirk. I enjoyed and understood The Downside of Upside but this one was a whole lot more fun to read and should make it clear to anyone who struggled with the first post. I am in 100% agreement about spending reducing as you age. I have seen it with my parents who have plenty of money but have no desire to spend 15 hours on airplanes to go on vacation. If I make it that long I'm sure I'll feel the same way too.

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  3. Hello. I'm new to your blog and enjoyed this post. I'm 65, retiring next month, and my Fidelity local rep is trying to talk me into switching my conservative income-producing investments to 70% stock 15% bonds and the rest in a single premium deferred annuity or a tax deferred annuity. And of course, she wants me to pay Fidelity to manage it with the strategic advisors program at about 1%. When I asked her what the total cost would be with the expense ratios of the stock mutual funds they put me in, she suggested that I research the expenses. All that to say that even at 65, I'm not thinking I want to try for more money at 70 or 75, Just one comment about spending less as we age - maybe that's true in terms of goods and services, but the risk of inflation could have us all spending a lot more on just the stuff we buy now to get us through our day to day lives.

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    1. My personal opinion is that management programs like Strategic Advisors don't add value, not value that is worth the cost, anyway. I think the literature is pretty persuasive that minimizing cost is far more effective and the way to do that is by investing in low-cost index funds. I just showed a friend the cost of Strategic Advisors compared to his returns and he got out of the program. Strategic Advisors, as I recall, waives loads but does not, of course, waive expense ratios.

      70% is a lot more than I would invest in stocks, though a SPIA would allow you to invest more aggressively than if you didn't have one. Your new portfolio, exclusive of the SPIA, could decline about 30% in a bad bear market. With 15% in a SPIA, as you suggest, you would still see 85% of that loss, or about 25.5%

      Regarding your last comment, the spending declines I noted are in real dollars, so the risk of inflation is already accounted for.

      Thanks for writing.

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  4. Thoughtful post - and an argument for longevity insurance? I think its good to reflect on one's potential changing consumption patterns, but the idea that spending just declines seems flawed. I may not be taking cruises when (if!) I'm 90, but I may need to pay for help to cruise in and out of the tub?

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    1. I'm not completely sold on longevity insurance, but I think it is the best of annuity options and is certainly worth considering, depending on your individual requirements. I like a paper by Jason Scott on the subject. (Google "The Longevity Annuity: An Annuity for Everyone?" by Jason Scott. I can't include links here.)

      The spending studies don't say that spending declines for everyone, it says that it declines for the "typical" retiree. You may have higher health care costs later in life, for example, but as Blanchett notes, "High health care costs become a factor in later years, but even then, real spending was lower overall than it was at the start."

      We can't predict that everyone's spending will decline in retirement, we can only note that in the past it has declined for most retirees.

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  5. HI Dirk. Nice post. I am long term advisor and have felt for many years that the products promoted by many investment firms and advisors are completely out of touch with how life actually unfolds for the average retiree and more in touch with the firms' and advisors' financial goals. When I have meaningful conversations with my clients - those in the middle class - they generally want security and stability throughout retirement and the opportunity to do things in the first 10 to 15 years. After that, they are realistic about their needs and fully expect to moderate their lifestyles. I also like this presentation - for me, simple is always better!

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  6. Thanks, Mark! Couldn't agree more with the "out of touch" comment. If I had met an advisor like you a couple of decades ago, I probably wouldn't have bothered to learn how to do it myself.

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  7. Dirk,

    Great post as always, and I'm sympathetic to your view. But let me try to defend the probablity-based side a little here.

    You're certainly right that for someone who has saved enough to lock their lifestyle goal with safer assets, it is certainly dangerous to get greedy and risk one's goal by striving for greater upside.

    But for someone who is not quiet fully funded, I don't think the situation for them is necessarily about investing in a way that _could_ give them a chance to increase spending later on. Rather, they would probably want to _amortize_ that greater spending potential over their lifetime by spending more today as well.

    Being aggressive in retirement can mean spending more aggressively and/or investing more aggressively. Maybe they see that they could lock in 4% today safely, but they really want to spend 5% today. That's where the need for upside comes into play, but that is also where, as you wisely suggest, they could dig themselves into a further hole and only be able to spend 3% tomorrow.

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    1. Wade, thanks for the comment. By the way, if you guys aren't reading Wade's blog at http://wpfau.blogspot.com/ you're missing out on the best retirement blog available. Period.

      Back to your comment.

      Fair enough. My post creates two classes of aspirations: retirees who hope to increase their spending IF AND WHEN their portfolio grows and those that have other goals, like leaving a legacy. I'm suggesting that the latter is a better fit for stock investments than the former and that the potential to spend more in later retirement isn't that attractive.

      You are noting that there can be a third class of retirees who want to spend more EARLY in retirement, speculating that they might make up for it with future stock returns. That is speculation, of course, because upside potential may never be realized. And since it is speculation, you might well lose that bet. Still, that is a valid strategy for retirees who find that risk acceptable. (I would never recommend it, for what that's worth.)

      Also my personal opinion, "want" doesn't factor in to retirement planning. I WANT to spend 15% every year. I just don't have enough wealth to do that. You can't invest your way out of under-saving. If you were that good an investor, you wouldn't have under-saved over the previous three decades.

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  8. bookmarked!!, I like your web site!

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