When “Probably” Isn't Good Enough

Financial planners have long discussed whether we should pay off the mortgage, or keep a mortgage and invest that capital in the stock market.

The naive argument is that one can borrow a mortgage at say, 4%, and invest the money for a 10% return in the stock market, netting 6% on the “arbitrage”. But paying off a 4% mortgage is risk-free. (It is not a function of stock market returns.) The 10% market return in this example has a standard deviation of 20%, far from risk-free, based on historical market returns since 1926.

If you could find a risk-free 10% and keep the mortgage, that would be a certain 6% net and true arbitrage. But, that ain't gonna happen.

You would, in fact, earn the 6% difference in the years in which you receive the expected market return of 10%, but half of annual market returns are expected to be more than 10% and half less.

The meaning of “10% expected return with a standard deviation of 20%” is that in about two out of three years the returns will fall within the range of a 10% loss to a 30% gain (+ or - one standard deviation from the mean). That means the net return after the 4% mortgage payments will fall between a 16% loss and a 26% gain two out of three years. In 2007 to 2009, market returns fell way over to the wrong side of two-thirds of returns.

The worst financial mistake I have made in retirement (I should add “so far”) was taking the advice of a well-known financial planner in Washington before I retired in 2005. I could have bought my retirement home with cash, but he convinced me to hold a mortgage and leave that cash in the market. He gave me this advice because he thought the market would probably return about 10% a year on average over the life of the mortgage. But probably isn't the same as certainly and average isn't the same as annually.

Two years later, in 2007, the stock market crashed. Had I paid for the house with cash, I would have had hundreds of thousands fewer dollars exposed to the stock market.

The housing market crashed, too, but I don't plan on selling my home for a very long time, so that wasn't painful. Even the stock market crash was tolerable because I held a quite large helping of bonds. But it bugged the hell out of me that I had borrowed money against my home and paid a lot of interest for the privilege of losing that borrowed money in the stock market and that I was advised to do so by someone I trusted.

Fortunately, I could handle the losses. The former home of a good friend remains empty to this day after that housing and stock market crash. I see it every day, falling into disrepair. His mortgage was foreclosed, which brings up the most important reason I know to not borrow a mortgage to buy stocks. If you buy stocks on margin and the market crashes, you may have to sell some of your stocks and take a loss. If you buy stocks margined with your home and the market crashes, you can lose your home.

My friend had a lot of money going into 2007. It didn't seem at all likely that he would lose his home within a year.

Losing my home is high on my list of unacceptable outcomes.

I just found a 2011 article by Michael Kitces entitled Why Is It Risky To Buy Stocks On Margin But Prudent To Buy Them "On Mortgage"? This column and the comments adequately vet the issues, so I'm not going to repeat it or start a similar thread here. The issue I actually want to bring up is one of the magnitude and probability of risks.

The Retirement Income Industry Association  (RIAA) describes this in perhaps the most stilted prose you can encounter. I include it here for your literary amusement:

“The diverging opinions about the value of flooring in practice may derive from the range of opinions – that cannot be proven a priori – about a practitioner’s (or a client’s) view of the primacy of the probability of failure vs. the magnitude of failure. Some believe that the probability of failure looms greater in people's minds than the magnitude of failure. Others believe that consequences always trump the odds. There is no way to tell, a-priori, who is right and who is wrong for a specific set of circumstances whose resolution and outcomes are yet ahead of us.”

There. Got that?

What they're trying to say, sort of, is that at some point the consequences of failing are so horrible that “probably won't happen” is no longer good enough for some people. This is an ongoing struggle in financial planning with the “probabilities” group arguing that you can invest in stocks and you probably won't go broke and the “safety first” group countering that you should first make sure that nothing really bad is going to happen and invest what's left over in stocks.

Note that neither group says that you can't lose a whole lot of money. One side merely argues that you probably won't. The other side agrees but argues that “probably” isn't good enough when it comes to losing your standard of living in old age.

I lean toward the safety-first school. My tendency is to first take the unacceptable outcomes off the table and as I mentioned, I consider losing my home an unacceptable outcome.

I'm not against people taking financial risk in retirement. Given the difficulty involved in funding a retirement with our current system, there is no risk-free way to achieve it. I'm only against people taking risks they don't understand.

I've talked with many people who lost their homes or fortunes and not one was able to say, "I understood the risks when I took them and, if I had it to do over, I would make the same bet."

My former neighbor was a business school graduate and he could probably explain the details of his mortgage and his foreclosure risks. I'm just not sure he ever internalized that risk until it was too late.

My point isn't specifically about mortgages, or stock investments, or when to combine the two. It's about risk, both its probability and magnitude. Don't dismiss a potentially catastrophic outcome because the probability of it happening is very low.

You might go broke with a systematic withdrawals strategy, but you probably won't.

You might lose your home if you take a large mortgage and invest it in stocks, but you probably won't.

You could come up short if you claim Social Security benefits early and live to 90, but you probably won't.

The question you have to answer is when “probably won't” is good enough for you.

Retirement Advice for People Who Aren't Rich

I write a retirement finance blog primarily to help people who don't have enough money to attract the interest of a good financial planner. (Hence, the tag line above.)

In reality, retirement planners are effective for a relatively small group of people who have enough money to be profitable for their planners but not so much that they don't need a retirement planner. Bill Gates doesn't need a retirement plan (though he certainly needs tax plans, estate plans, insurance plans, etc.) and households with no retirement savings probably won't find good, inexpensive planning help — except for my blog, of course!

There are ways that people who couldn't save enough money for retirement can improve their situations, by postponing Social Security benefits as long as they can work, for example, and I try to cover those in my blog.

Ron Lieber wrote a column in the New York Times entitled Retirement Advice for People Who Aren't Rich identifying some new services that may also provide retirement planning help for the "unwealthy". Betterment, Wealthfront, WiseBanyan and LearnVest are such services. Though they are all young and unproven companies, they sound interesting enough to consider.

A big caveat here, I have not vetted or used any of these services, so I can only recommend that you research them. I cannot recommend that you actually use them, though I will try them out in the near future. No one knows if these companies will flourish or fail.

The company I feel much better about is Vanguard. I am a longtime Vanguard customer. I love the company and its investment offerings. (I thoroughly dislike their banking services, however, and recommend you consider Charles Schwab if you are looking for a top quality investment company with outstanding and inexpensive banking services. I love Schwab Bank.)

According to Lieber, "Vanguard’s full-service offering, called Personal Advisor Services, costs 0.3 percent annually of the assets it’s managing. For now, customers need $100,000 in accounts there to join, but the company plans to drop the minimum to $50,000 at some point soon. An existing Vanguard service that resembles the new one costs 0.7 percent annually on the first $1 million and requires at least $500,000 on balance."

Vanguard is certainly not a start-up, and their entry into this market suggests that the smaller companies are on to something.

If you have any experience with any of these companies, or similar services, I'm sure my readers would love to hear from you.

The Chicken and the Pig

In the mid-nineties, I began an intensive study of retirement finances. I wanted to retire early. The Tech Bubble was just getting into full swing and dollar signs were flashing before me, none so brightly as the largest "terminal portfolio values" generated by Monte Carlo simulations of safe withdrawal rate strategies.

You know those best of the best-case scenarios where you retire with a million bucks, fund 30 years of retirement, spend $45,000 a year and then leave your kids a portfolio worth nearly eight mil? Never mind that those numbers are inflated dollars 30 years in the future or that they happen once in a blue moon. In the late nineties, everyone with a sock puppet was going to be rich.

I couldn't figure out exactly how that was going to work, so I built my own Monte Carlo simulator to learn the details. (I started my career as a software developer.) Then I really couldn't understand how that was going to work. Constant dollar withdrawals just made no sense to me but, hey, Money magazine was on board so there had to be something there.

(I think today, particularly after the Great Recession, most people have abandoned the constant dollar withdrawal folly and realize that they can spend more when their stock portfolio grows, but they will have to spend less if it shrinks.)

I was a big fan of systematic withdrawal (SW) strategies back then.

Then something happened in my life that caused the financial equivalent of a paradigm shift. You know "paradigm shifts" in science, right? Like when Copernicus explained that the earth revolves around the sun and not the opposite and everyone was like, "Whoa, Dude! This changes everything!"

I had one of those.

I retired.

When my mother-in-law retired from teaching she had said, "You can't imagine what it feels like to realize that you will never receive another paycheck."

I finally understood. Then I looked at my retirement savings and realized that I would also no longer contribute more earnings to that pile of money and, in fact, I would be spending from it every year. In effect, I would be swimming against the portfolio growth tide. When the market gave me 8%, I would be spending half of that, not contributing another 4% of my paycheck.

I had to make that money last an awfully long time to support my family. Three decades, maybe.

Suddenly, "There's a 90% to 95% chance that your portfolio will last 30 years" started to sound more like "there's a 5% to 10% chance that you'll go broke before you die".

Bam! Paradigm shift.

I could stop the story here with ". . . and that's how I became a safety-first guy", except that isn't the end of the story and I'm not a diehard safety-first guy. (But, I'm close.)

The sudden scarcity of paychecks after retiring wasn't the only shock. In 2000, a friend who was heavily invested in tech stocks lost his entire $4M nest egg just a few years before retiring. Literally dozens of my coworkers who held on to their company stock too long lost millions in paper profits that year and likely will never be even paper millionaires again. And those were just the people I knew. At just one of the tech companies.

Having a secure source of money to at least meet my non-discretionary spending needs began to sound pretty important.

Retirement funding is far more complex than systematic withdrawals versus floor-and-upside. Many factors come into play in selecting a strategy. Like, how much wealth you have.

A few of my former colleagues and Tech Bubble survivors escaped the carnage with tens or even hundreds of millions of dollars. They don't much need retirement plans. They can build a diversified portfolio and be pretty sure that even their grandchildren won't need a plan.

More than 90% of Americans, though, have not been able to save nearly enough for retirement. They probably shouldn't be risking anything in the stock market. Other factors that play into strategy selection include whether or not you are married and whether you have heirs. Your health is a factor. It isn't simply a matter of your risk tolerance.

I view retirement strategies as a continuous spectrum from life annuities and certificates of deposit (my mother-in-law's preferred investment) on the conservative end of the spectrum to systematic withdrawals on the riskier end. You can choose fairly precisely how much safety you want at the appropriate point along that spectrum. As a financial planner, I think my job is to place clients at the right point along that spectrum depending on their unique, current financial situations.

Sometimes, things will happen as we age to suggest moving that point along the spectrum in one direction or the other. Pulling the trigger on retirement may be one of those times. It may, as my mother-in-law tried to explain, significantly change how you view the world.

There's a fable about a chicken, a pig and a plate of ham and eggs. The chicken is involved but the pig is committed.

Most people seem like chickens to me before they retire. I was. Same goes for retirement planners who are still working. Chickens think more about spending than risk. When we retire, risk takes center stage.

Retirees are committed.

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