Monday, June 30, 2014

Defending Systematic Withdrawals

Jonathan Guyton and Michael Kitces are both leading advocates of systematic withdrawal strategies for retirement, as Wade Pfau pointed out in a recent post. Pfau observes that "it is somewhat uncommon to hear rigorous intellectual defenses of systematic withdrawals." Most academics prefer other strategies with greater downside protection.

The video is informative and I suggest you watch it regardless of how you feel about "safe withdrawal rates." Guyton and Kitces are two very bright people, but I am not a fan of systematic withdrawals except for households who have a lot of savings.

When I say "a lot", I'm referring to those over-savers who need to spend perhaps 3% or less of their savings every year in retirement. They probably have adequate risk capacity to manage the downside of SW.

As I watched this interview, I realized that I am perhaps not as far from Michael's position as I had thought. If you're wealthy enough, I have no problem with SW, and that is the target market for most financial planners. I focus my attention more toward retirees who are not over-savers, for whom I believe SW is often a very risky approach.

Risk tolerance, or how much risk lets you sleep at night, is different than risk capacity, or how much risk you can afford to take. (Here's a cute analogy to explain the difference.) Risk capacity is the limiting factor when choosing a retirement strategy and the more wealth you have relative to your annual spending, the greater your risk capacity.

Kitces notes in the video that in many cases the overall portfolio constructed with a floor-and-upside strategy (or "discretionary - non-discretionary strategy", as it is called in the video) is practically identical to what would be required for a SW strategy. This is technically accurate, but omits important points.

First, a major purpose of floor-and-upside and time-segmentation strategies is to make retirement finances more transparent and manageable. We could, using the same logic, organize our household budget into just two categories: "income" and "stuff I need to pay for". That wouldn't provide much transparency into our budget, however, so we create subcategories for food, rent, transportation and the like.

In this same way, floor-and-upside and time-segmentation strategies create subcategories, or "buckets", to help us visualize where the money will come from to pay our living expenses in future years, or whether a shortfall will jeopardize groceries and housing, or just the cable bill.

In other words, these strategies help us manage our retirement plan.

Time-segmentation attempts to minimize the risk of needing to sell assets when they are cheap and to provide a safe source for near-term spending. Floor-and-upside tries to ensure that in the worst case we can still pay for non-discretionary expenses. SW lumps them all into one large "total return" bucket, much like the "stuff I need to pay for" category.

The second important but unmentioned point is that SW recommends a spending rate that some might consider safe or sustainable. Life annuities also determine a spending rate based on the payout rate of the annuity we purchase. The SW rate is probabilistic while the annuity payout is contractual.

Time-segmentation and floor-and-upside strategies, to the contrary, do not inherently calculate a spending rate. SW rules of thumb and consumption-smoothing are two ways one could establish such a rate for these strategies.

Lastly, these strategies rebalance asset classes differently. The asset allocations may start out being quite similar, but they will most likely drift apart over time.

These are important differences   the strategies provide different spending, different risks and different asset allocations over time. The initial portfolio allocations may be "practically identical", but the strategies are not.

I find comfort in the observation that the strategies frequently have similar initial portfolio allocations because I would have a hard time explaining why they wouldn't.

One of them will perform best for you over your lifetime. Unfortunately, we can't predict which one that will be. That's the bet you have to make.

Kitces also mentions in the interview his personal quandary, which he has stated before, that a retiree who expects a wonderful retirement might consider it a failure if that retirement only turns out to be OK. This is the tradeoff one makes when forgoing the possible upside standard of living with the SW strategy in order to mitigate the risk of going broke in old age with a floor-and-upside strategy.

Personally, I don't understand the quandary. If I were offered the opportunity to take the worst-case scenario off the table (dying broke) by giving up the possibility of more trips to Europe and a second home, I'd jump at it.

But, that's a decision retirees with a lot of wealth will get to make for themselves.

Tuesday, June 24, 2014

Retiring with Children

Some of us have children at an early age and they are self-supporting when we enter retirement.

Many of us don’t.

For us late starters, having children who are young adults when we enter retirement is a substantial financial risk. I was reminded of that fact by an article written by Adam Davidson in the New York Times Magazine entitled “It’s Official: The Boomerang Kids Won’t Leave”.

Davidson writes, "One in five people in their 20s and early 30s is currently living with his or her parents. And 60 percent of all young adults receive financial support from them. That’s a significant increase from a generation ago, when only one in 10 young adults moved back home and few received financial support."

Davidson goes on to argue that this isn't a temporary financial blip, but may be a longer term trend.

I am also reminded by clients who plan on their children graduating from college in four years. Good luck with that one.

A Time magazine article from 2013 entitled, “The Myth of the Four-Year College Degree”  reports that, "According to the Department of Education, fewer than 40% of students who enter college each year graduate within four years, while almost 60% of students graduate in six years. At public schools, less than a third of students graduate on time.”

Each additional year that child remains in college means not only more tuition and books, but more rent and groceries and another year of not earning income. Losing early years of income can have a significant impact on your child's lifetime earnings, so it’s not exactly a bonus for  him or her, but tens of thousands of dollars for unplanned college expenses may be difficult for many retirees to deal with.

The surprises may not be college-related and, in fact, may appear long after your child's college years. I have spoken with several retired couples whose children (or grandchildren) had their own financial crisis. Not helping wasn’t an option.

Retirees with middle-aged children are often called upon to help after a health crisis, a substance abuse crisis, or extended unemployment.

Additional unplanned years of college and parental support don’t always happen when something goes wrong. They can also happen when something goes right.

My oldest son decided to go to med school and, after his third year, elected to take leave for two years to earn a masters degree. I’m very proud of my son and don’t regret one penny that I have spent on his education, but it wasn’t in my retirement plan.

The point is that those of us with children will retire with greater financial risk than will childless couples. When I think about the major risks of retirement, I think longevity risk, market risk, healthcare risk and long term care risk, but our children also represent a major financial risk that our plans need to consider.

I would start by planning for at least five years of college, if your kids haven’t already graduated. Then, I’d recommend reading the Davidson article and considering the distinct possibility that your children won’t simply go to college for four years, get a job right away, and become largely self-supporting.

Maybe you and I did it that way, but nowadays it isn’t that common.

Saturday, June 7, 2014

A Summer Break

I'm taking a few weeks away from musing about distribution strategies and risk tolerance to celebrate a most amazing week that I recently enjoyed. I'd like to take this opportunity to remind us all that there is more to life than money.

(I will hastily add that the more money you have, the easier it is to say that.)

A couple of weeks ago, within a seven-day span, my daughter was married, my wife and I celebrated our fortieth wedding anniversary and . . . OK, maybe a little about finance . . . I paid off the mortgage. We spent last week in Paris, a place we last visited not long after our wedding, celebrating our time together.

Some things money can't buy, like finding the love of your life at a young age and getting to live with her for a very long time.

Before long, I'll be writing again from my favorite neighborhood coffee shop, though I'll probably be daydreaming about those along Paris boulevards.

I wish you all the joys life can bring and I suppose I could drop one piece of retirement advice while I'm at it.

If you're looking for a place to retire with a reasonable cost of living. . . Paris ain't it.