Friday, September 12, 2014

Risk and the Life Cycle

I think most retirees probably have a moment not long after calling it quits when the risk of their new endeavour fully dawns on them. I think mine occurred about twenty minutes after I left the building.

Most retirees seem to intuitively sense that they have entered a stage of life with increased risk, but probably few can articulate the issue as clearly as William Bernstein.

In his latest e-book, Rational Expectations, Bernstein compares a young person who has just begun to save for retirement, a 45-year old executive who has already saved enough for retirement, and a retired person all at the beginning of the 1929 market crash.

The 45-year old in Bernstein's example saw his portfolio fall 74% by the end of June 1932, recover a bit by 1937 and fall another 48% by March 1938. Fifteen years later at age 60, he had permanently regained his 1929 purchasing power. He would ultimately have been fine, assuming he had the courage to stick with stocks through that storm. Most didn't.

The Great Depression is ultimately a boon for the young worker because he will be able to buy stocks cheap and their value would have increased dramatically over his working career. Bernstein has long pointed out that volatility and even market crashes early in life are ultimately a huge advantage for the young stock accumulator.

The retired investor, however, found himself in the worst position of the three. Without the ability to work longer, delay spending from savings, or accumulate stocks cheaply, the typical retiree would never have recovered. He would have needed a 3.6% spending rate to nurse his portfolio along for 30 years. In Bernstein's words,
"The overarching lesson of these three men, then, is that the older you are, and the fewer working years you have ahead of you (or, to use a four-bit term, the less human capital you have), the riskier stocks are. For the young saver, stocks are not that risky. For those in the middle phase of their financial life, they are quite risky. For the retiree, they are as toxic as Three Mile Island."
The important difference among these investors of different ages is human capital, or one's ability to earn wealth in the labor market. The young worker has tons of human capital and little else. The mid-career worker has human capital remaining but the retiree has almost none.

The following chart, from a Wade Pfau column in Advisor Perspective, shows the trends of human capital and financial capital over a typical lifetime. Financial capital includes your portfolio and all other financial assets. Human capital actually has a complex definition and several dimensions, but think of it here simply as the present value of all the income you will earn in the future.

The mid-career worker can use remaining but limited human capital to postpone retirement, delay spending her retirement savings, rebuild her savings over time and reduce the number of retirement years she will need to support. Her primary loss will have been not being able to retire as young as she had hoped.

The retired investor has little or no remaining human capital and must continue to spend retirement savings to live after a crash. He will continue to spend down his stock portfolio by selling when equity prices are at their lowest. He will have no cash to buy cheap equities. If retirement has a three-edged sword, surely this is it.

It is sometimes argued — incorrectly — that stocks become less risky the longer you hold them. Actually, stocks are risky no matter how long you hold them.

Stocks generally do become riskier, however, the older you get. Until well into retirement, at least. Their volatility isn't affected by your age, of course, but the financial damage that volatility can create is helpful when you are young, troubling by mid-career, and "toxic" after retirement.

That sense of fear one gets after packing his or her photos and awards into a cardboard box and carrying it to the parking lot for the last time isn't just fear of the unknown.

The trepidation isn't uncommon and certainly isn't unwarranted.

There are real sharks in that water.


  1. Dirk, I really like Bernstein, and have read this book. Your article captured my current feelings (about 6 months after I retired). My mindset concerning our finances has done a 180 degree shift. In a relatively short period of time I have gone from the joy of accumulating assets to an intense concern over preserving those same assets. You do your readers a great service in focusing their attention on this shift. It is a shift that has both emotional and financial consequences. I had no idea until recently that knowledge about preserving assets in retirement is just as important as knowledge about accumulating them during ones working life. My hope is that those who read your blog will avoid too much risk in the 5-10 yrs before and after retirement. I feel sad for anyone who, but for lack of exposure to a blog like yours loses a secure retirement because they took too much risk during this time. I can relate because this could have been me, but for circumstances that led me to you and your blog. Brad

    1. Thanks for your comment. Not only is preserving assets equally important, it is an entirely different game in a very different stadium than is accumulating assets.

  2. Hi Dirk, you make some good points. I've read all four of this series by Bernstein and agree with his main points.

    However, preserving ones principal may also be thought of as preserving sufficient principal for one's REMAINING lifetime. Since that gets shorter slowly, the principal amount may also get lesser. With stochastic simulations for that shorter period, the withdrawal rate can increase while retaining the same exposure to possibility of excess or possibility of spending adjustments.

    Also, the markets affect all retirees the same, the degree being one of exposure to market volatility. It doesn't matter WHEN they retired - what matters is what the markets are doing now.

    Your statements about stock risk when getting older ... and implied the realization that volatility never goes away ... are spot on and supported by our research too.

    Retirees should become comfortable with the ideas of changing values ... they do this through well thought out, and in advance, rules for what decisions to make and when related to how much the spend. They should spend less when share values are lower, relative than before, and may spend more if share values go higher. It's a year by year process. When done properly, there is always a portfolio value to support spending - unless stubborn overspending occurs when it shouldn't.

    A great summary with good commentary Dirk!

  3. Taking the 1929 crash as a starting point is a very good idea. But if only we had the information, we'd need to take the *next* crash as a starting point. There may not ever be a recovery from the next crash.

    In 1929, USA had her best economic days ahead of her, although it hardly seemed so at the time. For the next crash, USA may or may not have good days ahead of her. Our debt is staggering (and ever-increasing), our growth is stagnant at best, and we're now the policemen of the world: for decades, we were able to sustain a military second to none and fund a welfare state, while the Europeans (in particular) were able to fund their welfare states and leave the policing to us. By 2014, our welfare state is growing by leaps and bounds, and the need for policing appears to have increased tremendously.

    My point? The next economic crisis ain't 1929. It looks to be a lot worse in terms of retiree outlook. How I wish I could turn out to be mistaken!

  4. Mark, you could be right. Then again, you could be wrong. My argument would be that humans have a ridiculously bad record of predicting the future and that you should be prepared, to the extent that you can be, for both.

    Thanks for writing!

  5. I agree that there are times that those who retire have a moment where they are wondering about the risk of retirement. However I know that if you have a good plan for your future and you have revised and revised it multiple times with help from others then you shouldn't be worried. I have a friend who is retired who made a detailed plan and he is doing well to this day!