In my last post, Are Social Security Benefits a Bond?, I pointed out that many retirees might not be willing to implement a very risky upside portfolio simply because they have an income floor to rely on. Floor-Leverage Rule goes the 100%-equity bet one better.
The Scott-Watson Floor-Leverage Rule and Zvi Bodie's floor-and-upside strategy are two very different variations of the Floor-and-Upside retirement income
strategy. These variations recommend different floor
allocations. The basic floor-and-upside strategy, described in
Risk Less and Prosper: Your Guide to Safer Investing by Zvi Bodie and Rachelle Taqqu, calls for the floor to at least
cover non-discretionary expenses.
Floor-Leverage Rule takes a different approach, recommending 85% of
all assets be included in the floor portfolio without regard to which expenses that might cover.
More to the point, the strategies also recommend varying
allocations for the upside portfolio. I envision a reasonable, 50%
equity portfolio, but Bodie, for example, recommends that the upside
portfolio consist of 90% Treasury bonds and 10% long-term call options (LEAPs). (Nassem Taleb has also suggested this strategy.) Scott and Watson go even farther, recommending a 200%-leveraged (3x) stock
indexed ETF. One such fund, ProShares Ultra S&P500 (SSO), which is
“only” leveraged 100%, fell 79% in the last bear market. I can’t find a
3x leveraged fund that was around back then.
can implement the upside portfolio with any amount of risk you want.
Yours will still be a floor-and-upside strategy if you implement the
upside portfolio with something other than Bodie's or Scott's approach.
these experts, some of the most highly-regarded in the retirement
planning field, recommend such risky upside portfolios and are they a
I think these recommendations are made with
the assumption that retirees with a sound floor of income will be
willing to take huge risks with their upside portfolio, but I am not,
and I doubt that many retirees are. I think this may be another case of
the pig having a different perspective than the chicken.
also assume that retirees value floor assets
and upside assets equally, in other words, that losing their entire
upside portfolio would be OK if they had an adequate floor. Floor assets
and the upside portfolio are both wealth, but the upside portfolio has
something that the floor assets don’t and that retirees find quite
attractive — hope.
Recommendations for highly-leveraged
and risky upside portfolios appear to assume that a retiree will always
value guaranteed income at least as highly as they value having an
upside portfolio. In other words, were they to lose most or all of their
upside portfolio (a 3x leveraged portfolio is wiped out by a 33% drop
in stock prices), retirees wouldn’t be overly concerned because they
would still have Social Security benefits and annuities to meet their
needs. But, they would also have lost their upside potential. That
wouldn’t make me happy.
While I can’t produce
that show retirees would prefer not to make a huge, risky bet with their
upside portfolios, I believe we can infer that from other behavior. The
evidence seems clear that retirees are generally reluctant to annuitize
their entire savings at retirement, and many advisers recommend against
that, as well. I believe the reasons are reluctance to give up the
opportunity for improving their standard of living in a bull market
hesitance to give up all liquidity, among others. If an unforeseen
expense comes along, you can't withdraw extra cash from Social Security
benefits or an annuity.
we know that retirees are reluctant to create a retirement income
strategy that consists of all annuities (private or Social Security),
then we should assume that they would be reluctant to risk backing into that position by losing most or all of
their upside portfolio and being left with illiquid annuities. It would
follow, then, that they would not be willing to make huge, risky bets
with their entire upside portfolio. Although Bodie’s call options
strategy makes risky bets, it does so with only 10% of the portfolio. The
Floor-Leverage Rule risks losing all or most of the upside portfolio
and, with it, any chance of a higher standard of living.
In Three Portfolios, I showed
that considering Social Security benefits a bond forces most
retirees into a much riskier upside portfolio, often 100% stocks. Many
argue that a 100%-equity upside portfolio would be acceptable because
the retiree has a floor to rely on, but that again assumes that a
retiree values floor assets at least as highly as upside potential. I
argue that at the margin, this isn’t typically the case.
value floor assets quite highly at the beginning, but at some point they
will value upside potential and liquidity more than they value more
floor assets. In other words, they won’t want to fully annuitize their
savings and give up the opportunity to improve their lot.
you truly don't mind that your upside portfolio might take wild swings
or it won't bother you when your call options expire worthless because
you would be content with your floor, then these might be reasonable
strategies for you. If you don't have an iron stomach, then investing
100% of your upside portfolio, let alone 300%, might not be the answer.
not suggesting that these are inappropriate strategies for everyone;
one might be a perfect fit for you. I'm pointing out that any strategy
that puts your upside portfolio at high risk assumes that you would be
fine with losing most or all of it, along with any opportunity you might
have for improving your standard of living with stock market gains,
because you have an income floor.
A Floor-and a Lottery-Ticket strategy probably sounds better to chickens that it does to us pigs.