Friday, November 21, 2014

Hope and Your Retirement Strategy

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.

Three, actually.

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.

You 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.

Why do these experts, some of the most highly-regarded in the retirement planning field, recommend such risky upside portfolios and are they a good idea?

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.

They 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 studies 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 (hope) and 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.

If 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.

Retirees may 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.

If 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.

I'm 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.

Are you?

A Floor-and a Lottery-Ticket strategy probably sounds better to chickens that it does to us pigs.


  1. The leveraged ETF products are actually quite complex and unpredictable in their behavior due to tracking error issues in various investing environments. They also tend to have relatively high expense ratios around 0.9% that acts as an additional slow bleed, especially if the market is volatile within a trading range or dropping in value. Basically, since they are very susceptible to daily SOR risks and rewards,you could be adding an entirely new SOR risk profile to your retirement portfolio,

    Generally speaking these products were created for trading within a single day or maybe a couple of days at most, usually by professionals or day traders. The issuing firms themselves issue lots of caveats about viewing them as long-term investing products. I can't even imagine holding one of these for 30 years to fund late retirement.

    Here is a little study looking at the tracking error of some simple products from a few years ago. It was done in response to the fact that many of the leveraged short products did not produce good annual returns in the collapsing 2008-2009 market.

    They are also susceptible to liquidity issues, potentially at critical times as they are usually not traded in high volumes compared to basic ETFs like SPY.

    1. The ETF objection has been raised often since that paper was published, and I agree with it. I don't recommend that retirees invest in a leveraged fund like this, but then, I generally don't recommend that retirees invest in a leveraged anything.

    2. Many of these academic evaluations look at theoretical products instead of real-world products for comparisons. I like to compare things like my portfolio performance to actual real-world products that I can buy retail since that is the real performance universe that is achievable. The Vanguard LifeStrategy funds make very good benchmarks for the small investor since they are quite well diversified, have fairly static allocations, have very low expense ratios, and have been around for a couple of decades now going through a couple of major market cycles.

      It is pretty clear that the real-world tracking errors and fees associated with some of these more esoteric theoretical concepts may result in very different actual results in the future compared to the theoretical analysis. So it is not clear that the analysis is even correct, never mind appropriate.

    3. I agree with your sentiment, but a couple of points. It might be fair to characterize Floor-Upside Rule as a theoretical strategy, but SSO is a real product anyone can buy. I don't think it works the way the authors assumed, but I suspect the analysis is correct, though not implementable in the real world. I wouldn't advise retirees to invest with 3x leverage even if they could find a way, so the point is moot for me.

      Target funds like Vanguard LifeStrategy are also contentious. There's a nice post about this one at I don't want my assert allocation determined by a fund manager who picked it for a large class of investors. It's too easy to set an allocation based on my personal economic situation to settle for someone else's.

      If you know what you're getting into, I suppose either strategy might be a fit for you. I think both of these boil down to that old bromide, don't invest in anything you don't understand.

      Thanks for writing!

  2. Not sure whether the chicken came before the egg, the pig, or the other way around, but us chickens and pigs agree with you, we’re not going all-in on a single throw of the dice. The Floor-Leverage strategy uses a different meaning of ‘floor’ than those of us in retirement planning use—as leverage, it’s a floor against loss as opposed to a Floor to support lifestyle planners use. The Floor-Leverage allocation is an arbitrary split plucked from the air (as a multiple of the leverage) whereas the Upside/Floor retirement policy allocation comes from the household balance sheet and is an indicator of what you need to maintain your lifestyle (Floor) with whatever there is above that floor that can be exposes to risk for growth (Upside). The former is a gambler’s calculation, the latter, a homesteader’s way of ensuring survival and prospering.

    Exposing to risk for growth isn’t swinging for the fences. It means, at least in my view, prudently investing in a global market portfolio of risky assets—stocks—so that the Upside portfolio participates in the expected growth of the global economy. A global passively managed portfolio of equity index funds that roughly parallels the FTSE Global All Cap Index (VT) diversifies away business risk and leaves reliable market returns, whatever they are, year in, year out. Since it’s Upside and does not directly fund expenses, there’s no pressure to sell, especially if the market is in a downturn. You can wait it out. That’s prudent Upside investing.

    The Floor is not necessarily an annuitized portfolio. If you are well funded (ie, with significant Upside available), the Floor can be invested at-risk in bond funds (exposed to rate risk or even rate + credit risk), managed as the bond sleeve of a total return portfolio along with the Upside allocation. More typically we use risk-free Treasuries in a ladder for the floor to guarantee the income stream—very low risk but with liquidity if needed, though perhaps at a (small) loss if you are forced to sell a rung before it matures. Ordinarily laddering the Floor provides annual income from the whole ladder and that year’s maturing rung.

    Using the balance sheet to determine Upside and Floor, we have the expectation that the portfolio will grow over time by the expected blended rate of return for the Upside + Floor investments, so that even as Floor is spent to fund annual expenses, the portfolio contributes new growth to the Floor allocation to help sustain it over the life of the plan. We want this to be a prudent plan for growth, not a casino bet, one that we can stand alongside without panic while it recovers after downturn. And which over time reliably contributes a reasonable real risk premium to our lifetime savings.

    For more information about Floor/Upside and retirement policy allocation, check out the reading list on the RIIA website at or join a study group at

  3. For retirees who have no financial need for an upside portfolio, having such a portfolio is about more than hope. It’s also about introducing a form of excitement and unpredictability in one’s life. Psychologically, the latter is important for well-being (see Nassim Nicholas Taleb’s "Antifragile" book for more on this), but it need not be financially-centered. Case in point: My dad (in his mid-90’s) and I (just turned 60) are both retired and we both have more than enough to live comfortably without upside portfolios. Nevertheless, he keeps a substantial amount in the stock market and shifts his funds around fairly frequently; this keeps him sharp, gives him something “fun” to track every day, and something interesting to converse about. On the other hand, I have no upside portfolio and no interest in one, having decided to quit a game already won (to paraphrase Bernstein); however, I find plenty of excitement and unpredictability elsewhere (including dealing with the astonishment from others that I’m not invested in the stock market at all). Furthermore, why would I want to put cherished aspirational long-term dreams at the mercy of the stock market?