Tuesday, March 17, 2015

Dominated Strategies, Illogical Strategies, Problematic Strategies and Strategies That Just Make Me Queasy

In Pure and Mixed Strategies, I noted that we can make life simpler for retirees by winnowing out dominated strategies and strategies that are logically unsound. I showed in Dominated Strategies and Dynamic Spending that dynamic updating of sustainable spending amounts dominates the SWR-Fixed and SWR-Variable strategies, so I cross those off my personal list of reasonable alternatives for retirement income plans.

I believe that there are strategies that are flawed, some logically sound strategies with problems, and others that just give me a queasy feeling. So, in this post, I will share my feelings on those three categories of retirement income strategies.

Dominated Strategies: There are strategies that appear to be dominated by better strategies and, according to game theory at least, should not be played. In previous posts, I noted that SWR-Fixed and SWR-Variable strategies are dominated by a dynamic updating strategy. Are there other dominated strategies that are often proposed? 

The RMD Strategy, in which the retiree bases her spending on the required minimum distribution amounts the IRS mandates for IRA’s is also a dominated strategy. (You can read about RMDs here.) Dynamically updating all important variables of sustainable spending will always perform better than a strategy of updating only the retiree’s age and new portfolio balance, as the RMD strategy does.

Logically Unsound Strategies: There are also retirement income strategies that simply aren't logically sound, like the "Spend Dividends Only" strategy. This strategy seems to be based on a misunderstanding of how dividends work.

I won’t devote a lot of explanation here, because the topic has been thoroughly vetted by others. I recently recommended this explanation by Canadian Couch Potato.  But, in short, when a company pays you a dividend on a stock worth $10.00, they pay you perhaps 30 cents in cash and the market immediately reduces your stock’s value to $9.70. You are no better off and no worse off. (You may actually be a tad worse off if you hold the stock in a taxable account because dividend payments can be a taxable event.) Furthermore, investing primarily in dividend-paying stocks will limit your portfolio’s diversification.

I cross Spend Dividends Only off the list because it is illogical and, as Wade Pfau recently put it, simply isn’t a valuable strategy. 

SWR is another logically unsound strategy when applied literally. It ignores conditional probabilities of failure. A common counter-argument is that no one implements SWR literally. I hope that is correct, but I doubt it.

Problematic Strategies: Now, let’s look at an example of a strategy that has not been shown to be dominated and that is logically sound, yet still problematic. The Bond Ladder and Longevity Insurance (BLLI) strategy proposed by Professor S. Gowri Shankar, for example, is logically sound but suffers from two problems.

(If the BLLI strategy is unfamiliar, there is a nice summary of it and several other strategies in this paper by Wade Pfau and Jeremy Cooper.)

The BLLI strategy proposes building a 20-year TIPS Bond Ladder and funding later years (beginning age 85 for someone retiring at 65) with Deferred Life Annuities (DLAs). The idea is that the retiree won’t have to give up control of his capital for the first 20 years – a common complaint with annuities – and that deferred life annuities are cheaper than immediate life annuities. (See Wade Pfau's Why Retirees Should Choose DIAs Over SPIAs.)

The BLLI strategy, however, has an inflation problem. Because DIAs will provide income well into the future, insurance companies typically won’t offer them with inflation protection and, of course, "well into the future" is when inflation takes its biggest toll. When inflation protection is offered, it does not cover the period from purchase to the first payout, in this example 20 years.

This is different than funding half of your retirement income with a TIPS bond ladder and the other half of the income with annuities. BLLI suggests exclusively funding the first half (or so) of retirement with a TIPS bond ladder and the second half exclusively with annuities.

The idea of maintaining control of capital and liquidity is also somewhat problematic, since the retiree will need the money in her bond ladder for living expenses to age 85 and can’t really spend it in an emergency. Funding the entire 30 years with a TIPS bond ladder and prematurely spending the most distant rungs is problematic enough, but it is possible that she won't live the full 30 years and may not need to spend that money ever. Diverting funds meant to meet living expenses during the first 20 years of retirement is significantly riskier.

Nonetheless, it is neither flawed nor dominated and stays on the list.

Strategies that Make Me Queasy: Some strategies can be logical and not dominated and perhaps not problematic to some, but still make me feel uncomfortable. To wit, the Floor-leverage Rule and Zvi Bodie's floor-and-upside strategy of 90% TIPS bonds and call options (LEAPS). Both are known as "barbell strategies" because they invest in extremely safe and extremely risky assets with nothing in between.

As I suggested in Hope and Your Retirement Portfolio, most retirees won't be comfortable with the possibility of losing all or most of their upside "hope" even with a comfortable floor in place. Retirees who purchase call options will often see those options expire "out of the money", in other words, worthless. The financial argument will be that the options served their intended purpose, even the ones that expired worthless, and that is correct. Most of the retirees I know, however, will find that cold comfort when they see a few ten thousand-dollar call positions disappear in a poof of smoke. Actually, it isn't even that dramatic. It's just not there, anymore.

Zvi Bodie's friend, Jeremy Siegel, seems to agree (download PDF). On multiple occasions Siegel has said, "You know, I find it a little strange — Zvi says he’s giving conservative investment advice, and then advising all your clients to buy call options."

The Floor-leverage Rule makes the LEAPS approach look tame in comparison. The idea for its upside portfolio is to employ triple leverage at the equity end of the barbell. The typical investor can't purchase a stock portfolio with triple leverage. It's illegal. But, as Sharp and Watson point out, they can purchase shares of a 3x leveraged ETF like UPRO.

I'm crossing Floor-leverage off the list of reasonable strategies not because it makes me queasy to apply huge leverage to my entire upside portfolio (it does), but because the upside strategy doesn't work. The problem is that these ETFs are not the same as a triple-leveraged stock index fund. In fact, they aren't portfolios of stocks, at all. They're portfolios of derivatives that only track stock indexes for short periods of time. They're best suited to short term investments, which shouldn't be part of a retirement income plan.

Bodie's options strategy stays on the list. It's riskier than I can accept and I don't think it will fit the temperament of most retirees, but it isn't flawed. It will outperform other strategies in some scenarios, so it isn't dominated.

Some of the strategies I've crossed off the "sound" list may fit your individual financial situation and may be bets you're willing to take. Some of them will even be recommended by advisers. I would pare down the list of reasonable retirement income strategies by at least a third, as shown in the following table. This is my personal perspective and not everyone would agree.






12 comments:

  1. still can't get this dividend part out of my head. i think index etf also pays a dividend, so does that mean they are govern by the same illogical nature.

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    1. Kyith, they are nearly identical processes. When the stocks in a mutual fund or ETF pay a dividend, most managers will pay that dividend to fund share holders as an "ordinary dividends" distribution. You have to read the prospectus to find out if that's how your fund handles dividends, but most do it that way.

      So, the company pays a dividend to its shareholders (in this case, the shareholder is a mutual fund or ETF) and most mutual funds then pay that dividend to the shareholders of the mutual fund. It ends up being pretty much the same.

      Why does this seem illogical?

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    2. hi Mr Cotton, thanks for explaining. i stated it is illogical because the dividend spending strategy was classified as logically unsound strategies. perhaps i phrase it a bit wrong haha.

      i find that for an index etf, you have to decided to spend down dividends as well. if you decide to spend down only the dividends of 2% yield, it is similar to a dividend spending strategy.

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    3. Kyith, there is nothing wrong with spending dividends. The problems arise when you decide that dividends tell you the safe amount to spend, or that it is OK to hold a portfolio of nothing but high-yield stocks, or that spending dividends preserves capital.

      If you hold a diverse portfolio of stock classes, bonds and cash and correctly estimate a sustainable withdrawal amount, then you don't have a Spend Dividends Only strategy.

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    4. Let me say it differently to make sure we are in agreement. A diversified portfolio should hold large cap stocks, small cap stocks, foreign stocks, growth stocks, dividend-producing stocks, bonds, cash and perhaps other asset classes. A Spend Dividends Only portfolio would hold only dividend-producing stocks which would represent a bet on just one type of stock. There is a saying in the U.S. "Don't put all your eggs in one basket." I hope that translates. A Spend Dividends Only strategy puts all your portfolio "eggs" into a (dividend-producing) value stock basket.

      Spending dividends is not illogical or undesirable. Believing that spending only the dividends avoids spending capital is illogical. You receive the dividends because the company has decided, without your input, to convert some of your capital to a dividend.

      If your portfolio holds diverse asset classes and you spend no more than the sustainable spending amount, then there is no reason not to spend from dividends. In that case, however, you do not have a Spend Dividends Only Strategy.

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    5. hi Mr Cotton. thanks for explaining. i have a better idea about your spend dividends only strategy.

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  2. Spending dividends is just another way of saying "withdrawal." If the amount of dividends spent is not greater than your targeted withdrawal rate, all is good. Further, it also means that you probably aren't liquidating any growth stocks in the portfolio to meet income needs. Isn't that right?

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    1. Spending anything is just another way of saying "withdrawal", so yes. And, yes, if you spend anything (dividends, capital gains, interest) and it is less than your targeted withdrawal rate, that is a good thing. I wouldn't say "all is good", because you also need to maintain your portfolio allocation for diversification and that might mandate that you sell other types of assets, including growth stocks.

      It may or may not mean that you are liquidating fewer growth stocks, and you may or may not need to sell growth stocks, but you are liquidating income stocks, or rather the company is liquidating a piece of them for you.

      The problems come when you spend more than your sustainable amount simply because the companies you own declared a lot of dividends, and when you over-allocate your portfolio to income stocks and become under-diversified.

      There is nothing wrong with spending from dividends.

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    2. Mr cotton, i sense there is a distinct classification of different categories of stocks according to their role here. that may be why you determine that dividend spending strategies are unsound, that distinct income stocks that fall within that categories is a logical unsound strategy.

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    3. There are sub-classes of assets. Stocks with high dividends, often called "value" stocks behave differently than growth stocks, which tend to pay lower dividends. We should really diversify into both because we can't predict which one will outperform at any given time. Investing solely in dividend-generating stocks means less diversification.

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  3. Hi Dirk,

    I assume (based on the above graph) your preferred method would be Dynamic Updating based on each individuals unique situation correct? Brad

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