Wednesday, May 20, 2015

Retirement Expectations: A Reality Check

I got into an interesting discussion with some friends on FaceBook the other day about what Americans can reasonably expect from retirement. It made me think about what my own expectations had been and I realized that I had never really had many.

(Embarrassing full disclosure: I never thought much about retirement at all until I was about 50.)

Oh, I saved a lot of money in defined contribution plans over the years, but not because I was thinking about the future. I had a high-paying career and the tax deferrals were instant gratification. I knew down deep that I would have to pay those taxes someday, that they were merely deferred and not avoided, but I didn't give that much thought. I was interested in the current year's tax savings.

Surely everyone knows by now that a large majority of Americans under-save for retirement. Baby Boomers haven't saved enough and they get most of the venom from the press, but younger cohorts are in even worse shape.

How badly prepared are we?

The Employment Benefits Research Institute (EBRI) has prepared a "Retirement Readiness" report since 2003. A recent report (download PDF) from 2012 states,
"EBRI’s updated 2012 Retirement Security Projection Model® finds that for Early Baby Boomers (individuals born between 1948–1954), Late Baby Boomers (born between 1955–1964) and Generation Xers (born between 1965–1974), roughly 44 percent of the simulated lifepaths were projected to lack adequate retirement income for basic retirement expenses plus uninsured health care costs."
How do we compare to the rest of the world?

Natixi Global Asset Management produces a ranking of retiree welfare by country (PDF). In 2015, they rank U.S. retirees 19th in the world, slightly worse than France, slightly better than Slovenia, and four rungs below the Czech Republic.

A critical factor in the cost of retirement, of course, is longevity. The longer we live after we retire, the more our retirement costs. I suppose there is some "good news" in our world rankings, in a morbid sort of way. The CIA Fact Book ranks the U.S. 49th in life expectancy, slightly worse than Portugal, slightly better than Taiwan. (You can find the full ranking here.)

At least we don't have to fund Japan's retirements, with life expectancies of 84 years, let alone Monaco's nearly 90.

So, the problem that has evolved, for both Baby Boomers and younger cohorts, is that advances in medicine have extended our life expectancies significantly since World War II (though not as far as Portugal's, let alone Monaco's) and that has significantly increased the possible cost of retirement. Unfortunately, longer life spans increase the number of years at the end of our lives, while our earning years still end around age 65. We have the same length careers to fund potentially much longer lives.

For someone who lives to 95, that means perhaps 70 years of adulthood will have to be funded by about 40 years of working career. We get some help from Social Security retirement benefits, a few of us have pensions, and we can leverage time and our investments if we start saving early. But that's still a pretty tall order.

Wade Pfau wrote a paper in 2011 entitled, "Safe Savings Rates: A New Approach to Retirement Planning over the Lifecycle." (PDF) He calculated that the amount of our paychecks that we needed to save historically sometimes approached 25% for a household that needed to replace 70% of pre-retirement income with 30 years to accumulate savings. That's a lot when a household is doing all they can to raise a couple of kids and put them through college. (For some periods, the saving requirement was significantly less, but we can't know that in advance.)

That brings me around to how to think about retirement savings. We shouldn't think about retirement savings as this year's tax break, as they were marketed to Baby Boomers, or as a way to make our retirement years a little more golden.

We should think about retirement savings as transferring some of the wealth from those 40 working years to fund the last 30 after retirement. It isn't fun to think about the fact that in addition to supporting our families before we retire – which probably seems like an enormous challenge on its own – we need to earn enough to also support ourselves and our spouses for what could be a very long retirement.

If I were giving my twenty-something children retirement saving advice, that's what I would tell them. Save like you understand that the money you earn today has to pay the bills today and the bills after you retire. Because it does.

I would also tell them that funding a decent retirement in the U.S. is an extreme challenge that requires sacrifice while they are working and a great deal of good luck throughout their lifetimes.

Many households simply won't earn that much, or be that lucky, and that is the reality that ERBI is reporting. It's not the prettiest picture, and it's one you can't wish away.

Friday, May 8, 2015

Retirement Expenditures and Costs of Retirement

Some great questions and comments about my previous posts on spending in retirement, beginning with Spending Typically Declines as We Age, suggest that I should add a bit more to my explanation. Or as Ricky Ricardo might have said, "I got some 'splainin to do."

Will the cost of retirement decline as you age?

The fact is I don't have any idea how much you will spend late in retirement, nor does anyone else. I can't predict what a household's finances will look like in two or three decades (which is why glide path discussions don't much interest me). My arguments about declining expenses as we age and dynamic updating are about how much you can spend now based on what you now know, not about how much you will spend later in life.

(Reminder to readers: Hover your mouse pointer over yellow text for further explanation. Double-click any chart to see a larger version. Orange text is a hyperlink. "PDF" denotes that clicking will download a PDF of the referenced document.)

The Banerjee and Blanchett studies show that retirement expenditures typically decline with age. Expenditures, however, are not the same as the generally accepted definition of “cost". Think of expenditures as consisting of non-discretionary spending (“basic costs") and discretionary expenses (“lifestyle costs”). In fact, Blanchett showed that the group of retirees with high net worth and low spending are the ones most likely to experience an increase in expenditures, not because their costs go up in many cases, but because at some point they realize they can safely spend more money on their lifestyle than they have been.

No one knows if your spending or your costs will decline as you age, but these studies (and many others) show they are very likely to. Banerjee shows that expenditures decline for two out of three retired households. That is the best initial assumption until experience with your actual retirement results indicates that you are on a different track. (You can refine that initial assumption, as I explained in Retirement Spending Assumptions and Net Worth.)

Is it dangerous to assume that costs will decline?

Not really, and for two reasons. Theoretically, using this approach, if we assume costs will decline and they don’t, we will spend money early in retirement that we might come to need late in retirement. That’s a risk.

It's important to note that the risk of overspending early in retirement isn't exclusive to a plan that assumes decreasing spending. 

But, Banerjee showed that spending declines for about 66% of retirees and increases for about 16% in real dollars. If many of the 16% of retirees who eventually spend more do so because they realize they can afford to, then the danger zone is the 18% chance that spending will remain flat.

However, assuming declining costs in order to provide the most accurate assessment of how much money a retiree can spend today isn’t a one-time calculation, at least it shouldn't be. These calculations should be made annually (see Dominated Strategies and Dynamic Spending). A retiree who initially assumes declining expenditures but ends up in the 18% or so of retirees who don’t see declines in spending should quickly notice the divergence from plan and correct spending within a few years. Annually adjusting spending and assumptions about future spending should should provide for a quick and relatively smooth correction. This is the first way we hedge the risk of assuming declining expenditures.

The second hedge is control of our discretionary spending. We can budget discretionary spending to target a planned decline in spending as we age to increase the probability that our spending does, in fact, decline as we assumed it would. In other words, we have some control over those spending declines. As Blanchett shows, the larger the portion of our budget that consists of discretionary expenses, the more our spending is likely to decline with age. If your spending is largely non-discretionary, then your expectations for spending declines should be modest from the beginning.

There are other arguments for assuming flat spending, including building in a margin of error and having the excess available to pass to heirs. Perhaps the first argument is a matter of personal choice, but I prefer to make the best prediction that I can of future expenses and allow for a margin of error separately. I like to understand both the expected costs and the risk, and not have risk tossed in as an afterthought.

Assuming flat spending as a safety margin is, after all, quite arbitrary. Why not assume a half-percent annual increase in spending, instead of flat spending? Without studies like Banerjee and Blanchett, most retirees and planners couldn’t identify the magnitude of that margin, let alone determine if that is the correct safety margin. Regardless, in my opinion, the risk of running out of savings should be addressed in the floor portfolio, not as additional margin in the risky portfolio.

I have a similar concern with planning legacies as an afterthought of spending, first because I believe that any serious concern about a legacy deserves its own plan and, second, because Scott, Sharpe and Watson (PDF) have shown that planning with “reserves” (hedging sequence of returns risk with over-saving) can be very costly.

In my next post, Retirement Expectations: A Reality Check, I'll write about what we should hold as reasonable expectations of retirement. Hope to see you there.

Friday, May 1, 2015

Spending Rules That Fit the Patterns of Retirement, and Some That Don't

I noted in a recent blog post that Spending Typically Declines with Age after we retire. In a follow-up post, Retirement Spending Assumptions and Net Worth, I explored two recent papers on retirement expenditures that suggest how much spending might decline for you based on how much you plan to spend annually on non-discretionary expenses and your net worth.

I also pointed out that spending rules typically assume that spending will be flat throughout retirement, contrary to what Blanchett, Banerjee and several other researchers have found in studies of data for actual reported retirement spending.

The question most of these spending rules answer is, "how much can I safely spend from savings this year assuming I will spend that same amount every remaining year of retirement?", when the question retirees actually mean to ask is "how much can I safely spend from savings this year given what I assume I will need to spend in the future?"

The difference can be substantial. Quoting Blanchett from Estimating the True Cost of Retirement (PDF), 
"When combined, these findings have important implications for retirees, especially when estimating the amount that must be saved to fund retirement. While many retirement income models use a fixed time period (e.g., 30 years) to estimate the duration of retirement, modeling the cost over the expected lifetime of the household, along with incorporating the actual spending curve, result in a required account balance at retirement that can be 20% less than the amount required using traditional models."
Sustainable withdrawal rate models make this flat-spending assumption, though it isn't difficult to change the models to fit a different spending assumption. I ran my own Monte Carlo model assuming a 50% equity allocation with constant spending and estimated a 95th-percentile safe withdrawal rate of 4.1%. Then I modified the model to spend 1.5% less in real dollars for each year of ten thousand 30-year scenarios. The second model estimated a 95th-percentile safe withdrawal rate of 5%. That's 22% more annual spending, or $9,000 a year more "sustainable" spending than the SWR model suggests for a $1M initial portfolio balance.

Looked at from the wealth accumulation perspective, a retiree would need to save 18% less to generate the same annual spending if she expected expenditures to decrease 1.5% a year on average rather than assuming expenses would remain flat throughout retirement as most spending rules assume.

The ARVA (PDF) spending strategy model, or annually recalculated virtual annuity, is more problematic. ARVA assumes that the correct sustainable amount to spend in the current year is the amount that an inflation-protected life annuity purchased in the current year would pay out. The retiree doesn't actually need to buy the annuity, she can simply base spending on what would happen if she did. An inflation-protected annuity will pay out the same amount throughout retirement and it isn't clear to me how ARVA could be adapted to predicted declines in spending needs as we age.

This problem extends to life annuity strategies, in general. Inflation-protected life annuities will pay out a flat rate throughout your lifetime in real dollars that will not match declining expenditures. From that perspective, nominal life annuities may not be quite as bad as they seem, since inflation will eat away at the real annual payouts, but expenditures will probably decline, too. The problem is that even "normal" inflation of 2% to 3% is greater than the estimates of expenditure declines, so this is a poor way to match income and expenses. Runaway inflation could be devastating.

Moshe Milevsky's formula for calculating sustainable withdrawal rates without simulation also seems problematic, as it, too, assumes the sustainable spending that it calculates will continue to be spent throughout retirement. It isn't clear to me that regularly rising or declining spending could be incorporated into his probability models, let alone irregular net spending, but his math is well above my pay grade. Milevsky's formula doesn't accommodate the loss of a first spouse except under the assumption that spending doesn't decline. Based on his responses to similar questions in the past, I would guess he would tell us that these scenarios would have to be calculated individually with numerical analysis if we want to avoid simulation.

As I mentioned in Retirement Spending Assumptions and Net Worth, it is probably more common for a retiring household to experience irregular spending throughout retirement, and the SWR model can easily be modified to accommodate that expenditure, as well. I repeat that chart here for your convenience. The red columns show irregular spending. Your spending in retirement is much more likely to resemble this than a straight line.

Bond ladders work well with any spending pattern including irregular ones. It is simple enough to match bond purchases to different amounts of future spending.

If spending increases as we age in retirement, most spending rules will overestimate the safe amount to spend in the current year. It is more likely that your spending will decline over time, in which case these models will provide current-year safe spending amounts that are too conservative. With irregular spending, it's hard to know where to begin with most spending rules.

My last three posts have followed a theme. First, spending is more likely to decline as we age than to remain flat.

Second, by looking at our own non-discretionary spending and net worth, we may be able to determine a more accurate assumption for our own retirement expenditures.

And, third, most spending rules aren't based on a realistic financial model of actual retirement. They assume flat spending, fixed lifetimes (e.g., 30 years), constant risk aversion, and average market returns and they make other spherical cow assumptions that simplify the math but can lead to inefficient saving and spending.

I suggest modeling your expected expenses and income to consider expected market returns, life expectancy and expected expenditures. They are all "stochastic variables", which means they have a random probability distribution that can be analyzed statistically, but can't be predicted precisely.