Uncertainty Denial

Joe Tomlinson wrote an excellent piece at Advisor Perspectives last week entitled, “The Most Critical Planning Assumption – and How to Choose It.” The piece is primarily a warning to advisers who rely on a single estimate of future market returns for retirement plans, or who use planning software that limits them to a single estimate, but there is a lot of good insight in the piece for all of us.

The assumption Joe has in mind is the equity risk premium, or ERP, but to simplify the explanation, I’ll substitute a related and more familiar term, the expected market return.

We need to estimate future market returns and volatility to make a number of calculations, including how much we need to save, how much we can spend each year, and what an ideal asset allocation would be. We may also use this estimate of future returns and volatility to determine how much to allocate to a floor portfolio. If we think future equity returns will be quite high, we’ll probably feel less need for a large floor portfolio and vice versa.

Since so many plan parameters are dependent upon this estimate of market returns and volatility, Joe rightly calls it the most critical assumption. (I think there's a strong argument that life expectancy is the most critical assumption, but I'm sure Joe and I agree it's best to assume a long life.)

The issue Joe describes is that there isn’t a single spending rate, savings rate, asset allocation and floor allocation that are optimal across the broad range of possible returns suggested by such a mean and standard deviation. Picking the optimal parameters from the average (and most likely) scenario may be wildly incorrect if your retirement ends up significantly better or worse than the average case you predicted.

Plan results are very sensitive to the market return and volatility assumptions. A small change in a plan's market return assumption can make a large difference in what we calculate as optimal spending rates and asset allocations. The error in our estimate of future market returns gets magnified.

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"Pretending we can accurately predict a critical assumption like future market returns is dangerous overconfidence. "

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Tomlinson provides an example using Professor Aswath Damodaran’s estimated ERP of 6.25% with a standard error of 2.32% for the period 1928-2014. He assumes a 65-year old retiree with a 4% spending rate and $1M savings portfolio at retirement. He finds that depending upon where the returns actually fall within that broad range of potential outcomes, a retiree would have a portfolio failure rate ranging from 2% to 42%, a median bequest of $127,000 to $2M, and an optimal stock allocation ranging from 10% to 90%.

I ran those estimates through Moshe Milevsky's formula for lifetime probability of ruin (download PDF) and found 95^th percentile sustainable withdrawal rates ranging from 2.35% to 8.5%. Here's a chart with data from the Tomlinson piece and my own SWR calculations.

Source: data from the Tomlinson post plus author's calculations.

To quote Joe's post, a completely forthcoming (though, likely unacceptable) discussion with a client should go something like this:

“Your results will be heavily dependent on the extra return of stocks over bonds. Unfortunately, we have limited statistical evidence and don’t know what to expect. The best I can do is tell you that I’m 95% confident that you can expect a bequest in the $100,000 to $2 million range and that the probability of plan failure is somewhere between 2% and 40%. For an asset allocation recommendation, it could be anything from 10% to 90% stocks.”

I actually believe Joe is optimistic about our prospects here because even if we could accurately predict future returns with a relatively small variance (we can’t) we need to consider sequence of returns risk when we save to or spend from a volatile portfolio. Sequence risk is unpredictable and an unfortunate sequence of returns can ruin even a good average return. We need to know the return, the variance and the sequence of those returns.

The gist of Joe's post is that retirement plans entail a great deal of uncertainty and that pretending we can accurately predict a critical assumption like future market returns is dangerous overconfidence. (Please read his column – I don't do it justice.)

We tend to think that the estimates of our optimal asset allocation, floor allocation, safe spending rate and required savings can only be as good as our estimate of future market returns. I think it's correct that they won't be more predictable. The problem is that our plans are highly sensitive to market return assumptions, so those optimal parameter estimates can actually be a lot less predictable than our market return estimate.

Generally speaking, I think most of us understand that retirement finance, and investing in particular, is risky, but I also think we are overconfident in our ability to manage that risk. We pretend that we can accurately (or accurately enough) predict future market returns. Many of us seem to believe we know whether we will live long lives. We believe we can identify a precise sustainable withdrawal rate when that rate is a function of both the rate of return we can't predict and how long we will live, also unpredictable. We believe we can avoid stock market risk by simply holding stocks a very long time.

This is overconfidence. There are ways to manage this financial risk but even if we do the best job possible there will still be much uncertainty.

You're likely overconfident when you think, "I'm really not sure what my investments will return in the future, but I probably oughta' tweak my asset allocation by 5%."

Next post, I'll suggest an approach to accept and plan for this uncertainty in 100% Certain That We're Not Sure.

The Role of Xanax in Asset Allocations

It's amazing how often this happens. I publish a post and within 24 hours something pops up in the news that would have worked beautifully with it. The most recent post in this case is Homo Economicus and the something-in-the-news that works with it is an opinion piece I read in the New York Times online this morning by J.L. Cowles entitled “Defeating My Anxiety.”

Mr. Cowles' piece is actually about dealing with his anxiety. Investment results are just one cause of his angst (see his second paragraph below for a more complete inventory) but those results illustrate quite well the concepts of risk tolerance towards short-term portfolio volatility that I discussed in Homo Economicus compared to risk tolerance towards long-term volatility. The first two paragraphs from that Times piece are relevant to retirement:

When the stock market crashed in 2008, my wife and I were 70. And we saw half of our retirement funds disappear. Before the crash, we felt secure in the belief that we had enough money to last as long as we lived; after the crash, we feared that we would not, and I worried about it a great deal. I had a hard time going to sleep and an even harder time going back to sleep after getting up to go to the bathroom in the middle of the night. I came to hate going into that bathroom because I knew my demons resided there and would invade my consciousness immediately.

By the time the stock market began to recover and our savings were again at a comfortable level, I had become conditioned to associate my nightly bathroom trips with “worry time.” I would worry about everything: home repairs, trip planning, medical issues and all the vicissitudes of old age, fears of infirmity, dying and seeing my friends and loved ones die.

It was probably not Cowles' intent that my first thought after reading his article would be that his stock allocation had been too high, but it was. The stock market fell a little more than 50% from late 2007 to early 2009, so the Cowles must have been fully invested in equities. They had laid a lot of chips on the table.

I'm not a doctor, but if you can't sleep at night because you're worried about losing your retirement standard of living in a market crash, you have too much of those savings invested in stocks. If you can't sleep and need anti-anxiety medications because you're worried about your portfolio, you have way too much invested in stocks.

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"When the stock market crashed in 2008, my wife and I were 70. And we saw half of our retirement funds disappear."

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Cowles notes that “the stock market began to recover and our savings were again at a comfortable level,” though he doesn't say they fully recovered. His portfolio will probably eventually recover, assuming he didn't bail out at the bottom of the crash, but that's the big risk.

If Cowles decided near the bottom of the crash that in addition to finding anti-anxiety meds, religion, and meditation he needed to eliminate a source of the anxiety, he might have chosen to reduce his equity allocation (sell stocks). A lot of research shows that investors tend to buy at the top and sell at the bottom. With a lower allocation to stocks after the fall, the climb back uphill becomes even harder. Your equity allocation will already be lower because your stocks will have fallen faster than your bonds. Selling more stocks makes it worse.

As I mentioned in Homo Economicus, it's important to understand your risk tolerance before you retire. If you guess that your tolerance to short-term volatility is higher than it turns out to be, you are faced with two unattractive options near the end of your first bear market after retiring. You can sell equities to stop the bleeding, increase the sleeping, change your asset allocation to where it should have been all along, and severely hamper your prospects for fully recovering.

Or, you can fight through the pain and convince yourself, as your stockbroker tried to do, that the market always recovers. Keep in mind, of course, that your savings portfolio isn't the market.

The Cowles say they saw half their retirement savings disappear in 2008 at age 70. That's a lot of stress when you have no career to return to.

Insuring that you have a solid floor of income from assets not tied to the stock market may ease the pain of a bear market.

Perhaps you're one of the 14% of respondents to my informal survey (bottom of that page) who eats risk for breakfast, sleeps well and never takes anything stronger than vitamin C. In that case, your asset allocation should be based on factors other than short-term volatility. But if you're one of the 84% of respondents who need some bonds to help you sleep, or the 2% who want nothing to do with stocks in retirement, your tolerance to short-term volatility should be a factor in your asset allocation. That stock allocation may be smaller, for example, than one that would optimize a safe withdrawal rate over the long run.

I apologize that this post and the previous are somewhat redundant, but it's an important point and sometimes a real-life scenario is more convincing.

Homo Economicus

William Bernstein is my favorite financial writer. I have followed him since his early days at the Efficient Frontiers blog when hardly anyone without a neurological disorder had heard of him. I like him because he is brilliant; I love him because he writes wonderfully.

One of my favorite Bernstein lines came from Efficient Frontiers in reference to the 1999 book Dow 36,000. The argument put forth by the book's authors was probably based on a not-uncommon misreading of Jeremy Siegel's Stocks for the Long Run. Siegel had noted that over long periods of time, stocks nearly always outperform bonds and the authors of Dow 36,000 apparently understood that to mean that stocks are ultimately safer than bonds. If that were true, then stocks would have been tremendously underpriced in 1999. One day, investors would wake up to just how safe stocks are and the Dow would soar to 36,000 or higher.

Unfortunately for the authors of that ill-fated tome, and for all of us who invested in equities back then I suppose, sixteen years later the Dow is around half that value. Siegel's argument that stocks outperform bonds over the long run does not equate to stocks being safer than bonds. Stocks can and do take stomach-churning dives along the way and bonds don't. The short-term volatility of stocks is much greater than that of bonds and as Siegel and Zvi Bodie agreed in a famous interview (download PDF), stocks are risky no matter how long you hold them.

To quote Professor Siegel from that interview, “In other words, [stocks] are relatively safer in the long run than random walk theory would predict. Doesn’t mean they’re safe. . . Well, they’re not safer in the long run—that’s definitely not true.”

The Bernstein comment I have always remembered is “James Glassman and Kevin Hassett . . . in Dow 36,000 postulated a new species of homo economus [sic] impervious to short-term volatility.”

I suspect that the vast majority of us retirees are keenly aware of short term volatility, even if we firmly believe that the market will always recover, eventually. I haven't found research that specifically addresses this issue, so I recently conducted a simple survey to determine if at least some retirees care about short term volatility.

In that survey, I asked retirees and near-retirees if they would invest their portfolio totally in equities if their non-discretionary expenses were securely covered by a floor, noting that such a portfolio might have fallen 50% or more in value during the 2007-2009 bear market. The survey should not be confused with science – it's merely the thoughts of about a hundred and fifty or so readers of my blog – but the results do suggest that a lot of retirees care about short term volatility even when their living expenses are secure.

About 84% of respondents indicated that they would prefer to reduce portfolio volatility, presumably through a bond allocation, even with a secure floor. About 14% said they would go full bore with equities if their non-discretionary living expenses were safely covered, and 2% implied that they'd rather shave their head with a cheese grater than allocate any of their retirement savings to the stock market.

OK, not precisely in those words.

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84% of respondents to an informal survey say they would want to manage portfolio risk even with a solid floor of income.

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My take from this informal, unscientific survey is that there are at least some retirees who would need an allocation to bonds in order to sleep at night even with a bedrock-solid floor. (No one wants to sleep on the floor, but some are willing to risk it.) Whether the numbers are as dramatic as my informal survey suggests, I cannot say. My goal was simply to find out if I'm the only retiree who cares if his portfolio occasionally crashes.

To assume that retirees with a secure floor would not care about short term volatility is to recreate the Dow 36,000-postulated homo economicus, a retiree impervious to short term volatility. My standard of living was not threatened by the 2007-2009 crash because I had a sizable allocation to cash and bonds, but it was not a fun ride even so. I suspect that most retirees see a portfolio crash as the evaporation of wealth that can no longer be replaced by human capital and that they find that worrisome.

Some will be quick to point out that the market as measured by the S&P 500 index recovered to it's 2007 high by January 2013, but as I explained in this post, retiree portfolios don't recover as quickly as the market. The market doesn't take annual withdrawals to cover its living expenses.

Your tolerance toward market volatility, even when your floor is secure, is something you want to understand up front. Getting it wrong has consequences. If you believe you can tolerate the high-equity allocation roller coaster and find out after your first big bear market after retiring that you can't, your response will probably be to reduce your equity allocation at the worst possible time – after your portfolio has crashed and before it recovers.

It's tough to keep investing largely in equities, especially for a retiree, while you are watching your wealth vaporize day by day. For a real-life example, read my next post, The Role of Xanax in the Asset Allocation.

End of File-and-Suspend and the Breathtaking Medicare Spike that Wasn’t

Last week, Congress passed the Bipartisan Budget Act of 2015, the compromise deal that President Obama has said he will sign as early as Monday, November 2, 2015. Part of the bill effectively ends so-called “file-and-suspend” Social Security claiming strategies and mostly fixes a feared spike in 2016 Medicare Part B premium costs.

File-and-suspend is (was) one of several “claim now, claim more later” strategies for maximizing Social Security benefits, primarily beneficial for married couples. It typically involved having one spouse claim spousal benefits for up to four years between ages 66 and 70 before switching to his or her own larger retirement benefit. This allowed the higher-earning spouse to delay claiming and increase future benefits while the spouse received a smaller benefit for a few years.

That’s an over-simplification, but unless your household is grandfathered in, the details of a now-defunct strategy probably aren’t important to you. According to Michael Kitces, “restricted applications. . . to receive just spousal benefits and not individual retirement benefits” are grandfathered in for those born in 1953 or earlier, but “the new rules limiting suspended benefits will apply to anyone who tries to file-and-suspend after a 6 month grace period beyond the effective date of the legislation.” In other words, unless you’re at least 65 ½ years old Monday (assuming the bill is signed into law then as expected), file-and-suspend is no longer an option for you.

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The end of the “file-and-suspend” Social Security claiming strategies won’t affect most households.

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The press had raised alarms recently over an expected huge increase in Medicare Part B premiums for 2016 as reported, for example, in a recent article at AARP. The increase would have resulted from an obscure part of Medicare law that ties COLA increases to Part B premiums, combined with the lack of a Social Security COLA increase announced for 2016.

The Washington Post reports that the "Budget deal blunts, but doesn’t erase, increase in Medicare premium". Prior to the new law, about one in three older Americans would have seen a premium increase just north of 50% in 2016, but that increase will now be about 17%. According to the Post, the group subject to the increase includes "people who do not collect Social Security, will be enrolling in Medicare’s Part B next year for the first time, have incomes great enough that they are charged higher premiums, or are poor enough that they also qualify for Medicaid." Again, two-thirds of recipients won't be affected either way.

What does all this mean for the typical retiree? The changes to Social Security rules mean that, unless you are grandfathered in by your age, strategies like file-and-suspend are no longer available to you. If that was part of your retirement plan, you need to revise it. If you were worried about a Medicare Part B premium spike next year, it won’t be as breathtaking as the press has led us to believe, but that doesn’t guarantee there won’t be dramatic premium increases in future years. Remember, the spike was related to the fact that there was no Social Security COLA adjustment for 2016.

It also means that books and software about Social Security benefits optimization are now outdated. Mike Piper says he plans to update his book, Social Security Made Simple, very soon. Laurence Kotlikoff’s MaximizeMySocialSecurity website currently posts a warning on the site’s opening page saying, “Alert! Major SS Benefit Changes Pending!” Kotlikoff has also promised updates to his software as soon as possible.

In the meanwhile, if you are interested in the fine print, Wade Pfau, Mike Piper and Michael Kitces are my go-to guys for Social Security issues. Kitces has an excellent post at his Nerd’s Eye View blog. I also recommend Piper’s post  at the outstanding ObliviousInvestor blog and the excellent discussion at this Boglehead’s forum. Robert Powell has a very readable column on the topic at MarketWatch.

Sometimes the early reads on law changes gain clarity over the following days and weeks, so waiting until the dust settles and the books and software have been updated to see the law’s impact on your own retirement plan might be the best approach.

The end of the “file-and-suspend” Social Security claiming strategies won’t affect most households. Nearly half claim benefits at age 62, the earliest possible age, probably because they can’t afford to delay the income according to Motley Fool. U.S. News reports that only about 5% delay claiming until after full retirement age to maximize their longevity insurance. About 2% claim maximum longevity insurance at age 70.

The file-and-suspend strategy required the lower earning spouse to delay claims until full retirement age (currently 66 for those born between 1943 and 1954) and the higher-earning spouse to delay even longer (to 70 for maximum benefit).

No huge Medicare premium spike is good news for retirees and no more file-and-suspend is maybe not so good. This week's news illustrates a reality of retirement financial planning: good news or bad, very little is cast in stone.

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On a related note, see the sidebar for three timely pieces on Social Security written by Wade Pfau at the Retirement Researcher blog.

Second, thanks to those of you who responded to my survey regarding retiree attitudes toward investment portfolio volatility when non-discretionary expenses are safely covered by Social Security benefits, pensions and annuities. I promised to share the results here and, based on the first 100 responses, they are as follows:

• 15% would take maximum risk with their investment portfolio if they knew non-discretionary expenses were safe,


• 2% said they wouldn't invest retirement savings in stocks even if non-discretionary expense were covered,


• 83% said that, even if they felt non-discretionary expenses were safely covered, they wouldn't risk a huge loss such as they might have seen in the 2007-2009 bear market with an all-stock portfolio.

Please don't confuse this with a scientific poll – it is far from it – but it does suggest that many retirees still worry about portfolio volatility even when the rent and grocery bill are safe.