Wednesday, December 28, 2016

Publications, Peru, Piranhas and Machu Picchu

This is the week we traditionally review the past year. Personally, I had a pretty good one. Here are some of my 2016 personal accomplishments:

  • I caught two piranhas in the Amazon river in Peru with a fishing pole (literally, a pole) and ate them. They're pretty tasty.
  • I hiked to the Sun Gate above Machu Picchu, despite my concerns about altitude and the steep, wet stone path.
  • I published a paper co-authored with two of my children in a peer-reviewed academic journal.
  • Despite my intense acrophobia and to my daughter's amazement, I walked through the Amazon forest canopy along a swinging cable walkway. (She still can't believe I did it. Neither can I.)
  • I published my usual 50,000 words or so.

It was a pretty good year for an old guy.

I also blogged on several topics in 2016. The casual observer might assume my blog's goal is to educate people about retirement finance, but it's actually the opposite. I find that writing blog posts is the best way to educate myself. I spent a couple of months doing background research on reverse mortgages before posting about them, for example.

Here's a quick review of some things I learned in 2016.

First, I learned that the march to mobile devices continues unabated, so I redesigned my blog to be easier to read from smart phones. I test it with a nifty Google tool for mobile ease of use before publishing. I now put most links at the bottom of the post so people aren't tempted to jump to links until they've read the entire post.

I also learned from a reader that my email address had disappeared. It is now in the bio section of every post. You can reach me at

I started off 2016 with Why Retirees Go Broke. Bankruptcy is typically a result of spending shocks, not poor market returns.

What I Do When the Market Tumbles? Not much, because my portfolio equity allocation (about 45% equities) is set such that I am unlikely to lose more than I can stomach. I typically check my portfolio a couple of times a year.

2016: How I published a paper, ate a piranha and climbed past Machu Picchu.
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The upliftingly-named Death and Ruin is a post about the aforementioned paper I published under the same title with my kids. It explains the difference between absolute and conditional probabilities of death or depleting one's savings. What we really want to know is not the probability that we will die or go broke sometime during retirement, but those conditional probabilities given that we have reached a certain age: what is the probability that I will go broke or die given that I am now 77 years old, still alive and not already broke?

In Expense Risk in Retirement, I noted that the expense side of the retirement finance equation is at least as important as the income side and it's probably riskier. Despite this, most retirement plans focus heavily on the income side of the equation.

In Retirement Plan or Investment Plan?, I cautioned that any plan that only addresses asset allocation and withdrawals isn't a retirement plan – it's an investment plan. An investment plan is only one piece of the puzzle.

One of the most-read posts of 2016 was on the topic of health care costs in retirement. About Fidelity's Health Care Cost Estimate for Retirees considers AARP's statement that health care costs will consume most of the future Social Security benefits for some households.

Retirement Savings and Annual Spending, another highly-read post from 2016, discusses the frightening level of under-saving for retirement in the U.S. Not exactly news, but still quite important.

In addition to serving as a learning mechanism, blogging gives me an opportunity to think out loud. Back in May, I began perhaps my longest series of posts ever with A Model of Retirement Planning, Part 1, describing what I think a complete retirement plan should look like. It ended with Part 8 in July. I hope to turn this into a paper when it is completed to my satisfaction in 2016.

The Whoosh! of Exponential Retirement explains why retirement finances hit us like a high-speed train. Retirement finances begin at glacial speeds as we save a little in our 401(k) plan but they speed up exponentially over time and can blow by us like Usain Bolt in the final 10 meters. This post also contains the coolest GIF ever in a retirement blog (a low hurdle, I'll concede).

Exit Row Strategies describes one of my pet peeves and ties directly to The Whoosh! of Exponential Retirement – the idea that you can see bad things coming, like market crises, and just jump out of the way in time to avoid real pain.

Are your savings safe in bankruptcy? Is My Retirement Plan Protected? is a review of legal protections from creditors afforded different types of retirement plans.

I started a series of posts on reverse mortgages with The Mortgage is Dead; Long Live the (Reverse) Mortgage. Reverse mortgages have gained a great deal of popularity over the past couple of years. I fear that much of this is due to the unique current environment of low interest rates and a “quirk” in HECM reverse mortgage structure that can help retirees build more home equity credit than the market value of their home. I find reverse mortgages can be an extremely valuable retirement financing tool when used properly, but they aren't for everyone. The biggest risk is that a retiree will be forced to leave their home and trigger a loan call late in retirement after much of their equity is gone. For this and other reasons, I recommend they be used late in retirement and not at the beginning. I think “coordinated strategies” that essentially bet your home in the stock market are a particularly bad idea.

John Bogle has described the U.S. retirement system as a train wreck. I wrote Why the Retirement Train Wrecked as a brief history of retirement in the U.S. at the request of a University of Michigan business student. It was posted on his blog initially.

Trump, Monte Carlo and Insectivores is about overconfidence in computer technology and simulations in particular. That theme continues with Asset Allocation: Mike and the Robos. Computers don't magically improve retirement plans. That's a difficult confession for a computer scientist to make, but an accurate one.

So, there's 2016 at The Retirement Cafe´ in a nutshell. Here's hoping we both learn a lot more in 2016. I'll start by breaking down retirement into three phases in The Opening, the Middle Game and the Endgame.

Happy New Year!

You can fund your high-deductible insurance policy's Health Savings Account (HSA) directly from an IRA. You might want to do this because you don't have ready access to money to fund next year's HSA, or to transfer some cash tax-free out of your IRA and avoid required distributions on those funds when you turn 70-1/2. Consider doing this in January. It is literally a once in a lifetime deal.


Why Retirees Go Broke

What I Do When the Market Tumbles

Death and Ruin

Expense Risk in Retirement

Retirement Plan or Investment Plan?

About Fidelity's Health Care Cost Estimate for Retirees

Retirement Savings and Annual Spending

A Model of Retirement Planning, Part 1

The Whoosh! of Exponential Retirement

Is My Retirement Plan Protected?

Why the Retirement Train Wrecked

Trump, Monte Carlo and Insectivores

Asset Allocation: Mike and the Robos

Wednesday, December 21, 2016

Asset Allocation: Mike and the Robos

Robo-advisers are all the rage.

A robo-adviser is software – usually a website or an app on a mobile device – that provides financial advice or performs portfolio management online with minimal human intervention.

I'm not a big fan of robos because I have a finance background and I know how difficult retirement planning can be, but also because I'm a computer scientist and I know how difficult writing the algorithms can be. To develop a truly effective robo-adviser would require a great deal of financial knowledge effectively translated to a really good software developer. I don't think that happens often, at least not yet.

I'm also not a fan because my recent experience with robo-advisers has not been encouraging. Most are little more than simplistic games. The good ones, in my opinion, are better than a poor retirement planner and certainly better than not planning, at all.

The good robo-advisers are nowhere near as effective as a good, human CFP given the current state of the technology and none compares with a top financial planner. This is merely my opinion, but as I said I have a lot of training in retirement finance and I was once a damned good software developer if I do say so myself.  (I have considered writing a robo-adviser program for a long time. I haven't because I fully understand how difficult it would be to do it right.)

Several clients and readers have been stressed out by the chore of picking the “optimal” asset allocation for their retirement portfolio. I decided to try several free robo-advisers by creating a retirement planning scenario to run through each and then comparing the recommendations. I also asked retirement planner, Mike Lonier, to provide his recommendation representing the human race.

The scenario is the following. A husband age 66 and wife age 64 just retired and have saved $3.75M for retirement as shown in the table below. The husband will receive about $3,250 per month in Social Security benefits at age 70 and the wife about $2,000 per month at age 66. They have a small pension that will pay $1,000 per month beginning at the husband's age 66 and the wife will be entitled to a 50% survivors benefit. They believe they need to spend at least $180,000 a year and at most $220,000. The question I asked Lonier and the Robos (sounds like a 50's rock-and-roll band, doesn't it?) is how these funds should currently be allocated.

Desired annual spending Per Year
      "Wins the game" $220,000
      Minimum acceptable $180,000
      Taxable $1,750,000
      IRA/401(k) $1,500,000
      Roth $500,000
Social Security
      Husband at 70 $39,268
      Wife at 66 $24,703
Pension at husband's age 66 $11,000

The following table summarizes the results of the planners.

Planner/Robo-Planner Recommended Annual
Annuity Allocation Stock Allocation Bond Allocation Cash Allocation
AACalc with Annuity $260k 59% 41% N/A N/A
AACalc No Annuity $220k 0% 34% 66% N/A N/A NA 56% 44% N/A
Mike Lonier (1) $220k 8.0% 0% 86.2% 5.8%
Mike Lonier (2) $180k 8.0% 10.4% 77.4% 4.2% N/A N/A 45% 31% 24%
ESPlannerBASIC $191k N/A N/A N/A N/A
Fidelity Planning & Guidance N/A N/A 50% 40% 10% $192k N/A N/A N/A N/A
Vanguard Planning & Guidance N/A N/A 30% 70% N/A
Yahoo!Finance N/A N/A 50% 45% 5%
Elevator Ride with Annuities $150k [1] N/A 30% 70% N/A
Elevator Ride No Annuities $150k to $195k [1] N/A 40% - 60% 60% - 40% N/A

Let me explain each of the approaches., developed by Gordon Irlam is, again in my opinion, the most thorough asset allocation software available. AACalc asks several detailed, specific financial questions and explains its calculations well. (As you will see, some calculators ask generic – and frankly, sometimes plain weird – questions to generate a recommended asset allocation.)

The first two rows of the table suggest that a key differentiator among robo-planners is whether or not the client/user is willing to purchase fixed income annuities. (All of the annuities discussed in this post are simple fixed annuities without indexing. [4]) Row one shows AACalc results when fixed annuities are acceptable and row two shows recommendations when fixed annuities are not acceptable. Mosts robos don't even ask this question.

AACalc recommends in row one that a client willing to purchase annuities can generate $40,000 more lifetime income than one who won't buy them (row two). It recommends that the client invest 59% of assets in annuities and 41% in stocks. With income guaranteed by a secure floor of annuity and Social Security income, the client can be very aggressive with the remainder of the portfolio. Annuities replace bonds. This is the floor-and-upside strategy recommended by most economists.

For clients unwilling to purchase annuities, AACalc recommends a 34% stock allocation and 66% bond allocation. is perhaps the best-known robo-investment adviser. The website asked me just three questions, my age, my annual income and whether I was already retired, before advising me that I should invest 56% of my portfolio in stocks and 44% in bonds. It calculated this without knowing the size of my portfolio, whether I was married, or even how much I needed to spend annually from the portfolio. I clicked on "Details" to find a very precise breakdown of twelve sub-asset classes I should invest in – 4.8% in emerging markets, for example. Who knew retirement planning was so easy?

It isn't. And any planner, living or robo, who doesn't ask the right questions is subject to one of the oldest truisms of computers: garbage in, garbage out.

Mike Lonier also advocates the floor-and-upside strategy, unsurprisingly since he is associated with the Retirement Income Industry Association (RIIA). Lonier provided two recommendations, the first based on $220,000 annual spending and the second on $180,000 spending. For planned spending of $220,000 per year, he recommends an 8% annuity allocation (specifically, to a type of annuities called QLACs that are held in retirement accounts – see note in References below) with the remainder of the portfolio invested in bonds. He also notes a reasonably high concern that this level of spending may not be attainable.

For $180,000 annual spending, a level at which Lonier is more comfortable, he still recommends an allocation of 8% of assets to QLACs, but a 10.4% stock allocation with the remainder in bonds and cash.

Lonier elaborates on his approach:
"I don’t usually recommend “bonds” meaning bond funds. I recommend a lifestyle (floor) allocation built as a liability matched risk-free or guaranteed ladder of CDs, individual Treasury bonds held to maturity, and/or single premium income annuities (SPIAs) and deferred income annuities (DIAs). The SPIA/DIAs would be as floor ladder components, in addition to any DIAs that are part of longevity.  
With very-well funded clients, some percentage of the Lifestyle (floor) portfolio might be exposed to credit and interest rate risk in a partial allocation to bond funds, meaning that the very well-funded might follow, to some degree, an investment-based (MPT) portfolio rather than a strict goals-based approach, especially with funds above those needed to fund expenses in the ladder.  
My own algorithm, which analyzes the present value of assets and liabilities (current and future) on the balance sheet, indicates 0% and 10.4% for the Growth and Legacy (Upside) allocation for the two spending scenarios. My “human” adjustment changes that based on the balance sheet math but increased by the planner to 20% for the $220k scenario and 30% for the $180k scenario. The rationale is that there are sizable assets, so the concerning risk is spending risk, not necessarily asset loss (sequence of return risk), so the plan would manage spending risk while providing modest exposure to growth."
I should note that all of the robo's services I studied are free, though Mr. Lonier's services are not. Still, I believe he provides much better value. The above quote shows the additional value you get from human tweaking.

Next, I looked at Bankrate requests more relevant input than most robo-advisers but less than asked by Mr. Lonier or AACalc. In this scenario, Bankrate recommended 45% stocks, 31% bonds, and 24% cash. Still, if someone ran this scenario by me in an elevator, I would probably suggest a 40% to 50% equity allocation and be in the ballpark most of the time.

ESPlannerBASIC doesn't offer a recommended asset allocation that I could find, but it did suggest annual spending of $191,000 that I found useful.

Finding the calculator isn't always easy. After I had given up on Fidelity Investments offering an asset allocation calculator, I discovered the link that would provide one. Go to GUIDANCE & PLANNING > RETIREMENT PLANNING > PLANNING & GUIDANCE CENTER . . . You know what? Can you just trust me that there is an asset allocator in there somewhere if you look long enough?

Along the way, Fidelity posts a warning that their “advice” is for educational purposes only and shouldn't be used for actual planning. I feel like that warning belongs on all robo-advisers. In the end, Fidelity recommends 50% stocks, 40% bonds, and 10% cash.

My favorite robo-adviser so far is I've been working with founder Stephen Chen on this website and I find it closer to a real adviser than any of the alternatives. Unfortunately, the site doesn't provide asset allocation recommendations, at least not yet, but it did recommend annual spending of $192,000. I recommend you try out this website. It gets better all the time and I think it's already as good as the typical human planner.

Vanguard's Advice & Guidance tool recommended 30% stocks/70% bonds based on generic input. Still not much different than my elevator advice.

Lastly, Yahoo!Finance offered the most detailed asset allocation but again based on a few generic questions. With so little input data these calculators are giving the same advice to a huge range of clients. Yahoo! recommended 10% US large cap growth stocks, 15% US large cap value stocks, 10% US small/mid-cap stocks, 15% international equities, 45% bonds and 5% cash.

How do we compare such a wide range of recommendations? First, let's separate recommendations with annuity allocations from those without because these represent two very different strategies. The former is floor-and-upside while the latter is essentially a sustainable withdrawal rate (probabilistic) strategy. The two strategies provided by Lonier have low stock allocations because the required spending is high (4.8%) and because his strategy is to guarantee one's standard of living first and invest anything left over aggressively. (That's my approach, as well.) Also, note that the highest annual spending comes from these strategies and not from large stock market bets.

AACalc's no-annuity recommendation proposes a similar strategy to Lonier's, but invests in a bond ladder instead of annuities – secure the floor, then invest aggressively. Bottom line, these are quite similar strategies when annuities are allowed.

Looking at the remaining strategies, recommended annual spending ranges from $191,000 to $213,000. That's only an 11.5% difference.

The strategies without annuities recommend stock allocations between 30% and 50%. Personally, I would recommend more weight be given to calculators that require a lot of financial input instead of generic lifestyle questions. Those were AACalc and Fidelity with recommendations of 35% and 50% equities, respectively.

The goal of my readers and clients is presumably to narrow down an “optimal” asset allocation. But as I explained in The Whoosh! of Exponential Retirement, Irlam showed that the 95th percentile optimal asset allocation could range from 10% to 82% equities. The problem is that we simply can't predict future stock returns accurately enough to determine the optimal allocation so any of these allocations is mathematically defensible. The best strategy is to determine not the optimal asset allocation, but one that works well across a broad range of potential future outcomes.

My own approach is quite different and doesn't require a computer. It is based on the advice of William Bernstein and the idea that an asset allocation has two main purposes: to manage short-term volatility (my risk tolerance [2]) and to optimize long-term risk-adjusted return within my risk capacity.

Managing short-term volatility means implementing a stock allocation that won't lose so much money in a severe bear market that you might be tempted to bail out of equities. I believe I can personally tolerate about a 15% short term loss of my investments (though my risk capacity [3] is greater than that) and that has historically meant choosing about a 40% equity allocation. Bernstein suggests we begin there.

I can tolerate a
short term loss of
Equity Allocation
35% 80%
30% 70%
25% 60%
20% 50%
15% 40%
10% 30%
5% 20%
0% 10%

For investors who can ignore bear market losses, including the more than 50% loss during the Great Recession, an equity allocation can be much higher. Floor-and-upside strategies can recommend up to 100% equity positions because, with a floor, you're not betting your standard of living.

I personally find that my short-term volatility limit of a 15% loss is lower than any long-term asset allocation I calculate, so the latter becomes irrelevant for me. My advice is that investors who can't stomach large losses in a bear market go with the Bernstein max-loss allocation. For many, that will mean somewhere between 40% to 60% equities.

For those retirees who can tolerate short-term losses well, use AACalc to determine an allocation, remembering that its developer notes that an optimal asset allocation is probably unknowable. (In other words, don't sweat a 5% change in your allocation.)

Lastly, retirees with a secure floor can be as aggressive with equities as they like because even in the extremely unlikely event that they lose their entire portfolio, they won't lose their standard of living.

I'm a computer geek and have been since the early seventies. I'm also a statistics and modeling geek. I have found, though, that with many retirement planning calculations using extensive computer models don't give us dramatically new usable information. As you can see in the last two lines of the table, the recommendations I would give you for an asset allocation during a two-minute elevator ride don't vary dramatically from what robos recommend and I would be providing this advice with precious little information about your financial situation, as do most of the robos.

Importantly, the optimal asset allocation is unknowable so there's no sense laboring over a precise allocation, tweaking yours 5% one way or the other, or rebalancing frequently.

Worse, the computer calculations to four decimal places leave people who don't understand computers and models overconfident in their predictions.

If you use an asset allocation calculator, use a good one like AACalc that asks all the important financial questions instead of a pretty app with a lot of marketing pizazz and "ease-of-use" that doesn't. At this point, however, as a planner and a programmer, I prefer skilled humans.


 SWR spending rates and annuity payouts were taken from the Dashboard at Wade Pfau's Retirement Researcher blog.

[2] Risk tolerance describes an investor's emotional ability to deal with market volatility.

[3] Risk capacity describes a retiree's ability to risk investment losses and still achieve important financial goals.

[4] Fixed annuity, variable annuity and indexed annuity, defined at Investopedia.

The Intelligent Asset Allocator, William J. Bernstein, Table 8-1, page 144., robo-investment adviser.

Mike Lonier, Retirement Planner, email

AACalc, asset allocation calculator by Gordon Irlam.

RIIA, Retirement Income Industry Association.

QLAC, qualified longevity annuity contract., asset allocation calculator.

ESPlannerBasic, retirement planning website.

Fidelity Investments retirement planner.

Vanguard Investments retirement planner.

Tuesday, November 22, 2016

Trump, Monte Carlo and Insectivores

Some brilliant minds recently assured us that Donald Trump would lose the presidential election and probably lose it bigly. Nate Silver, the High Priest of Election Models and founder of the FiveThirtyEight blog, won the distinction of being the least wrong in predicting the outcome. Although he continually warned us that he might be wrong, his clear implication was that Hillary would win (see Donald Trump's Six Stages of Doom linked below if you question that). Others seemed to feel nearly certain.

In theory, no outcome was completely missing from the predictions, but many were given extremely low probabilities. There was even a possibility that Evan McMullin would win, just not a very big one. (See How Evan McMullin Could Win Utah And The Presidency, linked below.)

Wired magazine ran a story, obviously before the election, entitled, “2016’s Election Data Hero Isn’t Nate Silver. It’s Sam Wang.” To quote Wang, a professor of neuroscience at Princeton and now-famous insectivore who writes the Princeton Election Consortium blog, “It is totally over. If Trump wins more than 240 electoral votes, I will eat a bug.”

Crunch. Crunch.

(The more precise term may be entomophage.)

Nate Cohn at The Upshot needs to eat a bug or two himself, as do the election markets. They all predicted much higher probabilities of a Clinton win than did Silver. I'm not sure there are enough bugs to go around.

These are a lot of high-powered minds with deep understandings of statistics and modeling but they were all – to quote The Donald – Wrong!

How could that happen and what does it have to do with retirement planning?

Predicting election results is social science. Models using Monte Carlo simulation are good at predicting outcomes for physical science in which objects tend to behave in predictable ways under the same conditions. People are not so predictable.

There is an entire social science discipline, called behavioral economics, whose sole purpose is to explain the unpredictable and irrational economic behavior of humans. This unpredictability is a primary reason why statistical modeling won't be as predictive in social science fields as it is in physical science. (see The Marketplace of Perceptions, linked below.)

Monte Carlo simulation was created by physicists. Enrico Fermi used Monte Carlo techniques in the calculation of neutron diffusion in the 1930s. Atoms tend to behave in the same probabilistic ways under the same conditions regardless of emotions, doubts, fears, and biases. People don't.

Silver, Wang, Cohn and the gang have to build a lot of judgments and assumptions into an election model and in 2016 many of these were obviously erroneous. As the exit polls come in, you will hear each expert explain why he was wrong or that he was actually right but we didn't interpret his results correctly. (Like Cohn's Putting the Polling Miss of the 2016 Election in Perspective, link below.)

In other words, we had a lot of confidence in the models and that was a big mistake on our part.

OK, poll aggregators, I can accept my responsibility here and promise to never put much stock in your predictions from now on – my bad. I actually drew comfort from the fact that so many models suggested the same result (a Clinton win) but apparently there was a strong correlation between models that I overlooked. Apparently “herding”, the tendency of polling firms to produce results that closely match one another, especially toward the end of a campaign, is a problem not only with pollsters but among poll aggregators, as well.

Physics models can be more accurately defined than social system models and can use better-defined input data.

The radioactive decay rate of 239Plutonium is pretty consistent. “With a half-life of 24,100 years, about 11.5×1012 of its atoms decay each second by emitting a 5.157 MeV alpha particle.” Monte Carlo simulation models of decay can predict outcomes pretty accurately.

Compare that with “We have a poll from the L.A. Times, but our judgment is that it is skewed a point and a half toward the conservative candidate most of the time so we give it a rating of B+ and weight its contribution a little lower.” You get both an imprecise measurement and a judgment of its quality.

A few weeks later, the L.A. Times poll will show a different result, but 239Plutonium will still be decaying at precisely the same rate. Plugging more accurate and consistent inputs into a statistical model provides more predictive calculations.

Then there is the “one-time event” problem. If Silver was correct and Trump had a one-in-four chance of winning (it was probably much greater than that) then if the election were held one hundred times under identical conditions, Trump would win 25 of them. But the 2016 election was a one-time event. Trump won 100% of the election and Hillary lost 100% of it. Your household's retirement is also a one-time event.

We frequently use Monte Carlo simulations for retirement research. I think that is a far better application than for individual retirement planning precisely because research isn't trying to predict an outcome for a single household. It should be used much more carefully for the practice of retirement planning.

So, predicting the results of a one-time election event in a social system with imprecise and conflicting data sources turns out to be a very difficult thing to do and clearly far more difficult than many of us who believed in the modeling understood. In simplest terms, we are attempting to predict the future, or at least to characterize it fairly precisely, and you know what Yogi said about predictions – they're hard, especially about the future. Statistical models enable us to guess the future of social systems and be wrong with amazing accuracy.

There are so many variables, both known and unknown, so little high-quality clear data, and so much difficulty predicting human behavior that I suspect it's a fool's errand to try to predict a close national election. Someone pointed out that the models would have worked better if the electorate weren't so evenly split. That's probably true, but if the electorate weren't so equally split and the winner was more obvious, then why would we need the models?

A friend from my AOL days, Joe Dzikiewicz, made an interesting observation about the Electoral College (EC) and chaos theory. (So you don't spend the rest of your day wondering, it's pronounced “Ja-kev'-itz”). One attribute of chaotic systems is that a small change in initial conditions can result in dramatically different outcomes. If a small change either way in the popular vote can swing the Electoral College vote and greatly change the future path of world history, then the EC actually creates chaos, or "unpredictability." The outcomes may simply be unpredictable by statistical inference models under the initial condition that the electorate is closely divided. As I suggested in Retirement Income and Chaos Theory, the constant-dollar withdrawal assumption probably makes Monte Carlo retirement models chaotic, as well.

What does this have to do with retirement planning? Retirement planning is economics, a social science, not engineering. William Bernstein warned against using engineering techniques and historical data to develop retirement plans in a 2001 post at Efficient Frontiers entitled "Of Math and History" (link below):
And of course, if you’re a math whiz, then all of life’s problems can be solved by spinning proofs and running the numbers. Not a week goes by that I don’t get a spreadsheet from someone demonstrating how this allocation or that strategy led to great riches over the past five, twenty-five, or seventy years.
The trouble is, markets are not circuits, airfoils, or bridges—they do not react the same way each time to a given input. (To say nothing of the fact that inputs are never even nearly the same.) The market, though, does have a memory, albeit a highly defective kind, as we’ll see shortly. Its response to given circumstances tends to be modified by its most recent behavior. An investment strategy based solely on historical data is a prescription for disaster.
My philosophy of retirement planning is summed up beautifully in that last sentence.

The financial planning industry currently depends very heavily on Monte Carlo simulation for retirement planning. In fact, I have written that we often use Monte Carlo simulations instead of actual planning. Many of us try to show that the probability of failure is so low that we shouldn't worry about it (like Trump's odds of winning) and we give short shrift to actually planning for such a catastrophe as outliving our wealth, should it happen.

Assumptions and judgments can dramatically affect the results of retirement simulations. There may be a 95% probability that you won't outlive your wealth if you get good advice, but if you do you will be 100% up that famous creek. Precious few of the planners who use Monte Carlo simulation have Nate Silver's skills, but they make critical judgments and assumptions just the same.

Some of the retirement model assumptions are ridiculous, like assuming that retirees will keep spending the same amount until they go flat broke and the assumption that our limited availability of historical market returns data is adequate to predict the future with reasonable confidence. The election models struggle with assumptions about human behavior, but the typical retirement model is based on a particular human behavior that we all agree would be irrational.

Yeah? Well, Hillary had a 95% chance of being elected President.
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Though the polls were clearly flawed in many ways, thousands were available on which to base a prediction of election results in 2016. For retirement planning, we have about 200 years of data representing about seven distinct 30-year periods of market returns. We use rolling periods, a technique that is statistically flawed, to create 170 or so rolling 30-year periods. That still isn't much data to predict the future. Such a limited amount of historical market returns data makes for some very large confidence intervals.

As I noted in The Whoosh! of Exponential Retirement, Moshe Milevsky assures us that we can be 95% certain that a shortfall probability of 15% actually lies somewhere between 5% and 25%. Gordon Irlam showed us an example in which the optimal asset allocation has a huge 95th-percentile confidence interval of 10% to 82% equities. That's not a lot of confidence.

If predicting the results of a presidential election is difficult, retirement planners try to predict the probability of a one-time social event (a client's retirement) with far less data.

My point is this. If you think an election not turning out as predicted is a poor outcome, imagine that the 95% probability of success your planner promised ends with spending your late retirement living off Social Security benefits alone. (Somebody has to fall into that 5%, who says it won't be you?) The tools that didn't predict the election are basically the same ones that planners use to predict retirement finances and those tools failed in the election with better data, a more rational model and entire teams of more highly-skilled statisticians running them.

I'm not suggesting that retirement simulations are worthless; they can provide valuable insights but they should occupy an appendix of a retirement plan and be viewed as one more interesting data point, not as complete plans.

We had confidence in the election models and that was a big mistake on our part. Let's not be overconfident about retirement forecasts.

The next time an advisor hands you a Monte Carlo simulation and says you have a 95% chance of funding your retirement, tell them, “Yeah? Well, Hillary had a 95% chance of being elected President.”

Then ask him if he's willing to eat a bug.


Donald Trump's Six Stages of Doom, Nate Silver, FiveThirtyEight blog.

2016’s Election Data Hero Isn’t Nate Silver. It’s Sam Wang, Wired magazine.

Putting the Polling Miss of the 2016 Election in Perspective, Nate Cohn, The Upshot blog.

Princeton Election Consortium blog.

How Evan McMullin Could Win Utah And The Presidency, FiveThirtyEight blog.

The Marketplace of Perceptions, Harvard Magazine.

Of Math and History, William Bernstein,

Friday, October 14, 2016

Reverse Mortgages: When the Last Resort is the Best Resort

Recent research into reverse mortgages to fund retirement suggests that the conventional wisdom of spending home equity as a “last resort” after other savings are depleted should be rethought. On the contrary, I believe there are many retirement scenarios in which spending home equity as the last resort is the best resort.

The “don't wait” philosophy stems primarily from a paper written by Barry Sacks and Stephen Sacks in 2012 and the current unique circumstances for HECM reverse mortgages.

In a paper entitled, “Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income (2012), Barry Sacks and Stephen Sacks write:
A retiree whose primary source of retirement income is a securities portfolio and who also has substantial home equity must decide early in retirement whether to live within the safemax limit set by his or her portfolio . . . This decision is a fundamental component of overall retirement planning . . . The decision process also must take into account the degree of economic discipline required to live within the safemax limit.

If the retiree does conclude that he or she would, on balance, prefer to live beyond the safemax level and wants to remain in his or her home as long as possible, a reverse mortgage, including its substantial costs, is one tool to consider.”
The term “SAFEMAX” derives from the work of William Bengen and typically refers to a “safe withdrawal rate.” Historically argued to be around 4% to 4.5%, more recent work by Wade Pfau suggests that in the current low-interest rate environment the “safe” rate may be closer to 3%.

Sacks (2012) actually makes a fairly modest claim compared to the explanations subsequently provided in the media that spending as a last resort might be unwise. They state that the strategy isn't for everyone. The authors note that “particularly in the range of initial withdrawal rates between 5 percent and 6.5 percent, we have found substantially greater cash flow survival probabilities when the reverse mortgage credit line is used in either of two active strategies rather than in the conventional, passive, strategy as a last resort.”

In other words, for retirees willing to risk spending more (about 5% to 6.5% instead of 3% to 4%) from a volatile portfolio than planners have conventionally considered safe, using home equity to leverage an investment portfolio might provide better outcomes. That's a far cry from claiming that the conventional wisdom of spending home equity as a last resort is wrong, as subsequent reviews of the paper may have suggested.

Wade Pfau concluded in his 2016 book, Reverse Mortgages, that a simple strategy of opening a HECM reverse mortgage early in retirement and not using the line of credit until late in retirement outperformed both of the currently-proposed “coordinated strategies” and the use of tenure payments.

"Of the six strategies that use home equity," Pfau reports, "the strategy supporting the smallest increase in success is the conventional wisdom of using home equity as a last resort and only initiating the reverse mortgage when it is first needed . . . Meanwhile, the "use home equity last" strategy provides the highest increase in success rates."

(Note that Pfau compares two “Last Resort”strategies. The first spends as a last resort but waits to open the reverse mortgage until it is needed. That strategy performs worst, but opening the reverse mortgage early in retirement and letting the line of credit grow before spending as a last resort after savings are depleted performs best. Pfau refers to the latter as “using equity last.” Pfau further notes that if your goal were to create the greatest legacy and not to maximize the probability of successfully funding retirement, tenure payments provided the best strategy most often.)

The current unique circumstances for the HECM are the increased loan limit of $625,500 and present historically-low interest rates. When combined, these two factors could allow a borrower to create a very large line of credit, perhaps greater than the home's fair market value over a long retirement. As Jim Veale recently explained in a comment, the maximum HECM loan amount was increased from $417,000 to $625,500 as part of the American Recovery and Reinvestment Act of 2009. Many believed the increase would be temporary but it has thus far survived.

Regardless, there are many conceivable retirement scenarios in which spending home equity as a last resort, as the conventional wisdom holds, would be advantageous, given that opening the line of credit early is a clear benefit with any strategy.

Avoiding risk to home ownership when it may never become necessary

Some retirees want to pass their home debt-free to heirs. They probably should not borrow a reverse mortgage. Some don't plan to keep the home in their estate and won't mind risking ownership. Still others would like to leave their homes to heirs but realize they might not be able to pay for retirement without using home equity. By spending home equity as a last resort instead of committing it early in retirement, the latter group might find that they never need to risk their home or that they can at least minimize the amount of equity they do need to spend.

Think of it as matching home equity to contingent late-retirement liabilities.

Not encouraging overspending

Imagine a couple that divorces late in life after spending a lot of their home equity. Neither wants to continue living in the home. Perhaps neither can afford to continue living in the home, given their new financial situations. Their best financial alternative may be to sell the home, in which case their HECM will have to be repaid. Although they had planned to age in the home, they find themselves leaving the home and without much remaining home equity to pay for new housing.

I was recently asked to explain how this couple would have been better off by not borrowing the HECM. The answer is that the HECM may have encouraged them to spend more than was safe early in retirement, leaving them with little financial reserve in a crisis.

Giving the household more time to see how retirement will unfold before committing resources

Committing to an early-spending reverse mortgage strategy (matching home equity to early-retirement liabilities) involves betting that the household will remain in the home and age in place. It is a bet against divorce and the early death of a spouse. It is a bet that you will feel the same about your home in 10 to 15 years that you do at the beginning of retirement. It is a bet that your home will accommodate future infirmities.

As Shelly Giordano's book on reverse mortgage suggests, waiting a decade or so before committing to spending your home equity provides more time to see how your retirement will unfold.

Holding a reserve for spending shocks

As I explained in Why Retirees Go Broke, the reason is usually a positive feedback loop of financial setbacks stemming from spending shocks, not from sequence of returns risk or poor investment results. Health care costs are an obvious risk, but there are many potential spending shocks that could leave a HECM borrower unable to afford their home going forward. In those instances, the HECM will need to be repaid leaving the borrower with little equity to help with housing costs.

Just in the past few weeks, I have heard the following stories of financial crises in which a HECM borrower would sorely miss home equity as a last resort after having used it to increase early-retirement consumption:
  • A wealthy corporate executive was driven into bankruptcy by his wife's Alzheimer's disease.
  • A woman's home is being taken by the state using eminent domain to build a highway through the property.
  • An elderly HECM borrower ran out of money and asked her loan originator to “send more.”
  • A couple needed to move his father into their home as his dementia progressed.
These crises might also occur after you spend your savings and begin spending home equity as a last resort, of course. In that event, you simply ran out of money and neither spending strategy was likely to save you. The danger is in finding the opportunity for additional consumption early in retirement too attractive and experiencing a more critical need for the reserves later in retirement.

Controlling balance sheet leverage

Leverage is risk and like any financial risk can be beneficial if appropriately exploited and dangerous if it is not. Any balance sheet that includes debt is leveraged and anyone who simultaneously holds a mortgage, conventional or reverse, and an investment portfolio has leveraged those investments. Understanding this leverage risk is important and maintaining a prudent amount of leverage is critical. (Michael Kitces explained it well here.)

Retirees who spend home equity as a last resort after depleting their portfolio will not simultaneously hold reverse mortgage debt and an investment portfolio – they will hold them sequentially. That doesn't mean they won't have leverage from other debts, or that the amount of leverage created by the reverse mortgage will be imprudent. That depends on the rest of the balance sheet. But, it does provide an opportunity to manage that leverage.

When spending home equity as a last resort is the best resort.
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There are a number of advantages to spending home equity late in retirement. Retirees who don't live a long time may find that by waiting to use home equity they never need to risk their home to fund retirement. Delaying may enable the retiree to better observe how her retirement financial situation will unfold before committing to spending home equity. Some retirees will find a more critical need later in retirement than additional consumption early in retirement. Borrowing later may help control balance sheet leverage.

On the other hand, the argument that spending home equity early in retirement beats conventional wisdom isn't particularly compelling. Sacks (2012) argues only that it might provide better outcomes for retirees willing to commit home equity early and to spend more than most planners would consider safe. Pfau's analysis showed that the best outcomes were the result of simply opening a HECM line of credit early in retirement and waiting to spend it until after the savings portfolio is depleted.

If you expect to remain in your home throughout retirement, my advice is to consider opening a HECM line of credit today, while interest rates are low and the maximum HECM loan value is high, but to hold off on spending much of it until you see what life has in store. Often when spending home equity, the last resort will prove the best.

Your retirement planner says you have a 95% chance of funding retirement successfully? Find out what that means in my next post, Trump, Monte Carlo and Insectivores.


Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income, B. Sacks and S. Sacks, Journal of Financial Planning, 2012.

Reverse Mortgages: How to use Reverse Mortgages to Secure Your Retirement, Wade Pfau, 2016. Available on Amazon.

Friday, September 23, 2016

The Risks of Reverse Mortgages

My last couple of posts, beginning with The Mortgage is Dead; Long Live the Reverse Mortgage, have extolled the virtues of the improved FHA HECM reverse mortgage products. Given that the typical American family has far greater home equity than all other assets combined, making more productive use of that home equity to fund retirement should be a big help to many households.

No retirement strategy is perfect for every household, though, and there are some risks with HECMs that you should understand. Here are a few.

A HECM does not guarantee that you can keep your home.

A HECM guarantees that you can keep your home for as long as you, a spouse or a non-borrowing spouse still live in it. It also guarantees that you can't owe more when you repay the loan than could be recovered by you selling the home at fair market value. HECMs provide the opportunity for you, your estate, or even your heirs to pay off the loan with other assets and keep the home. But, they don't guarantee that you will have the financial means to do so.

We are told by late-night TV commercials that a HECM borrower can never have their loan foreclosed except for three reasons: failure to pay property taxes, failure to keep insurance in force, or failure to maintain the property so long as the borrowers or a non-borrowing spouse live in the home. But, that's really four reasons, isn't it?

Tom Selleck (I think he plays an amazing Police commissioner in Bluebloods, by the way) is reported to say the following:
When you get a reverse mortgage, you are getting a loan. The bank is loaning you money in much the same way as it loans you money when you take a home equity loan. And when you die, the home is still yours to pass on to your heirs.
Some of this is correct. Banks are rarely involved, as I will explain below, but that’s a quibble. When you leave the home, and not necessarily because you died, the home is still yours to pass on to your heirs if you have other assets with which to pay off the loan or your heirs can arrange a new mortgage. The home is, in fact, still yours (or more accurately your estate's) after you die, but the home was collateral for the loan. If you or your estate can’t pay back the loan from other resources, you can’t pass on the home to heirs. It must be sold by your estate to pay back the loan.

Should you decide that you no longer want to live in the home, you will also have to repay your HECM. More importantly, if you are no longer able to afford the house and need to sell it, your HECM loan will also become due and payable. A retiree who loses a spouse, gets divorced, or incurs huge medical expenses, for example, may find the home no longer affordable or perhaps just no longer desirable.

Imagine an executive at an oil company whose wife develops Alzheimer's disease and is bankrupted by the cost of her care. Why might a HECM not enable them to stay in the home? Maybe because they can no longer afford a mansion in a high cost of living area even with no mortgage payments or perhaps they need to access home equity in excess of their HECM credit limit.

Every retirement plan should consider the possibility of a spouse's death, a divorce, spending shocks or any of a number of life-changing events. HECM borrowers should also consider the possibility that these changes might leave their home unaffordable or undesirable and necessitate paying off the loan long before they had planned. Retirees with expensive homes in areas with a high cost of living are at greatest risk of deciding to sell because they will see the largest benefit from selling and relocating.

If you can't repay the loan, you won't be able to keep the home.

A reverse mortgage can be a great idea, but understand the risks.
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A forced repayment can happen at the worst possible time.

Repayment of a HECM loan can be forced by foreclosure, by the borrower’s choice to move, or by the borrower’s need to move when she can no longer afford the home.

In Why Retirees Go Broke, I explained that elder bankruptcies are usually the result of expense shocks and not poor investment results. I referred to Dr. Deborah Thorne's study showing that these bankruptcies are usually the result of multiple interconnected causes – loss of a job or huge medical costs, for example, leading to excessive credit card usage that leads to insolvency.

In Retirement Income and Chaos Theory, I showed how insolvency can result from a downward spiral of continually worsening financial problems. If those interconnected problems also result in a HECM borrower needing to move out of an expensive home to stabilize her finances, her HECM will need to be paid back at the worst possible time – during an ongoing financial crisis – and may accelerate the downward spiral.

As Shelley Giordano pointed out to me, it is also possible that a HECM loan might stabilize the downward spiral and save the retiree’s finances. That would be a rational strategy when there is adequate credit to address the crisis. When the credit is not adequate, the forced repayment might accelerate the spiral.

For example, if you have a $100,000 HECM line of credit and incur a $100,000 medical expense, the HECM might well stabilize and save your financial situation. If the spending crisis costs $200,000 it may not stop the spiral and, in fact, may force you to sell the home and trigger repayment. Given that you already have a crisis on your hands, repayment might simply accelerate the downward spiral.

The tax implications of a reverse mortgage aren't all clear and even the clear issues are complex.

Funds borrowed from a HECM are considered loans and not taxable income. That much seems clear. How you will be taxed should you borrow more than the fair market value of your home and take advantage of the non-recourse character of HECM loans is less certain, as are eligible tax deductions. That uncertainty is risk.

Taxes aren't deductible until you leave the home because that’s when they are paid. While the HECM protects you from having to repay more of the loan than the sale of your home will bring, a non-recourse loan doesn’t protect you from taxes. If your line of credit grows beyond your home’s fair market value, you might end up with a sizable capital gains tax.

Dr. Barry Sacks and his co-authors wrote a paper entitled Recovering a Lost Tax Deduction (link below) that explains how to capture the potential interest deduction. (If nothing else, it will convince you that the tax implications are complex.) Tom Davison wrote an excellent overview of the tax implications of reverse mortgages at his Tools for Retirement Planning blog (link below), though I think he would readily admit that it is not a complete treatment of all issues.

Your risk isn’t so much that the tax law is uncertain (it is a bit uncertain) but that the laws are so complex that you will borrow a HECM loan without understanding the potential impact of taxation. Even if you have difficulty understanding the taxation of HECMs, it is important to recognize its uncertainty and complexity when making your decision to borrow. Uncertainty and complexity are risks.

Tax and estate planning on this topic are in order to take advantage of the opportunities and to avoid leaving your heirs a possible nightmarish tax issue. I’ll leave this point with a quote from Wade Pfau’s excellent new book, “How to use Reverse Mortgages to Secure Your Retirement”, available at Amazon.
A more complex area relates to eligible deductions for reverse mortgages. These taxation issues are still relatively untested and not fully addressed in the tax code. Researchers Barry Sacks and Tom Davison have recently been exploring deeper into the tax code to better understand these aspects. Individual cases vary, so a tax professional with reverse mortgage experience should always be consulted.” (Emphasis mine.)
Just because your reverse mortgage can't be foreclosed doesn't mean you can't lose money.

Some argue that a HECM line of credit is essentially risk-free due to its lenient repayment terms. Who cares if you run up a HECM line of credit when you don't really have to repay the loan or the interest and fees until you die?

Borrowing from a HECM is not risk-free. As I pointed out above, that works great if the rest of your finances go well, but when your finances collapse (see Why Retirees Go Broke for a list of reasons this can happen) and you need or want to sell the home, those lenient terms disappear. The loan becomes due and payable.

Even retirees who are able to stay in the home for the rest of their lives spend real wealth. The loans they borrow reduce future potential consumption. Once you spend the money from the line of credit your wealth has decreased in the same way as spending from any other resource. A HECM line of credit won't be foreclosed so long as you meet the four conditions but spending from it does reduce your wealth, just like any other form of credit.

Borrowing to invest is imprudent for most retirees, especially when their home is the collateral.

AARP, FINRA and most economists and financial planners warn that a household should not use home equity to invest in the stock market. Risking your home to invest in volatile assets is a bad bet. After retirement it becomes a worse bet because the borrower no longer has a stream of job income from which to make the loan payments. Retirees should not rely on good investment results to repay loans. With a HECM and an investment portfolio, poor investment results alone may not force you to leave the home but they may leave you unable to eventually pay off the loan and keep the home in your estate.

Borrowing early in retirement may limit your options later in retirement.

Some strategies like borrowing from a HECM to pay taxes on a Roth conversion or to help delay claiming Social Security payments require borrowing early in retirement. Doing so might cut off important options later in retirement that might be even more beneficial.

A large HECM balance might complicate a decision later in retirement to downsize or move to a retirement home, necessitating paying back the loan. A HECM line of credit might be more valuable late in retirement to pay long-term care expenses than borrowing earlier in retirement to avoid taxes or delay claiming Social Security benefits.

Retirees who borrow early run the risk of needing the funds later in retirement even more. In What's the Deal with Reverse Mortgages, Shelley Giordano discusses the value of borrowing later in retirement not only to allow the line of credit from a mortgage taken out earlier to grow but also because many issues like where you will live may become more settled as you age.

Large banks have exited the reverse mortgage business.

This issue is not solely one for reverse mortgages. An article in the August 20, 2016 issue of The Economist describes it as follows:
The trouble is that, in America, the banks are only part of the picture. There is a huge, parallel structure that exists outside the banks and which creates almost as much credit as they do: the mortgage system. In stark contrast to the banks it is very badly capitalised. It is also barely profitable, largely nationalised and subject to administrative control.
After the housing crash, the federal government moved to shore up big banks and increase their capital requirements, but those changes don't apply to the non-bank portion of the mortgage market where most reverse mortgages are held. Mortgages of all types may be riskier than we realize.

Tenure payments last the life of the mortgage, not the life of the retiree.

Tenure payments from a HECM are a lot like a life annuity from an insurance company, but they are quite different in important ways. The HECM tenure payments will go away when the borrowers move out of the home or the mortgage is foreclosed.

Once the mortgage is paid off, it may be difficult to find a replacement source for tenure income. That won't be a problem if it is your estate that is paying off the HECM, but it might be one if you are forced to repay the mortgage earlier than planned and were counting on a lifetime of income from the HECM tenure payments.

An annuity guarantees income for life no matter where you live. HECM tenure payments are not portable. The risk is that you will plan to live in the home for the rest of your life but will not be able to, or that you will change your mind.

Tom Davison points out that HECM tenure payments have a mitigating feature. Unlike life annuities, HECM tenure payments will return any unused equity when the loan is repaid. Pfau’s new book compares tenure payments and annuities in Chapter 8, The Tenure Payment as an Annuity Alternative. There are distinct advantages and disadvantages to each.

The credit line growth feature could be limited in the future.
The growing-line-of-credit feature of HECM adjustable rate mortgages is a unique and powerful feature, so much so that one wonders if it is too good to be true over the long term. AARP's Policy Guide recommends that HUD "should prohibit the use of reverse mortgages as a portfolio hedge for wealthy individuals and should eliminate the credit line growth feature of adjustable-rate HECM loans where borrowers choose a line-of-credit payout.”

The present seems to be a nearly ideal time for HECM adjustable-rate mortgages. The program contains what I consider to be a loophole based on the assumption that borrowers wouldn’t typically take out a HECM reverse mortgage and not borrow from it for decades. Combine that with the current low-interest rate environment and you have the potential for some huge future benefits that the program probably didn’t consider.

For these reasons, most of the HECM experts with whom I spoke suggested that the loophole is likely to be closed at some point in the future. Some of the strategies currently suggested for HECMs in retirement would be far less attractive if that loophole were closed or interest rates rise, as they likely will.

This is perhaps my most important point: these risks are not reasons that retirees should avoid HECM loans; they are reasons that retirees should plan.

They’re reasons to learn about HECMs, prepare for taxes, and understand the reverse mortgage’s role in your retirement plan. I'm suggesting that you shouldn't run out and borrow a HECM reverse mortgage without understanding the complexities and probably not without some professional guidance. That may well be worth the effort for many households.

No retirement product is perfect for every household but if we understand both the risks and benefits then we can incorporate them into a retirement plan that exploits the advantages while mitigating the risks.

In my next post, I'll discuss when spending home equity as a last resort is the best resort.

Once again, I need to thank several people for discussing the issues in this post including Wade Pfau, Shelley Giordano, Ron Heath, Jim Dean, Jim Veal and Mary O'Keeffe. (I should point out that none of us are in full agreement regarding HECMs, yet, but if we were, this wouldn't be fun. The disagreements are enlightening.) 

In particular, I want to thank Tom Davison for a marvelous three-and-a-half hours of discussion at a coffee shop on his way to catch a flight and to Wade for publishing a book this week that felt like it was intended specifically for me.


How to use Reverse Mortgages to Secure Your Retirement” by Wade Pfau, available at Amazon.

AARP Policy Book on HECMs.

What's the Deal with Reverse Mortgages by Shelley Giordano, available at Amazon.

Tax Deductions and Reverse Mortgages: August 2016 Update by Tom Davison.

Recovering a Lost Tax Deduction, Barry Sacks, et. al.

Comradely Capitalism: How America accidentally nationalised its mortgage market, The Economist, August 2016.