Friday, May 27, 2016

The Intersection of What's Desired and What's Possible, Part 6

Those of you who have been following this series of posts, beginning with A Model of Retirement Planning, Part 1, know that in my last post, A Mission Statement for Retirement, Part 5, I borrowed a mission statement from the strategic planning process for businesses. I tweaked it a bit so that in the retirement plan context it explains what we hope to achieve with a retirement plan.

But, as a famous financial planner who attended the London School of Economics once informed us Boomers, “You can’t always get what you want.” To put it simply, our ability to achieve our financial desires in retirement are constrained by the state of our household’s financial resources and the outlook for the economy.

The strategic planning process for businesses proposed by Pearce and Robinson explains that the correct choice of business strategies lies at the intersection of “what is possible” and “what is desired.” The proposed strategic retirement planning process has different blocks than Pearce and Robinson's for businesses, but the principles are quite similar. Their diagram looks like this (click to enlarge).

The possibilities for a business’ strategic choices are bounded by the external environment (competitors, regulators, etc.) on one side and an internal analysis (the company's strengths and weaknesses) on the other. The internal analysis is essentially a review of strengths, weakness, opportunities and threats, commonly called a SWOT analysis. The company mission statement identifies what the company hopes to achieve.

An analogous strategic retirement planning process also needs to find its strategies at the intersection of what is possible and what is desired. In our case, the external environment is essentially the economy and it includes those factors that affect all households (“systematic” factors) – the realm of game theory’s “nature” – such as capital markets, changes in tax laws, changes to the Social Security program, interest rates, changes in our health care system and health insurance availability.

Our internal analysis (or “household wealth analysis”) will review our resources for funding retirement including savings, pensions, our health, options for employment, our household's expected Social Security benefits and insurance, for example. It will also include a strengths and weaknesses analysis. In other words, the internal (household) analysis identifies the assets and skills available to us to fund retirement, which determines the limits of what is achievable by our individual household. These factors are referred to as “unsystematic.”

Having “longevity genes” is an internal financial weakness because it increases the odds of a long, expensive retirement. Having lots of children and grandchildren who may need our financial help is a weakness. Having under-saved for retirement is a weakness while having over-saved is a strength. Financial expertise is an obvious strength while the lack thereof is an obvious weakness. Having a job you can keep, or perform part-time, as you age is a strength while employment as a construction worker might be a weakness because your profession might be limited by age and health.

Opportunities and threats are external to the household. Political movements to limit Social Security benefits are external threats to your retirement finances. The current and future capital markets can be opportunities or threats; the current low-interest rate environment is an external threat. Sequence risk is an external threat, as is inflation. These external or "systematic" factors would impact everyone’s financial situation regardless of their household’s strengths and weaknesses.

In retirement planning, we typically think of financial risks. Weaknesses are our internal risks; threats are our external risks.

The challenge of retirement planning is to find a strategy (and there may be several) that meets the desires of our mission statement but also falls within the limits imposed on us by the economy and our household’s resources.

The benefit of a strategic plan is that it focuses priority on meeting the most important financial goals of retirement (maintaining standard of living, avoiding bankruptcy, leaving a legacy, aging in place, etc.) and relegates the technicalities, such as asset allocation, safe spending rates, insurance and tax management to a supporting role.

Good retirement strategies are found at the intersection of what's desired and what's possible.
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While we may find several strategies that meet the strategic objectives of our mission statement and also fall within the bounds imposed on us by the economy and our household's resources, there may also be none that does. For example, imagine that you have saved only $50,000 for retirement but "desire" to spend $100,000 a year. There is no strategy that will meet that goal. As that great British financial guru (no, not Keynes) went on to suggest, “if you try sometimes you might find you get what you need.”

If there is no reasonable strategy to be found, we will need to create a more modest mission statement that is more about what we need than what we want. The creation of the mission statement and strategy selection are an iterative process through which we create a mission (our goals) and then determine if we can develop an acceptable strategy to meet that mission. If we cannot, we create a more modest mission statement and repeat the process.

On the upside, strategy selection might also show that our mission statement was initially unnecessarily conservative, in which case we can increase its scope and search for strategies again. I would argue that Mick, for example, has probably ended up with more than he initially wanted and could upgrade his expectations, though I concede that having too much success is a poor starting point for a good blues song.

Having discussed the mission statement in my previous post, we need to add two more lists to our plan: an assessment of the economy and an assessment of our household resources.

An assessment of the external environment, the economy, will include our estimate of future market returns, inflation expectations, tax expectations, and interest rate expectations, for example.

(An excellent place to find current information on interest rates, annuity payouts, and inflation expectations is Wade Pfau's Retirement Income Dashboard. For market valuations, I like Robert Shiller's CAPE Ratio. The ratio is currently around 26, with a long-term mean of 16, so the market appears to be over-valued in historic terms, at present. The Society of Actuaries created an excellent summary of retirement risks entitled, "Managing Post-Retirement Risks: A Guide to Retirement Planning.")

We also need to add an internal household wealth analysis, using wealth in the broadest terms to include human capital and knowledge, that identifies our resources for funding retirement. I have listed some possible contents for the mission statement, analysis of the economy and household wealth analysis here.

Once the mission statement, assessment of the economy and household wealth analysis are complete the real planning can begin. (Until now, we have only defined our goals and the constraints for a plan.) This is where the skill, experience and knowledge of a good retirement planner come into play because this is the point at which we must imagine a retirement income strategy that meets our mission objectives within the constraints of what is possible given our wealth and the current economy.

I have mentioned that there may be many acceptable strategies that meet our criteria with a high probability of success and that any of them is a rational choice. Let’s refer to this as the “best strategy set.”

It will be difficult to accurately assess the probability of success for each acceptable strategy, so we should select a strategy from this best strategy set without trying to narrow down the best individual strategy. The selection of one from among these many may depend on individual preferences. For example, we may find a strategy that uses annuities and one that does not, both with about equal probabilities of success. Some retirees will prefer the former and some the latter though both meet the strategic objectives with similar risk.

This may sound like a planner should imagine several good strategies and work with the client to select one, but that would be an inefficient approach. Instead, the planner should make her best efforts to identify a single strategy within the best strategy set. The strategy can then be reviewed with the client to determine if there are aspects of the plan with which the client is uncomfortable. The planner can then suggest alternatives and verify that the new candidate plan indeed falls within the best strategy set. The planner may also explore possibilities within the best strategy to improve on the current strategy selection.

The last step of the creation of the initial retirement plan is to establish objectives by which the plan’s progress can be measured over the coming year.

To review the high-level process of strategic retirement planning as proposed, the steps are as follows.
1. Household develops a Mission Statement explaining their strategic objectives for retirement.
2. Planner works with household to identify retirement resources (RIIA refers to this as the “household balance sheet”) including internal strengths and weaknesses.
3. Planner provides an analysis of household wealth and an analysis of economic outlook for key variables.
4. Planner searches for a strategy that meets the objectives stated in the Mission Statement within the constraints of the economic outlook and household wealth analysis.
5a.) If no acceptable strategy is found, planner and household review and reduce the scope of the mission statement and planner repeats step 4.

5b.) If the scope of the mission can be met and unallocated resources remain, planner and household review and increase (if clients desire) the scope of the mission statement and planner repeats step 4.

6. Household reviews the strategy for possible concerns.

7. Planner reviews the strategy for possible improvements.

8. Planner develops objectives by which the plan’s progress can be measured over the coming year.
Of course, you might be both the planner and the client.

If I appear to dismiss the complexity and challenge of step 4 for many households, during which the planner searches for suitable strategies, that is not my intent. This is clearly the step in which retirement planning training, skill, and experience are brought to bear. The strategic approach is intended only to place the search for a retirement income strategy within a strategic framework to better define its objectives and constraints.

You may be asking yourself how this approach is different than other retirement planning processes. Why not just sit down and try to make all the pieces fit into a workable plan? First, it's a better process because we get a better answer when we ask a better question.

Second, strategic planning focuses on developing a top-down strategy that begins with your most important retirement goals and the major constraints on meeting those goals. Tactics are addressed only as the means to achieve strategic goals. The choice of asset allocations, for example, is considered within the context of the entire plan and not on its own merits.

The top-down strategy is important when we consider that nearly every tactical decision we make in retirement planning affects most other aspects of the plan. For example, selecting a sustainable spending rate independently because we are comfortable with the resulting probability of depleting our savings portfolio has other ramifications. That decision may also affect (or be affected by) our asset allocation, our floor strategy, our estate plan and even when we choose to claim Social Security benefits.

The top-down approach forces us to consider all of the implications of tactical decisions because each of them must support the strategic goals identified in the mission statement. (There is a good reason that armies are organized into generals, lieutenants, and infantrymen.)

And, finally, strategic planning provides a framework for identifying the best strategies, those that have the best chance of meeting our mission within the constraints of our household’s wealth and those of the economy at large.

The best retirement strategies will come from envisioning the big picture first.
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To summarize, start your retirement plan by identifying the major goals you hope to achieve with a mission statement. Identify the limitations imposed on all of us by the economy and the limitations imposed on us individually by our financial situation. Then search for a strategy with a strong chance of achieving your mission within the constraints you identified. (You may want to work with a good planner on all of these.) Repeat annually, because over time it is likely that your household finances, the economic outlook, and even your retirement goals will change, perhaps dramatically.

The best retirement strategies, just like the best business strategies, will come from envisioning the big picture first.

See how this all plays out in The Retirement Plan I would Want, Part 7.


  1. Excellent, informative post--- much more specific than any others I've read about how to plan. Thanks!

    However, putting children and grandchildren on the weakness side? Well, maybe in some families; but in mine, they fall on the asset side.Being widowed and retired, I have to keep my 6 children and 23 grandkids from helping out too much, they are generous to a fault.

    So I'd say plan and execute as above, your advice is good, but remember that if the plans all fall apart, a strong loving family is the ultimate safety net.

    1. We're discussing financial strengths and weaknesses, of course. I don't recommend that you disown your family.

      Children can be a financial strength, a financial weakness, or both. My sister-in-law has enabled her Dad to continue living in his own home at age 98. That's a strength.

      I also have friends whose adult child in his 40's lives with them because he has a severe substance abuse problem. They have to take care of him. He is also a liability issue for them. Those are weaknesses.

      Many Boomers have children who are struggling with their careers and continue to need help. That's a weakness. Some have sons who are doctors. That's a strength.

      It's fantastic that you have so many loving, generous children and grandchildren. You are truly blessed. But we should also be honest about our financial risks, strengths and weaknesses.

      Sounds like your heirs all show up in the plus column. We should all be so lucky.

      Thanks for writing.

  2. Great job, Dirk! Your entire six part series on developing a spending plan was superb. So good, in fact, that it was just a little bit hard for me to believe that you were thinking all this stuff up on the fly. You truly deserve your "Thought Leader" status. As with the earlier parts of your series, I have recommended my blog readers read the last two parts in my most recent blogpost.

    I especially like the concept of the intersection of what's desired and what's possible, as I encourage my readers to use the Actuarial Approach to find that same neighborhood.

    1. Thanks, Ken! It's true, I'm thinking out loud. In fact, I don't know the ending, yet. We'll see where it goes together.