Tuesday, June 28, 2016

The Retirement Plan I Would Want - Part 7

In recent posts, beginning with A Model of Retirement Planning – Part 1, I've explored a strategic approach to retirement planning based on the Pearce-Robinson model for strategic business planning. I'll pick that up now, after a two-week interruption to visit Machu Picchu, to have a shaman in the Amazon basin release my negativity, and to catch and eat two piranha. (Despite what you may have heard, they're pretty tasty. Wonder if that's what they say about us?)

The typical retirement plan report is centered around a spreadsheet that purports to anticipate our future wealth annually for the next three decades despite all evidence that such forecasts are well beyond human capabilities. Even if these forecasts were credible, such a presentation makes it difficult to explain or understand the underlying strategy and it places too much planning focus on terminal wealth.

The typical retirement plan is centered around an overconfident pro forma projection of future wealth.
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Dr. Moshe Milevsky recently wrote a piece entitled, "It’s Time to Retire Ruin (Probabilities)" (download PDF). In it, he states, "there are misguided notions that (1) people with sizable nest eggs will “outlive their assets,” (2) one can actually place a probability on this event, and therefore (3) one should manage financial assets and use insurance products to minimize this metric."

Milevsky provides an example Monte Carlo outcome with a "15% probability of ruin" that might have a 95% confidence interval of 5% to 25%. In other words, the probability of ruin probably falls not at precisely 15%, but between 5% and 25% in 95% of simulations. This broad interval is the result of sampling error given the limited amount of historical market return data at our disposal. (I wrote a similar argument last year in Time to Retire the Probability of Ruin?, but Milevsky does a better job.)

The bottom line is that it is impossible to predict your finances well into the future with any accuracy whatsoever and analyzing a retirement plan using such a projection as the central assumption is unwise. We end up with retirees looking at their plans and saying, "Wow! In thirty years, I'll still have $10,264.32 in my bank account! I'm set."

Furthermore, retirement plans organized around pro forma projections of future retirement wealth are somewhat opaque when it comes to understanding the underlying strategies and tactics that generated the projections, or even the objectives they attempt to achieve. As a result, they are difficult to explain in a holistic way and more difficult to understand.

A strategic plan for retirement would address these issues by clearly linking strategies and tactics to desired and achievable strategic objectives so planner and retiree understand both what the plan hopes to achieve and how it proposes to achieve it.

After the loss of my negativity (can't say I miss it), I have concluded that my next step should be to consider how the process would work in real life. One way to do that is to identify what I would personally want to see in a retirement plan that someone developed for me.

The first thing I would expect from a planner is to hear my Mission Statement repeated back to me in the planner's own words to assure me that the most important goals of my retirement had been accurately communicated.

Next, I would want the planner to explain her recommended strategies to achieve each of the goals of the mission statement. Addressing the goals one by one, I would want to hear not only how the goal would be achieved, but why the selected strategy is the best choice. For me, that would include a brief explanation of alternative choices and why they were rejected. I want to understand what decisions were made on my behalf.

For a mission statement that includes a guaranteed lifelong minimum standard of living objective, for example, I'd like to hear, "The best choice is a fixed annuity. The second-best choice, given your other goals, is a TIPs-bond ladder. I recommend the annuity because it is possible to outlive the bond ladder, but not the annuity. However, you have expressed concerns about purchasing an annuity, so you have a choice to make."

The strategic planning process I have suggested incorporates the possibility that strategic objectives may need to be revised in an iterative process bounded by what is possible and what is desirable and this might be one of those times. Unless you are quite wealthy, it may not be possible to achieve both your goal of guaranteed lifetime income and your goal of avoiding annuities, for example.

Achieving desired and achievable goals is a key part of the plan; understanding risks is another. I would expect a planner to present the important risks of the retirement plan and to explain how each will be addressed. There are four basic ways to address financial risks: accept them, avoid them, mitigate them or insure against them. 

While most retirement planning literature today focuses on risk of ruin, the probability of depleting a portfolio of retirement savings isn't the worst possible outcome. In fact, depleting the portfolio before the end of life can be a rational strategy. Losing one's standard of living is a worse outcome and bankruptcy is the worst. I would want to see the estimated probabilities of all three. 

Today's retirement plans inevitably include Monte Carlo simulations and those do provide some valuable information. One thing I can guarantee about a pro forma plan for thirty years of retirement, though, is that your actual retirement is unlikely to closely follow those projections. The projections are informative but not predictive. I would look at them if they were included in an appendix.

Lastly, the process includes an annual review, so a retirement plan should include the tactical objectives to be achieved in the first year. This part of the process ensures that our plan stays on track.

This all suggests an outline for a retirement plan that looks something like this:

I. Mission Statement

A. Strategic Objective One
     a. Recommended strategy to achieve objective one
     b. Alternative strategies
     c. Justification for strategic choice

B. Strategic Objective Two, etc.

II. Risk Analysis

A. Risk One
     a. Recommended strategy to mitigate (avoid, insure, accept)
     b. Alternative mitigation strategies
     c. Justification for strategic choice

B. Risk Two, etc.

III. First Year Tactical Objectives for Annual Review

IV. First Year Action Plan

IV. Appendices

A. Household resources understood by planner (See Blanchett and Straehl for a detailed explanation, download PDF)
     a. Financial Assets
     b. Human Capital
     c. Pension Wealth
     d. Housing Wealth

B. Budget expectations understood by planner

C. Major planning assumptions

D. Monte Carlo Simulation Results

E. Tactical Plans (Tax plan, Investment plan, etc.)

Where are the traditional retirement plan chapters like a Tax Plan, Investment Plan, and an Estate Plan?

Tax plans, investment plans, and estate plans are tactical plans, not strategic objectives. No retiree really wants an estate plan, we want to efficiently transfer our terminal wealth to our heirs and that strategic objective probably demands some kind of estate plan. We don't want a tax plan, we want to meet our strategic spending objectives and that probably requires a tax plan, the point being that we want to satisfy our major strategic objectives and these tactical plans are means to achieving those ends, not ends themselves. They belong in the appendices.

These tactical plans will be developed by a good retirement planner and should be part of the report but they should be explained to us, the retirees, in terms of the objectives they attempt to achieve and not as standalone plans.

Ultimately, a strategic plan replaces an overconfident pro forma projection of future wealth as its centerpiece with a logical mapping of strategies to objectives, clearly defining the objectives and clearly showing the rationale for the strategies. It should also draw the planner's focus toward meeting key plan objectives and away from increasing the probability that the portfolio balance after thirty years will be greater than zero. Lastly, a strategic plan should address critical risks, especially risks that don't show up in Monte Carlo simulations because they are too random to model with probabilities.

I find the focus on the retiree's strategic objectives to be the major advantage of a strategic planning approach. By its nature, the plan explains how the various tactical plans work together to achieve strategic objectives and I suspect that will provide an explanation for the retiree that is far more understandable: "this is what you said you wanted to achieve and here is a plan that shows, point by point, your best shot at achieving it."

I'll give risk mitigation a deeper look next time in Managing Risk Is a Strategic Objective, Part 8.


  1. Dirk, how much would you expect to pay for this plan? The are very few people who have the expertise required to deliver, in a customized way, what you are describing. We can't do it for less than 20 hours, and we charge $200 an hour.... even then we often eat time and spend far more hours than what we charge for. Yet, people balk at the price.

    1. Excellent question!

      When I was just married and starting my career, a hundred bucks was a lot of money for me, so I filed my own tax returns. It was laborious, especially since I didn't know what I as doing, and I constantly feared that I would make a mistake and trigger an audit or at least a huge tax bill.

      One day, for reasons I no longer can recall, I visited a tax preparer. He explained to me that I could save $50 on my taxes by filing Maryland returns separately, instead of jointly as I had been, and that I could file five years of amended returns and be repaid $250. That $250 put me into the plus column with just a free consultation. And that was just my state return. If he made a mistake on my taxes, he would deal with the IRS or state. All I had to do was hand him my tax records and a hundred bucks. That was around 1979 and I have never filed my own return since.

      That was a value proposition I couldn't beat. Is paying your firm four or five thousand dollars for a retirement plan a good value proposition? It would be for someone like me.

      I sadly agree that there are relatively few people who can deliver a high quality customized plan and that they are expensive to build. On the other hand, what would I pay for a less-than-high quality plan or one that wasn't customized? Nothing. I wouldn't read it if you handed me one for free, which is what a lot of alternatives cost, or at least appear to cost.

      One cost-free alternative is online planners. Recent research (download PDF) shows that these “robo-planners” provide a huge range of recommendations for the same retiree. How, then, does one trust any of them? (I don't.)

      An option that *appears* to be free is to use a planner compensated by commissions. The plan itself will be “free” so long as you implement it with products that the advisor recommends, which may not be putting your interests first. A friend used one such “free” plan from a major mutual fund company until I showed him how much he was paying in annual fees on the funds. The advisor assured him that “all fees on the funds had been waived”, which was true if you exclude 12b-1 fees. (I don't.)

      When I look at your service or refer clients to your firm, I see the following value proposition. The fee you suggest of $4,000 to $5,000 or so is a small percentage of my wealth and of my pre-retirement income. (If I earned a low salary and had little savings, it would be a much larger percentage and, given that retirees in that situation have relatively few retirement decisions available to them, I probably wouldn't see the value.)

      Is it worth your fee to avoid a Social Security claiming mistake that could cost tens of thousands of dollars? To save $150,000 in investment fees that don't improve portfolio performance? To save me from the loss of my standard of living when I allocate too much to stocks right before the Great Recession? To make me aware of the many retirement risks that can lead to loss of savings, loss of standard of living or bankruptcy? To make sure my wife's finances are in trusted hands when I am no longer around to manage them? To provide a second set of eyes on my own plan?

      Personally, it sounds like a bargain. But, if people are balking at your price, then they either don't understand your value proposition or your value proposition isn't a good one . . . for them. I suggest to my readers that if the fee for a high-quality, individualized plan is a small percentage of their wealth, it's probably cheap insurance. You can also save money with do-it-yourself dentistry. (I don't.)

  2. I agree that the cost of $4000 or so for such a plan could be money well spent, but where I get stuck is that this cost includes no follow up (unless Assets are under management also which costs I think 1% annually which is not of interest to me). I'd gladly (well, that might be a bit strong) $4-5000 to Dana's firm if it included an annual check in.....

    1. An annual checkup shouldn't take more than a few hours and shouldn't cost a lot. Most years, I look at my own plan and change nothing.

      I suspect many planners would gladly negotiate the cost of the annual review if it's a problem for you.

      Planners have to make a living. Some target markets will find the AUM model attractively priced. A planner's pricing model may or may not fit your individual needs, which simply means you aren't in their target market. I expect you are in someone's.