Friday, July 29, 2016

Exit Row Strategies

Back in the 70's, there was a short-lived comedy called Chico and the Man, starring comedian, Freddie Prinze. After Prinze's untimely death, I watched a made-for-TV movie about his life called, "Can You Hear the Laughter?"

In that movie, Prinze' character counseled a friend in L.A. whom he had asked to visit him in New York. The friend replied that he couldn't because of his fear of flying.

"What are you afraid of, dying in a plane crash?" I recall Prinze' character asking.

"Of course," replied the friend.

"No problem! Sit in an exit row next to the window. Look out the window. If the plane starts to crash, wait 'til it's like, three feet above the ground and jump out!"

I refer to these as "Exit Row Strategies". They get a few laughs when uttered by a comedian, but they shouldn't be part of retirement planning. The best-known Exit Row Strategy is market timing. Invest in stock markets and sell before a major market decline. Tons of research shows that market timing doesn't work – people tend to jump out (or in) at the worst time. (Here's Morningstar's take.)

Similar advice says, "Don't buy an annuity until you see your invested retirement savings fall in value." In other words, bet it all on the market. If that doesn't work out, dive out the window onto a soft, cushy annuity just before your portfolio hits the ground.

In my last post, The Whoosh! of Exponential Retirement, I described the nature of exponential change. It can seem like nothing changes much for a very long time, only to have events whoosh! by us at the end. The higher the exponent, the faster the growth and the greater the whoosh! effect – the effect of 3% annual inflation doesn't whoosh! nearly as loudly as the effect of 8% annual portfolio growth when we save for retirement.

Retirement risk happens fast. Don't count on having time to jump out its way.
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Here's a description of how saving for retirement, portfolio depletion and bankruptcy can feel. Imagine you're standing on a station platform in Omaha and you see a train in the distance. Actually, you see a dot on the horizon at the end of a very long, straight stretch of track. You watch for what seems like forever, but the dot doesn't get much bigger. After a long period of waiting, the train finally becomes bigger and bigger and suddenly it passes you on the platform unbelievably fast. (No problem – not your train.)

Seemingly out of nowhere, you are bankrupt. Or, you met your retirement savings goals in the last decade before retiring. (Remember from my last post that exponential change can be bad or good.)

How are Exit Row Strategies risky in real life? Let's imagine that you retire in 2005 with $500,000 saved and are debating whether to annuitize some of it. You can purchase a life annuity that pays $625 monthly ($7,500 annually) per $100,000 contract, based on the chart below from, so if you annuitize the entire $500,000, you could receive $37,500 annually for as long as you live.

You figure you need $25,000 to support your lifestyle, so you think you have lots of margin for error and you invest it all in stocks. If and when your portfolio declines to $333,333, you plan to buy an annuity with a 7.5% payout that pays the $25,000 minimum you figure you need in the worst case.

(Note that you are guessing that the payout will still be 7.5% when you buy sometime in the future. This illustrates another risk in planning to buy immediate annuities in the future: annuity payouts are based on interest rates and both are impossible to predict, as is how much principal you will have on hand to purchase them. Annuity payouts increased from 2005 to 2009, but they declined dramatically after that. Also, annuities get cheaper as you age, so your future annuity payout will also depend on when you eventually decide to buy. That's a lot of guessing.)

Unexpected (by anyone), the Great Recession hits two years later and the market falls 50% in just 18 months.

Sadly, your portfolio declines nearly 50% to $250,000 over the next 18 months and you can now only purchase about $18,750 of guaranteed annual income at 2007 annuity payout rates. On the positive side, annuity payouts increased 8% from 2005 (about 7.1%) to 2009 (8.1%), so you could actually buy $20,250 of annual income. But, that's still 19% less than you need.

Your losses whooshed! right by before you could jump out the exit window. Doesn't that $37,500 of guaranteed annual income look pretty good now? Rather than planning a last minute bail-out, a more prudent move might have been to nail down the $25,000 income you needed when you could in 2005 (nail down a floor, get it?) with $333,333 of your savings and take a shot at upside with the remaining $166,667.

"But wait," I can hear risk-takers protesting, "I can just wait until the market recovers!"

Maybe, and I would guess it probably will, but as I explained in Even Your Portfolio Heals More Slowly as You Get Older, recovering from bear market losses while you are still working, earning income, and buying stocks at discounted prices is one thing.  Recovering those losses after you start spending in retirement using stocks that have fallen in value and having no income to buy discounted stocks is quite another. This analysis is all about the income side and totally ignores the risk that you will have unforeseen major expenses just when your portfolio has declined.

Exit Row Strategies are a lot harder to implement in a crisis than you might think and, by their nature, they are always executed in a crisis.

Some recent work by Wade Pfau and by Barry and Stephen Sacks regarding the use of reverse mortgages to fund retirement is the opposite of an Exit Row Strategy. The studies suggest that applying for a reverse mortgage early in retirement has significant benefits over using home equity as a last resort late in retirement. (Setting up the mortgage early makes perfect sense to me. Using it to mitigate sequence risk is a step farther than I am willing to go at present.)

The train analogy isn't perfect, of course, because the train isn't actually accelerating exponentially, it just feels that way to a distant observer. But, it loosely ties back to the speed of the approaching ground for Freddie's friend and to an old baseball joke. ("The ball kept getting bigger and bigger. . . and then it hit me. . .")

This post isn't about reverse mortgages, investing or annuities, though, it's about taking risk that you believe you can foresee and therefore somehow deftly avoid.

Life comes at us fast.

We can't depend on having time to jump out of its way at the last second.

In a USA Today interview and a paper, It's Time to Retire Ruin (Probabilities), Dr. Moshe Milevsky explains why "probability of ruin" isn't a good retirement management tool. I wrote about this in Time to Retire Probability of Ruin. (Don't let the similarity of titles fool you, Milevsky does a much better job.)

Now that you paid off your mortgage before retiring, are you ready for a new one? Check out my next post, The Mortgage is Dead; Long Live the (Reverse) Mortgage.

Friday, July 22, 2016

The Whoosh! of Exponential Retirement

I recently read a couple of articles on artificial intelligence, one an interview with historian, Yuval Noah Harari, and the other written by computer science geek (like me), Tim Urban. I was intrigued not by the technology discussion, but by the discussion of the exponential nature of human history.
Quick math refresher. An exponential curve is a function that increases by a power of x (2, 4, 8, 16, 32 . . .). A linear curve (a straight line) increases by a factor of x (2, 4, 6, 8 ,10 . . .). The following graph shows four exponential curves with growth rates of 3%, 7%, 15% and 55% per period. The 55% growth rate is extreme but comes into play shortly.

Urban explains the exponential nature of human development in an interesting way that I will summarize here. An adult from 1750 would be overwhelmed if he were transported forward by time machine 266 years to 2016. To achieve a similar state of awe in 1750, a person living in that year might have to have been transported back 14,000 years in time, according to Urban.

Meanwhile, we Baby Boomers would probably have been shocked back in 1960 to see what life would be like today, 56 years later.

In 1985, there were no cell phones, let alone smartphones, my Telemail email account was a rarity (most people had no idea what email was), global terrorism wasn't nearly the issue in the U.S that it is today, the Cold War had just ended, personal computers stored data on 10-megabyte hard disk drives (1/100,000th the capacity of today's one-terabyte hard drives), and driverless cars were a pipe dream.

In the early 1990's, I flew the supersonic Concorde from London to New York. My grandfather rode to school on a horse. In 1991, the Cold War ended.

Urban also includes the following illustration of exponential growth courtesy of I won't repeat the entire explanation here since it's explained well at the post, but here's the gist. If you started refilling a dry Lake Michigan in 1940 by adding 1 ounce of water and then doubled that amount every 19 months, after 70 years you wouldn't have much more than a very large, extremely shallow puddle. But, “by 2020, you have about 40 feet of water. And by 2025 you're done.” Exponential growth can crawl along glacially for a long time and then whoosh! right by you.

If I handled such large numbers correctly, the annual growth rate in the Lake Michigan demo is about 55% a year. Not many things grow that fast for any sustained period, let alone 85 years, but the whoosh! effect is pretty dramatic at this rate. The greater the growth rate, the more dramatic the difference between “waiting forever while nothing much happens” and “whooshing! by”.

Consider it an exaggeration for effect.

The demo also explains rather dramatically why a bear market late in our careers can be devastating. Half of the six quadrillion-gallon lake is filled in the last 18 months of the 85-year process. Your 401(k) growth is not nearly so dramatic, but your balance could double in the last 10 years of your career. Not as awesome a whoosh! as filling a lake at 55% annual growth, but still, one you don't want to miss.

As you can see, the length of time required to inspire awe becomes shorter and shorter at an amazingly fast pace. That's the nature of exponential growth. The implication for retirees is that if human development (and computer development, as the AI argument goes) continue at this incredible rate of growth, it is not only unreasonable to believe that you can predict how your life will change over a 30-year retirement, but it will become more and more unreasonable for future generations to do so.

We retirement planners are massively overconfident in our ability to predict the future.
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Still, nothing much grows this fast for very long.

Exponential growth usually doesn't last forever. Whether or not these exponential growth rates of human development and computer technology can continue is unknown and unknowable, but highly questionable. Moore's Law is showing signs of age.

Microsoft went through a super growth phase, as most successful startups do, but as annual revenues became huge, it became harder and harder to increase them exponentially. Microsoft reported $119M in revenues in 1984 and $95B in 2015, according to It's much easier to grow $119M by 20%, increasing sales by $24M, than to grow $95B 20%, increasing sales by $19B. Super-growth can't last forever.

A company can grow revenues 100% in a year when previous year sales were a million dollars. When sales are in the billions, 8% growth would be good. Pretty soon, if you're McDonalds, you need to sell hamburgers on Mars to create any kind of real growth. If the curve of history continues at an exponential growth rate, we will soon be awestruck annually and that doesn't seem reasonable.

Reasonable exponential growth in investment portfolios can continue for a long time – Harvard's endowment is an example – but probably not forever. As William Bernstein has reminded us, cataclysmic change can occur in a few decades, as Germany demonstrated twice in the first half of the 20th century, ending all growth, at least for a while.

There is bad exponential growth, as well. Exponential growth of malignant tumors, for example, is self-limiting. Exponential growth in cost is also bad. Inflation grows exponentially, but currently at only about 1% a year, which is manageable. Health care costs are growing around 3.6% annually and are quickly becoming unmanageable, as seen in the following chart from

Change can seem to whoosh! This is the fallacy of retirement strategies that suggest trying risky things and then bailing out if and when you see danger approaching. If you've read my posts on elder bankruptcy, they don't seem to result from a long, slow degradation of one's standard of living, but as a quick and deadly combination of correlated setbacks.

In Why Retirees Go Broke, I wrote about the positive feedback loops that characterize elder bankruptcies, referencing the research work of Dr. Deborah Thorne. These loops start slowly, gather speed and then whoosh! by. The two families I watched go into bankruptcy during the Great Recession went from comfortable middle class to insolvency in less than a year.

Exponential curves are representative of several retirement finance components. The current rate of change of our society makes planning a 30-year retirement mostly guesswork. On the other hand, exponential growth of investments enables many households to save enough to retire comfortably. I often hear clients who have saved a sizable nest egg say, “I'm not sure how this happened. I didn't really have a lot of savings until the end of my career.”

It isn't voodoo. The Rule of 72 tells us that a portfolio earning 7% annually will double in value about every decade. It will seem to grow slowly for many years and then – if you're lucky enough to avoid a bear market just before retirement – your nest egg balance will appear to whoosh! by in the exhilarating final decade of your career. On the other hand, if the bear gets you just before retirement, the biggest part of the whoosh! will fizzle. It will sound more like "who?"

Aging after you retire feels exponential, too. By age 70, most retirees stop traveling internationally. By age 80 most stop traveling domestically. By age 90, the roughly 30% of us who are still around may rarely travel much beyond the backyard.

These rapid changes affect retirement planning. We shouldn't plan on spending the same amount when we're 80 as we do at 65, though David Blanchett (downloads PDF) and Sudipto Banerjee (downloads PDF) have shown that spending typically declines roughly 1.5% to 2% a year as we age. That's exponential growth, but so slow it's almost linear.

What does this mean for retirement planning? A few things, I think.

First, when you're “standing on an exponential curve”, it probably looks linear into the immediate past and future. Don't fall for projecting this straight line. Interest rates are historically low and have been since December 2008. You might assume that they will stay that way for the rest of your retirement now, but that is highly unlikely. One day they will increase, and it will seem to happen quickly. The following diagram from Urban's post explains.

Second, and more important, I have recently explained in several ways that trying to predict an individual's retirement wealth several years into the future is impossible. Our limited data on historical market returns is such a small sample that our estimates of return have a huge confidence interval. Our future liabilities are probably more uncertain than market returns. The length of our retirement is unknowable.

Moshe Milevsky has written 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%. Simulations are informative but not predictive.

The exponential nature of societal change provides more evidence that predicting our financial situation 30 years or more into the future is a fool's errand. Let's face it – we have no more idea what life will be like in 2046 than we could foresee today in 1986. With exponential change, the next 30 years will see a lot more changes than the last 30.

Lastly, when you see computer output that appears to predict your wealth from age 65 to 95, make sure you understand precisely what you are seeing. It's a pro forma wealth statement that shows one example of what might happen. (If you want a chuckle, ask the provider for a guarantee.) This shouldn't be the central tenet of your retirement plan. If you base your retirement plan on your ability to predict the future, you are likely to be sorely disappointed.

We humans are massively overconfident in our abilities to predict the future, and we retirement planners (ourselves included) are even more overconfident in our ability to predict the future wealth of a single retiree.

What does an 80's comedian have in common with bad retirement advice? Check out my next post, Exit Row Strategies.

Thursday, July 7, 2016

Managing Risk Is a Strategic Objective, Part 8

In the model for strategic retirement planning, avoiding risks are strategic objectives. I have addressed them separately so far purely for organizational reasons because there are important distinctions between risks and objectives.

Objectives tend to be positive desires. I want to fund travel and maintain my standard of living. Risks tend to be stated negatively. I want to avoid going broke as the result of unexpected medical expenses and I want to avoid outliving my wealth.

Desires tend to be more personal. I want to retire in Florida. I don't want to burden my three children.

The Mission Statement is where we create our own personal definition of success. Desires in the Mission Statement identify those objectives we believe would make our retirement a financial success if they are met. Risks are those outcomes that we believe would make retirement successful if they can be avoided.

Risks tend to be the bad outcomes that most or all retirees face. Not everyone has children or wants to retire in Florida, but no one wants to go bankrupt, see their purchasing power eroded by inflation, or go broke late in life as the result of long-term care expenses.

Whether we sort these into two different lists for organization purposes or combine them all as simply strategic objectives, they need to be treated the same in the negotiation process (remember what is desired and what is possible?). In other words, they all belong in the Mission Statement, even though we may create the lists separately because that's the way we think. I want to retire in Florida and I don't want to be wiped out by inflation are both strategic objectives.

The negotiation process is where we reconcile what we want with what we can afford. As an example of the negotiation process, we might desire not to be bankrupted by long-term care costs but we may not have adequate wealth to make the premium payments for LTC insurance. In the negotiation process, we might need to change our insurance strategy to a Medicaid strategy and create more modest strategic objectives accordingly.

What, then, are the common financial risks of retirement?

During a panel discussion a few years back, my friend and colleague, Robert Powell, waved a list of retirement risks at me while asking a question. I recently got around to asking him for a copy of the list and he referred me to a piece written by the Society of Actuaries (download PDF). It lists fifteen risks and I think it's a great place to start. These include:

Society of Actuaries Retirement Risks List
Longevity The risk of outliving retirement resources
Inflation Loss of purchasing power.
Interest Rates Lower interest rates make retirement less affordable.
Market Risk Loss of invested retirement savings.
Business Continuity An annuity provider or pension plan goes out of business.
Employment Loss of supplemental job income.
Public Policy Loss of social program benefits or tax increases.
Unexpected Health Care Costs A major cause of bankruptcy.
Lack of Access to Caregivers Unavailability or unaffordability.
Loss of Independence Accident, illness or chronic disease.
Change in Housing Needs Housing that doesn't accommodate physical decline.
Death of Spouse Can be a major financial setback.
Other Change in Marital Status Divorce can be a major financial setback.
Family Member Needs Family members outside the retired household need support.
Bad Advice, Fraud, Theft Can result from declining mental acuity. 

Probability of Ruin estimates (or attempts to estimate) the probability that a retiree will deplete a portfolio of investment savings invested in stocks and bonds, but there are worse things than depleting a portfolio. Losing one's standard of living, for example, would be worse. With an adequate floor of safe income, a retiree could deplete a savings portfolio and still maintain his or her standard of living. In fact, depleting a savings portfolio and living out one's final years funded by pensions and Social Security benefits is a rational strategy.

Are these common financial risks addressed by your retirement plan?
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Bankruptcy, or insolvency, would be worse than either of these outcomes so the list of financial risks in retirement should include the major risks of bankruptcy. I previously wrote about an elder bankruptcy study by Dr. Deborah Thorne in Why Retirees Go Broke. Dr. Thorne's study identifies the following reasons that bankrupt elder Americans cited as the cause for their insolvency:

Cited Reasons for Bankruptcy from Thorne Study
Credit Card Interest and Fees
Illness and Injury Duplicate
Income Problems Duplicate
Aggressive Debt Collection
Housing Problems Duplicate

These reasons should be included in a comprehensive list of retirement financial risks, though some overlap items in the SOA list. Only “Credit Card Interest and Fees” and “Aggressive Debt Collection” are not included in the SOA list. I would personally add "Legal Liability" to the lists and encourage retirees to consider relatively inexpensive Umbrella Liability Insurance policies.

Lastly, the Institute for Financial Literacy also provides a list of financial risks of retirement cited by bankruptcy filers that includes:

Bankruptcy Reasons Cited by Institute for Financial Literacy
Divorce (15.1%) Duplicate
Birth or Adoption of Child (9.7%)
Death of Family Member (7.5%) Duplicate
Retirement (forced or poorly timed, 6.7%)
Identity Theft (1.9%) Duplicate

The only risks cited by IFL not arguably cited by the SOA or Thorne Study are "Birth or Adoption of a Child" and "Retirement, forced or poorly timed".

I'm going to modify the plan outline I proposed in The Retirement Plan I Would Want, Part 7 just a skosh by rolling Risk Mitigation objectives into the Mission Statement:

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

B. Strategic Objective Two, etc.

Risk Mitigation Objectives

C. Strategic Objective Three
     a. Recommended strategy to achieve objective three
     b. Alternative strategies
     c. Justification for strategic choice
The risks I identified above should be included under the Risk Mitigation Objectives heading. I've probably missed a few risks and hope to see the omissions noted in your comments. Otherwise, this should offer you a fairly comprehensive list of potential financial risks of retirement. Are they addressed in your retirement plan?