## Friday, January 22, 2016

### Death and Ruin

An MBA and a med student walk into a bar.

(Stop me if you’ve heard this one.)

My son and I had just shot a round of sporting clays (“catch-and-release hunting”) on a hot summer day and we stopped into City Tap in Pittsboro on the drive home for a couple of ice cold, locally brewed adult beverages and a lunch of disgusting chili dogs, and by “disgusting” I mean “outstanding”.

Here in the South we often have a couple of beers after shooting because several generations of experience have taught most of us that having the beers before shooting is sub-optimal in so many ways.

I soon began complaining about the quality of much of the retirement finance research dealing with portfolio survival, as clay shooters often do (OK, not really). My son is on a “Physician-Scientist” track and spends much of his time researching patient survival. He immediately noticed that portfolio survival research isn’t terribly different than patient survival research and that medical research has better tools to study this than we have in financial research.

Portfolio survival is a lot like patient survival but medical researchers have better tools to study it.
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We had a “you-got-peanut-butter-in-my-chocolate” moment and decided to co-author a paper studying portfolio survival by using two medical research survival study tools, Kaplan-Meier analysis and Competing Risks analysis. Our paper hasn’t been published, yet, but here’s a sneak preview.

In clinical trials, information on some patients will be incomplete. Some patients will drop out of the trial, move away, or the trial will end without discovering the patient’s eventual outcome. Kaplan-Meier analysis is a statistical technique that makes as much use as possible from the incomplete data available for these patients. Kaplan-Meier analysis also removes patients who are no longer at risk from the calculated probabilities.

Kaplan-Meier analysis divides time into intervals and for each interval survival probability is calculated as the number of patients surviving (or portfolios, or whatever is being studied) divided by the number of patients still at risk. In portfolio survival studies, simulated retirees who die or go broke are no longer at risk of going broke before they die. They should be removed from the denominator of the probabilities. (This is referred to as “right-censoring.”)

The probability of a patient or portfolio surviving to any point in time (or age, in our study) is estimated from the cumulative probability of surviving each of the preceding time intervals. This all no doubt sounds very complicated, and it is, but it is easier to see if we look at a Kaplan-Meier curve.

The following graph is the result of a portfolio survival study assuming annual withdrawal rates of 3%, 4% and 5%. The analysis used actuarial tables to generate random lifetimes for a retired couple of the same age retiring at age 65. (Double-clicking any Retirement Cafe´ graphic will enlarge it in a separate window.)

To read the curves, for example, a retiree who withdraws 5% annually from her retirement savings portfolio (blue curve) has about an 80% probability of portfolio survival if she survives to age 90. With 4% withdrawals (green curve), she has about a 93% probability of portfolio survival if she lives to age 90.

Reading the curves more generally, retirees don't outlive their savings before about age 80 to 85 assuming any reasonable (say, 5% or less) annual withdrawal rate. Then, the percentage of outlived portfolios heads south, the higher the withdrawal rate, the steeper the fall.

Portfolio survival studies typically calculate a single lifetime probability of survival, commonly quantified around 95%, that doesn’t show how that probability decreases with age, or the effects of random lifetimes. Kaplan-Meier curves do.

Most portfolio survival studies calculate absolute "lifetime" probabilities, or the percentage of all retirees in the study whose portfolios can be expected to fail at some point in their lifetimes. Kaplan-Meier analysis calculates conditional probabilities, meaning the percentage of failed portfolios expected among retirees who are still alive and haven't already depleted their savings.

There is a big difference between losing most or all of your retirement savings, thereby losing some standard of living, and experiencing financial setbacks so dire as to lead to bankruptcy. In my previous post, Why Retirees Go Broke, I suggested that very few retirees will go broke due to sequence of returns risk though there is a possibility of losing standard of living for that reason. Our portfolio survival research, combined with bankruptcy rates by age, is part of that argument.

As the following graph shows, few simulated portfolios are outlived before age 80 to age 85 (blue curve) but most bankruptcies (red curve) are filed before that age – portfolio ruin accelerates about the same time that new bankruptcy filings become negligible. By about age 83, nearly everyone who is going to go bankrupt has, while portfolio ruin has just begun. Thus, the probability that a retiree filed bankruptcy due to sequence of returns risk is quite small – retirees go broke for several reasons, but sequence of returns risk doesn't appear to be a major contributor.

(Note the vastly different scales of the y-axes. Portfolio survival probabilities range from about 80% to 100% in this scenario while bankruptcy probabilities are always less than half a percent. I present the graph this way to emphasize the timing of the two events.)

We applied Kaplan-Meier analysis to a portfolio survival model that included random lifetimes to provide greater insight into the portfolio ruin process. This should help you understand how your risk of outliving your savings – as a function of market volatility – will change as you age. (There are other "non-market" reasons that you might deplete your savings, like devastating medical expenses. Portfolio survival studies typically only look at ruin due to poor market returns.)

We also considered another statistical method from the medical research field, competing risks analysis.

I’ll discuss that in the near future.

Special thanks to my son, Cary, of whom I am obviously ridiculously proud, for collaborating on this research and for helping me explain it in a blog post.

## Saturday, January 16, 2016

### What I Do When the Market Tumbles

When stocks take a dive, investors call their financial advisors and ask them what they should do. I received a few of those calls this week. Most advisors respond with some version of “Don’t panic.”

Here’s what I do when the market crashes: nothing.

To be completely honest, I wasn’t aware that the market had fallen 8% so far in January until my wife told me late this week. I don't watch business news – life is too short. She picked it up on CNN while she was watching election news. (I don’t follow that, either.)

Here’s my theory. If you have such a high allocation to equities that market declines make you anxious, you own too much stock. Find the allocation at which severe bear market losses won’t keep you up at night.

In the 2007-2009 bear market, the S&P 500 fell over 50%. My portfolio fell just 15% because I had a 40% equity allocation. As one of my favorite baristas, Mandy, would say, “It didn’t feel totally awesome.” On the other hand, I didn’t lose sleep.

William Bernstein addressed this in a couple of his early books, including The Four Pillars of Investing (page 268). He suggests that the initial pass at the correct asset allocation for you be based on how much you can tolerate losing in a bear market. He provided the following table:

I can tolerate losing
this percent
in a bear market
Invest this
much in stocks
35% 80%
30% 70%
25% 60%
20% 50%
15%  40%
10%  30%
5%  20%
0%  10%

Every December I evaluate my finances and plan for the coming year. I calculate my desired asset allocation, which might not be the same as last year’s. If my current allocation is within an absolute 5% or so of my desired allocation, I do nothing. Otherwise, I may trade a few funds or ETF’s to implement my new allocation. In reality, this rarely happens because my allocation doesn't often stray very far.

Because I am willing to lose 15% in a severe bear market, I don’t labor over my portfolio value daily. I probably check it four times a year, at most. I retired to enjoy the remainder of my life, not to fret over the stock market.

6 Tips for Investors When the Stock Market Tumbles –NY Times via @Retirement_Cafe
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Here’s some advice from other advisors I trust. Wade Pfau suggests reading this piece in the New York Times entitled, “6 Tips for Investors When the Stock Market Tumbles.” It’s a good one.

Dana Anspach suggests that if you feel that you must do something, instead of selling stocks, enroll in her free online class on retirement – another great idea.

Joe Tomlinson and I provided suggestions in Robert Powell’s USA Today column, “Advice for investors during crazy stock market volatility.”

If you’re retired or plan to be soon, set your asset allocation to a level of equities that you can tolerate. By definition, that means you won’t feel the need to do anything at all when stocks tumble. For young people still accumulating savings for retirement, invest most of your portfolio in stocks and don’t you do anything, either. In fact, do less than nothing. Time will fix this for you. As I recall, the 22% loss on a single day on Black Monday in 1987 didn’t feel totally awesome, either, but now it is barely a blip on the history of the S&P 500.

So, here’s my advice: pick an allocation you can stomach and ignore the noise. If you owned too much equity this time, gradually adjust it downward.

You'll know you're at the right allocation when the market takes a dive and you don't feel a need to call me.

Oh, and don’t panic.

While you're ignoring current market volatility, read about the changing nature of sequence risk as we age in my next post, Death and Ruin. Or, follow me on Twitter by clicking the FOLLOW button on the right side of this page and I'll link you to the best web sources of retirement information. Or, heck, do both!

## Friday, January 8, 2016

### Why Retirees Go Broke

According to the American Bankruptcy Institute, the number of personal bankruptcy filings by Americans of all ages peaked at 1.5 million in 2010, the highest level since 2005, when the Bankruptcy Abuse Prevention and Consumer Protection Act made it more difficult to have debt forgiven. Filings declined to about 935,000 by 2014.

The Institute for Financial Literacy reports that older people are making up an increasing proportion of bankruptcy filers. The over-65 group made up 8.3 percent of all filers in 2009, or about 99,600, a rise from 7.8 percent in 2006.

Most bankruptcy filers were employed when they filed, but about 10% were retired.

Retirement research suggests that retirees can set up their spending and asset allocation to limit their “probability of ruin” to about 5% or so, but that is only the probability that he or she will deplete a savings portfolio as a result of market volatility and sequence of returns risk. Actually, there are several reasons a retiree might go broke.

The top five reasons for filing bankruptcy, according to a study entitled, “The (Interconnected) Reasons Elder Americans File Consumer Bankruptcy”, conducted by Dr. Deborah Thorne in 2010, are shown in the following chart recreated from her paper:

Other reasons for bankruptcies that were cited by filers and reported by the Institute for Financial Literacy included:
• Divorce (15.1%)
• Birth or adoption of child (9.7%)
• Death of family member (7.5%)
• Retirement (6.7%)
• Identity theft (1.9%)
Respondents could choose more than one reason, so the total exceeds 100%.

The “retirement” reason includes both unplanned and unwanted retirement (another form of unemployment), and bankrupt retirees who believed they had adequate financial resources to retire but discovered they did not.

It is conceivable that some number of the filers who cited “retirement” as a cause for their bankruptcy succumbed to sequence of returns risk, though that data is not directly available. However, probability of ruin models show that portfolios are rarely depleted in less than 15 to 20 years for reasonable withdrawal rates, or until a 65-year old retiree is 80 to 85 years old. Research shows that bankruptcy filings decline significantly beginning at age 65 and the bankruptcy filing rate for age 85 and older is negligible. About 40% of elder bankruptcies are filed between ages 65 and 74. The fact that portfolio ruin is much more likely at older ages after bankruptcy rates actually decline suggests that sequence risk is probably not a large portion of this 6.7% of bankruptcy filings.

In other words, most bankruptcy filers in the study were too young to have depleted their portfolios as a result of a poor sequence of market returns.

Note that there is no category of reports of bankruptcies due to market losses or sequence of returns risk, so if this reason for bankruptcy were cited by any filers it wasn't in the top ten. One might reasonably expect “Income Problems (41%)” to include loss of income from assets, but a closer read of Thorne (2010) shows this category refers to unemployment issues and not loss of income generated from savings.

According to Thorne (2010), the probability of an American over age 65 filing bankruptcy is less than half a percent (about 0.43%), an order of magnitude less than the probability of ruin studies predict for premature portfolio depletion. The causes of bankruptcy are predominantly an unexpected increase in expenses, an unexpected loss of income or, more often, a combination of the two.

I will refer to the risk of bankruptcy from either lost income or unexpected expenses as spending risk, combining the two because the net result is the same whether we have too much expense or too little income, and a crises will often include both. Most retirement income research doesn’t address either disruptions due to large unexpected expenses or those due to loss of income, focusing primarily instead on the risk of outliving one’s savings resulting from disappointing market returns and poor sequences of returns. I will refer to the latter as earnings risk, or the risk that portfolio returns don't ultimately support the chosen spending rate.

Dr. Thorne goes out of her way to note that the reasons elder Americans file consumer bankruptcy are interconnected, including the term parenthetically in the study’s title. As I argued in two recent blog posts, Positive Feedback Loops: The Other Roads to Ruin and Retirement Income and Chaos Theory, I believe the causes are more than simply interconnected.

“I agree,” Dr. Thorne responded in an e-mail. “It's a cascade effect of really unfortunate events.”

Five top causes of elder bankruptcy: credit cards, illness, income problems, aggressive debt collection, housing problems.
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Thorne notes in her study that “it appears that there is seldom a single reason for their bankruptcies; instead, elder debtors often file because of the cascading effects of multiple interrelated life crises, each as consequential as the last.” The percentage of respondents reporting the number of the five leading reasons for bankruptcy were:
• None of the five reasons (8%)
• One of the five reasons (22%)
• Two of the five reasons (23%)
• Three of the five reasons (27%)
• Four of the five reasons (18%)
• All five reasons (3%)
This is consistent with my theory that bankruptcies primarily result from positive feedback loops that initially develop from an income or expense shock, then form a positive feedback loop and spiral out of control. In other words, I believe that retirement income/expense systems, especially when spending crises are included in the model, are chaotic.

When credit cards are mentioned as a reason for bankruptcy, some assume that these households used consumer credit to live beyond their means. This is surely true of some households, but in many instances credit cards are the last resort for households whose finances are spiraling downward for other reasons, such as unemployment, medical expenses, or the death of a spouse or divorce.

For example, I helped a household with their finances in 2008 when bankruptcy was imminent. They owed more than \$60,000 in credit card debt but the charges had been made for living expenses such as feeding and clothing three teenagers, not for shopping at Neiman Marcus. The reason for their bankruptcy was a prolonged period of unemployment.

We may have created the impression that retirees who invest in stocks and bonds and spend from a volatile portfolio have about a 5% probability of going broke, but retirees don’t go broke as a result of sequence of returns risk. They go broke as a result of illness, injury, unemployment, housing problems, divorce, birth or adoption, death or illness of a family member, forced retirement, identity theft, consumer debt and aggressive debt collection and the interconnected, cascading effects of all of the above.

Retirees can, however, lose their standard of living due to sequence of returns risk. This might or might not contribute to bankruptcy.

Are there actual retirees who go broke due to a sequence of poor returns? I’m not convinced. I’ve never met one. Or, read about one by name. I would think that if 5% of retirees were going broke for that reason, we would spot one or two occasionally and the elder bankruptcy rate would be much higher than half a percent. I have not found data describing the number of retirees whose standard of living was significantly lowered by sequence of returns risk, but I have seen anecdotal evidence from retirees who experienced this.

On the other hand, there were nearly 150,000 Americans over age 65 who filed for bankruptcy for other reasons in 2010.

Retirees who invest in equities are exposed to earnings risk, often referred to as sequence of returns risk or probability of ruin. All retirees are exposed to the risk of a spending crisis, whether or not they invest in a volatile portfolio. These are two very different risks.

Sequence of returns risk develops slowly and allows time for mitigation through spending reductions, requiring at least one to two decades to deplete savings. It might contribute to bankruptcy, but it is more likely to reduce the retiree's standard of living at worst. (Rational retirees will reduce spending when their savings decline in an effort to avoid ruin.)

Sequence of returns risk can be mitigated by reducing spending and, to a lesser degree, by managing portfolio allocation. This risk, which appears to be roughly 5% to 10% with reasonable withdrawal rates, is an order of magnitude more likely than the risk of bankruptcy from spending crises, but the magnitude of the risk is smaller, entailing reduced standard of living but probably not bankruptcy. This is the risk that attracts the most retirement research and planner attention.

Earnings risk can also be mitigated by a floor of safe, income-generating assets like TIPS bond ladders, annuities and Social Security benefits.

Spending risk, on the other hand, is a bolt of lightning that can reduce an apparently stable household to bankruptcy in a year or less. (I provided examples in Positive Feedback Loops: The Other Roads to Ruin.) Retirees who invest in stocks and those who don't appear about equally at risk of a spending crisis.

Once the downward spiral begins, it often cannot be stopped. Reducing spending is, by definition of the crisis, not an option – if we had the ability to adequately reduce spending, we wouldn’t be in a spending crisis. The magnitude of this risk is greater than that of earnings risk, entailing both loss of standard of living and bankruptcy.

Retirees with a volatile portfolio and a low, “safe” spending rate are not immune from spending risk. The low spending rate mitigates only the risk of portfolio depletion resulting from market volatility. It does not mitigate the risk of portfolio depletion resulting from say, a huge medical bill.

Spending risk can also be mitigated by a "floor" of protected assets, such as Social Security benefits held in a separate account or assets held in a retirement account. Delayed Social Security benefits would also be protected until received (the creditor risk is to benefits already received and commingled).

Spending risk is seldom considered in retirement studies. The closest relevant research is bankruptcy studies that allow us to separate data for older bankruptcy filers, though age is not an exact proxy for retirement status.

When we ignore expense and income shocks in our retirement models and simply assume that we will always be able to reduce spending whenever our portfolio balance declines, we ignore the risk of unacceptable outcomes from spending crises. Retirement plans should anticipate and plan for both risks. As Michael Kitces recently pointed out, a projection of future asset values is not a plan.

Our goal isn’t to avoid going broke due to market volatility and sequence risk.

It’s to avoid going broke.

Our goal isn’t to avoid going broke in retirement due to market volatility and sequence risk. It’s to avoid going broke.
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A version of this post was recently published at Advisor Perspectives.