Wednesday, May 24, 2017

Sun Tzu or a Rubik's Cube?

The ancient Chinese military strategist, Sun Tzu, wrote, "Know your enemy" around 500 years before the birth of Christ. A better translation is something along the lines of "Know your enemy and know yourself and you need not fear a hundred battles."

I readily confess that I have not read The Art of War, or at least don't remember reading it, though I have read many things written about it. I stumbled across such a reading this week.

I would paraphrase the "general" idea (pun intended) behind "know your enemy" as recommending that the more you know about your opponent in a strategic game with uncertain outcomes[1] the better your chances of success. Retirement finance is such a game. Knowing a lot about your enemy doesn't guarantee success in warfare or in retirement finance.

The "enemy" I have in mind is the loss of one's standard of living in retirement. It helps to understand this enemy but understanding it doesn't guarantee you won't succumb to it.

This brings me to the Rubik's Cube I noticed in the back of my closet this week. I could only remember how to solve one face but I recalled that there are well-defined algorithms for solving the entire cube and I googled one[2]. Follow these directions and you will solve the Rubik's Cube every time.


Retirement finance is harder to solve than a Rubik's Cube.
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There is no equivalent set of algorithms to solve the retirement spending problem with certainty. Sure, we can fund retirement solely with Social Security benefits and fixed annuities but that only guarantees the income side of the equation. The expense side will always be uncertain and our goal in retirement isn't really to secure income but to secure non-negative cash flow.

Warfare and a Rubik's Cube are both complex problems to solve but unlike warfare, the Rubik's Cube problem has no opponent – neither man nor nature – to introduce uncertainty.

The problem is that many of us hope to approach the retirement planning problem as a Rubik's Cube instead of a battle, a stochastic game against nature, or a visit to a roulette wheel[3]. Buy an annuity, time-segment your portfolio, invest in index funds, minimize your taxes. Surely there is some list of directions on the Web like those for solving a Rubik's Cube that more or less guarantees a successful retirement, right?

Unfortunately, there is not. Retirement finance is intrinsically fraught with risk. We can know our enemy well but the main thing we know about that enemy is its uncertainty. We can do all the right things and fail. We can do all the wrong things and succeed.

My favorite example of doing the wrong things and succeeding is my friend Gerry's blackjack hand. I once watched Gerry split a pair of fives in a blatantly rookie move, turning a pretty good hand of ten into two bad hands of fives . . . and win both hands.

Sometimes the force is with you.

If you retired in 1982, according to a column written by Wade Pfau[4], and lived 30 years you would have had a hard time depleting your savings with a reasonable sustainable withdrawal rates strategy. Pfau figures a 9.8% annual withdrawal rate would have avoided portfolio depletion. The same retirement beginning in 1966 would have survived only 4% withdrawals. Those who retired in 1982 could split a pair of fives and probably still win.

My favorite example of super-intelligent people creating lovely, complex algorithms that failed miserably is the story of Long-Term Capital Management. This hedge fund, the subject of the book When Genius Failed by Roger Lowenstein, was initially highly successful under the leadership of a former Wall Street bond manager and two future Nobel laureates. Eventually, however, LTCM failed, bankrupted its founders and brought the global financial system to its knees.

(I highly recommend Roger Lowenstein's book, but Business Insider published a synopsis at the link below.)

As an aside, I often quote the William Bernstein dictum, "When you win the game, stop playing." Occasionally, someone will write me to say that's a bad idea (Note: Bernstein doesn't have a lot of bad ideas).

Buffett: …It’s…an interesting story…The whole story is really fascinating because if you take John Merriwether, and Eric Rosenfeld, Larry Hilibrand, Greg Hawkins, Victor Haghani, the two Nobel Prize winners, Merton and Scholes, if you take the 16 of them, they probably have as high an average IQ as any 16 people working together in one business in the country…an incredible amount of intellect in that room. Now you combine that with the fact that those 16 had had extensive experience in the field they were operating in…In aggregate, the 16 had probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor that most of them had virtually all of their very substantial net worths in the business. So they had their own money up. Hundreds and hundreds of millions of dollars of their own money up. Super high intellect, working in a field they knew. And essentially they went broke. And that to me is fascinating…

…But to make money they didn’t have and didn’t need, they risked what they did have and did need, and that’s foolish. That is just plain foolish."[5]

Sounds like Warren Buffett and William Bernstein agree on this point.

My point is this. Retirement finance is a probabilities game. There is no set of rules that guarantees a successful outcome like the set of rules for solving a Rubik's Cube, even though both are complex problems. Retirement finance is more of a Sun Tzu thing.

Had Sun Tzu been a retirement planner of the probabilist school, he might have said, "Know your enemy and know yourself and you need not fear about 95 out of a hundred battles."



REFERENCES

[1] A Tiny Bit of Game Theory, The Retirement Cafe´.



[2] How to Solve a Rubik's Cube.



[3] Retirement Roulette, The Retirement Cafe´.



[4] What If Retirees Don’t Want To Run Out Of Money In 30 Years? by Wade Pfau.



[5] WARREN BUFFETT ON LTCM, BLIND SPOTS, LEVERAGE, AND UNNECESSARY RISK,



[6] The Epic Story Of How A 'Genius' Hedge Fund Almost Caused A Global Financial Meltdown, Business Insider.

Tuesday, May 2, 2017

Retirement Planning Explained Backwards

Some time ago, I began looking for research identifying what a good retirement plan document should address and a process for developing one but was surprised to find very little written on the subject.

The best resource I found was from the Retirement Income Industry Association (RIIA)[1]. RIIA's philosophy is that planning begins with a Household Balance Sheet® that identifies all of the resources available to the retiring household.

That's fine as far as it goes, but I like to begin planning a step earlier. From my perspective, the RIAA approach jumps into figuring out how to get there before figuring out where we want to go. I suspect RIIA would say this is implied, but I think it should be written and agreed with the client from the start.

I'd rather identify the highest-level goals in a mission statement[2] and then implement the RIAA or an equivalent process as step two rather than try to accomplish three different things in one step. I refer to this second step as finding the intersection of what's desirable and what's possible[3] but that is essentially what the RIIA process does.

I believe that retirement planning should be top-down like the strategic planning process used by many businesses[5] but I suspect that the entire process is easier to understand when explained from the bottom up.


Let's use this process to plan a vacation. First, we decide on a mission. Do we hope to spend our days relaxing, learning about another culture, visiting old friends, communing with nature? Say we choose "learning about another culture."

Next, we decide on our objectives: where we want to go, how long we'll stay, and how much money we have available to spend – and this is key – to learn about another culture. In other words, our objectives stem from our mission.

Lastly, we choose the specific tactics to meet the objectives that achieve our mission. Will we fly United (insert joke here) or Spirit (insert joke here). Will we stay at a Marriott, a Holiday Inn Express or a campground? What will we pack? Those decisions depend on our objectives and our objectives depend on our mission.

This may seem obvious and intuitive but it isn't uncommon to hear someone say that they have decided to fund retirement with annuities, a stock portfolio, or even an increasing stock allocation when they have documented neither their mission nor their objectives. That's a little like deciding to fly American Airlines and then deciding where you want to go and then deciding why you want to go there.

So, let's start at the end of retirement planning. We'll start with the bottom layer, Step 3. in the diagram above. Every year we need to place a series of bets, though often these will only be a tweak of existing bets. I identified several of these bets in Retirement Roulette[4]. They include a bet on a retirement date, a bet on an amount to spend this year, a bet on stocks, a bet on bonds, a bet on cash, and so on.

I further noted in Retirement Decisions with Expiration Dates[6] that not all of these bets will always be available. We might be able to place a bet on long-term care insurance this year, for example, but a future disqualifying decline in our health could take that bet off the table. If we claimed Social Security benefits last year we can't claim them again this year.


Retirement plans explained backwards.
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We can't effectively plan year-at-a-time without the context of long-term retirement objectives. That context comes from our strategic retirement plan. We can't identify the next leg of our journey without knowing our next milestone, so we need to identify those strategic objectives in the step before making our annual bets.

A strategic plan is based on The Intersection of What's Desired and What's Possible[3]. It identifies the strategic goals or "milestones" we believe we need to meet in order to achieve our mission, so we need to identify that mission in the step before identifying our strategic objectives.

We should begin retirement planning by crafting A Mission Statement for Retirement[2] that is effectively our idea of what would constitute a successful retirement. Again, this may sound intuitive and obvious, but most retirees to whom I recommend this process find it challenging to articulate their mission in a paragraph or two. Many want to say, "My mission is to retire and not run out of money." That's probably true but not terribly helpful.

While these three components of a strategic retirement plan constitute a "living document", they will change with different frequencies. An annual operating plan will be changed most frequently, although the changes will range from substantial to minor tweaks.

Strategic plans should be changed infrequently as the result of major unexpected changes in our life that affect our finances (divorce, death of a family member, bankruptcy, major illness, etc.)

A mission statement might change on rare occasion but is intended to be an enduring statement of retirement goals and personal values and hopefully is written as such.

I have explained the steps of developing a retirement plan in reverse order because I believe it is easier to understand the entire process that way, but I suggest that retirement planning should be a top-down process. In simplest terms, it goes something like this:
  1. Write down the major things you hope to accomplish in retirement. Accomplishing these major goals constitutes what you would consider to be a "successful" retirement[5]. I want to maintain our standard of living. I want to live in Peru. I want to leave the family home to my children.
  2. Identify the strategic objectives that would achieve your mission. If an important part of your mission statement is to never outlive a certain standard of living, for example, annuities, Social Security benefits and/or bond ladders might be your chosen strategies.
  3. Review your mission statement and strategic plan every year and modify them if necessary when there have been major life changes.
  4. Identify the steps you need to take in the coming year to progress toward the strategic objectives you just reviewed and perhaps modified. Decide if this the best year to buy an annuity or claim Social Security benefits, for example. As I said in Retirement Roulette, place your bets.
What if you have already retired and didn't do any of this stuff? 

Get started. It's never too late to plan.



REFERENCES

[1] Retirement Income Industry Association (RIIA).



[2] A Mission Statement for Retirement, The Retirement Cafe.



[3] The Intersection of What's Desired and What's Possible, The Retirement Cafe.



[4] Retirement Roulette, The Retirement Cafe.



[5] A Model of Retirement Planning, Part 1, The Retirement Cafe.



[6] Retirement Decisions with Expiration Dates, The Retirement Cafe.