Friday, December 15, 2017

Closing Out 2017

As the end of 2017 approaches and the holidays demand more attention, let me suggest a few topics to mull over a cup of hot cider. (See what I did there?)

The current status of a tax bill with major potential impacts on personal finance is the reason I don't spend a lot of time contemplating future taxes like Required Minimum Distributions at age 70½. Tax laws are just too unpredictable beyond the next few years.

My view of tax management is tactical and opportunistic. Republican Tax Bill Overhauls Rules Many Were Counting On from the New York Times[1] describes the impact of the new tax bill on people who "had a plan." I don't try to plan my taxes 15 years from now when I'm not sure what the law will be in 15 days, or whether future Congresses will change it back in 15 months.

To misquote an old, Yiddish proverb, "Man plans and Congress Laughs."

Some thoughts on closing out 2017. 
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Speaking of opportunities, if you're early in retirement and will pay little or no federal tax for 2017, ask your tax planner about a Roth Conversion to pay little or no tax on some of your IRA savings. You have to make the conversion by the end of the year but if you later learn that you converted too much you can put back all or some of it with a "recharacterization."[2]

Retirement strategies span a spectrum from "safety-first" to "probabilist", the former recommending a safe floor of income from annuities, Social Security benefits and Treasuries before investing for upside potential, while the latter proposes that equity investment can solve both problems.

Another way to refer to these strategies is "risk pooling versus risk premium", or annuities versus stocks. In Risk Pooling Versus Risk Premium[3] Wade Pfau concludes that "Those favoring spending and true liquidity will find that it is much more difficult than commonly assumed for an investments-only strategy to outperform a strategy with partial annuitization." Pfau addresses some key issues like "true liquidity" and the diminishing advantage of stocks for leaving a legacy at advanced ages.

I've recently chatted with a start-up called Blueprint Income[4] that offers what is effectively a "mutual fund" of deferred income annuities. They will partner with top insurers to allow workers to "Contribute the amount you’re comfortable with whenever you see fit."

I find the idea quite interesting as it overcomes the issue of writing a single, large check and also provides diversification among the safest insurers. Take a look at their website linked below.

I have said before that as both a retirement researcher and computer scientist, I don't yet trust "robo-advisers." I am working with one that I believe is trying to do it right, though, A Forbes column, NewRetirement: A New Approach to Retirement Planning, interviews its founder, Stephen Chen. The website is operational and you can try it at no cost.

Thanks for reading Retirement Cafe´ in 2017. I have a long list of posts to write beginning right after the holidays, but in the meanwhile, I'm going to have that cup of mulled cider and listen to the Pentatonix.

Wishing you and yours a great 2018.

Cheers. . .


[1] Republican Tax Bill Overhauls Rules Many Were Counting On - The New York Times

[2] 6 Things to Know if You Are Thinking about a 2016 Conversion | Ed Slott and Company, LLC

[3] Risk Pooling Versus Risk Premium, Wade Pfau.

[4] Blueprint Income | Introducing the Personal Pension

[5] NewRetirement: A New Approach to Retirement Planning, Forbes.

Friday, December 8, 2017

The Return You Need

A topic that frequently appears in the comments section of my posts compares market returns to annuity or Social Security retirement benefits (also an annuity). The comment is usually some form of “I would only need a return of x% on my investment portfolio to outperform purchasing an annuity (or some other low-risk alternative) today.”

One of the most common mistakes I see retirees make is looking at a good return on a nearly risk-free investment and concluding that they would do better in the stock market because it has a higher long-term average return.

This is a good opportunity to review liability matching.

Long-term market return averages are interesting when we have an investment portfolio that isn't used to fund specific future liabilities (expenses).

Once we begin to spend periodically from that portfolio, we introduce sequence-of-returns risk[2]. We're trying to fund many expected future annual expenses and not knowing the price we will receive for those future stock sales introduces risk. The sequence of returns is often more important than long-term market return averages.

On the other hand, when we are saving and investing in stocks for a single future expense, like buying an annuity or paying for a wedding, we can't be sure that we will be able to sell the stocks at the price needed to pay that liability when it comes due. We may know how much the wedding will cost and when it will be held but we won't know the future value of our stock investments until the big day arrives. This doesn't introduce much sequence risk because we only sell one time instead of every year. This a "duration-matching", or "liability-matching", problem.

Two recent comments effectively asked what market return would be needed to make buying an immediate annuity (SPIA) in the future a better deal than buying a deferred income annuity (DIA) today. One commenter wants to claim Social Security benefits early, invest them in stocks, and use the proceeds to purchase a SPIA in four years. He asks what average market return would make this strategy come out ahead of postponing claiming benefits, which would increase them by 8% a year (simple interest).

The second reader wants to postpone buying a DIA, invest the purchase money in stocks, and buy a SPIA after 15 years. He believes that if he can earn 5.37% or so on stocks, he will break even on payouts.

Both questions are posed as the rate of stock returns these strategies will "need" to provide outcomes identical to buying a DIA now or postponing Social Security benefits. The needed rates of return, however, aren't the key to this analysis and besides,  the fact that you "need" a certain return, in my experience, doesn't make you more likely to earn it. Mick told us that if we try sometimes we might find we get what we need. Notice the words "sometimes" and "might."

Before we consider liability-matching, let me point out a few other concerns.

First, the presumed ultimate goal of these strategies is to purchase future "safe" income in the form of an immediate annuity or larger benefits. Does it make sense then, to expose the assets you have earmarked for safe income to stock market risk for four, 15 or any other number of years first?

It's a little like saying, "I really need to buy some very dependable income with this money but I think I'll bet it at the racetrack first because if I win I'll be able to buy even more safe income!" You need to consider other possibly less attractive outcomes.

Second, DIAs are significantly cheaper than SPIAs[3] and postponing Social Security benefits is an even better deal than DIAs. So, that means you not only have to outperform the 8% additional Social Security benefit for every year you postpone to age 70, but you also have to offset the cost advantage of DIAs or postponing Social Security benefits.

Third, buying a SPIA today or postponing benefits are relatively risk-free strategies — you know exactly how much income you will receive and when — while a stock investment is quite risky. You don't really "break even" when you earn the same benefit through a much riskier strategy.

If you wade through a swamp to get a cold beer, your buddy takes a boat, and you both end up with identical bottles of beer on the other side, your buddy got a better deal. Way better.

Finally, Social Security benefits are adjusted for inflation and most annuities aren't. You can purchase inflation-protected annuities but they are quite expensive and that makes the SPIA even less competitive in this analysis. It's very difficult to match the price or features of Social Security benefits on the annuities market.

A great example of what could go wrong with these strategies is available as recently as the Great Recession from late 2007 to early 2009. Stock indexes fell more than 50%.

Imagine that you employed the four-year early-claiming strategy in 2005 and ended up with half the money you needed to buy that SPIA in 2009. Or, imagine you implemented the 15-year strategy in 1994. The long-term market return average would have been irrelevant. The problem would have been needing to pay the bill at a market bottom.

Which brings us back around to liability matching, which offers the solution to this problem by matching the timing of a liability to the duration of the investment that will fund it.

I've talked about duration before, but here's a simplistic explanation. Duration measures the number of years that an investment needs to recover from a loss. The longer the asset's duration, the longer it takes to recover from losses.

If I know I will need $1,000 for an expense in four years, I can buy a $1,000 Treasury bond that matures in four years and know with relative certainty that I will have a thousand dollars to pay that expense in exactly four years. How much money will I have in four years if I invest in stocks, instead? That's unknowable. And, stocks have durations often measured in decades.

What if I buy bonds that mature in two years, instead of four? Then I will earn less interest because shorter bonds pay less. Ideally, the bond's maturity (equalling its duration as it nears maturity) will match the timing of the expense. Too short and we earn less, too long and we can't be sure of its value when the expense arrives.

The proper investment vehicle to fund this 4-year strategy would be short-term bonds that currently earn a percent or so, not stocks. Clearly, a percent or so return won't outperform postponing benefits. Investing in stocks might, but is it a high-risk strategy. It will sometimes miss badly.

"Might." "Sometimes."

Likewise, the 15-year investment to avoid purchasing a DIA today should match liabilities. That means investing in stocks for at most the first five years and then in much lower return bonds for the final ten years. Even if you're willing to risk your "safe money assets" in the market for five years before buying safe income, the average return you would need on stocks, with ten subsequent years of today's low bond yields, would be nearly 13%, not 5.37%.

And still, you couldn't know how much your stocks would be worth at the end of that five years, or your total capital after 15.

So, to summarize, investing in stocks to meet a known future liability like purchasing an annuity or even retirement itself is a risky strategy. It may be fine to invest in stocks when the liability is a decade or more in the future, or when there is no specific liability. But, as the liability's due date approaches, its far safer to begin shifting to lower duration, lower yielding, liability-matching assets.

Just ask the many workers who had to postpone retirement in 2009 because they no longer had the amount of savings they needed. That's why we recommend cutting your stock exposure the decade before retirement. They had a date when they expected to need retirement savings but they had to postpone retiring for several years until the market recovered because they were holding too much stock.

And, don't forget Occam's Razor[4]. In my experience, cute, complex or tricky strategies to fund retirement are generally flawed. The simplest answer is generally the best. Retirement advice contains many strategies that are "too cute by half."

There is a role for stocks in an adequately-funded retirement plan; providing secure income isn't it.

Take the boat.

Long-term average stock returns aren't the key issue.  The problem is market bottoms messing up your wedding. (And you were worried about rain!)

The analysis isn't as simple as comparing expected returns. You can drown in a river that averages a foot deep and you can go broke in a market that averages 9% returns over the long-term.


[1] The Retirement Café: Clarifying Sequence of Returns Risk (Part 1)

[2] What is Duration? Investopedia

[3] Financial planner, Tom Morris, provided some quotes for a $1M DIA at age 62 today and a $1M SPIA at age 70. The DIA, if purchased today, would pay out $5,551 monthly when the 62-year old reached age 70. The SPIA would immediately pay out $3,227 monthly to a 70-year old if purchased today. The probability that a male aged 62 will live to receive income from the DIA is 89%. The probability that at least one spouse of a couple would is 99%.

[4] Occam's razor.


Some older posts at The Retirement Cafe didn't convert well when I changed the format a few years back. I'm told some are difficult to read. I may someday go through hundreds of posts to find and correct them (really, it could happen).

In the meantime, they can easily be read from your mobile device which displays a black-on-white rendering. Or, if you prefer your computer, click the "View the mobile version" link at the top right of this page.

Alternatively, if you enter your email address in the Follow by Email box you will receive a black on white email version each time I post in the future, though that won't fix the older posts.

Thanks! And, sorry for the inconvenience.

Monday, November 27, 2017

Social Security Benefits: the Big Picture

In a previous post, Income Annuities: Immediate and Deferred, I discussed the problems that single-premium immediate annuities (SPIAs) and deferred income annuities (DIAs) can solve and I included the two charts below. These two problems are also considerations in deciding when to claim Social Security benefits.

The first chart demonstrates the use of an immediate annuity to increase the floor of safe income for retirees with otherwise inadequate Social Security benefits or pensions. (By “safe”, I mean income generated by assets that are not subject to market volatility. No asset is completely safe.) These are households that need safe income as soon as they retire.

Chart 1. Inadequate safe income throughout retirement.

The second chart demonstrates the use of a DIA to mitigate the risk of declining wealth late in retirement, should the retiree live that long.[3] This declining wealth could be the result of a failing portfolio, for instance, though as this chart shows, portfolios rarely fail before age 80.

Chart 2. Portfolio Depletion Risk in Late Retirement
Loss of standard of living can also result from an increase in expenses late in retirement even if the portfolio is successful, or it can be the result of a combination of portfolio losses and increased expenses. In either case, the DIA can mitigate the risk of a loss of standard of living later in retirement.

What does this have to do with Social Security benefits? A lot – Social Security retirement benefits are a deferred income annuity, the premiums for which are effectively paid from our FICA taxes. We can begin the benefits payout at age 62 or defer those benefits up to age 70.

I discussed the trade-offs between deferring benefits or claiming them early in Delaying Social Security Claims (or Not), but here’s a quick review.

We can increase our monthly Social Security retirement benefits by about 8% for each year we defer them up to age 70. This can ultimately result in receiving a check that is 32% larger when claimed at age 66 rather than age 62 and up to 76% larger when benefits are postponed from age 62 to 70.

However, there are risks to postponing. Single retirees who decide to postpone benefits to age 66, for example, and die before that age, would receive no benefits, at all. (A lower-earning spouse would receive survivors benefits as if the deceased had claimed retirement benefits at full retirement age.) In fact, the retiree would need to live several years past age 66 for the larger payments to repay the benefits that were skipped. (This isn't as unlikely as it sounds.)

If we spend from an investment portfolio to provide additional income while postponing benefits (instead of working longer, for example), we may increase sequence of returns risk at the worst time, early in retirement. Over-savers might not see a significant increase in sequence risk but retirees with smaller portfolios probably will.

In exchange for taking these risks, we can receive much higher total lifetime benefits, perhaps hundreds of thousands of dollars more, in the event that we live to an old age. In this way, we are mitigating the risk of scenarios shown in Chart 2 above (declining wealth and/or increasing expenses in late retirement). By claiming benefits at age 62, we are mitigating the early-retirement risks of scenarios with inadequate safe, floor income as shown in Chart 1.

There are a few common strategies for claiming Social Security benefits. One, the “break-even” strategy, suggests that a retiree claim benefits early if they don’t believe they will live past the age when the total of the (fewer) larger benefits overtakes the total of more, smaller benefits.

There are several problems with this strategy, the largest being that many healthy people seem to believe they know how long they will live with very little evidence to support that belief. (They are overconfident.) The second problem with break-even analysis is that it doesn't consider life expectancies and it's easy to underestimate the probabilities of surviving to the break-even age.

Here's an example from Brian O'Connell at US News and World Report.[1]
"The breakeven point, when the total dollars received by waiting until age 66 begin to exceed total dollars received by beginning at age 62, is approximately age 77," he adds. "Life expectancy tables show that a person who has attained age 62 will live to be 85.5, and a person who has attained age 66 will live to be 86.2. This means that if you have a normal life expectancy, you will end up with less dollars received [by claiming at 62]."
I often hear retirees say things like, "But I'd have to live 15 more years just to break even!"

In fact, the probability that a 62-year old male will live 15 more years to age 77 and profit by delaying claiming is about 72%, meaning that there is a 72% chance that he would lose the break-even bet by claiming at age 62.

A second common strategy, advocated by many Social Security optimization tools, is to postpone claiming benefits as long as you can to maximize lifetime benefits in the event that you live a long time. This is a “safety first“ strategy and one I prefer to guessing how long I will live.

Claiming Social Security retirement benefits: the big picture.
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Although I prefer the second strategy to the first, both are missing critical elements of the decision by proposing that we claim Social Security benefits as an isolated exercise. In reality, the correct claiming decision is largely influenced by the composition of the remainder of our retirement plan.

A retiree with limited savings, for example, probably cannot afford to delay claiming Social Security benefits except by working longer. In that case, the claiming decision is strongly influenced by the retiree’s opportunity to continue working (her "human capital") and the amount of her retirement savings.

A household that has accumulated several million dollars in retirement savings, at the other extreme, won’t rely heavily on Social Security benefits, at all. It might be wise to claim late as longevity insurance. These households might even claim benefits early and invest them in the stock market since losses there would be unlikely to reduce standard of living. A household with marginal savings would risk their standard of living with this strategy.

Retirees with a significant pension and eligibility for Social Security benefits (those with "public" pensions are probably not eligible for both) would be less dependent on Social Security benefits for either immediate income or for mitigating the risk of loss of standard of living late in retirement. So, the availability of pension income is also a factor in claiming Social Security benefits.

Households that choose to fund retirement primarily with safe income assets like government bonds and income annuities avoid the risk (and rewards) of market volatility late in retirement. The more safe income they have, the less risk of depleting wealth late in retirement. The extent of the presence of these assets in the household retirement portfolio is a factor in the Social Security benefit-claiming decision.

I simulated a large number of retirement scenarios randomizing several of these factors including claiming benefits at age 62 and at age 70. I noticed an increase in the number of scenarios that did not meet spending demand throughout retirement when claiming at age 70.

Upon further analysis, I found that delaying claiming benefits increased spending from the investment portfolio in the failed scenarios for those early years of retirement, when sequence of returns risk is at its peak, and in marginal market return scenarios. In these specific scenarios, the additional portfolio spending was enough to deplete the portfolios a few years earlier than claiming at age 62 would have. The impact of increased portfolio spending on portfolio survival when delaying benefits is yet another factor not typically considered by claiming strategies.

Retirees may work longer to delay Social Security benefits, in which case there would presumably be no adverse impact on portfolio spending. In fact, portfolio spending would be delayed, reducing the risk of premature portfolio depletion.

On the other hand, retirees who claim Social Security benefits before Full Retirement Age (currently aged 66 for those about to retire) and continue to work will see their benefits reduced until they reach full retirement age.[2] 

In other words, your Social Security-claiming decision will be affected by how long you plan to work after you claim benefits before Full Retirement Age, the decision again depending on the human capital component of your retirement plan.

Perhaps the most challenging consideration is the risk of spending shocks. Even retirees with significant retirement savings face the risk of large unexpected expenses after they retire.

Retirement plans that contain long-term care insurance policies, umbrella liability policies and the like are at less risk of losing standard of living, though the risk is always non-zero. Not every retiree will be eligible for an LTC policy or will be able to afford one, and for those retirees postponing Social Security benefits will help mitigate that risk. The presence and extent of insurance policies in the retirement portfolio will, therefore, influence the claiming decision.

Marital status is another consideration. Claiming early not only limits one's own lifetime retirement benefits, it also limits survivors benefits for a lower-earning spouse. (When a spouse dies, the surviving spouse's survivors benefit will become the larger of the two previous retirement benefits.)

Deciding when to claim Social Security benefits is much like deciding when to purchase immediate annuities, deferred income annuities, neither or both. Claiming early mitigates the inadequate floor income problem and claiming late mitigates the risk of lost standard of living in late retirement.

One last consideration is the cost of retirement, which is largely dependent on how long we live. Retirees who postpone claiming and don't live long will indeed "leave money on the table." Then again, they will have had a relatively inexpensive retirement that they could probably still afford. Retirees who live a long time will have a very expensive retirement and will likely need the extra income later in life. In other words, postponing claiming Social Security benefits will reduce income for retirees who don't live long, but their cost of retirement will be lower, too.

The decision isn’t as simple as guessing how long you will live or figuring how to maximize lifetime benefits in the event that you live a long time. The best claiming decision depends on the retirement problem(s) you’re trying to solve and how Social Security benefits will work with the rest of your retirement plan. Following is a table of conditions that suggest claiming early and those that suggest claiming later.

Social Security benefits can solve the same problems as immediate and deferred annuities with even greater economic efficiency. The nature and extent of those problems, however, will be determined by other interrelated retirement plan decisions.

The key point is that a retirement plan is a portfolio of income-generating assets that interact with one another in much the same way as do stocks and bonds in an investment portfolio. Choosing a Social Security benefits-claiming strategy in isolation from the other decisions of the retirement portfolio excludes critical considerations and is likely to provide sub-optimal choices. It's like trying to pick a stock investment without considering what's already in your portfolio.

The same goes for setting an equity allocation, choosing an annuity allocation, implementing a tax strategy and most other major decisions. They're all interrelated. They work as a team.

The retirement financial model is so complex that I don’t see an obvious alternative to simulation to make the best decision. It's extremely challenging to look at one change to a spreadsheet and understand how it will affect other components. Without simulation, I would never have noticed, let alone have been able to measure, the impact that delaying claiming Social Security benefits might have on portfolio survivability.

If neither you nor your planner is able to perform the simulations, then my original recommendation stands: postpone claiming benefits for the higher-earning spouse as long as you can. Weight your decision using the factors in the table above. If you need the income right away, the decision has been made for you.


[1] The Pros and Cons of Taking Social Security Early | Investing | US News, U.S. News and World Report.

[2] What happens if I work and get Social Security retirement benefits?,

[3] Competing Risks: Death and Ruin, Cary Cotton, Alex Mears and Dirk Cotton, Journal of Personal Finance Vol 15 issue 2, Aug 24, 2016, page 36.

Tuesday, November 7, 2017

Income Annuities: Immediate and Deferred

Annuities are insurance contracts that you can purchase to provide a stream of income for as long as you live. Think of them as life insurance in reverse. With life insurance, you pay premiums periodically while you are alive and your beneficiaries receive a large lump-sum payment when you die. Annuities are just the opposite — you pay a large lump sum to the insurance company up front and they make periodic payouts to you until you die, no matter how long that might be.

The following diagrams show the cash flows for life insurance, single-premium immediate annuities (SPIAs) and deferred income annuities (DIAs). Blue cash flows go to you and red cash flows represent payments you make to the insurance company.

The difference between an immediate annuity and a deferred income annuity is that immediate annuities begin payouts in less than one year, while deferred income annuity (DIA) payouts can be deferred for many years.

I can purchase a $500,000 single premium immediate annuity today and begin receiving payouts next month if I wish. I can purchase a $100,000 single premium deferred annuity today and elect to not receive those payouts for ten years, for example, if I prefer.

Why would I want to defer an annuity’s payouts? Because deferred annuities and immediate annuities solve two different retirement problems.

Immediate annuities can be purchased at the beginning of retirement to help provide a lifetime of safe "floor" income. Retirees with little secure income may want to augment that safe income with an immediate annuity. Retirees with significant Social Security benefits and a pension may have plenty of safe income and not need an immediate annuity.

The following diagram shows the problem an immediate annuity can fix. The retiree has only a small portion of income generated from pensions and Social Security and may be exposed to a good deal of market risk in the red area. The green "floor" of safe income can be raised throughout retirement with an immediate annuity.

Some households may feel that they have adequate income in early retirement but worry that they might not have enough remaining wealth to fund their desired standard of living late in retirement should they live a very long time. Deferred annuities, also referred to as "longevity insurance", can solve that problem.

An immediate annuity (SPIA) provides income beginning in less than a year and continues those payouts for as long as the annuitant(s)[1] live. A deferred annuity (DIA) begins payouts at some contracted date in the future if and only if the annuitants survive to that date. At that time, DIA payouts also continue for as long as the annuitants live, but because the insurer will make fewer payouts with a DIA, and none at all if the annuitants don't survive until the future date, DIAs are a less expensive way to fund late retirement than SPIAs and much less expensive than spending from an investment portfolio.[2]

A good candidate for a DIA might be a household that relies on spending from an investment portfolio and is confident that the portfolio will fund early years of retirement but concerned that it will be prematurely depleted. A study my son and I conducted found that depleting a portfolio before age 80 should be quite rare.[3,7] A DIA is a good way to insure income after age 80 or so in the event of a failed portfolio.

See how portfolio survival rates begin to decrease sharply (risk of ruin increases sharply) once we reach age 80 to 85? Deferred income annuities can provide cost-effective protection against that increasing risk in late retirement for retirees who depend on an investment portfolio for income.

Why buy a deferred income annuity now and defer payments 20 years instead of just waiting 20 years to buy an immediate annuity? Because the DIA will be much cheaper and because there is no guarantee we will still have enough remaining savings to afford an immediate annuity when that time comes.

Assuming 3% annual inflation, a 65-year old man could buy a DIA today that would generate $10,000 of income per year in 2017 dollars ($15,580 in 2032 dollars) beginning at age 80 for a one-time purchase of $41,560.

An 80-year old could purchase an immediate annuity today that will generate $10,000 of immediate annual income for $91,070. It's much cheaper to buy the late retirement income in advance.

The immediate annuity would generate significantly more lifetime income, of course, but it requires more than twice the initial outlay. For households that only expect to need additional income in the event of a very long life, the DIA is the better choice.

This is not an apples-to-apples comparison. This assumes that life expectancies and interest rates will remain roughly the same over those 15 years. I have figured in 3% inflation, which could be high or low. The SPIA purchaser will almost certainly receive some income while the DIA purchaser will receive nothing unless she survives to age 80.

Nonetheless, the annuitant who does live to 80 will fund income the least expensive way. The DIA is longevity insurance and that's how insurance works. We accept a certain loss (premiums) to protect us from a potentially very large loss (running out of money in late retirement). We pay someone else to accept our risk.

Deferred annuities, like retirement finance in general, have an accumulation phase and a distribution phase. But, the phases might be easier to understand if we describe them as two different products.

When to buy a deferred or immediate annuity and when you probably don't need one, at all.
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Imagine that the accumulation phase of a deferred income annuity (DIA) is like having a fixed-interest rate savings account. The money invested in this savings account is illiquid because the insurer can charge high surrender fees if the annuitant makes withdrawals sooner than the annuity contract allows. Taxes on earnings are deferred until they’re withdrawn, so sort of like a savings account held in a traditional IRA but without a tax break on the contributions.

The value of this account grows until the DIA is annuitized, or converted into a stream of lifetime income, or until the annuitants die, in which case the account value becomes zero. If the annuitants die during either phase, even if payouts have not begun, the results are pretty much the same as with an immediate annuity. That means that unless riders are purchased to guarantee some payout to your beneficiaries, the deferred income annuity will have no residual value.

The second product (the distribution phase) is a life annuity that you will choose to purchase with funds from the “savings account” if you survive the deferral period.  If the annuity is funded from an IRA or 401(k) — a “QLAC”, described below — you must begin annuitization by age 85. Funded outside a retirement account, you can often delay annuitization until age 90.

An annuitant might reach the age they expected to convert to an annuity, not need the income, and elect to delay annuitization until they do. Or, they might find they need the income sooner and move back the annuitization date a few years.

Inflation is a greater concern with deferred annuities than immediate annuities. While most deferred annuities don’t offer inflation protection, those that do offer it don’t provide inflation protection during the accumulation phase. The inflation protection kicks in only when the account is converted to an annuity. Since the deferral period can last a long time, inflation can become a significant issue as your axccount compounds during the accumulation phase at bond-like interest rates.

Another advantage of DIAs compared to immediate annuities is that they require a smaller cash outlay because they only provide income if you survive until late in retirement. According to researcher David Blanchett, "The cost of a DIA, for example, that would provide $10,000 a year of income, if you buy it at age 65, it would cost about 20% of what it would cost to have a SPIA starting today at age 65 to provide that same level of income." [4]

Wade Pfau wrote a column entitled Why Retirees Should Choose DIAs over SPIAs[5]. The short answer is that deferred annuities are the most economically-efficient way to finance the latter years of retirement should a retiree or spouse live a long time. The more technical answer is that DIAs "expand" the retirement income efficient frontier and create opportunities with higher expected returns for a given level of risk.

There is a special type of DIA worth mentioning, a qualified longevity annuity contract (QLAC). A QLAC is a deferred annuity that you can purchase with qualified funds from your retirement accounts with payouts deferred to as late as age 85.

According to Motley Fool[6], “a QLAC allows the insured to withdraw 25% — up to a maximum of $125,000 for single folks and $250,000 for married couples — from their qualified retirement accounts and exempt these funds from being considered in their RMD calculation from age 70½ onward.

I recently recommended a QLAC to friends. They plan to annuitize it at age 82, but if they reach that age and their portfolio has held up well, they can choose to defer payouts up to three more years and receive larger checks then. On the other hand, if their portfolio underperforms, they can choose to annuitize a few years earlier and receive slightly smaller checks sooner.

Annuities are not particularly popular although interest in DIAs has recently grown.

One of the problems, I believe, is that retirees often consider annuities in isolation and not as part of an integrated plan. True, the money used to purchase an annuity cannot be left to your heirs. (Unless you buy special riders to continue payouts to your beneficiaries for some guaranteed minimum number of years. Those essentially offset mortality credits and defeat much of the purpose of buying the annuity.)

On the other hand, if you purchase an annuity and die early in retirement, the good news (financially) is that you will have had a relatively brief and inexpensive retirement. That may mean you had plenty of savings apart from the annuity to leave your heirs.

If you live to an old age, an annuity might help you avoid spending other savings that you can leave to heirs. Owning an annuity may give you more confidence (or may not, depending on your personal risk aversion) to invest your portfolio more aggressively and improve your odds of earning a greater return. As Pfau’s research shows, annuitants often end up with greater terminal wealth.

The point is that you need to consider annuities as an integrated part of a retirement plan and consider the entire plan’s terminal wealth instead of focusing on the fact that the annuity has no value at death. If the annuity ultimately becomes worthless but it has preserved other assets, it will have done its job.

This isn’t a thorough treatment of deferred annuities. My goal is simply to explain their salient characteristics for comparison with immediate annuities and Social Security benefits. If you want more information — and certainly if you are considering purchasing one — please see the references below.

The most important takeaway is that deferred income annuities (DIAs) are the most economically-efficient way to fund late retirement by providing "longevity insurance." Single-Premium Income Annuities (SPIAs) are a better way to provide income throughout retirement for retirees with an inadequate "floor" of safe income. The correct choice depends on the problem or problems you are trying to solve — you might even need one of each.

As I have mentioned often, I believe that retirees should plan retirement in a way that makes them happy. Some people hate annuities; some won't invest in the stock market. If you understand the pros and cons of each and can't be persuaded, buy what lets you sleep at night.


[1] An annuity can cover a single life (annuitant) or joint lives (annuitants).

[2] The 4% Rule-At What Price?, Scott, Sharpe, Watson.

[3] Competing Risks: Death and Ruin, Cary Cotton, Alex Mears and Dirk Cotton, Journal of Personal Finance Vol 15 issue 2, Aug 24, 2016, page 36.

[4] Pros and Cons of 2 Key Annuity Types, David Blanchett interview video.

[5] Why Retirees Should Choose DIAs over SPIAs - Articles - Advisor Perspectives, Wade Pfau, 2013.

[6] What Is a QLAC, and Why Might You Want One?.

[7] Note that these curves show the cumulative conditional probability of portfolio survival. Most studies show the probability, for instance, that a 65-year old's portfolio will survive to age 95. A Kaplan-Meier curve shows the probability that a retiree who actually lives to 80 and has not depleted her portfolio, for example, will experience portfolio failure at later ages. Retirees who have already died or already depleted their portfolios are not included in the Kaplan-Meier calculation of future probabilities.

Friday, October 13, 2017

Why a Rational Retiree Might Keep Going Back to that ATM

In particular, the presumption that a client will adhere to a deterministic spending schedule, wake up one morning, go to an ATM, and discover that the “money process” has reached zero is silly and naive.” — Moshe Milevsky[1].

Milevsky refers to periodic, constant-dollar spending from a volatile portfolio, as simulated in sustainable withdrawal rates (SWR) research.

It is with no small measure of sadness that I find myself disagreeing, at least under certain conditions, with three of my favorite retirement researchers — Moshe Milevsky, Michael Kitces . . . and me.

For Michael’s perspective, I refer to a comment he made somewhere on the Internet some time ago referring to a paper entitled, “A 4% Rule — At What Price” by Jason Scott, John Watson and William Sharpe[2]. That research showed the high cost of mitigating longevity risk by over-saving. The large amount of “fettered” assets that must remain untouched to survive long periods of poor market returns make SWR strategies economically inefficient and expensive. Wade Pfau has referred to fixed spending from a volatile portfolio as the least efficient strategy.

I couldn’t locate that comment from Kitces so I will do my best to paraphrase from my (aging) memory. The problem with the Scott analysis, I recall Kitces suggesting, is that retirees don’t “do that.” They don’t just keep spending the same amount no matter the circumstances.

That was my intuition, as well. And in fairness, we were all three mostly right, though the devil is in the details.

It was hard to imagine that rational retirees would keep spending the same amount from a portfolio that appeared to be spiraling into ruin. (Cue Richard Thaler laughing aloud[4]). But, while Michael used that intuition to question the Scott research, I have always considered it an invalidation of the constant spending model as a planning tool. (As a research tool, it taught us about sequence risk.)

A predictive model says, “If you do this (follow the model’s policies in real life) then you can expect these results. If we don’t expect people to follow those policies, then we shouldn’t expect the outcomes that the model predicts. And, clearly, most of us don’t expect rational retirees to “do that.” So, why believe the results?

Why rational retirees might keep going back to that ATM.
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I still have serious problems with the model, and not just this behavioral assumption, but it took a retiree going broke in his early 80’s to help me understand that there might well be rational reasons for a retiree to keep showing up at that ATM until it spits her card back at her.

(Please note this evidence that actual retirees go broke with SWR strategies and this isn't a hypothetical outcome that occurs only in Monte Carlo simulations. Considering elder bankruptcy rates, however, the evidence seems to show that the rate of ruin is an order of magnitude less than SWR models predict. On the other hand, I suspect the rate of reductions in standards-of-living is higher.)

A retiree contacted me after depleting his savings portfolio at age 82 with a failed SWR strategy. He was down to Social Security benefits and a little home equity and hoped I could show him a way out of selling his home and living off Social Security benefits.

Sadly, neither I nor several retirement planner friends could offer a suggestion beyond a home equity loan, which didn’t work out. It’s tough to rebound after you age out of the labor market.

After our discussions and a little thought, I realized that households with substantial savings relative to their spending might well see portfolio failure looming and reduce spending. If they do, they will likely see their portfolio recover, as I showed some time ago in a series of posts entitled, Clarifying Sequence of Returns Risk. You don't go broke with variable spending from a volatile portfolio. On the other hand, the spending is, well . . . variable.

Households with limited savings, on the other hand, may well find that their non-discretionary expenses gradually overwhelm their safe level of portfolio spending. Even though the portfolio would be doomed by continued spending, they will still need to pay for groceries and housing and may have little recourse other than to keep spending and pray for a tremendous bull market. They may find themselves in a “spending trap” in which they must sustain their level of spending simply to pay non-discretionary expenses with the knowledge that doing so will most likely soon bankrupt them.

If we consider that credit card debt is a major cause of elder bankruptcy, then we can expect retirees in such a spending trap to max out their credit cards to pay bills before depleting their credit along with their portfolio. (The 2017 Retirement Confidence Survey from EBRI notes that "18 percent of all workers describe their level of debt as a major problem and another 41 percent call it a minor problem.")

A credit card debt spending trap is similar. The household continues to spend from credit well past the point where they believe they can repay because it has no good alternative. We would not expect excessive credit card spending to be normal, rational behavior but if it is the best of a set of bad alternatives, we probably have to call it rational. Again, this occurs in households with little or no remaining savings.

I learned this lesson long ago when I was asked to help a lady who had run up $60,000 in credit card debt while her husband suffered a long bout of unemployment. "I didn't use the card at Nieman Marcus," she explained. "I bought groceries and clothes for my kids." Not irrational.

A similar conundrum applies to reverse mortgages. The sales pitches strongly suggest that a mortgagee can’t be forced from the home by foreclosure so long as the home remains their principal residence. In other words, just stay in the home and the reverse mortgage can’t be foreclosed. True, but notice how easily that suggestion rolls off the tongue.

A reverse mortgage borrower can lose her home through processes other than foreclosure. A retiree who chooses a reverse mortgage might find that despite her expectations when she retired, she no longer wishes to live in the home or can no longer afford its maintenance or the local cost of living. “Just” keeping the home as her principal residence might not be an attractive option.

I recently learned of a wealthy, retired corporate executive who lived in an expensive suburb of Houston. His wife developed dementia and her care bankrupted the household. Reverse mortgages were not a part of that story but it is easy to imagine that, had he borrowed one and spent most of the equity, he would choose to move to less expensive housing in a less expensive community even though that would trigger the mortgage’s repayment. While he could postpone repayment by just remaining in the home, that might not be his best option. Moving out, though it would trigger mortgage repayment, might be the rational choice.

So, returning to that “deterministic spending schedule,” I, too, prefer to believe that most people would note their deteriorating finances and reduce spending in time, but retirees with more limited resources might end up in a spending trap in which their portfolio’s death march is the best of a poor set of choices. They might also fall victim to the "boiling frog" scenario in which the deterioration is so gradual that it fails to set off trigger points in time (although the whole boiling-frog thing is fake news, according to The Atlantic.[3])

As a friend and Duke philosophy professor recently told me when I questioned people voting against their own interests, sometimes people are acting in their own interests but we just don't understand what those interests are.

This week that the Nobel Committee conferred its award to Richard Thaler seems appropriate to remind ourselves that our financial models are fairly irrelevant if we ignore the human behavior element or oversimplify it.

Sometimes a retiree may keep returning to that ATM for as long as possible because she has no better alternative. That's rational.


[1] Financial Analysts Journal : It’s Time to Retire Ruin (Probabilities), Moshe Milevsky.

[2] A 4% Rule - At What Price? by Jason S. Scott, William F. Sharpe, John G. Watson.

[3] The boiled-frog myth: stop the lying now! The Atlantic.

[4] Richard Thaler, A Giant In Economics, Awarded The Nobel Prize, Forbes.


I will participate on a panel of retirement advisers in a Twitter chat sponsored by Thomson Reuters and entitled "When Can You Retire?" on Wednesday, October 18 from 2 p.m. to 3 p.m. ET. Follow @Retirement_Cafe and @ReutersMoney to join us.

A fellow retirement planner was told at a seminar this week that "95% of retirees should get a reverse mortgage at the beginning of retirement to create income." Aside from writing a will, I can't think of any single thing that 95% of retirees should do. I am told that Mark Warshawsky estimated that 14% of 62+ households could potentially benefit. Sounds much more reasonable to me. Still others might benefit from a reverse mortgage to create an emergency fund.

Monday, September 11, 2017

The Equifax Breach and Freezing Your Credit Reports

In the wake of the Equifax breach, I have received a number of questions about what happened and what we should do to protect ourselves from identity theft. Identity theft is a significant financial risk to retirement. Fraud risk is number 13 on "the list" (Retirement is Risky Business – Here's a List.)

The Problem

Identity theft can hurt us financially in several ways but the two aspects I'll discuss here are theft from an existing financial account (PayPal, credit cards, Amazon, a broker, etc.) and thieves creating new financial accounts in your name.

Here are two examples of theft from an existing financial account.

Three or four times a year I am contacted by one of my credit card companies to inform me that they have detected fraud in my account, often before I even see it. Their solution is to issue a new card with a new account number. That fixes one problem but causes others because three or four times a year I have to change my card number at places that store it like Netflix and Amazon. Another time, Amazon informed me that someone had ordered a $4,000 TV from my account but that they had stopped the order because it was clearly fraudulent.

Most of these incidents work out OK, except for the inconvenience, because my credit cards are insured against fraud by the issuer.

A lot of elder theft and fraud, however, is committed by family members. If a family member steals your credit card, Social Security check or ATM card, you probably won't be reimbursed unless you are willing to file legal charges against that family member. Sadly, you need to take extra precautions to protect your PINs, passwords and other vital information from family members. Remember that many of them will have physical access to your computer.

The second risk involves someone stealing your identity and opening a new account in your name. Unless you are vigilant, they can use these accounts undiscovered for some time and you will have the nightmare of proving you aren't responsible for the charges. The accounts they open could be anywhere from PayPal to a home equity loan.

Who Steals Your Identity?

Often, the hacker who steals your identity is not the person who steals your money. Hackers steal personal information and sell it to fraudsters over the Internet. (The magic of specialization.) Thanks to the Internet, the hackers and fraudsters can be anywhere in the world. Russia, North Korea, and Eastern European countries are common homes for this activity, but it happens everywhere.

What does this mean to you? It means that you can take extensive precautions to ensure that you protect your valuable identity information only to see the thieves just steal it from someone you do business with who also has your information. 

The latter is largely beyond your control. You can't control your personal information that Experian or Target keeps and has promised to protect.

Where Do Thieves Find Your Information?

They can look over your shoulder for your password while you log onto the Internet or enter your PIN at an ATM. They could steal your wallet. They can steal your credentials while you use a public Wi-Fi connection at a coffee shop (I use a VPN to protect against this.) They could hack into your computer. But, the least-cost approach is to steal millions of ID's at a time from places like Equifax, Target, and Yahoo.[1]

If bank-robber Willie Sutton were an identity thief, he'd explain his attacks on large companies by saying, "Because that's where your data is."

Why rob your home, steal your wallet or hack into your PC to steal one ID when a thief can hack Yahoo and steal millions?

If the Home Depot breach was a bank robbery, the recent hack of the credit-reporting agency Experian was like robbing the Federal Reserve.

Should you freeze your credit reports? Yup.
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The Credit Reporting Agencies

There are three major credit reporting agencies, Experian, TransUnion, and Equifax. Most people have a file at all three, which should (but doesn't always) contain the same information about you. (You should check all three regularly at to correct any discrepancies.)

In addition to the three major agencies, there are about 40 others[2], most of which specialize. You should focus on the top three (and perhaps Innovis.)

When you apply for a new credit card, an apartment lease, or a reverse mortgage, for example, the company accepting your application will first check your credit record. Unless you have frozen your credit report at the credit-reporting agency they choose to check, this will be done easily and will not be reported to you.

This simplifies your life but, unfortunately, it also simplifies the life of the thief opening an account in your name.

Freezing Your Credit Reports

You also have the option of "freezing" your credit reports at these reporting agencies. If you order the agencies (plural, it only makes sense to freeze all three) to freeze your reports, they will provide you with a PIN number to unfreeze the account when you need to.

The bad guys can't open an account in your name without your PINs. This is less convenient for you because you have to unfreeze your reports when you want to open a new account. (This is typically less inconvenient for retirees because we tend to open fewer new accounts.)

My reports have been frozen for years, so when I recently opened a new account the lender called me to tell me that he couldn't run a credit check because my credit report was frozen. I try to remember this and unfreeze the account when I submit an application, but I often forget.

I asked the lender which agency his company uses and was told Experian. I knew then that I only needed to unfreeze the Experian reports so I logged onto, entered my PIN, and unfroze the account.

I could choose to unfreeze it for everyone or for one specific lender so I chose the latter. I could also unfreeze it until I chose to freeze it again or for a specific time period, so I chose to unlock my credit reports for this single lender at one agency (Experian) for five days, after which the account would once again be frozen to everyone.

Inconvenient? Yes, it cost me a few more days in the application process because I had forgotten about the freeze, but not nearly as inconvenient as identity theft.

Credit Monitoring Services

Many companies, including the reporting agencies, offer a service to monitor your credit report. Note that this is not the same as monitoring your credit accounts. After a breach, the hacked companies inevitably offer a year of free credit report monitoring service to help repair their image. "Free" is a fair price for this service and I generally take them up on it.

The problem with these services is that they won't notice a problem until your creditor reports it to the credit-reporting agency. (Again, they monitor your credit report at the agencies, not your actual Visa or PayPal accounts.) This is somewhat akin to checking the obituaries each morning to see if you're in them.

You may have seen a TV commercial that shows a bank being robbed while a security guard just watches. "Aren't you going to do something?" a customer asks while lying face down on the floor.

"Oh, I'm not a security guard," he responds. "I'm a security monitor. My job is to tell you when your bank is being robbed. By the way, your bank is being robbed."

The credit report monitoring services are even less useful. They tell you that your bank was robbed, not that it is being robbed.

Protecting Against Fraudulent Accounts

Though credit freezes won't stop the first problem I described, someone accessing your existing financial accounts, they can prevent someone from opening a financial account in your name.

I protect my existing accounts with two-factor authorization everywhere it is available.[3] I also set up email notifications on every financial account that offers them to immediately notify me of unusual transactions, like those for large amounts or charges outside the U.S. Lastly, I set up email notifications for accounts that don't offer this service at[4]

For the second risk, someone opening an account in your name, I highly recommend that everyone — especially retirees, since they open fewer new accounts and may be more financially vulnerable — freeze their credit reports at all major credit reporting agencies. It may cost a few bucks, depending on your state laws[5] and it will be a little inconvenient, but it is worth the effort.

Here are some directions if you choose to freeze your credit reports.
  • Assume that your ID has already been stolen. That's the safest assumption and it's probably true. Many IDs have been stolen and the thieves are waiting for someone to buy them. Maybe they just haven't gotten around to yours — yet. Once you accept this fact, you will focus more on how to protect yourself after your information has been stolen.
  • Log on to all three credit reporting agencies (links below under "References") and freeze your credit reports.[6-8] Follow their directions. You will need to provide a good deal of personal financial information to do this online so they can be sure that you are you, but you always have the option of calling the phone number they provide.
  • Don't do this, of course, over a public Wi-Fi network.
  • Request a freeze at the smaller agency, Innovis, because as the Washington Post asks, "Why not?"[9]
  • Some concerns have been raised regarding weak PINs provided the agencies and whether PINs were stolen in the Equifax breach.[10] Equifax says they were not, but not everyone is willing to trust Equifax' word right now. To play it safe, you might want to change your PIN if you already had one. Equifax says they will add that ability immediately and begin providing more random PIN numbers, as well. 
I'll be changing my PIN because, well. . ., "why not?"


[1] 2017 Data Breaches - The Worst Breaches, So Far | IdentityForce®.

[2] Credit Reporting Agencies: Big 3 & Alternative Bureaus | WalletHub®.

[3] Two-factor authentication: What you need to know (FAQ) - CNET.

[4] Mint: Money Manager, Bill Pay, Credit Score, Budgeting & Investing.

[5] Details of credit freeze laws in all 50 states.

[6] TransUnion Fraud Alert

[7] Equifax Alerts

[8] Fraud Alert Center at Experian

[9] Innovis Security Freeze.

[10] After Equifax Breach, Here's Your Next Worry: Weak PINs, New York Times.

Friday, September 8, 2017

Social Security Claiming and Pig Races

The retirement planning question I am asked most frequently is when to claim Social Security benefits. I received a letter from a reader and a question from a friend at the local cafe on this topic just in the past three days.

Another friend sitting three rows behind me at a baseball game once stood up in the middle of an inning and shouted, "Hey, Dirk, what is the break-even age for claiming Social Security benefits?"

Since most Americans have not saved nearly enough for retirement, when to claim is often moot. Most people need their benefits right away and can't afford to delay them. But, if you can afford to wait, let me try again to explain why you probably should.

Here's the comment from a reader.
"My wife and I will retire in 4 or five years at about 66. We will each have small pensions and access to a little investment income. Social Security will be the 4th revenue stream. A financial adviser really wants us to wait until 70 to claim Social Security, but I'm concerned that we will have to erode our investments during that 4 or 5 year wait. Trying to forecast what that will cost us in lost investment income vs the higher Social Security benefit when claimed later is like betting on the pig races at the fair. An educated guess, a WAG, a stab in the dark. It doesn't help with the confidence and security we seek in retirement."  – Chris
(Isn't it interesting how often pigs come up in my retirement blog? I need to give that some thought. Think Like a Bayesian Pig.)

Chris, I believe the reason you are not getting a satisfying answer is that you're not asking the right question.

I deduce from your comment that you understand that if you live a long time, you will be better off financially by delaying claiming your Social Security benefits but, if you don't live a long time, you will be better off claiming them right away.

You are having difficulty deciding whether to bet that you will live a long time or a short time after you retire. You might as well bet on that pig race because just as you have no idea which pig is fastest, you have no idea how long you will live.

Social Security retirement benefits are a form of insurance. In fact, Social Security is the commonly used term for the federal Old-Age, Survivors, and Disability Insurance (OASDI) program. Before we delve into old-age insurance, let's consider a more familiar form of insurance, auto insurance.

By car insurance industry estimates, you will file a claim for a collision about once every 17.9 years.[1] That isn't terribly interesting information because you might not be average. You might go 30 years without an accident or have one tomorrow.  Planning your retirement or buying insurance based on averages is a very serious fallacy. Insurance should protect you from catastrophes, not from average losses.

You might ask – though, you probably don't — why you should pay thousands of dollars each year for car insurance when there is a 50% chance that you won't have an accident for nearly 18 years.

The answer is simple. A car accident could be financially catastrophic. Without insurance, it might cost you $40,000 to replace a car, not to mention hospital bills and a million-dollar liability judgment. So, we pay insurance premiums hoping that we never need to file a claim in order to avoid a potentially catastrophic outcome.

That's the definition of insurance. We accept a small, guaranteed loss (the cost of insurance premiums or delayed Social Security benefits) in exchange for protecting us from an unlikely but potentially catastrophic loss.

A reader asks: Is claiming Social Security benefits harder than betting on pig racing?
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How does that relate to delaying Social Security benefits, a.k.a., Old-Age, Survivors, and Disability Insurance?

Delaying Social Security benefits is like purchasing additional longevity insurance. The equivalent premium payment is forgoing some Social Security benefits that we would otherwise receive if we claimed at age 62.

The equivalent catastrophic loss in retirement is becoming impoverished when we are very old. Delaying claiming Social Security benefits is a way to buy more longevity insurance. Said differently, it's a way to transfer some guaranteed income early in retirement to provide more income later in retirement should we live to be very old.

This is the catch, of course. We don't know if we will live a very long time and, if we don't, we will have given up those early benefits for no reason, like buying auto insurance and never needing to file a claim.

When we buy auto or life insurance, we don't know if we will have a huge accident or die while dependents still need our job income, either. We may be paying those premiums with no return and, in fact, we hope we are. We don't make a bet on when those things might happen, we buy insurance to protect ourselves if they happen because an uninsured loss could be really bad. The alternative is to hope we're lucky.

Short retirements are cheaper than long retirements. Let's assume that you will need $50,000 a year to cover your living expenses after you retire. A retiree who leaves the workforce at age 62 and dies at age 67 will need $250,000 to fund retirement. A worker who retires at age 62 and lives to age 92 will need $1.5M to fund retirement.

(Both numbers are actually smaller than this when we consider the time value of money, but let's keep it simple for now.)

In other words, if you don't live long, your retirement will be relatively cheap and if you become quite old it will be relatively expensive.

When you delay claiming Social Security benefits and only live a short time, you will reduce your income but it won't hurt much because you will also have a cheap retirement. If you live a long time, you will increase your income by delaying claiming and you will need the additional income because you will have a long, expensive retirement.

Now, let's look at the alternative bet of claiming your benefits early.

If you live only a short time after retiring, you will have maximized your Social Security income for a scenario in which your retirement wasn't that long or expensive. If you live a long time, you will have minimized your Social Security income for a scenario in which your retirement is relatively expensive.

The goal of delaying claiming your Social Security benefits is to make sure you have more money in the worst case scenario, living a very long, very expensive retirement. It's like taking some small, certain losses by buying car insurance to avoid an improbable catastrophic loss if you have the big accident.

Now, Chris, I suspect that you're trying to place a bet on whether or not you will live a long time. If you're healthy, you can't know how long you will live. If you're going to place that bet, you're correct, you might as well bet on the pigs.

A better way to frame this decision is as a purchase of additional longevity insurance to protect your household against a very long, expensive retirement instead of framing it as a bet on how long you might live.

Your comment says, "It doesn't help with the confidence and security we seek in retirement."

If it's confidence and security you seek, buy insurance. You get that by delaying claiming Social Security benefits as long as you can afford to do so, thereby taking the catastrophic scenario, inadequate income in old age, off the table.

You also say, "Trying to forecast what that will cost us in lost investment income vs the higher Social Security benefit when claimed later is like betting on the pig races at the fair."

You're trying to compare two very different things. Your investment portfolio is a liquid asset with no longevity guarantee — you can outlive your portfolio. Annuities and Social Security benefits are illiquid but they will provide income if you live to 120. You probably need both.

Like not knowing how long you will live, you can't know how much investment income this decision will cost you. You can only guess. If your investments go south, you will have been much better off with more Social Security income, and vice versa.

Since you don't know how long you will live or how your investments will turn out over the long term, the trick is to make sure you have an adequate floor of Social Security benefits, fixed annuities and the like to protect against a very long life and poor investment results. Invest what's left for upside potential and liquidity.[2] That will tell you whether delaying benefits is a good strategy for your personal situation.

It's a somewhat complicated optimization, but presumably, that's why you asked your advisor for help in the first place.

Delaying claiming Social Security retirement benefits is the most cost-effective longevity insurance you can buy. If you think of it as insurance and not a bet on how long you will live, you may find it makes more sense than pig races.


". . . no one knows the best asset allocation in advance", Does The 4% Rule Work Around The World?, Wade Pfau.

NOTE: My blog seems to be having problems accepting comments, as it does from time to time. Sorry, I hope to have that corrected soon. Meanwhile, you may need to click the "comments:" link in the very last line of the post that begins " 1 comment:" to display the comment entry box. If that doesn't work, you can email me at


[1] How Many Times Will You Crash Your Car? Forbes magazine.

[2] The Retirement Café: Build a Floor, Place a Bet.

Thursday, August 31, 2017

Three Degrees of Bad

The terms retirement writers use to describe retirement plan failure can be confusing. There are three progressive levels of failure: a loss of "market-funded" standard of living, a loss of standard of living below the household's "floor", and bankruptcy.

A fourth kind of failure, depletion of one's investment portfolio, can contribute to any of these three levels of failure or none of them depending on the extent to which the plan relies on investments to support the standard of living.

Investopedia defines standard of living as "the level of wealth, comfort, material goods and necessities available to a certain socioeconomic class or a certain geographic area."

Merriam-Webster defines standard of living as "a minimum of necessities, comforts, or luxuries held essential to maintaining a person or group in customary or proper status or circumstances."

Retirement writers and researchers often use the term "standard of living" in a more specific way that refers to the cost of purchasing these "comforts, material goods and necessities." For example, we might say that a household has adequate retirement assets to fund a $50,000 annual standard of living when what we mean is that the household can enjoy whatever standard of living $50,000 a year can purchase. We turn a dictionary definition into a dollar amount.

Losing Standard of Living

The term "floor" describes the amount of relatively safe income available to a retired household. The floor is generated from assets with no market exposure. It is often used in the context of "floor-and-upside" retirement funding strategies as I described in Unraveling Retirement Strategies: Floor-and-Upside.

Floor-and-upside strategies use financial products with no market risk, like fixed annuities, TIPs bond ladders, and Social Security benefits, to provide a floor, or minimum, of reliable income before investing any remaining assets in the stock market to provide the "upside" opportunity. The theory is that the retiree will be able to maintain some minimum standard of living (the "floor") even in the event of disastrous investment results in the upside portfolio.

Since nearly all Americans are eligible for Social Security benefits, virtually all of us have some amount of floor but the level of that floor can vary greatly. Wealthy households will be able to build a floor that completely protects their standard of living regardless of investment results, while other households may have a floor consisting of only Social Security benefits that provides very little safety. The higher your floor, the less market losses will harm you standard of living. A floor is insurance and the more wealth you have, the more insurance you can afford.

For example, assume that $50,000 a year is a retiree's desired standard of living but she believes that in the worst case scenario she could get by spending $40,000 annually. Spending less than this $40,000 a year would imply a significant change in her lifestyle.

With a floor-and-upside strategy, she might try to build a $40,000 floor with Social Security benefits and fixed annuities and invest any remaining assets in the stock market. She hopes to generate $50,000 or even more annual income at the risk of having only $40,000. Whether she generates more or less than the additional $10,000 annually depends on her investment results – it's "market-funded."

At the first level of retirement plan failure, our retiree would suffer a loss of standard of living providing less than her desired $50,000 of annual income but not falling below the floor level of $40,000.

Losing Standard of Living Below the Floor

At the second level of failure, the retiree suffers a greater loss of standard of living that drops income below $40,000 a year and requires a significant lifestyle change, but isn't a large enough deterioration of her finances to trigger bankruptcy.

If $40,000 of income is provided by "safe" floor assets, then how can a retiree's standard of living fall below $40,000? There are two ways.  First, no asset is perfectly safe, though TIPs bonds are pretty close. Social Security benefits might be reduced in the future. A pension plan might fail. In this context, "safe" means not exposed to market risk. A floor isn't totally safe from all risks but it is relatively much safer than an investment portfolio.

Second, standard of living can also be disrupted by unexpected expenses. A floor guarantees income; it does not guarantee that income will exceed expenses.

One challenge with this model is that the same standard of living has different price tags in different places. $50,000 purchases a higher standard of living in Manhattan, Kansas than in Manhattan, New York. Another challenge is that defining a floor amount is much easier in theory than in practice as you will see if you try making a list of living expenses you could live without.

Bankruptcy - The Real Ruin

A household whose wealth continues to decline below the floor level may end up in bankruptcy when liabilities significantly and permanently exceed assets. About 0.5% of retirement-aged Americans file for bankruptcy at some point[1], usually early in retirement. (The bankruptcy filing rate declines with age after early retirement.)

The term "ruin" better applies to bankruptcy than to portfolio depletion, which may or may not lead to bankruptcy.

Even in bankruptcy, a well-planned retirement can protect significant retirement assets. Social Security benefits are protected from creditors[2]. According to NOLO Press[3], "ERISA-qualified retirement accounts are generally protected from judgment creditors, as are employee welfare benefits (like medical insurance, HSAs, and employer disability benefits)". Non-ERISA plans are typically not protected.

Your state may provide additional protections in bankruptcy. A few states, for example, such as Florida, New York, and Texas, protect any annuity owned by a resident of the state from creditors. Check the bankruptcy laws for your state of residence.[7] Federal law also affords bankruptcy exemptions.[8] According to NOLO, "state law determines whether you can use federal exemptions or whether you must use your state property exemption list."

Portfolio Depletion

Perhaps the most common term to identify retirement plan failure is "ruin", as in "probability of ruin." In finance, this term is used in a number of ways that leave its definition somewhat imprecise:
"Risk of ruin is a concept in gambling, insurance, and finance relating to the likelihood of losing all one's investment capital or extinguishing one's bankroll below the minimum for further play." —Wikipedia.

"The complete loss of one's money and other assets." —Oxford Dictionary.
Definitions range from the total loss of all assets to the practically-total loss of investment capital only. In retirement finance, however, "ruin" almost always refers to the depletion of one's retirement savings investment portfolio.

While many retirees focus on the probability of totally depleting their investment portfolio prematurely, retirement's so-called "probability of ruin", a decline in portfolio value large enough to lower their standard of living without actually depleting their investment portfolio is far more likely and less catastrophic.

The magnitude of this risk depends on how much of the household's standard of living is funded by an investment portfolio compared to how much is funded by financial assets with no market risk. Higher "floor" lines, blue in the chart above, mean less risk to standard of living.

When sustainable withdrawal rate advocates say there's a 95% chance that you won't deplete your savings portfolio, they aren't promising a 95% probability that you won't lose standard of living. And when they say there's a 5% probability of ruin, they're referring to depleting your portfolio, which might or might not ruin your retirement.

A household that funds its standard of living entirely with Social Security benefits and fixed annuities can accept a greater probability of portfolio depletion — which is to say they can spend more, invest more aggressively, or both — than a household that depends on an investment portfolio to fund part of its standard of living.

Research by Wade Pfau[4] shows that purchasing fixed annuities can actually lead to larger final estates for this reason. "Though SPIAs [single-premium immediate annuities] do not offer liquidity, they provide mortality credits and generate bond-like income without any maturity date, and they support a higher stock allocation for remaining financial assets. Altogether, this allows a client to better meet both retirement financial objectives [spending and a legacy]".

In fact, there is a valid argument that depleting an investment portfolio before the end of retirement and relying on fixed annuities and Social Security benefits thereafter can be the most efficient way to fund retirement in some scenarios.

Three degrees of bad: Level of retirement plan failure.
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To quote more research by Pfau, "Certain circumstances, which we will explore, may allow retirees to accept a higher probability of “failure,” and spend more aggressively from their investment portfolio. Depleting the investment portfolio is not always catastrophic."[5]

Depleting the portfolio can be part of an efficient retirement plan, no big deal for household's with other sources of income, or catastrophic for a household that greatly depends on income from the portfolio.

How does this relate to the list of risks I posted in Retirement is Risky Business – Here's a List?[6]

Portfolio Depletion Risk is a combination of risks already on that list. A retiree's portfolio can be depleted by withdrawing too much from her portfolio periodically (excess withdrawal risk, overspending risk), by experiencing an unfortunate sequence of market returns early in retirement (sequence of returns risk), or by experiencing unexpected spending shocks (unexpected financial responsibility risk, health expense risk, and others), so I think this one is already well covered.

Although my previous list didn't identify bankruptcy risk separately, it did identify other risks that often lead to bankruptcy. Less than half a percent of elder Americans claim bankruptcy but the consequences are usually grave.

The magnitude of bankruptcy risk often depends on how well the retiree has protected assets from creditors. Since it demands a different kind of mitigation (asset protection), bankruptcy really should be identified as a separate risk. I'm going to add bankruptcy risk to the list and define it as the probability that a retired household will need to claim bankruptcy and its magnitude as the total value of all assets not protected from creditors.

Retirees with an investment portfolio may be exposed to the risk of losing market-funded standard of living. I will also add it to the list and define it as the risk of losing standard of living due to investment losses, presuming that standard of living does not fall below the household's floor of safe income. The amount of standard of living at risk is the amount expected to be generated by the investment portfolio. The probability of the risk can be estimated with Monte Carlo simulation.

There are three degrees of retirement plan failure that should not be confused. The first is a decline in market-funded standard of living. Not the best outcome, but still better than having your standard of living decline below what you might consider unacceptable. Mitigate this risk with a higher floor.

The second is a decline in standard of living below what the retiree considers to be the minimum acceptable floor. This will likely result from expense shocks. Mitigate these risks with insurance when possible (health insurance, umbrella liability insurance, and long-term care insurance, for example), by setting aside reserve funds, or both.

The third level is bankruptcy, which represents the most severe failure of the retiree's finances. Asset protection is an important component of a good retirement plan. It is also worth carefully considering those risks that most often lead to bankruptcy, the first five on the list[6].

An unplanned, premature depletion of the household's investment portfolio can lead to poor outcomes but that event is not a single level of failure. Depending on the extent to which the retiree depends on that portfolio to support his standard of living, portfolio ruin can expose the household to one of the three levels of retirement plan failure or it might be acceptable.

A good retirement plan will address each of these potential poor outcomes (risks) separately as they have different levels of severity and are mitigated in different ways. You can identify these levels of risk in your retirement plan by:
  • Calculating the amount of your standard of living that will be market-funded (subject to market risk).
  • Calculating the amount of floor income that will be generated (from safe bonds, Social Security benefits, pension plans, fixed annuities, etc.)
  • Calculating the total of assets protected from creditors. Review your state's bankruptcy protections. If your state permits use of federal exemptions, review those, as well.
Sketching a chart like the one above from this information may provide some interesting insights into your plan's levels of risk.


[1] The (Interconnected) Reasons Elder Americans File Consumer Bankruptcy: Journal of Aging & Social Policy: Vol 22, No 2, Deborah Thorne, Ph.D. (Downloads PDF).

[2] Can I Keep Social Security Benefits in Chapter 7 Bankruptcy?,

[3] Can Judgment Creditors Go After My Retirement Accounts?,

[4] An Efficient Frontier for Retirement Income by Wade D. Pfau, Wade Pfau, Ph.D.

[5] Taking Portfolio Spending into the Real World For Retirees, Wade Pfau, Ph.D.

[6] Retirement is Risky Business – Here's a List? (download spreadsheet).

[7] Bankruptcy Exemptions by State,

[8] The Federal Bankruptcy Exemptions,