Friday, January 26, 2018

Unraveling Retirement Strategies: Floor-and-Upside (An Update)

When a reader recently quoted me from a four-year-old post, I realized I needed to update a few of them. I've learned some things in the past few years and, like many of us who research retirement finance, my thinking has "evolved."

(My wife would undoubtedly question both claims, but I refer specifically to retirement finance matters at present.)

Sometimes reading an old post is like seeing a photo of yourself from 1975 with mutton chop sideburns a la Neil Young and saying out loud, "What was I thinking?"

One such post is Unraveling Retirement Strategies: Floor-and-Upside[1], from February 6, 2014. I've made a few changes to reflect my updated perspective and to incorporate some of the excellent reader comments that post attracted. Specifically, I've become more enamored with annuitites and less with TIPS ladders.




The floor-and-upside strategy for financing retirement is sometimes referred to as “safety first” and derives from The Theory of Life-Cycle Saving and Investing[1].

The basic idea behind floor-and-upside is that a retiree devotes some of her retirement funding assets to building a lifetime stream of income and the remainder to an investment portfolio to provide liquidity and the possibility of increasing wealth over time.



It's important to note that growth of the upside portfolio isn't guaranteed and, in fact, the "upside" investment portfolio may shrink over time or even be depleted prematurely (an "upside portfolio" also has downside). The "floor" is a safety net that will provide income should the upside portfolio fail. The rest of your retirement plan should ensure that having to live off the floor income alone is very unlikely.




Assets suitable for constructing the floor portfolio include Social Security retirement benefits, life-contingent annuities, and pensions. A TIPS bond ladder is not guaranteed to last a lifetime but it is conceivable that one could be built for 35 years, for instance, that would be highly likely to outlast a joint lifetime. Whether or not the cost of the ladder would be acceptable is another matter.

You could build a really simple floor-and-upside strategy by using part of your retirement savings to buy a life annuity to guarantee a certain amount of income for as long as you live and then investing whatever is left of your savings in an S&P 500 index fund.

In fact, since most Americans are eligible for Social Security retirement benefits, most Americans have a "floor." Those who also have some savings to invest in retirement, therefore, have a floor-and-upside strategy. Social Security benefits alone, however, may not provide as much floor as desired.

Deciding how much floor income you should build into your plan is sometimes easy. I've had clients say, "I don't care about upside potential, I'm not as impressed with my husband's investing skills as he is. I just want a check in the same amount monthly for as long as I live." This is a person who wants nothing but floor.

I also have had clients and readers say, "I believe in my investing skills and that the market will always eventually go up throughout my lifetime." Since some suggest that they should invest their Social Security benefits, too, I assume there is a group of retirees who want no floor at all.

In between these extremes, the decision can be more difficult. The best I can recommend is that you imagine that you are 85 and your upside portfolio balance just went to zero, a victim of sequence of returns risk. What is the least amount of income you could have remaining that would not make your life an economic misery? This is the floor level you wish to have.

The next question, of course, is whether you can afford that much floor and your level of wealth may or may not dictate that you choose a lower level. Interest rates are historically low at present so floors are expensive.

(A reader once commented that anyone who can afford a floor doesn't need one. Not true. Everyone can afford some level of floor even if it consists only of Social Security benefits. No one suggests that your floor cover 100% of what you hope to spend in retirement. That would indeed be expensive. Floor income should cover food, housing, clothing, and the like, but not the annual European vacations you planned before your upside portfolio confirmed your wife's suspicions about your investing skills.)

Here's an example. Let's say you want to spend $60,000 annually in retirement and your household expects $30,000 from Social Security retirement benefits. Non-discretionary spending totals $48,000 of the $60,000 total. (The floor doesn't have to be your non-discretionary expenses, it can be whatever makes you comfortable, but that's a reasonable starting point.) You have saved a million dollars for retirement.

You need another $18,000 of longevity-protected income. Wade Pfau's Dashboard[3] (or a quick online annuity quote from someone like myabaris.com) tells us that a single-premium income annuity (SPIA) for a 65-year old couple today will generate about a 5.63% payout at today's rates. Divide 18,000 by .056 and you can estimate that you need to annuitize about $320,000 of your savings to generate the safe floor you desire.

Invest the remaining $680,000 in stocks and bonds (I recommend index funds) and you have a floor-and-upside plan with $48,000 of longevity-protected income (from Social Security benefits and the SPIA) in the unlikely event that you prematurely deplete your savings portfolio.


An update on Floor-and-Upside Strategies.
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There are a few critical concepts to consider at this point. First, the income from both the floor and upside portfolios assumes normal expenses. There will always be a risk of unpredictable, catastrophic expenses — a lawsuit, medical expenses, a child or grandchild who needs your financial support — that can blow up your retirement plan. Insurance may help and a reserve fund might, too, but there is always the risk that neither will be enough. We're planning only for the expenses that we can predict to some extent.

The second important concept is that, if we depend on a portfolio or a TIPS bond ladder for income, their liquidity is somewhat illusory. Both are sometimes referred to as "fettered" assets because we depend on them for future income. We often can't really spend them on something else. Spend from either of these sources when they're intended to provide future income and we give up all or part of that future income.

An annuity will become worthless at death unless you purchase (often ill-advised) options to prevent that. A TIPS bond ladder or an investment portfolio may have a remaining balance at death but that residual balance will be available to our estate, not to us while we are living.

It is true that an annuity provides less flexibility (more liquidity) than a TIPS ladder but the flexibility of the ladder is limited. A large medical expense can't be paid immediately from an annuity, it's true, but paying it from a TIPS ladder isn't much better. You're paying the expense from the source of funding for future years of retirement. An annuity will always provide more income than a bond ladder so you might be better off using the higher income to pay the large expense over time.

Bottom line, if you suffer a huge uninsured expense in retirement, you have a serious problem with any strategy.

A third important concept is that in many scenarios annuitizing part of your savings will result in a larger estate. This is counter-intuitive. In the above example, many retirees would think, "I just took $320,000 out of any future estate value because the annuity will be worthless when I die."

But, the annuity enables the upside portfolio to be invested more aggressively and lowers the retiree's sequence of return risk by reducing the periodic amount spent from savings. This will often lead to a larger estate than a portfolio-spending strategy alone.

Floor-and-upside is a compromise between using all our savings to buy annuities and investing it all in the stock market. We buy enough annuities to provide a safety net and invest the rest.

Annuities will provide for maximum lifetime consumption but have no value at death. Depending entirely on the stock market will provide more consumption and possibly a residual balance at death if the stock market gods favor us and less spending and a smaller bequest if they don't.

How does this fit into the theory of life-cycle saving and investing? That economic theory suggests that households should prefer reducing their consumption a bit in good times if it will improve consumption a bit in bad times ("consumption-smoothing"). We buy health insurance when we are healthy in good economic times, though it may have no immediate benefit, so we will be able to consume more at times when we are unhealthy and have large medical expenses.

Floor-and-upside gives up some of the stock market gains in the good outcomes to make sure we have a bit more income in worse scenarios with poor market returns.

The floor-and-upside strategy will combine the two such that they provide a safety-net level of lifetime income and an opportunity for more consumption if those stock market gods smile down on us.

If they find us annoying, we'll still have the safety net.

In my next post, I'll describe the Constant-Dollar Spending Strategy (the "4% Rule").


REFERRALS

From time to time, I am asked for retirement planner references. In the past week, I received such a request as a blog comment. I would prefer you make the request by emailing me at JDCPlanning@gmail.com.

Also, there are relatively few retirement planners that I know and would trust with my own family and they are scattered around the country. All of them work remotely, primarily via email and phone as I used to, but if you want a planner you can meet in person, it is very unlikely that I will know one near you.

Thanks.


REFERENCES

[1] The Retirement Café: Unraveling Retirement Strategies: Floor-and-Upside.



[2] The Theory of Life-Cycle Saving and Investing, Federal Reserve Bank of Boston.



[3] Dashboard, RetirementResearcher.com.






Saturday, January 13, 2018

That Time I Maximized Regret

My last post, Minimizing Regret, described a decision tool that was used by Jeff Bezos (now reported to be the world's richest person, by the way[1]) and Harry Markowitz, and one I have used extensively throughout my adult life when faced with important decisions. Last week I regretted not using it more.

My home has two HVAC systems, one for the downstairs and one for the upstairs bedrooms and bathrooms. I had both installed after we moved here eleven years ago.

Eleven years isn't an awfully long lifespan for a modern HVAC system; one hopes to get 15 years and perhaps 20 years of service before replacing them.

Ours had become unreliable. We had failures at least once in each of the past three winters so I decided to replace the downstairs unit with a more efficient gas furnace last fall. I hoped to get a year or two more service from the upstairs unit and reasoned that, even if it failed, we could limp along with the new downstairs unit while we repaired the upstairs. Besides, squeezing a couple more years out of the old unit and postponing the replacement costs was only good economics, right?

Last week, the Raleigh area experienced the worst cold spell in the past 130 years according to local news reports and measured at RDU. No doubt it was actually longer but they've only kept records for 130 years. Not surprisingly, our upstairs unit failed (heating systems rarely fail around here in July) plunging our bedroom and bathroom into a permafrost zone as temperatures outside fell to as low as 4º F.

(As an aside, please note that improbable events are not impossible, like 4º low temperatures in Chapel Hill, NC and investment portfolio failures, but I digress.)

Now, that may sound wimpy to the sturdy folks of Embarrass, Minnesota, but let's just say that I had different expectations when I retired to North Carolina.

Given the cold spell's demand on local HVAC service companies, it took two days to have a repairman spend 10 minutes determining that the cost of repairs would be nearly the cost of installing a new system. I learned this late Friday afternoon and had to wait until Monday morning to have the new furnace installed.


That time I maximized regret.
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We lost heat on Wednesday, the day the cold spell began, and had an operational system again on Monday evening, the day the cold spell ended, proving for the umpteenth time that Murphy was not only a genius but also an optimist.

For five days, I slept in long flannel pajamas, wool socks, and a hoodie with a hot water bottle near my feet. (And let me just throw this out there: hot water bottles are a delight that we maybe shouldn't relegate to history's dustbin, as they say.)

I learned to shower, shave and get dressed in under 90 seconds.

Had I followed my own advice when deciding to delay installation of the upstairs heat pump instead of replacing both during the perfect temperatures last fall, I would have anticipated my regret from all possible outcomes.

Had I replaced the upstairs system last fall and missed out on the few dollars of savings I would gain from delaying, my inner financial analyst would have regretted the lost savings opportunity.

I would have anticipated regretting much more my actual outcome, a week of frosty indoor temperatures for the want of saving a hundred bucks or so.

By failing to give my decision the gravity it deserved, I maximized regret.

To put this into a retirement planning context, consider the ever-popular "probability of ruin." We can build a retirement plan that has "only" a 1-in-10 to 1-in-20 chance that we will outlive our savings, but it's probably worth a few minutes considering how much we might regret our plan if we lost that bet.

To my credit, I avoided the Tech Crash by reasoning that, while I would regret selling my tech stocks if prices continued to soar, I would regret far more losing the financial security I had already attained on paper.

A dear friend lost his entire $4M retirement savings when MCI crashed. He was nearing retirement age. That's a lot of regret.

It was 34º when we headed for the coffee shop the morning after we got the heat fixed.

It felt downright balmy.


REFERENCES


[1] Mr. Amazon Steps Out, The New York Times









Monday, January 8, 2018

Minimizing Regret

I'm reading Algorithms to Live By: The Computer Science of Human Decisions by Brian Christian and Tom Griffiths[1]. Following is an excerpt.
Regret can also be highly motivating. Before he decided to start Amazon.com, Jeff Bezos had a secure and well-paid position at the investment company D. E. Shaw & Co. in New York. Starting an online bookstore in Seattle was going to be a big leap—something that his boss (that’s D. E. Shaw) advised him to think about carefully. Says Bezos:
"The framework I found, which made the decision incredibly easy, was what I called—which only a nerd would call—a “regret minimization framework.” So I wanted to project myself forward to age 80 and say, “Okay, now I’m looking back on my life. I want to have minimized the number of regrets I have.” I knew that when I was 80 I was not going to regret having tried this. I was not going to regret trying to participate in this thing called the Internet that I thought was going to be a really big deal. I knew that if I failed I wouldn’t regret that, but I knew the one thing I might regret is not ever having tried. I knew that that would haunt me every day, and so, when I thought about it that way it was an incredibly easy decision."
Regret minimization can be a powerful tool for making retirement planning decisions. I have always used a similar approach to my critical life decisions. I wrote about it in a post some time back, but my process works like this.

I imagine myself at some point in the future long after having made the decision and I imagine that it turned out very badly. My future self then asks, "Do I still think it was a good decision? Would I make it again?" If my future self answers no, then my present self doesn't make that decision.

Even though I assume my decision turned out badly, I recognize that good decisions can have bad outcomes. I can accept bad outcomes if I made the best decision available to me at the time. A poor decision that ends well is just dumb luck.

Imagine that you are a basketball player about to take a game-winning (or losing) shot. Your shot is a low-percentage gamble but you can also pass to a teammate who has a better shot.

If you take the shot and win, you will have a great outcome from a poor decision. Try that often and you will lose a lot.

If you pass to the open teammate and he misses, you suffer a poor outcome from a good decision. Make that kind of decision often and you'll win more than you lose.

The fact that nearly all retirement finance decisions are probabilistic means that we can make bad decisions that turn out well or good decisions that turn out badly. To complicate matters, our own retirement is a one-time event. If we could have many retirements, a 90% probability of success would mean that 90% of our retirements would be successful, but we only get one. We can and should bet on the 90% probability but if we lose the bet, 100% of our outcomes (there will only be one) will be bad. When we lose the bet, the outcome won't be bad 10% of the time or only 10% bad.

Still, the better strategy is to consistently make good decisions or "the best bets", if you prefer. While we only get one shot at claiming Social Security benefits, for example, we will make many other retirement decisions and if we choose the 90% probability bet every time we are likely to win most of them.

Recently, a reader commented that since we can't be sure that delaying Social Security benefits will have a good outcome we really can't make a blanket assessment of the strategy. We can't make a blanket statement about the outcomes, true enough, but we can make a blanket statement about the quality of the decision.

Minimizing regret is an excellent tool for deciding when to claim Social Security benefits, assuming your financial circumstances afford you the option.

Retirees who delay claiming and die early in retirement might regret that they could have received greater benefits had they not delayed, at least to the extent that people who are no longer living have regrets.

Married retirees, however, will have surviving spouses whose survivors benefits may be limited (if they are the lower earner) by the higher-earning spouse claiming early and that spouse may not regret your decision to delay even if you do regret it.

Retirees who claim early and live a very long time will likely regret their lower lifetime benefits. Widows who live on reduced survivors benefits long after their husband passes because he claimed early might regret having let him make the financial decisions.

We might regret delaying claiming if Social Security were to be abandoned entirely by the federal government early in our retirement. I wouldn't regret my decision to delay in that scenario because I assign a low probability to my cohort losing those benefits. After that outcome, I believe I would say that I would make the same decision under the same circumstances if I had it to do over.

You, however, might not agree with that assessment or might be substantially younger and have a different outlook. Regret minimization can be subjective and risk can be dependent on one's life expectancy.

Regret can be a personal thing, though it can often be measured objectively in dollars. The dollar amount of regret can be defined as the difference between the outcome you expect and the outcome that would have resulted from clairvoyance, ie., from knowing the best answer. If the best possible strategy would have resulted in a $100 profit and yours results in $90, you have $10 of regret.


Minimizing regret can help you make better retirement planning decisions.
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One way to look at the Social Security claiming decision is to consider how much you or your surviving spouse would regret that decision in various scenarios and to make the choice based on avoiding scenarios with the greatest regret. This process won't favor delaying claims for every person in every scenario, but often it will.

Minimizing regret doesn't have to be the only tool you use for a specific decision but it may provide an additional perspective. Optimization tools like MaximizeMySocial Security[2], Financial Engines[3] or AARP[4], for example, also provide useful input.

Likewise, Social Security claiming isn't the only retirement decision for which regret minimization might be useful. Let's look at asset allocation.

I am thoroughly enjoying Algorithms and plan to read it again as soon as I finish. Be forewarned, however, that if you're not a computer scientist, you might be happier reading tax tables. That having been said, here's another excerpt that I enjoyed.

Harry Markowitz won the Nobel Prize in Economics for developing Modern Portfolio Theory (MPT). MPT calculates an "efficient frontier" of portfolio allocations that maximizes portfolio returns for various levels of market risk.

MPT determines an optimal asset allocation based on risk tolerance, market volatility, risk-free rates and the covariance of asset classes.

How did the father of Modern Portfolio Theory allocate the assets in his own retirement portfolio?
"I should have computed the historical covariances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions fifty-fifty between bonds and equities."
Interestingly, a 50% equity allocation falls into the sweet spot of several very different research strategies. Using a complicated simulation strategy, Gordon Irlam found that the 95% confidence interval for the optimal asset allocation ranges from 10% to 80% equities.

Using a much simpler simulation strategy, William Bengen's work on sustainable withdrawal rates shows optimum asset allocations between about 35% and 60%.

In a paper entitled Nearly optimal asset allocations in retirement[5], Wade Pfau concludes, "with Monte Carlo simulations based on historical data parameters, a 4.4 percent withdrawal rate for a 30-year horizon could be supported with a 10 percent chance of failure using a 50/50 asset allocation of stocks and bonds. But the range of stock allocations supporting a withdrawal rate within 0.1 percentage points of this maximum extend from 27 to 87 percent."

That's a lot of research to find answers consistent with "My intention was to minimize my future regret. . . So I split my contributions fifty-fifty."

The Markowitz story also struck a chord with me on a topic to which I have been giving a great deal of thought lately.

We have faster computers, better algorithms, and more in-depth research into retirement financial planning but very little empirical evidence to show how much they actually improve outcomes.

There is talk of "evidence-based" strategies, but retirement research doesn't work like medical research. We can't ask one group of retirees to use a portfolio-spending strategy and a control group to buy annuities and compare the results after 30 years. Even if we could, market uncertainty means we can't expect similar outcomes the next time we run the experiment.

What we will find is evidence of uncertainty.

If Harry Markowitz thought that a fifty-fifty regret-minimizing strategy was preferable to mean-variance optimization, I won't argue.

Next, let me tell you about That Time I Maximized Regret.

REFERENCES

[1] Algorithms to Live By: The Computer Science of Human Decisions by Brian Christian | Goodreads


[2] When Should I Take Social Security to Maximize My Benefits? | Maximize My Social Security


[3] Social Security Retirement Calculator | Retirement Readiness


[4] Social Security Calculator – AARP


[5] Nearly optimal asset allocations in retirement, Wade Pfau.