Friday, March 30, 2018

The “Future” of Retirement Planning

When we decide how much money we can spend in the present year of retirement we need to know not only how much spendable wealth we have today but our best guess of how much we will have in the future. Likewise, on the expense side of the ledger, we need to know not only what our expenses were last year but also our best guess of what our expenses will be in the future. We can spend less this year, for example, if we know there is a big expense looming in the future and more if we’re pretty sure we’ll have more money in the future, say a sizable inheritance.

In short, we need a model of our retirement future to properly plan for it and even to determine a safe amount to spend this year.

Of the four inputs to this model I just mentioned, only one, our current wealth, is fairly certain.

If our entire future income will come from annuities, pensions and Social Security retirement benefits then it's relatively predictable, too. To the extent that future income will come from investments, that income is fairly unpredictable.

Expenses are unpredictable, as well. All we know for sure is how much we spent over the past few years. We can’t even be certain of the coming year’s expenses, so they too are uncertain. Retirement spending studies have shown that spending tends to decline as we age [2,3] but it doesn’t for everyone so we can’t assume that ours will. According to David Blanchett, whether or not it declines, annual spending volatility is relatively high (unpredictable from one year to the next).

When we take spending shocks into consideration, the future spending becomes even less certain. I spent $15,000 in the past year for two HVAC systems that I expected would last at least five more years. That has a much greater impact than my cable bill going up 5%.

The primary determinant of retirement cost is longevity. A five-year retirement will be far cheaper than one of 35 years. Our individual life expectancy is completely unpredictable assuming we are healthy.

As researcher Larry Frank keeps telling me, everything in an individual household’s retirement funding is stochastic, i.e., unpredictable.

Following is a graph of 200 randomly-selected portfolio value paths from a simulation of 10,000 scenarios for a retiree with a $1M portfolio from which she plans to spend $45,000 a year. All calculations are in real dollars and life expectancies are randomized using actuarial tables. It assumes a real 5.25% expected market return with a standard deviation of 12%.


Notice that most terminal portfolio values end up lower than the initial $1M portfolio value in real dollars. In this simulation, the median terminal portfolio value was about $860,000. About 75% of the scenarios ended with smaller portfolio values than the $1M they started with. This is typical of simulation results, though spending less would shift the bulk of those blue lines upward and spending more would do the opposite. The central mass of those blue lines would rotate around the starting point like clock hands, farther clockwise with more spending.

I read a comment on a retirement blog this week from a reader who said, “Retirement is uncertain so planning is useless.”

That’s like saying we shouldn’t plan outdoor activities because we can’t know future weather conditions with certainty. It’s like saying that companies shouldn’t bother developing business plans because they can’t know future economic conditions for sure. Of course you can plan where outcomes are uncertain and the best way to do that is with probabilities.

We develop retirement plans using models of the future but some models are much better than others. Nor is the model a plan. If we schedule a picnic for tomorrow and the weather models predict a 20% chance of rain, calculating the 20% is not the plan. The plan is deciding to take an umbrella or planning a backup activity. As in retirement planning, we use the model results to help create the plan.

Another blog suggested that Monte Carlo simulations can generate hundreds of thousands of future scenarios but that using them for planning is a mistake because a retiree can’t know which one she will experience. The first part of that statement is true. Your retirement's future finances might follow one of the blue lines in the chart above — assuming we ignore spending shocks — but it is impossible to know which one is yours.

There is a small chance that yours will follow a better path than any of these and a small chance that it will follow one worse and we can't ignore the latter's risk. (The former would just be sweet – we're OK with things turning out much better than we expected.)

Though it is true that we can't foresee our future path, it is also irrelevant — the purpose of the Monte Carlo model isn’t to predict an individual retiree’s path through the future (that’s impossible) but to explore a broad range of possible scenarios and develop some estimate of the probability of each actually being realized. Simulation is essentially a gigantic "what-if" analysis.

The weather forecasting model is likewise imperfect but the probabilities it provides are extremely useful. If there is a 5% chance of rain tomorrow perhaps we forego the umbrella. With a 95% probability or rain, we might cancel the event altogether. We don’t say, “No use planning based on the weather probabilities because we can’t know for sure.”


Determining how much you can safely spend this year requires a good model of the future.
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The alternative the blogger suggested was simply to build a spreadsheet for a near-worst-case life expectancy using an expected market return and ignoring stock return variance. Ignoring variance, of course, ignores sequence of returns risk. This is the model of the future you get using a spreadsheet that assumes the same expected market return every year. It's the kind of analysis we did before Bengen. It's the kind of thinking that led Peter Lynch to suggest 7% annual spending from a stock and bond portfolio would be safe.

(When I say "spreadsheet" in this post, I'm referring to any model that assumes zero portfolio volatility and a fixed life expectancy. Actually, you can use a Monte Carlo simulator and set the portfolio volatility to zero and get the same results. On the other hand, you can build a Monte Carlo simulator with market volatility in an Excel spreadsheet – I have the scars to prove it. You can download the Mother of All Monte Carlo Spreadsheets at the Retire Early Home Page[1].)

The path to the median outcome is also in that jumble of blue lines above, so the first question we should ask the blogger is, "If you can't know which of those blue paths to choose, why did you go ahead and pick one (the one with the mean annual return), anyway?"

The following chart shows all those blue paths again with the "spreadsheet" prediction of the future superimposed (red) assuming a fixed 30-year retirement and zero market return variance. That’s effectively what a spreadsheet model produces.


Why is the spreadsheet future a nice, smooth upward curve while all the simulated blue lines are jagged and head off in all directions including ruin? 

The answer is sequence of returns risk. The spreadsheet ignores market volatility and consequently, it ignores sequence risk. The model in the simulation is much more realistic.

And why does the spreadsheet portfolio end up so large compared to most of the blue lines?

The answer is sequence risk plus longevity. Note that life expectancies are simulated to generate the blue lines (they end at different years of retirement), while the spreadsheet model assumes a fixed-length retirement of 30 years. Real-life portfolios and retirees don't often last 30 years so their portfolios most often have less time to grow.

Of all the paths on this chart, the red spreadsheet path is by far the least likely for you to experience. Twenty consecutive years of identical positive portfolio returns is unimaginable.

With 10,000 simulated scenarios, fifteen survive 20 years and end up within 1% of the spreadsheet path value at 20 years. These are fifteen possible paths to reach the spreadsheet value at 20 years and they don't get there in a straight line, as you can see on the following chart. So, the spreadsheet path is in there, but why one would choose it as the representative outcome remains a mystery.


The path that reaches the median terminal portfolio value, among the 10,000 simulated scenarios, is shown on the graph above in orange. It ends at year 17, which is roughly the median life expectancy for this 65-year old. The spreadsheet path presumably uses average historical market returns, so why is its outcome at 20 years ($1.2M) so much higher than that of the median simulated outcome of $860,000?

The chart shows that using the average market return every year in a spreadsheet (the red line) doesn't produce the average outcome (the orange line). You're probably tired of hearing me say "sequence risk and stochastic life expectancies are the difference" but simulations model them and spreadsheets don't.

The spreadsheet path is quite optimistic. If you insist on a spreadsheet model, you should at least reduce the expected return to compensate for sequence risk. In this comparison, you would need to reduce the expected portfolio return in the spreadsheet model from 5.25% to 3.5% to obtain results similar to the simulation's median outcome at 20 years.

Lastly, let's look at a density histogram of all portfolios that survived at least 20 years.


The blue bars show the portfolio values after 20 years for those 956 portfolios and retirees who survived at least that long. It's a probability density histogram, so the total area of the blue bars equals 1.

The orange curve shows the continuous density. As you can see, the distribution is right-skewed and not a symmetrical normal distribution. The median is less than the mean due to all those huge but highly improbable outcomes along the right tail.

We're more interested in the median ($645,000), the value at which half of the portfolios are larger and half smaller. About 57% of the outcomes after 20 years are less than the mean ($702,000) compared to the 50% of outcomes that are less than the median. The median is the more representative statistic with this skewed distribution.

Finally, the red vertical line represents the spreadsheet model's portfolio value after 20 years, $1.17M. At the 20-year mark, that red portfolio value is larger than 88% of the simulated portfolios that survived that long. $645,000 is a much more representative expectation after 20 years than the spreadsheet prediction.

It's true that you can't predict which of those 10,000 blue paths your future will mimic but the spreadsheet outcome is one of those. Pick it and you simply decided to pick a path from the 10,000 choices after saying you couldn't. And, then you picked a very unlikely and optimistic one. The spreadsheet predicts portfolio values in the absence of sequence and longevity risk and tells you nothing about the probability of realizing them.

Furthermore, the purpose of simulation isn't to predict your future but to explore the possibilities, so you aren't intended to choose one.

We need a model of the future to plan retirement. We need it to even calculate the safe amount to spend this year. Simulation is a good starting point.

The takeaway, for now, is that if you have planned your retirement with a spreadsheet model, you should take another look, especially if your plan shows a single straight path to doubling (or more) your initial portfolio. It could happen; it just isn't likely and if it does happen it certainly won't be a smooth path.

If you're using an online calculator, make sure it incorporates simulation. There's a Monte Carlo version of E$Planner, for example, and there are free simulators online.

But simulations have issues, too, so they're only a starting point. I'll discuss the shortfalls of simulation next time before describing how to make sense of that jumble of blue lines.



REFERENCES

[1] Download The Retire Early Home Page spreadsheet.


[2] Expenditure Patterns of Older Americans, 2001‒2009, Sudipto Banerjee, Employee Benefit Research Institute. (Download PDF.)


[3] Estimating the True Cost of Retirement, David Blanchett. (Download PDF.)




Thursday, March 15, 2018

The Pros and Cons of Bucket Strategies

Continuing recent posts updating my past descriptions of retirement strategies, let's look again at time-segmentation (TS) or "bucket" strategies.

The basic implementation of time segmentation strategies sets aside enough cash and short-term bonds to cover the next few years of retirement expenses, let’s say five, then covers the following few (let's say years six through ten) years' expenses with intermediate bonds, and finally allocates any remaining assets to stocks.

Note that this is a markedly different way of allocating assets than is typically used by other strategies that base equity allocation on the largest loss a retiree can stomach in a market downturn and the optimal asset allocation to avoid prematurely depleting a savings portfolio.

Many retirees will find that setting aside five or six years of expenses in a cash fund will be a significant portion of their investable assets so this might be a dramatically different allocation.

Here's an example. A retiree wants to spend $40,000 annually from a $1M portfolio. She invests a little less than $200,000 in cash and short-term bonds (the discount rate is low, especially in today's capital markets, so we can roughly just multiply annual spending by 5) to cover expenses for the next five years. She invests a little less than $200,000 (less because they yield a little more) in intermediate bonds and roughly $600,000 in stocks. It is her estimated future spending that determines her asset allocation of 20% cash, 20% bonds and 60% stocks.

TS strategies don't typically recommend an annual safe spending amount like the $40,000 in this example but this can be estimated by any of the (preferably variable) spending strategies.

This part of the TS strategy is based on matching asset duration[1] to the duration of expenses and is financially sound.

Asset duration, in simplest terms, refers to the recovery period typically needed after a market downturn or interest rate increase. The duration of an expense is essentially the number of years until it is due but expected inflation must be considered, too.

Matching a near-term liability with a long-duration asset like stocks would provide a greater expected return but less confidence that the money would actually be available when needed if stock prices declined. Matching a long-term expense with an intermediate bond would have greater certainty but a lower expected return. "Liability matching" provides the greatest asset return for which the expense can be reliably met and is a key component of TS strategies.

Short-term bonds may have a duration in the neighborhood of three years, intermediate bonds 5-10 years, and stock market duration is measured in decades. This simply means that we can be pretty sure of the value of a 3-year bond in three years but not less, the value of cash next year, and that we probably need to invest in stocks for 7-10 years to be pretty sure our investment won't be looking at a loss.

Planners often recommend that the bonds are set up as a ladder held to maturity to mitigate interest rate risk but many planners simply use bond funds of short and intermediate durations assuming that the results will be "close enough" to those of bond ladders.

The expressed goals of TS strategies are to match expense durations to asset durations, to help retirees better understand the purpose of their different assets, and to weather bear markets without the need to sell stocks at depressed prices and thereby avoid “panic selling” in a market downturn.

Liability-matching is a sound financial policy, while the latter two are primarily psychological benefits. In fact, from a financial perspective, to quote Wade Pfau:
... it must be emphasized that on a theoretical level, income bucketing cannot be a superior investing approach relative to total returns investing.[2]
The reason is that bucketing typically requires a much larger cash and short-term bond allocation than other (total return) strategies. The difference between the returns available from these two assets and what their value might have earned in the stock market is referred to as "cash drag." You simply earn less money if a larger portion of your portfolio is held in cash instead of invested in stocks.

In a paper entitled, “Sustainable Withdrawal Rates: The Historical Evidence on Buffer Zone Strategies[3], authors Walter Woerheide and David Nanigan showed that the drag on portfolio returns from holding large amounts of cash can be significant.

In other words, the comfort of a large cash bucket can come with a heavy cost. According to the authors, the performance drag imposed by a large cash bucket actually leaves the typical portfolio less sustainable. That suggests that TS strategies increase the security of income for the next ten years but do so at the cost of less security of income in the years beyond.

Said differently, the goal of TS strategies is to reduce sequence risk, i.e., to reduce the probability of outliving one's savings, by encouraging the investor to avoid selling stocks at low prices. Woerheide and Nanigan, however, show that this strategy's cash drag is typically greater than the benefit of avoiding selling low and often achieves the opposite, a less sustainable portfolio.



Are bucket strategies easier for retirees to understand or is their explanation simply easier to get away with?
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The goal of building a cash bucket to weather bear markets conflicts with the goal of maximizing portfolio returns (and thereby increasing portfolio sustainability) and can backfire. The longer the cash bucket the greater the cash drag. The shorter the cash bucket the less likely it is to outlast a bear market.

It has also been argued that TS strategies reduce sequence of returns risk and they probably do when they work, meaning when they outlast the bear. But, Moshe Milevsky showed in “Can Buckets Bail Out a Poor Sequence of Investment Returns?” that this strategy cannot always avoid sequence risk. When a retiree spends all his cash in a market downturn he can be left with an extremely risky all-equity portfolio, possibly before the bear market ends, with the postponed selling having had the unhappy effect of waiting to sell stocks until near the market's bottom.

Technically, bucket strategies are not “floor and upside” strategies but, as I have noted in previous posts, most Americans are eligible for Social Security retirement benefits. Consequently, most Americans have a floor, no matter which strategy they prefer, though it may not be what a retiree would consider an adequate floor — living off Social Security benefits alone isn't pretty.

While floor-and-upside strategies are meant to provide confidence that the retiree will never fall below a certain level of income for a lifetime, bucket strategies attempt to inspire that confidence (not always justified, as Milevsky explained) for only the length of the bond ladder.

I often think of the floor issue by imagining that my upside portfolio has been completely depleted. This is an unlikely scenario to be sure unless one is spending from that portfolio, but it forces me to imagine my circumstances in a potential failure scenario. Using a bucket strategy, I would have no stocks from which to replenish the longest rungs of the bond ladder in that event, so my income beyond this "rolling ladder" is clearly dependent upon equity performance and is not secure.

The stock allocation will decline with age as the short- and intermediate-term buckets slowly come to dominate the portfolio. At some age, the portfolio will contain mostly bonds and cash.

TS strategies recommend spending first from cash, then from bonds, then from equities, but as the Michael Kitces explains[4], that is pretty much what happens when we rebalance a SWR portfolio. Rebalancing results in selling assets that have recently experienced the highest growth. If stock prices have fallen, rebalancing ensures that it is other asset classes that will be sold. With rebalancing, stocks are sold after their prices go up.

Lastly, how many retirees — or planners, for that matter — understand these risks?

It's simple enough to explain to a retiree where the funds are coming from to pay bills for the next several years. But, unless she also understands that buckets can fail, that increasing the cash bucket to avoid failure dilutes her expected portfolio returns, and that income for future years funded by the stock market is still at risk, then this benefit of bucket strategies is not a true understanding but simply a psychological salve.

If that's the case, are bucket strategies easier for retirees to understand or is their explanation simply easier to get away with? The arguments for bucket strategies are not that the strategy itself is easier to understand but simply that it is easier to understand the purpose of their asset allocations.

Planners report that bucket strategies improve the bear-market behavior of their clients and their planners find that quite valuable. There's nothing wrong with that if the retiree understands the cost of this behavior management — the long-term sub-performance of an overly-conservative TS portfolio is likely outweighed by the losses they avoid by not selling low.

It's hard to evaluate that comparison because it is largely dependent upon the retiree's self-control but it seems a steep price to pay for this guardrail, especially compounded over a long retirement.

A strong urge to sell in bear markets could just be a sign of an overly aggressive asset allocation. Finding a more tolerable asset allocation between that and a 20% cash allocation might be a better answer.

No retirement funding strategy is perfect and I think a sub-optimal strategy is better than no strategy. Or, as my friend, Peter is fond of saying, bad breath is better than no breath at all.

Ultimately, I firmly believe that the best retirement plan is the one that lets you sleep at night.



REFERENCES

[1] Efficient Frontier, William Bernstein.

[2] The Yin and Yang of Retirement Income Philosophies, Wade D. Pfau, Jeremy Cooper.

[3] Journal Sustainable Withdrawal Rates: The Historical Evidence on Buffer Zone Strategies, Walter Woerheide and David Nanigan.

[4] Is A Retirement Cash Reserve Bucket Unnecessary?, Michael Kitces.