Wednesday, May 29, 2019

Remember Inflation?

I've noticed lately that our country is highly polarized.

No, I'm not referring to social media or cable news. I'm thinking about the great divide between Baby Boomers and every other younger cohort on the topic of inflation risk.

Baby Boomers worry about inflation.

Many of us graduated college into the jaws of 1970s "stagflation" (a terrible-sounding word describing a stagnant economy with high inflation) and watched our grandparents' pensions, paid in nominal dollars, slowly disappear over two decades as they aged. It was common to hear them say, "We're living on a fixed income" but they were not — they were living on a disappearing income in terms of purchasing power.

Fast forward to 2019 and a GenX'er recently suggested that we "old-timers" have too much fear of the "big bad inflation wolf."

I have no idea whether inflation rates the likes of which we experienced in the 1970s and 1980s will reappear anytime soon. Long-term inflation is unpredictable. I hope the GenX'er is right but I'm not willing to bet my retirement that he is. High inflation can be catastrophic and when we plan for retirement we should take catastrophic outcomes off the table when we can.

Inflation peaked at over 13% in 1980. I had a 14% mortgage.  Inflation rates were even higher in earlier decades. But annual inflation is a snapshot. Prolonged inflation is the real monster.

I stumbled across the following chart recently at inflationdata.com[1]. It shows historical annualized inflation rates by decade. Inflation for the decades of the 1970s and 1980s averaged 7.25% and 5.8% per year, respectively. Again, much lower than the annual peak in 1980 but destructive in its persistence.


We can now update inflation from 2010-2019 to 1.78%.

Notice that periods of high inflation come and go with no regularity. Also, notice that the high inflation of the 1970s and 1980s was immediately preceded by very low inflation in the 1950s and 1960s. No one saw it coming.

We sometimes speak of high inflation rates as "tail risk" but four of the previous eleven decades experienced average annualized inflation significantly higher than the long-term average of 3%. We haven't seen high inflation since the 1980s so we're probably experiencing recency bias.

There are a number of ways a household can mitigate inflation risk. I will write about one, CPI-adjusted annuities, soon. In the meanwhile, you can read a paper that economist, Zvi Bodie and I recently co-authored on that topic[2].

Buying TIPS bonds instead of nominal bonds is a near-perfect inflation hedge that transfers inflation risk to the U.S. Treasury. Your home equity might keep up with inflation. Social Security benefits are inflation-adjusted.

Although stocks are commonly referred to as an inflation hedge, they are not truly a hedge because real equity returns are not correlated with inflation. Stocks typically perform poorly in times of high inflation. Rather than "protect" against inflation they more or less "eventually outrun it", which is fine if both you and your portfolio survive long enough.

Economist, William Sharpe was recently quoted on this great divide. "I realize that it is hard to make the point that inflation can get out of control with the generations that grew up after the early 1980s, but perhaps we can point to other countries in more recent times, then ask them whether they think we are virtually guaranteed to have low and relatively steady rates of increases in prices for the rest of their lives.”

It's a good question to ask yourself or your advisor.

Don't forget inflation.




REFERENCES

[1] inflationdata.com.



[2] Hedging Inflation Risk with Real Annuities, Zvi Bodie and Dirk Cotton.




Friday, May 10, 2019

Going it Alone with Retirement Planning Software

I love models. I build and research models almost every day and have for almost two decades. For the past year, I have explored online retirement models while co-authoring a paper with an econometrician. Modeling is pretty much all econometricians do.

I don't like bad models, or models used for the wrong reason, or models used by people who don't understand them, especially when people who don't understand them try to explain them to other people who don't understand them.

It also concerns me that many people attribute mystical powers to computers. A computer model is no better than the human that programs it. It's just a whole lot faster and doesn't get complacent or bored.

So, I certainly don't like all models.

If you're going to use computer models to help plan your retirement, there are many things to consider.

First, economic models can be very useful to study your retirement prospects and figure out the best bets but they in no way predict your future. As the saying goes, all models are wrong but some are useful.

A Monte Carlo model, for example, can test thousands of possible future scenarios for your household but your retirement is a one-time event. There is no way to know which one of a multitude of simulated scenarios might be similar to the future you will experience or if any of them will. The tendency is to guess that your retirement will be like the median model outcome but that means you will be overly optimistic half the time.

The output that models create is only as realistic as the assumptions we feed them. Unfortunately, we can't estimate with any precision what future market returns will be, how long we will live or even how much we will need to spend over the coming decades. These are some of the key assumptions that drive models and we are, for the most part, guessing at what they might be.

In computer science there is an old saying, garbage in, garbage out. What we mean is that the output of a program is only as good as the input. Make a wild guess at the input and the output will be a wild guess. Unfortunately, many of our guesses, or "assumptions", are by necessity fairly wild.

A reader recently commented that "retirement planning is an unsolvable problem with unlimited variables." You could say that about chess, too, but some players clearly solve it better than others.

Retirement finance is unsolvable if your definition of "solvable" is finding a single, optimal solution in advance for your individual household. But, there are lots of "games" in economics that are probabilistic — retirement planning can be considered a "stochastic game against nature" in game theory parlance — for which we can determine the best strategies even though we can't be guaranteed to win.

We should never expect a model to provide a single, optimal solution to the retirement planning "game", nor should we expect that from a human advisor. The optimal solution can only be identified with certainty after retirement is over and that isn't very helpful for planning purposes.

Our goal, like that of the chess player, should be to find and implement strategies that produce the outcomes we want and avoid the ones we fear more often than alternative strategies do.

Many so-called retirement models concentrate almost solely on investment results. Those are investment models, not retirement models. A comprehensive retirement plan will consider many factors including Social Security maximization, annuitization, life insurance, estate planning, taxes, and others.

It is possible to use multiple models (perhaps an investment model, a Social Security model, and a tax program) to solve these problems individually but a comprehensive plan needs to also consider the interplay of these factors. (See a sample list of free limited-purpose models below.) Change any of these factors and other factors will be impacted. We would pay a big price in the planning process if we didn't consider that. A comprehensive retirement planning model is a much better tool.

A major benefit of Monte Carlo models is that we can test changes to many factors and see how they interact in one model run.

Assume, for example, that we are planning retirement with a spreadsheet model, such as the Bogleheads spreadsheet below, that considers many retirement-funding options. Let's say that I want to run the spreadsheet to consider all possible combinations of market returns ranging from 4% to 10% in 1% increments, asset allocations from 0% to 100% equities in 10% increments, and annuitization from 0% to 50% in 10% increments. Considering just those three factors, I would need 462 runs to capture the combined effects with a spreadsheet model or I could capture them and many more with one run of a Monte Carlo model. There are actually several other factors I should include and note that the spreadsheet is not modeling sequence risk.

It is unlikely that a retirement toolkit provided by an investment firm will give annuities, life insurance or reverse mortgages consideration equal to equities and vice versa. Better to find a model with no agenda.

It's also important to know who built the model and their qualifications. I have a lot of confidence in the Bogleheads and more in Laurence Kotlikoff, who created MaxiFi. Wealthfront identifies the developer of their retirement model. But, unless you know the qualifications of the model builder, I'd steer clear. Anyone can build a model and post it on the Internet.

Building a retirement model requires an understanding of finance, modeling skills, expertise in the computer language used (even if it is only Excel), and a sound understanding of statistics and probabilities. If you don't have all four, then building your own model is a very bad idea.


Retirement planning software can answer a lot of questions but you have to know what to ask.
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Models can answer a lot of questions but you have to know what to ask. A model is unlikely to suggest that Roth conversions might be profitable, for example, or that you should consider a combination of annuities, whole life insurance, and equities, as Wade Pfau and Michael Finke have suggested.[1] A good human retirement planner knows what to ask.

I am wary of models that use probability of ruin as their metric of success.[2] Probability of ruin measures the probability of portfolio failures but does not measure the magnitude of losses. For example, it will count a strategy that funds 29 out of 30 years an unequivocal failure. It will count a retirement strategy that successfully funds 30 years as a success but no more successful than one that funds 50 years.

As Zvi Bodie points out, probability of ruin doesn't consider utility. Presumably, retirees will be less satisfied coming up $100 short of paying the bills than they will be satisfied with a $100 surplus. Paying the bills is a necessity; having a little extra is a nicety.

Probability of ruin is a particularly bad metric for Monte Carlo models because, among other reasons, results can change significantly by changing nothing but the random number draw. If you use such a model, try running it several times with the same input and see if you get nearly identical results each time. If the results change a lot for each run and never converge then the model is problematic. If the results are precisely the same for each run with the same input it may be because the model always uses the same set of random numbers for every run to speed up computation, so we still can't say for sure that the model is properly constructed.

If you are going to plan with a "retirement toolkit", I recommend the following:

  • Be aware that today's retirement models are not a replacement for a human advisor. If you plan your own retirement with these models then you and not the model will be replacing the advisor.
  • Understand that no model can predict your future, certainly not for 30 years. You will need to recalculate periodically.
  • Know the credentials of the model builder.
  • Use models to explore the possible outcomes and better understand the economic forces at play. When you see bad outcomes, try to come up with a way to mitigate them.
  • Be aware that a model is only as good as the input we provide and the assumptions we make and that we can't make very precise assumptions. That means we won't get very precise results.
  • Understand that a model is not a retirement plan. It is one tool to help build a plan.
  • Find a model from a provider that won't profit from the sale of retirement-funding products.
  • Find a comprehensive retirement model that tests several key factors — spending rules, taxes, Social Security claiming, pensions, annuities, life insurance, asset allocation, etc. — and their interactions instead of trying to combine the results of single-purpose models.
I think the best and most comprehensive retirement planning software with a reasonable price tag for consumers at present is Laurence Kotlikoff's MaxiFi.com. It's not free but it is affordable. It can be tricky to use and, again, the more you know about retirement finance, the better the results you can expect. MaxiFi provides all the capabilities that I mentioned above and more and it completely avoids probability-of-ruin issues by maximizing lifetime consumption, instead.

What should you do with this information?

Use all "toolkits" with caution. I have a toolkit in my garage that contains all the tools needed to perform most household plumbing chores but for some reason, my wife still insists that I call a professional plumber.

Given that finding a great retirement planner can be challenging and expensive and that many of this blog's readers tend to do their own planning, it's easy to see the allure of finding a great software package and doing it yourself. Today's software, however, is much closer to a toolkit than to a "robo-advisor." Those who choose this path should avoid being overconfident in the results and should build plenty of safety margin into their plan.



Sample List of Free Limited-Purpose Retirement Planning Tools

  • Estimate a budgetary amount to spend from savings for the current year: Ken Steiner's How Much Can I spend in Retirement SpreadsheetNote: Ken Steiner mentioned to me that my original wording here, "safe amount to spend" should instead say "budgetary amount to spend", as we agree there is no way to predict a "safe" spending amount. Ken's goal is to provide a budgetary spending estimate based on sound actuarial principles.



REFERENCES

[1]Improving Retirement Outcomes with Investments, Life Insurance, and Income Annuities, Wade Pfau and Michael Finke.



[2] Toward Determining the Optimal Investment Strategy for Retirement, Javier Estrada.




Thursday, April 18, 2019

Black Holes, the Higgs Boson and Retirement Planning



The first image of a black hole. Credit: Event Horizon Telescope collaboration et al.

What do relativity theory, quantum mechanics and retirement planning have in common? Not a lot and that's actually an important point.

Black holes were implied by Einstein's work on general relativity in 1915 but the first one wasn't discovered until 1971[1]. Physics was able to predict the existence of one of the largest elements of the universe 56 years before one was discovered.

At the other extreme, on the quantum scale, Peter Higgs and five other scientists proposed the existence of the Higgs boson in 1964. Its existence was confirmed in 2012 based on collisions in the Large Hadron Collider at CERN. The existence of the Higgs boson was predicted 48 years before it could be confirmed.

In retirement planning, we do well to predict finances somewhat accurately more than a year or two in advance. Retirement planning is clearly not rocket science.

Physical sciences and their predictions are based on physical laws of the universe. Acceleration due to gravity on Earth is about 9.8 meters/second2, or about 32 feet per second per second as we Boomers learned in high school physics back when a meter in the U.S. was something one paid a quarter to park. On Mars, it's about 3.7 m/s2. Light travels at about 300,000 kilometers/second.

Drop an object from a height of 10 meters on earth and we can predict that it will reach the ground in 1.43 seconds traveling at 14 meters/second at impact. We can build models that predict such things with great accuracy.

Economics, however, is a social science, not a physical science. Finances can be modeled mathematically but actual outcomes are highly dependent upon the behavior of the humans involved. That makes the models far less predictive.

Unlike the universal laws of physics, the inputs for financial models are often unknown, so we make our best guesses. The most important factor of retirement finance, how long you and your spouse will live, is largely unknowable. Half of a group of people like you may live another 18 years but you might live twice that long or get hit by a bus tomorrow.

We know that stock markets have returned about 9% a year over the past 150 years but you won't be retired for 150 years. The geometric rate of market return you would have historically experienced over any single 30-year retirement during those 150 years could have been less than 3% per year or more than 10%, depending on the year you retired. The range of returns is broader for shorter periods.


Black Holes, the Higgs Boson and Retirement Planning.
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Retirement models, whether mathematical, spreadsheet, or Monte Carlo simulation, can't predict the future the way models do in the physical sciences. Monte Carlo simulation was developed for the Manhattan project and was accurate enough to help develop the atomic bomb when the world had minuscule computing power. MC could predict how atoms would behave but it can't predict your retirement finances.

In 2001, William Bernstein published a blog post entitled, "Of Math and History" noting that "it’s the engineers who most often give me the willies."[2]
"The trouble is, markets are not circuits, airfoils, or bridges—they do not react the same way each time to a given input. (To say nothing of the fact that inputs are never even nearly the same.) The market, though, does have a memory, albeit a highly defective kind, as we’ll see shortly. Its response to given circumstances tends to be modified by its most recent behavior. An investment strategy based solely on historical data is a prescription for disaster."
(It's a great read, by the way, as is just about everything at EfficientFrontier.com.)

There is huge risk in believing that we can accurately predict our financial future, market risk or returns, a safe amount to spend annually from our savings portfolio, our optimal asset allocation, our probability of successfully funding retirement, or any such metric with any degree of accuracy for any period beyond perhaps a couple of years, let alone for a retirement that could last 30 to 40 years.

I recently told an audience at a retirement finance conference that the greatest risk of retirement is overconfidence. Believing you can accurately predict the things in the previous paragraph is a prime example.

You might rightly ask, given my perspective of uncertainty, why I spend much of my retirement days building simulation models. The answer is that I don't use the models to predict probability of ruin or to predict anything, for that matter. I use them to study many possible outcomes for hints for improving my retirement plan. I readily admit that I have no idea which simulated scenario, if any, ultimately will be similar to mine. I just want to find the bad outcomes and say, "Whoa! How can I avoid those?"

I was once asked what I think is wrong with spreadsheet models of retirement. My answer is that they only consider a single possible scenario and not a realistic one, at that. It is highly unlikely that you will live precisely 30 years in retirement, for example, and there is an infinitesimal probability that your market returns or expenses will be the same each of those years.

(You could run a spreadsheet model several times with different assumptions, of course, but you can generate tens of thousands of different scenarios in a few seconds with MC.)

The tools we use in the physical sciences can be useful in social sciences like economics but they cannot be as predictive because people, unlike atoms, are unpredictable. Computerized retirement models can look impressive when a computer spits out thirty pages of Monte Carlo simulated data but less so when one considers the huge assumptions that have been input into the program. Computers and simulation cannot remove risk from your retirement but they can help identify and understand it.

In an earlier post, I suggested that the most important retirement decision you will make is how much of your wealth to allocate to safer income assets and how much to risk in the market. Don't be overconfident in your ability to predict the risk and returns of the latter. Have a backup plan (a floor of safe income) in case of portfolio failure. Retirement models are simply the best estimates we can make of a largely unknowable future.

And, if someone tells you that you will die with $5.3M in your investment portfolio or that you can spend 4.27% of your portfolio balance annually with a 95% probability of not outliving your savings for at least 30 years, consider that with a large dollop of skepticism.

Remember when you're considering your retirement plan that all models are wrong but some are useful.



Zvi Bodie explains "America's best-kept secret", I bonds for inflation protection.


The American College of Financial Services has created a wonderful collection of brief video interviews with Rick Miller on topics of personal financial planning.


REFERENCES

[1] Who Really Discovered Black Holes?, BBC Science Focus Magazine.



[2] Of Math and History, William Bernstein.





Thursday, April 4, 2019

The Mystery Of Dividend Preference And The 'Spend Dividends Only' Strategy

A good many retirees seem to be enamored with the "Spend Interest and Dividends Only" strategy for spending down their retirement savings. The foundation of this strategy is a preference for the value of a dollar generated from dividends over the value of a dollar generated from the sale of stock, or capital gains.

This preference has long been recognized but never quite understood.

The reason for this preference for dividends is so confounding that economists in the field of behavioral finance find it an interesting research topic. One of those researchers is Samuel Hartzmark, an Associate Professor of Finance at the University of Chicago's Booth School of Business.

Hartzmark thinks dividends fall under the category of mental accounting. He describes a "free dividend fallacy", in which investors view dividends as a source of return that is independent of the price of the stock when in reality the price of the stock is immediately reduced by the value of the dividend when it is paid. This fosters the mistaken belief that dividends are the same as bond interest.


Samuel Hartzmark describes a "free dividend fallacy" in which investors view dividends as a source of return that is independent of the price of the stock.
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This false equivalence of bond interest and dividends probably influences some investors to turn to high-dividend stocks when bond interest is low without considering the additional risk that equities bring. They are not the same, of course. When a $10,000 bond pays out $300 in interest, the bondholder is still owed $10,000 in principal at the bond's maturity date. When $10,000 of stock pays out $300 in dividends, the value of the remaining stock immediately drops to $9,700 at payout. Unlike bonds, there is no "maturity date" or any promise of the stock's value at some future date.

In fact, there are tax advantages to generating income with capital gains in a taxable account, despite the fact that qualified dividends and capital gains are currently taxed at the same rate. The investor can postpone capital gains tax until the funds are actually needed whereas a cash dividend (the most common type) will be immediately taxable when the company decides to issue it. An added bonus of capital gains is the ability to minimize taxes by selling specific lots.

In a post entitled, "Buffett: You Want a Dividend? Go Make Your Own,"[1] Motley Fool describes Warren Buffett's explanation for Berkshire Hathaway's refusal to pay dividends and how it is actually more efficient for both Berkshire and their shareholders if shareholders "create their own dividends" by selling shares.

In "Vanguard Debunks Dividend Myth"[2], financial researcher Larry Swedroe notes,
"But this preference isn’t entirely new; it has long been known many investors have a preference for cash dividends. From the perspective of classical financial theory, this behavior is an anomaly. It’s an anomaly because dividend policy should be irrelevant to stock returns, as Merton Miller and Franco Modigliani famously established in their 1961 paper 'Dividend Policy, Growth, and the Valuation of Shares.'"
Swedroe further notes that concentrating on dividend-producing stocks reduces diversification benefits. Concentrating is a key word here because adding some dividend-producing stocks to a portfolio can increase diversification. Said differently, there is nothing wrong with dividend-producing stocks but investing in only those stocks can be hazardous to your portfolio's health. As is often the case, too much of a good thing is too much.

Swedroe concludes that "both theory and historical evidence demonstrate there isn’t anything unique about dividends."

Strategies have been proposed to eliminate sequence of returns risk with high-dividend stocks. This wouldn't have occurred to me because sequence risk is caused by systematically selling stocks when prices are low. Cash dividends don't avoid sales at low prices; they are effectively a forced sale that will occur regardless of the stock's price and with timing decided by the company.

A recent series of three posts at the EarlyRetirementNow blog entitled "The Yield Illusion: How Can a High-Dividend Portfolio Exacerbate Sequence Risk?,"[3] shows that a high dividend yielding portfolio doesn't mitigate sequence risk and can, in fact, exacerbate it.

As always, the bottom line is what a retiree should do with this knowledge. My advising philosophy is that so long as a household understands a strategy and its alternatives, they should do what makes them comfortable.

I once had a client say, "I know I am behaving irrationally but this is what I am most comfortable doing." I don't know how I can argue with that or even if I should. As Michael Finke says, our job as advisors is to make clients happy.

Furthermore, there is no way to prove that even a poor strategy won't turn out well or a good one poorly for an individual household. We can only say what is probably a good or poor bet.

But, if you plan to spend down retirement savings with a strategy based on preferring a dollar of dividends to a dollar of capital gains, you are betting against economic theory, portfolio theory, historical evidence, tax law, behavioral finance and the wisdom of Warren Buffett.

Then again, maybe you will be lucky.



REFERENCES

[1] Buffett: You Want a Dividend? Go Make Your Own, Motley Fool.



[2] Vanguard Debunks Dividend Myth, Larry Swedroe.



[3]  The Yield Illusion: How Can a High-Dividend Portfolio Exacerbate Sequence Risk?, EarlyRetirementNow blog.




Sunday, March 3, 2019

Negotiating The Fog Of Retirement Uncertainty

Households who want to pay retirement expenses from an investment portfolio turn to spending rules like the 4% Rule, fixed percentage rule, or IRS Required Minimum Distribution (RMD) rules, to estimate how much they can spend each year. Retirees hope these rules will offer both a high probability of paying their future bills and a low probability of outliving their savings.

Many retirees and retirement planners are heavily invested in spending rules, with the 4% Rule most widely known. Spending rules attempt to protect us from outliving our savings but don't promise to pay our future bills. Retirees need both. Whether a retired household will actually outlive its savings will be determined by:
  • the length of retirement,
  • realized sequence risk (not market return expectations),
  • portfolio spending needs (actual needs, not spending-rule estimates), and
  • portfolio value.
If we could know all of these future values today, we could precisely determine how to fund retirement, so these are the factors we should include in a model to estimate how to fund it with portfolio spending.  

A household's length of retirement is the most important factor in determining sustainable portfolio spending. (A one-year retirement is easy to fund; a 30-year retirement, not so much.)

The length of retirement depends on longevity at the age of retirement. If two households have the same joint life expectancy but one retires five years sooner, the latter household should expect a 5-year longer retirement.

I simulated household finances for a sample of retired households from the Health and Retirement Survey (HRS). The average retirement age for this sample was 64 for men and 60.4 for women. Life expectancies were randomized using Society of Actuaries actuarial tables. About two-thirds of single-household retirements in this sample lasted from 14 to 23 years.


Spending rules attempt to protect us from outliving our savings but don't promise to pay our future bills. Retirees need both.
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About two-thirds of two-person household retirements lasted from 22 to 32 years. The length of your retirement is quite uncertain and, since your household is a sample of one, could actually range from less than a year to 40 or more. Life expectancy simply provides an average for many people who are a lot like you and there is no reason to believe yours will be average.

Sequence of portfolio returns is the second largest determinant of retirement success after retirement length (for retirees who spend from a portfolio, of course) and is even less predictable than retirement length. The sequence of your future portfolio returns is unknowable and, as Karsten at EarlyRetirementNow.com[1] explains, the sequence of returns is much more important than average returns. "Precisely what I mean by SRR [sequence of returns risk] matters more than average returns: 31% of the fit is explained by the average return, an additional 64% is explained by the sequence of returns!"  

Spending needs (expenses) are the third most important factor of successfully funding retirement when we spend from a portfolio. (They're second when we don't.) Most spending rules ignore how much you will actually spend or even probably spend and instead make the dubious assumption that whatever amount of spending that will not likely deplete your savings portfolio will also be enough to pay your bills.

In a recently published paper entitled, "LDI Misapplied", David Blanchett and Thomas Idzorek explain how liability-driven investing, when used appropriately, is an improvement over asset-driven portfolio optimizations like Modern Portfolio Theory's mean-variance portfolio optimization (MVO)[4]. The primary difference is that LDI optimization also considers future spending requirements while MVO only considers portfolio assets.

Similarly, spending rules that also consider future liabilities are an improvement over spending rules based on assets alone. In both contexts, adding liabilities creates a more realistic model of future household finances.

Blanchett has published several studies on spending and the cost of retirement. Estimating the True Cost of Retirement finds that on average spending tends to decline as retirement progresses but not for all households. In fact, the study says that "households that are overfunded and not spending optimally (the “low spend, high net worth” group) actually tend to increase consumption." 

In the most recent study, Blanchett and Idzorek find that:
50% of the households experienced relatively small changes between [biannual HRS survey] waves. However, the other 50% of the 288 households experienced larger changes in spending, with the 5th and 95th percentiles indicating large changes in wave-over-wave spending. Focusing on the 5th and 95th percentiles and the five distributions in Exhibit 14, for approximately 90% of the households the wave-over-wave change was less than plus or minus 30%.
Blanchett notes that actual spending variability is probably even substantially higher than measured in this sample, as some outliers were rejected.

These two studies suggest that both the long-term trend of retirement spending and year-over-year spending can vary substantially for individual households. In other words, our household's future retirement spending is relatively unpredictable.

Even when we do include future spending in the spending rule estimate, we do so with substantial uncertainty. If we don't include it, we ignore a lot of risk. 

The value of the portfolio over time is also a key factor in determining sustainable portfolio spending. The future value of an individual household's portfolio is uncertain because the three previous factors are uncertain. Assuming sustainable spending will equal some pre-determined spending rule percentage of an unknowable future portfolio value is equally uncertain. 4% of an unknowable number is another unknowable number.

All four major determinants of sustainable portfolio spending are uncertain individually. Combining the distributions of random variables increases the uncertainty but ignoring one or more of them is worse.

It is extremely unlikely that our actual spending path throughout retirement will even remotely mirror sustainable spending predictions. The 4% Rule suggests larger percentages of spending as remaining life expectancy declines. RMD requires percentage withdrawals from tax-deferred portfolios that increase with age. Fixed percentage rules suggest a constant withdrawal percentage at all ages. All three are percentages of an unknowable future portfolio value.

When actual spending exceeds the spending rule estimates, the household is exposed to greater risk of underfunding retirement than the spending rule previously suggested. When estimated spending rates exceed actual needs, the household becomes more likely to underspend.

This isn't to say that spending rules have no value but they're at best a ballpark estimate from within an enormous ballpark. On the other hand, as my friend, Peter frequently reminds me, bad breath is better than no breath at all. The errors of the estimates are reduced as we age and we experience diminishing uncertainty about the future.

Spending rules that consider all four factors provide a better model and should provide a better estimate. Most rules consider three or fewer.

The key is to recognize that a spending rule estimate is good for perhaps a year. They should be recalculated at least annually. Retirement plans based heavily on spending rules have a one-year planning horizon.

Managing with a one-year retirement planning horizon is like driving while looking only at the road immediately in front of your car. When we can't see clearly what lies ahead, on foggy days perhaps, most of us respond by becoming less confident and driving more conservatively.

The important question is how confident we should be in spending rule estimates and the answer is not very.

Why is this important? As I mentioned in Honey, What's Our Retirement Plan?, the most important decision you will make in retirement planning is how much of your resources to allocate to the upside and floor portfolios. The less confident we are in our upside portfolio's ability to deliver on its promises, the more we should allocate to the safe floor portfolio.

Many retirees and even some planners seem to be massively overconfident in upside-portfolio spending rules.

Perhaps they haven't noticed the fog.


REFERENCES

[1] EarlyRetirementNow.com blog.



[2] LDI Misapplied, David Blanchett and Thomas Idzorek.



[3] Estimating the True Cost of Retirement, David Blanchett.



[4] Liability-Driven Investment.




Friday, February 15, 2019

Retirement Advice from a Prussian Military Commander

We have to understand both the nature of plans and the nature of retirement finance before we can build a successful retirement plan.

[A version of this post first appeared at Forbes.com.]

It's only rational to update any plan (not just retirement plans) to account for new, important information. Say that on Monday, the weather forecast for Friday is warm and sunny so we plan a day at the beach. If the weather forecast on Thursday changes to a wet and cold Friday, then we need to change our plans. It no longer matters on Thursday what conditions were last Monday.

While that no doubt sounds obvious to all of us, not everyone thinks about retirement plans that way. As a top retirement researcher recently pointed out, “Your retirement plan is probably wrong in less than a year.” Or, to paraphrase a Prussian military commander from 1880, no plan survives initial contact with the enemy.

In retirement planning, uncertainty is the enemy.

Key retirement plan inputs can change every year. Our remaining life expectancies will decline a little less than one year for every year we survive and we're one bad checkup away from downgrading that.  It can change significantly for the better, too, as CML leukemia patients experienced with the introduction of the miracle drug, Gleevec.


Your retirement plan may only be a good one until its next encounter with the enemy.
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We may marry, get divorced or become widowed. Our investment portfolio will likely go up or down, perhaps by a lot at times.

We may experience expense shocks or receive an unexpected inheritance or not receive an expected one. Our expectations of market returns and our risk tolerance can also change.

As I mentioned in a series of posts at The Retirement Cafe, the first step of retirement planning is to define our financial goals. Goals can change dramatically, too. A plan to pay for a grandchild’s college education might change, for instance, when she gets a full ride to her chosen college.

These are all critical inputs to a retirement plan and if they change, your plan should change along with them. Receive a large, unexpected windfall and you may want a new plan. Notice that your savings portfolio is half-depleted after the first five years of retirement and you need a new plan.

Again, this may all seem obvious but when it comes to retirement plans, some of us think, “What the heck, this plan was good enough in 2001 so it’s good enough for today!” Or, “I only need a planner when I retire and I’ll just tweak that plan for the next 30 years.” Or my favorite, “I can safely spend $35,000 this year because that was 4% of my portfolio value when I retired 20 years ago.”

We can think we understand the need to change our plan but plan in ways that belie that understanding.

Some retirees and planners who would agree this is obvious also believe they can determine a safe amount to spend throughout retirement based on their financial situation back when they first retired (the so-called 4% Rule). Liabilities don’t care how much money you used to have—that's last Monday's weather forecast.

They might also believe they can develop a retirement plan today that will at worst need “tweaking” from time to time. That would be a lucky coincidence, indeed. Or, that their estimate of the size of their estate 30 years from now is somehow accurate. Or, that they can know at age 65 what their asset allocation should be when they are 85. So, we can say that changing our plan to accommodate changes in our situation is obviously necessary but plan as if it isn't.

Some important observations can be made when we accept that a rational retiree will change her plans when her goals, resources or expectations change significantly.

The first and most important observation is that retirement planning is a lifelong endeavor.

Plan updates often require more than having a planner calculate a new safe spending amount annually or rebalance your portfolio. The entire plan needs to be reviewed annually or anytime there is a significant change in your goals, resources or expectations.

The good news is that you can change many facets of your retirement plan fairly easily at any time, though some retirement decisions are essentially irreversible. It is difficult in the U.S. to un-buy annuities, for example, but easy to buy more. You can mitigate this by annuitizing in smaller chunks over time. For all practical purposes, you can’t un-claim Social Security benefits (there are limited exceptions).

You probably can’t re-enter the workforce after more than a few retired years with anywhere near your previous pay. You need to make these decisions with great care and understand their irreversible nature.

Choose to spend from an investment portfolio and you probably won’t be able to rebuild it should it become significantly depleted. You might need to take remedial action quickly to avoid a dangerous level of depletion and you often won't be able to take it fast enough. You'll need a new plan.

Most of the other important retirement decisions, however, can be re-made every year. You can even change your strategy. Perhaps as you get older you will become more risk-averse and trade your floor-and-upside strategy for an annuity strategy or more risk-tolerant and invest more in equities.

Being able to substantially revise your plan every year also means it’s never too late to develop a plan if you don’t have one.

Our financial circumstances, goals, and expectations can change dramatically from year to year. It’s irrational to imagine that our plans won't need to change accordingly or that our plan's probability of succeeding hasn’t changed.

Retirement planning is a lifelong process and your current plan may only be a good one until its next encounter with the enemy.


Economist, Zvi Bodie provides a wealth of life-cycle economic, or "safety-first" retirement finance information at ZviBodie.com. Readers who appreciate advice dispensed in video format will find that section quite rewarding. I am especially fond of one of the longer videos (about an hour) entitled "Zvi Bodie on Investing for Retirement."




Monday, February 4, 2019

Honey, What's Our Retirement Plan?

Retirement planning is a complex problem we can simplify by first focusing on what matters most. The key is getting the big decisions right.

[An earlier version of this post appeared at Forbes.com on January 25, 2019.

The "big picture" retirement finance problem definition is straightforward. How can we work for perhaps 40 years to pay our household's living expenses and simultaneously save enough that, when combined with Social Security benefits and pensions, we can maintain our desired standard of living for one to perhaps 35 more years?

Straightforward, but daunting, right?

The most important step, often given too little consideration, is defining the goals and challenges for your unique household (see The Retirement Plan I Would Want - Part 7). Identifying and agreeing your retirement financial goals with your spouse and planner is a critical first step before the financial strategy even comes into play.

Sometimes, one spouse wants a total return investment plan and the other just wants a guaranteed monthly check for life. On occasion, I even find a client who has self-conflicting goals of his or her own, like wanting to maximize retirement spending and leave a large bequest (a perfect example of wanting to have your cake and eat it, too, by the way). It's difficult to solve a problem when no one agrees what the problem is.

Once the goals are resolved, we can attempt to meet them financially. There are many factors we might consider but some are far more important than others.

The most important factor in determining retirement outcomes is how long we will be retired. Nearly anyone can maintain their standard of living throughout a retirement that lasts a year or two but far fewer households could fund one that lasts 40 years.

We can't predict how long a healthy retiree or retired couple will live, what we call "longevity risk," so the safest bet is to plan for a long, expensive retirement. But, you may not want the safest strategy. Perhaps you're willing to take a little more risk hoping to spend more. This should be clearly evident from your agreed goals. If it isn't, your goals need more work. Regardless, there is one inescapable fact: if you spend more you will have more risk.


The key to retirement planning is getting the big decisions right.
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If you're with me so far, then the most important decision of retirement planning—the first "big decision"— is how to deal with longevity risk and that is largely determined by the funding strategy we choose.

Many funding strategies have been proposed in the research literature so even this first step can seem intimidating. Wade Pfau and Jeremy Cooper identified eight proposed strategies ranging from safety-first (expensive but safe) to probability-based (less expensive but riskier)[1]. If you haven't heard of most of them, there are good reasons. Some are too complicated for retirees and advisors to grasp, some are challenging to implement, and some are not broadly palatable, like using a triple-leveraged risky portfolio for the Floor-leverage rule.

How should we choose from this extensive menu? Actually, I suggest that you don't.

I'm going to make a claim that may sound a bit outrageous: there is only one grand retirement-funding strategy. That strategy is to allocate some amount of retirement plan resources to generate a floor of safe lifetime income, to invest the remaining assets, if any, in a risky aspirational portfolio, and then to decide how to spend the risky assets throughout retirement. The correct balance will depend on how willing you are to risk losing your standard of living for the chance of having an even higher one.

We can allocate zero dollars to the floor portfolio, in theory at least, and have a purely total return strategy. In reality, nearly all Americans are eligible for Social Security Benefits or a public pension and will, consequently, have some floor whether they want it or not.

This grand strategy may simply sound like the strategy we call "floor-and-upside" (see Unraveling Retirement Strategies: Floor-and-Upside). But, choose to allocate nothing to the safe income floor portfolio and to spend 4% of the initial value of the risky portfolio and we have a "sustainable withdrawal rate" strategy. Change the "4% of initial portfolio value" spending rule to "4% of remaining portfolio value" or RMD-spending, for example, and we have one of Pfau and Cooper's variable-spending strategies. They're different takes on the single grand strategy.

Retirees who fund part of their spending needs from a risky portfolio will also need a spending strategy. For them, this will be important decision number 1(b).

By making the important decisions first instead of selecting from a list of strategies, you can simplify the planning process. Decide how much risk you are willing to take with your standard of living in exchange for the possibility of improving it and allocate retirement resources to your floor and risky portfolios accordingly. If you decide to fund a risky portfolio, then also decide on a spending strategy that equally fits your risk tolerance.

These decisions will have a far greater impact on your outcome than say, tweaking your equity allocation 5% or worrying about whether equities get safer the longer you hold them. You may find that this process provides a better high-level understanding of your retirement plan. You may even be able to describe the important parts of your plan in a couple of sentences.

"Honey, what's our retirement plan?"

"Glad you asked! Here's the big picture in two sentences. . ."

How sweet would that be?

Identify your goals, get the big decisions right, and your plan will be 80% to 90% of the way home.


REFERENCES

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



[2] The Retirement Plan I Would Want - Part 7, The Retirement Cafe.






Friday, January 25, 2019

When the Market Kicks Like a Mule

Retirees are just now opening their 401(k) statements after an ugly fourth quarter and raising the inevitable question spawned by every significant market decline: should I rush for the exits?

There will be the requisite response from every financial columnist in the country and most will say, "do nothing."

Ah, if life were that easy!

Here's my alternative response. First, what you should do depends on your age and whether you are in your earning years, approaching retirement, early in retirement, or late in retirement. For those still working with at least a decade until planned retirement, "do nothing" is often a good idea. You have many years for the market to recover and to save more.

It might be a good answer for those in the other three life stages, too, but that depends entirely on your financial situation. I wouldn't hazard a suggestion without those details.

Regardless, a significant market downturn can be very educational. During a long bull market, it's easy to decide that you're a risk-taker and that a 25% decline in the S&P500 index wouldn't prompt you to panic-sell at a market bottom. But, you truly understand your risk tolerance only when the decline is actually happening.

My goal for clients is to make them so comfortable with their investments that, like me, they never even think about market downturns. If last quarter's market correction caused you significant anxiety, what it hopefully taught you is that you have too much invested in the stock market. In that case, the correct answer is to sell some of your stocks (as your stomach is trying to tell you to do) and invest the proceeds in something safer, like CDs or a short-term bond fund.

I have about 40% of my portfolio invested in equities so it is unlikely that I will lose more than 15% of my total portfolio in a severe downturn like 2007-2009. A temporary dip of that magnitude wouldn't threaten my standard of living so I ignore downturns.

A friend called this week, noted that her 401(k) had declined in value last quarter and asked what I thought she should do. Some of her colleagues were bailing out of the market but her inclination was to do nothing. She got it right. Perhaps they did, too.

The first question I asked was if she thought she would need to spend the money in her 401(k) investment portfolio anytime soon. Her answer was no, so I told her to ignore the market until she has a need to spend from her portfolio.

If you don't need the money anytime soon, then you needn't care if stocks decline in value temporarily. Those lower prices are what someone would be willing to pay for your stocks today but you're not going to sell them today.

If you have money that you will need to spend in the next 5-7 years, then it shouldn't be invested in stocks. You might be forced to sell stocks at market-bottom prices to pay those expenses before the market has a chance to recover. There is no guarantee that stocks will recover from losses in 5 to 7 years, either, but the odds are pretty good that they will.

Selling stocks and getting back into the market later is called market timing and it is a terrible idea. Research shows that hardly anyone can successfully time the market and investors who try consistently lose money. If you decide to sell because you have too much invested in the market and it's keeping you awake at night, don't be tempted to buy back in during the next bull market. That's a loser's game.

A good retirement plan, by the way, would anticipate market declines and tell you how to deal with them.

Get off the Rolaids Treadmill in two steps. Take any funds you expect to spend in the next 5-7 years out of stocks and put them in a safer place. Then make sure the amount that remains in stocks doesn't exceed your risk tolerance.

As a guideline, investing 40% of your portfolio in stocks would probably result in a 15% portfolio loss in the worst of bear markets compared to a 25% portfolio loss for a 60% stock allocation.

If you lost enough of your portfolio in the recent downturn to cause you pain, don't waste a learning experience. Fix it now. As a Senator from Kentucky likes to say, there's no education in the second kick of a mule.

And that's a record for me—a two-blog post day. You can check out the other at Forbes.com. Now, I need to soak my overworked fingertips (metaphorically) in a glass of something else Kentuckians like to say.



Friday, January 18, 2019

Take Your Best Shot at a Retirement Plan

This column was first posted at Forbes.com on January 11th. I will continue to post here at The Retirement Cafe´and the columns that originate here will tend to more in-depth. I invite you to follow me at both blogs (forbes.com/sites/dirkcotton and theretirementcafe.com) and on Twitter as @Retirement_Cafe. You can receive my posts via email by entering your address in the "Follow by Email" box in the right column.
I've been retired for more than a decade and I'm often asked about my biggest retirement regret. It's an easy call for me. I most regret retiring with an inadequate understanding of the risk I was taking.

It could have been disastrous. Research documents the risk of poor investment returns early in retirement, "sequence of returns risk," and I retired in 2005, just before the Great Recession. A relatively conservative equity exposure and substantial retirement savings saved me and I weathered the storm quite well. Still, I have the lingering feeling that I won a bet without fully understanding the odds.

Sometimes it's better to be lucky than good.

A better description of my mistake is that I was more focused on investment performance than the risk to my standard of living. I've come to understand that retirement planning is, from most perspectives, more risk management than portfolio management, although the latter seems to get all the love.

Retirement planning is often explained in terms of two schools of thought, a probabilist school and a safety-first school. Probabilists focus largely on maximizing portfolio returns and minimizing the probability of a shortfall. In a sense, they try to outrun standard-of-living risk with better portfolio returns.

In the safety-first school, the goal is to first insure the risk of an unacceptable standard of living with annuities, maximized Social Security benefits, TIPS, bond ladders and the like, and only then to pursue greater portfolio returns. For safety-first advocates, almost any probability of a disastrous outcome is too much risk.

We can look at retirement income as a portfolio optimization problem in which we try to sustain or improve our desired standard of living. The downside is that we could make it worse.

Alternatively, we can view it as a risk management problem and try to minimize our risk of losing our standard of living as we age, at the possible cost of limiting our upside. Of course, nothing says we can't choose a goal in between that better fits our risk tolerance, insuring more or less downside and risking more or less upside.

A result of focusing my retirement decision primarily on investing is that it drew my attention from the other risks of retirement, like unexpected expenses. There was a risk that I would have high medical expenses and very expensive health insurance (I did). There was a risk that my adult children would need substantial financial assistance (they did). There was a risk that we would retire into a brutal bear market (we did.) There was a risk that I wouldn't be able to buy affordable long-term care insurance (I can't).

There were dozens of other risks, some manageable, some not, that I didn't consider but would have had I approached my retirement planning more from the perspective of risk management than simply as an investment game.

As I said, I weathered the first decade of my retirement in great shape. Still, I feel a little like a basketball player who took a really poor game-deciding shot and somehow saw it go in.

If I had it to do over, I'd take a better shot.



REFERENCES

Retirement is a Risky Business –– Here's a List, Dirk Cotton.