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.
[Tweet this]


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.
[Tweet this]


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.