Saturday, June 6, 2020

Life Cycle Economics and the Safety First Strategy

Well-read retirees will no doubt recognize the terms "Safety First" and "sustainable withdrawal rates (SWR)". "Safety First" refers to a retirement-spending strategy in which retirees first cover their essential retirement spending needs with assets that have no stock market risk and only then invest in a risky portfolio. SWR or "the probabilist school" as it is sometimes referred includes a strategy primarily based on stock market returns to fund both essential and non-essential retirement spending. The 4% Rule is a probabilist strategy.

The Safety First school is based on well-established Life-Cycle Economics theory that can be traced back to the early 1950s work of Franco Modigliani and his student, Richard Brumberg.  Zvi Bodie, Jonathan Treussard and Paul Willen wrote a discussion paper for the Boston Federal Reserve entitled, "The Theory of Life-Cycle Saving and Investing" that is far more accessible than the relevant economics literature.[1] Still, a lot of us checked out of ECON 101 the first time the professor said, "marginal propensity to consume" so I imagine there are many of us who could use a little extra help.

The authors identify three principles for applying the life-cycle theory to financial planning.

  1. Principle one tells us to focus not on the financial plan itself but "on the consumption profile that it implies.” Consumption equals income less savings during our working years and withdrawals from savings less health expenses in retirement.

  2. Principle two says to view our financial assets as vehicles for moving consumption from one location in the life cycle to another. We can move consumption from our high-earning years to retirement by saving.

  3. Principle three says a dollar is more valuable to an investor when consumption is low. A dollar of income is more valuable to us when we are unemployed, for example, than when we have a high-paying job.

Why should you care about life-cycle economics? It is a theoretical model of retirement finance and a decision-making framework that can serve as a guideline for answering our retirement finance questions. Life-cycle economics is based on Modigliani's observation that people make consumption decisions based on both how much wealth they have today and how much they expect to have in the future. In other words, they desire a consistent standard of living across their entire lifetime.

When a young worker saves some of her earnings in a retirement plan, she is deciding that she may need some of the wealth she could otherwise spend immediately after she retires. Her behavior is consistent with life-cycle economics in that she is considering not only her current spending needs but also deferring some of that spending to her retirement years when she may need it more.

Life-cycle economics can provide guidelines for far more than retirement finance questions. We can use it to decide how much to save, whether to buy insurance or how to finance the purchase of a home. The answer to each question can be different depending on our current position in the life-cycle. It will provide a different answer to the question of how much to save, for example, for a household in early adulthood, middle age, and late working years.

Now we have the basis of life-cycle finance. It's a set of guidelines, a "framework", for making financial decisions based on our stage of the human life cycle, our current financial situation, our expectations of future financial condition and, most importantly, science. Life-cycle economics tells us that our goal should be to maximize our happiness (utility) of consumption (spending) over our lifetime. This is a far different goal than maximizing total portfolio returns as the SWR strategy recommends.

We allocate our current wealth such that our standard of living will be consistent throughout our lifetimes in good times and bad. This provides a framework for making retirement finance decisions. As Bodie, Treussard and Willen state in their discussion paper,"The theory teaches us to view financial assets as vehicles for transferring resources across different times and outcomes over the life cycle."

The following graph from Laurence Kotlikoff's esplanner.com website explains this process. The red line is the household's lifetime maximum sustainable living standard (consumption). The blue curve is lifetime earnings by age.

When earnings exceed the desired standard of living (the blue line is higher than the red), the household saves for future times when earnings may decline (blue line falls below the red). We smooth the peaks into the valleys until we find the highest "sustainable" amount we can spend (Kotlikoff's MaxiFi product makes this complex decision for you.[2])

We allocate our current wealth such that our standard of living will be consistent throughout our lifetimes in good times and bad. This provides a framework for making retirement finance decisions. As Bodie, Treussard and Willen state in their discussion paper,"The theory teaches us to view financial assets as vehicles for transferring resources across different times and outcomes over the life cycle.”


ADDITIONAL READING






REFERENCES

[1] The Theory of Life-Cycle Saving and Investing, Zvi Bodie, Jonathan Treussard and Paul Willen.


[2] Smarter Personal Financial and Retirement Planning Software | MaxiFi Planner, Laurence Kotlikoff.


[3] Risk Less and Prosper, Zvi Bodie and Rachelle Taqqu.


[4] The Future of Life Cycle Saving and Investing, Zvi Bodie, Dennis McLeavey, CFA, and Laurence B. Siegel.


[5] Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement, Wade Pfau.






Friday, April 17, 2020

Some Reading While We Wait

Staying home and social-distancing is a pain but it does have an upside. It creates an opportunity to catch up on reading and perhaps gain a new perspective. The following are some excellent columns and one video that may help pass some of that time profitably.

The video is a nine-minute YouTube explanation of a key economic issue, opportunity cost. It uses a Boston College football game as an example and features Nobel prize winners Robert Solow and Paul Samuelson.

I was also sent a link to Known Unknowns, which author Allison Schrager describes as "a newsletter that is coming to terms with uncertainty." The April 13 issue of Known Unknowns is about making sense of the market and features a discussion with economist, Zvi Bodie. The newsletter is free and you can subscribe (as I did) by supplying an email address at Allison's website, allisonschrager.com.

Don't stop with this issue of the newsletter, follow the links to other columns, like "better understanding of risk and uncertainty", and you will be well rewarded.

Peter Neuwirth provides an excellent column with outstanding writing at Medium.com. I thoroughly enjoyed his recent insightful essay, Making Smart Bets in the Age of COVID-19. The column leans heavily on the studies of Nassim Tabem. A key bit of wisdom can be found in the conclusion, "At the end of the day, we also believe that what is most important is that you be aware of the bets you are making as you are making them, that you become aware of the emotional and cognitive biases that may lead you astray, that you avoid all-in bets when you can, and that you make your life as anti-fragile as you can."

The April 16 issue of the Retirement Income Journal includes a column on the CARES Act by George A. (Sandy) Mackenzie. The author summarizes the column as "an updated summary of the Coronavirus Aid, Relief and Economic Security (CARES) Act, and then turns to the growing debate over how best to aid American small businesses—businesses with less than 500 employees—and their workers."

What am I reading in addition to these?

First, I am reading The Great Influenza: The Story of the Deadliest Pandemic in History by John M. Barry. It not only provides a detailed history of the 1918 "Spanish Flu" epidemic but of the political environment prior to World War I. It is fascinating and one can draw parallels to the current Covid-19 epidemic.

Lastly, unrelated to any of this, I'm reading Agency by William Gibson. Agency explores different timelines in which the last US election and Brexit turned out differently.

There's a lot of good stuff to read out there right now. I hope you find some of these enlightening. Stay safe.

Monday, March 30, 2020

The Question We Should Have Asked All Along

Do I believe there is an unacceptable risk that during my retirement the economy will not look like the recent past but will suffer from a major disruption (a pandemic, 70s-style low stock returns and high inflation, a depression, etc.) that should be considered in my retirement plan?
When planning for retirement, we traditionally assume that the future will look a lot like the past. That isn't a great assumption but it often seems like the only guideline we have.

One of the problems with this approach is recency bias, the human tendency to overemphasize more recent data. Boomers who lived through the high inflation of the 70s think it could happen again; millennials who didn't can't imagine that inflation will ever exceed 3.5% again because it hasn't happened recently. We can't both be right.

Of course, neither cohort lived through the Great Depression so the concept of another depression and deflation doesn't typically creep into either of our thoughts. That doesn't mean it can't happen again, only that we can both suffer from a lack of experience and a failure of imagination.

This creeps into our retirement planning by ignoring a question that we should answer first but haven't bothered to do so in such a long time.

Why don't we ask? Because we intuitively believe that the risk of the future not looking like the recent past, "business as usual", is so low that it can be ignored. We believe that because it has been true for several decades. It's human nature. It's behavioral finance.

This isn't a yes or no question. The question isn't whether we believe the risk of a very different future exists but what probability we assign to it. We might, for example, believe that we probably won't experience a depression but assign a probability of 5% that we will. If 5% meets our risk tolerance threshold, we might decide in the spirit of taking the worst-case outcomes off the table that our retirement plan should address the possibility. If we're comfortable with a nineteen-in-twenty (95%) probability that it won't happen then we can build our retirement plan around the assumption that the future will look like the past.

The "D" word has become much more prevalent in the past month.

Economist, Laurence Kotlikoff, believes a depression is certainly possible.

"We have absolutely no game plan that will make any day of the next year look any better than today. Instead, we can expect each passing day to look worse thanks to all the layoffs and bankruptcies coming down the road."

He has posted a number of columns on the topic at his website that I urge you to read, perhaps beginning with "My Stock Tip –– Sell".  (I also recommend a more recent Kotlikoff column in REFERENCES below.)

As one would expect when dealing with opinions about the future, other economists are not as convinced that a depression is imminent or the most likely outcome, though most I have spoken with lately don't rule it out and that is the important takeaway.

If a depression develops, then the best "risky portfolio" will not be stocks but, as Kotlikoff recommends, T bills are good, TIPS are safe. Inflation and long rates will go up. He also recommends shorting long Treasury bonds, though short sales can be challenging for the typical retired household.

Personally, I have no idea whether we are looking at a "business as usual" serious market decline and an 11-month recession or a depression. (An MIT Sloan study places the odds of a recession in the this year at a whopping 70%.) I only know that I now consider the risk of the latter as non-trivial and that I need to address that possibility in my retirement plan. You, of course, may not feel the same.

If you do now believe that a depression isn't out of the question then you may have the wrong retirement plan based on the assumption that the future always looks like the past.

Michael Finke, PhD, at The American College of Financial Services, writes an excellent piece entitled, "How Financial Plans Must Adapt to Market Crashes", at Advisor Perspectives. To quote Finke, "If the advisor decides not to course-correct because of faith that equity markets are going to “bounce back,” then they are guilty of subjecting their client to expectations that no longer match their current reality."

A key issue that you will need to address is your human capital. A well-paid 40-year old tenured university professor, for example, can take tolerate a lot more financial risk than someone who is already retired and has no human capital. Economist Zvi Bodie is the expert on this topic. If human capital is an unfamiliar term, a good place to start is Bodie's column entitled, "The Impact of Human Capital on Retirement Savings" or a little more detailed explanation entitled, "Retirement Investing: A New Approach".
 
Let me say again, I am not predicting a depression. I am only suggesting that it isn't an unreasonable outcome to consider in your retirement plan.

What to do now? If the risk of a severe economic downturn is one you feel you can tolerate, then stay the course with the traditional retirement plan advice. If, like me, you can't tolerate the risk of losing a funded retirement, then consider making changes to your portfolio that let you sleep at night. Since neither of us can predict the future, it largely boils down to your personal risk tolerance, risk capacity and human capital.

The first question we should have asked all along is whether we believe there is an unacceptable risk of a future that doesn't look like the recent past. Unfortunately, decades of good times taught us that the answer was always no.

I don't think that's a question we can simply ignore any longer.




REFERENCES

Group Testing Is Our Surefire Secret Weapon Against Coronavirus, a more recent post from Kotlikoff, recommends a strategy to "save potentially millions of lives and immediately restart the economy", exploring the inextricable link between the Covid-19 pandemic and our economic outlook.  




Monday, March 16, 2020

How to Score Free Ben and Jerry's as a Retirement Planner

I recently received an email from a retired couple I work with noting that the market had fallen 20% at that point and asking what they should do. The wife admitted that she was beginning to feel a bit anxious.

"You actually don't need to do anything", I replied.

"The market is down 20% but your portfolio is only down about 6% because a lot of your portfolio is in I Bonds and TIPS bonds. The annuity we purchased isn't subject to market risk, either, nor are your Social Security benefits, and those two pay most of your living expenses. The remainder is a small draw from your portfolio. So your spending hasn't been impacted and the market will eventually recover. So, why the seeds of panic?"

I assume the reply helped because the couple shipped me five quarts of Ben and Jerry's. (Who knew you could ship Ben and Jerry's?! Is this a great country or what?)[1]

The stock market has gone from raging bull to a bear market (roughly defined as a 20% decline or greater from a recent high) in just a few weeks. We recently experienced the longest bull market in history, so bear markets will come as a shock to many who have never experienced one but this is the way they work. The market drops precipitously. Life in the market seems grand and all of a sudden you’re trying to “catch a falling knife.”

I’d like to offer some perspective without the typical “stay the course” bromides that you can find anywhere, though I agree that’s good advice at this point.

First, you may have noticed that your risk tolerance has fallen as fast as the market. This is normal. During a roaring bull market, we have the feeling that we can tolerate a lot more risk than we feel we can tolerate during a bear market. It's human nature. Now is the time to reassess your risk tolerance, not during a sunny bull market. If you feel panic then your stock allocation is likely too high. Now is the time to adjust that for the next bear — you’re too late for this one.

Let's delve a bit deeper into why this couple is not panicking and I'm scoring ice cream big time.

Let’s say that before our mutual planning sessions a recently-retired couple had saved $1.5M in their two IRA accounts. The wife is quite risk-averse; the husband less so but strongly focused on ensuring that his wife is comfortable with their finances. Before planning, they owned mostly stocks and bonds but had no idea what they owned, why they owned it, or how much of each they owned. (I see this frequently, by the way.) Let’s guess they owned 50% equities and 50% bonds.

When the market fell 20%, their portfolio would have fallen about 10% or 11% with a 50% equity allocation (bond returns minus stock losses). Not nearly as frightening. That $1.5M would have been reduced to about $1.35M simply due to a less risky asset allocation.

But they had better news. To reduce risk to meet the wife’s risk tolerance, we had purchased a single premium income annuity (SPIA) with about $500K. The SPIA, when combined with joint Social Security retirement benefits, pays most of their living expenses and reduces the spending rate from their IRA’s to about 3% — a very sustainable draw.

A chart of 2020 year-to-date S&P 500 returns is fairly ugly right now, as you can see below from the chart of the Vanguard S&P 500 index fund VFINX produced at Morningstar.com. Hopefully, as a retiree, you weren’t 100% invested in stocks. If your portfolio were perhaps 50% stocks and 50% bonds, for example, before the bear, then your losses would be about 10% or 11%.


Also as a retiree, your investment horizon is a lot longer than one calendar quarter. So, let’s jump in Mr. Peabody’s Way-Back Machine and look at market returns from the beginning of this bull market, or right after the Great Recession that began in the fourth calendar quarter of 2007 with S&P500 market losses exceeding 50% by first quarter 2009. As the following chart shows, market returns since early 2009 have been fantastic.


(Also note that your recent losses occurred after an 11-year holding period, which belies the argument that stocks get safer the longer you hold them. The proper metric for retirement portfolio risk is terminal portfolio value, not annualized volatility. The range of possible portfolio value outcomes gets larger, not smaller, with time.)

I’m not going to suggest that you ignore the fear that comes with a precipitous market decline any more than I would ask you to stop touching your face or not see an elephant in your mind’s eye right now. There are some behaviors we simply can’t adopt.

Nor will I suggest, as many do, that “this is a perfect time to buy stocks”. Maybe it is and maybe it isn’t but market timing doesn’t work. Stocks are cheaper than they were last month but they may be cheaper still in the near future. Or not. No one really knows.

Interest rates are equally unpredictable. A year ago, many advisors would have recommended that retirees not purchase annuities given then historically low interest rates of a few percentage points. Overnight, rates are now near zero and that previously-purchased annuity looks pretty good. If you're trying to predict stock market prices or interest rates you're playing a loser's game.

What I do suggest is that you consider a longer perspective of market returns and realize that you were way ahead before you gave some back. Rebalance your portfolio once a year or so but only if your allocation is off by about 10% or more.

A reader emailed me not long ago to say that her advisor wanted her to sell stocks, incurring fees and taxes, because her asset allocation was off by a couple of percentage points. That’s pure folly. No one knows exactly what their asset allocation should be but it is a cinch that we can’t know it within a couple of percent.

According to CNBC[3], had you invested $10,000 in an S&P 500 index fund when the bull began in 2009, that investment would be worth about $45,800. Of course, you probably weren't 100% invested in equities so your portfolio return was lower but you’re still ahead of the game.

More importantly, because your portfolio probably wasn’t invested 100% in equities, especially if you follow my blog, your losses should be much less. My example retired couple lost only about 7% when the market fell 20% because we had set up an investment strategy that matches their risk tolerance. Not fun but certainly tolerable.

Purchasing a SPIA with some of your savings also removes market risk exposure and ensures lifetime income to pay your living expenses. That may help you invest the remainder of your portfolio more aggressively without causing too much angst.  Remember when you hear that the S&P 500 has fallen X percent that a properly positioned portfolio has fallen only a fraction of that. (The same is true when the market rises X percent.)

Lastly, reconsider your risk tolerance and plan to make any changes to your target asset allocation that will help you sleep through these occasional bear market. It’s too late to do anything more about this one. I haven’t even looked at my portfolio since my annual review last December and have no plans to do so. If you, too, can reach that point then your planner has done a great job.

I’m pretty happy with mine.


REFERENCES

[1] How to Order Ben & Jerry’s Ice Cream Online | Ben & Jerry’s

[2] The market's 10-year run became the best bull market ever this month

[3] S&P 500 Return Calculator, with Dividend Reinvestment