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[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.


[1] 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]

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 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."