I'm Not Ready for Social Security

My high school classmates will be eligible for Social Security benefits in a year or two. I need to write the rest of this post quickly before that sinks in and I feel old.

Aw, crap. Too late.

The age when you claim Social Security benefits might have a huge impact on your standard of living after you retire.

For some people, it's an easy decision. If you're no longer working and can't get by without the benefits, you should claim them as soon as you can. Since about 95% of American workers haven't been able to save much for retirement, a lot of households won't have to think long about when to claim benefits.

They'll take them as soon as they can get them.

Some people believe that Social Security won't be around for them because conservative politicians will eventually shut it down. But, 2015 will mark the 80th anniversary of the Social Security program and the 79th anniversary of conservatives' efforts to eliminate the program.

Yet, it survives.

Others believe that the “breakeven age” is so high that they're better off claiming early than expecting to live past about age 78. That seems a bizarre argument to me.

Social Security retirement benefits, formally Old Age and Survivors Insurance, are longevity insurance intended to mitigate the risk that you will run out of money when you are very old.

Breakeven is an argument that you don't believe you will live to age 80. Unless you have received bad news from your doctor, I would suggest that you have no idea when you will die and that you need to protect against the cost of living to a ripe old age.

If you don't plan to live a long time and you do, the cost of your lost bet is quite high.

Here's the argument. I know that if I claim early I will be significantly worse off should I live a long time. In fact, I know that my spouse's survivors benefits will be significantly limited if I claim early. But I don't want to die young and leave benefits on the table, so I'm betting I won't live to 80 or beyond.

This is probably the same guy who, at a younger age said, "Buying life insurance is just bettin' against yourself", or in other words, "I'm betting I live a long time." It shows a fundamental lack of understanding of insurance.

I don't imagine many people forgo homeowners insurance because their house probably won't burn down or auto insurance because they're pretty sure they won't have a major accident, yet they're willing to bet old age in the poorhouse that they won't live past 80.

Social Security retirement benefits and the intertwined survivors benefits for married couples can amazingly complex. If you can afford to delay those benefits even a year or so, you have strong financial incentive to do so and you will probably need help with your decision.

You can discuss this with a professional financial advisor, of course, but there are also some excellent websites that can help. One website, MaximizeMySocialSecurity.com (MMSS) is available from the same company that provides E$Planner software. There are other websites, free and not, that I have not tried for the most part. Several are listed in this Wall Street Journal article.

I did try the AARP site. It provided recommendations similar to MMSS, but the inputs are fairly limited. It assumes you will live to your life expectancy, but there is a 50% chance that you will live longer than that. It doesn't let you see what would happen if you live to say, 85 or 90. Nonetheless, it recommends claiming as late as you can.

MMSS, unlike E$Planner, is a website so there is no software to download. You can run it from any web browser on any most hardware platform. It costs $40 the first year with an annual upgrade for $20, but unless your life changes dramatically, a few weeks is probably all you will need.

Next time, I'll show you the results of an actual scenario and what MMSS suggests in my post, "Need Help With Your Social Security Claiming Decision?" You may be amazed at the difference a good decision can make.

Moving the Red Line

In a previous blog, Your Own Personal Fiscal Cliff, I showed that retirement planning is about finding the maximum standard of living you can enjoy during your working years that you can maintain after retiring. That is the green “smoothed-consumption” line from the graph in my previous post that I will reproduce here.

I’ll remove the blue “over-saved” line from this chart to avoid the visual clutter, since I don't think over-saving for retirement is exactly epidemic or that it soon will be. 

I'm defining standard of living as the amount of discretionary spending you can have at a given age. Sometimes I refer to that as your “spending”, or “expenses” or “consumption”, but I mean basically the same thing — how much money you have to spend as you please.

Ideally, we'd like to find the highest (green) line that doesn't move up or down substantially after we retire like the red and blue lines above do. So, how do we move the rightmost portion of the red line up after we retire?

There are several ways. Some move the right half of the red line up by moving the left half down (decreasing our pre-retirement standard of living), but a few don't.

After you retire, you will no longer pay FICA taxes. That money can now increase your standard of living after retirement, moving the right half of the line upward (Spending money on FICA taxes did nothing for your standard of living before you retired.) 

Same goes for amounts you saved for retirement, into your 401(k) for example, on the left side. That ends when you retire. Maybe your taxes will be lower, maybe not. There may be other expenses that go away and that money can now increase your standard of living after retirement.

Social Security benefits and pensions move the right half of the red line upward. The problem with Social Security benefits, though, is that they replace at most 30% of you pre-retirement income. For most households, that will still leave quite a gap to fill.

Delaying your Social Security retirement benefits will increase them about 8% a year. If you can afford to do that, it's the best insurance against a long, expensive retirement.

You may be able to move the right half of the line upward for a while with part-time employment. Be aware, though, that your Social Security benefits will be impacted if you claim before full retirement age (66 for most people nowadays).

The obvious way to move the red line on the right upward is to increase your retirement savings while you're working, but that also lowers the red line on the left — you're saving more so you spend less.

Yet another way to nudge the line upward on the right is to cut your discretionary spending after you retire. Your pre-retirement standard of living might be cheaper somewhere else. And you don't have to move to Ecuador. Property taxes in my hometown of Chapel Hill, NC are far higher than those in Orange County just a couple of miles away, for example.

Of course, if you can't generate enough income after you retire, you will have no choice but to cut expenses and reduce your standard of living. Since Social Security benefits constitute 90% or more of retirement income for many families, that’s going to happen a lot.

Paying off your mortgage might increase your standard of living in retirement, though I would be concerned that you might be tying up a lot of your savings in a way that's difficult to undo. It's harder than you might think to convert home equity into cash after you retire. Banks, for instance, want to see a steady income before they loan money against your home and most retirees don’t have that.

Nonetheless, Professor Laurence Kotlikoff at www.ESPlanner.com says his experience is that paying off the mortgage nearly always increases retirement spending.

It is also worthwhile considering lowering your pre-retirement standard of living, the left half of the red line, so you don't have to move the right half of the line so far. By that I mean buy a reasonably affordable home. Maybe trade cars less often. A lofty standard of living while you're working sets a high hurdle for retirement. Living a little below your means before you retire is probably a great idea.

Before we move on, here is a summary of ways you might increase your standard of living after you retire:

·       Increase retirement savings while you're earning
·       Maintain a reasonable standard of living before you retire
·       Maximize your Social Security retirement benefits
·       Relocate to a place where your standard of living will be cheaper
·       Consider paying off your mortgage
·       Work part time

What is the bigger picture? I'll cover that in my next post.

Please stick with me.

Are There Other Ways to Fund Retirement?

I need your help with something.

I’ve pointed out many times that our retirement funding system simply doesn’t work for most people, and by “most” I mean around 95% of American workers approaching retirement.

On the other hand, I have spoken with many people, some of them clients, who seem to feel fairly secure in their retirement, despite not having been able to save several hundred thousand dollars over their career.

Some of those people inherited money, a home or a farm. Some had a sweet pension deal with their public or private employer. My optometrist loves his job and is still working as he approaches 80.

Others found a home in an area with a very low cost of living. (One retired to Ecuador.)

I’m curious about what other circumstances may have secured retirement for households that weren’t able to accumulate a lot of retirement savings. If you don’t believe that you will have retirement savings exceeding $200,000 by the time you retire, but you feel pretty good about your retirement prospects nonetheless, please add an anonymous (if you wish) comment to this post below.

Please describe in a few sentences why you expect to enjoy a satisfactory retirement despite limited savings.

If you prefer, e-mail your thoughts to me at JDCPlanning@gmail.com.

Maybe your thoughts will inspire someone else in a similar situation.

Thanks!

P.S. Same goes for retirement finance questions you may have. Post a comment to any blog or email me at the address above and I'll get back to you.

Your Own Personal Fiscal Cliff

Each of us faces a personal "fiscal cliff" when we retire. The challenge of avoiding that cliff can perhaps best be shown with a graph of typical lifetime income.

The green columns represent your lifetime earnings and the red columns your lifetime expenses. The problem, of course, is that earnings stop when you retire, but expenses don't. That's only a problem if you live long enough to retire, but it becomes a really big problem if you live to age 95 or 100.

See the earnings after age 65? That's a fiscal cliff.

This may surprise you if you are 25 (I didn't give it a lot of thought back then), but if you live long enough, one day you will no longer be able to work for a living but you will still need to eat.

Economists tell us that we can "smooth consumption" by saving when we have lots of income and borrowing when we have less.  The principal assumption behind consumption smoothing is that people don't want to live royally while they are working if it will mean living as a pauper after they retire. Nor do they want a lavish retirement if it means scrimping for the forty years prior. Instead, the assumption is that people would prefer similar standards of living before and after retiring.

The approach has its limits. No one (except your parents, perhaps) will loan you much money when you are 25 because you expect to earn a lot when you are 55. Also, when you're 25, you haven't saved a lot of money so you can't borrow much from your own savings.

Nonetheless, it seems reasonable that we can smooth our lifetime income to some extent at certain times of our life when we are not "borrowing-constrained".

A good time to smooth our consumption (spending) would be between our working years and our retirement years. Rather than spend all of our money while we are earning it, we could delay some of that consumption until after we retire.

We could save money while we are working so we can spend it after we retire and that reduces our standard of living before we retire. We could also just spend less after we retire, reducing our standard of living when we are older. The idea behind consumption smoothing is that you minimize the differences so you have a decent standard of living before you retire and a similar one after.

If you save too much while you work, you unnecessarily reduce your standard of living before you retire. Save too little, and you see a big decline in your standard of living after you retire.

Even saving enough is an incredible challenge, so I wouldn't worry a lot about saving too much. In retirement planning, the first goal is to avoid the worst case scenarios and that would be saving too little and running out of money before you die. Unfortunately, as I have explained in prior posts, it is nearly impossible to know how much "enough" is.

The challenge, then, is to balance your standard of living before and after retirement while having no good way to predict either. Here's a "save too much" chart, a "save too little" chart", and an "ideal savings" chart.

None of the figures behind these charts is even a little predictable (your lifetime earnings, your lifetime expenses, how long you will live, etc.), but we can use them to see the principles we should establish for paying for our retirement years. Like a lot of things in the field of economics, the models are better at explaining how things work in general than they are at predicting outcomes with any precision.

The idea is that we can lower the red line on the left side of the chart by saving and then spend those savings after we retire, which raises the red line on the right. The closer we bring those two parts of the red line toward the green line in between, the more our standard of living in retirement is like the one we had while we were working.

(It works in reverse for the blue line, which represents the unlikely "oversaving" scenario.)

There is an excellent paper on the subject entitled The Theory of Life-Cycle Saving and Investing by Zvi Bodie if you're interested in a more rigorous explanation. There is also an excellent website and software product ($ESPlanner) created by Professor Laurence Kotlikoff if you'd like to play around with consumption smoothing.

So, in a nutshell, the Standard of Living v. Savings chart above explains retirement planning: finding the maximum standard of living line before retirement that you can sustain after retirement. In other words, to save the amount that moves your consumption close to the green line.

Next, in Moving the Red Line, we'll talk about how to move those lines.

Average Annual Returns Mean Less Than You Think

Ask anyone what stock market returns they should expect and they will quickly respond with something like 8% or 10%. Ask them how they arrived at that number and they will tell you it's the historic market return average, more often than not meaning the S&P 500 index.

The time period we use to calculate that average can have a significant impact on those numbers. Do we measure the real returns since 1871 provided by Robert Shiller of about 6.7% a year? Do we measure from the Great Depression (about 7.5%)? The end of World War II (about 6.5%)? How about the past 50 years (about 7.6%)?

(These are real “after inflation” returns. Nominal returns are about 3% higher.)

No matter how you measure, compound growth rates (CGR) are probably less important than you think.

Market averages tell us how a market index performed over a given time period. There are 1,332 rolling 360-month periods of S&P 500 market returns in the Robert Shiller data from 1871 through 2012. The average real return for those periods was 6.7% a year (8.9% after inflation). But as an individual with a 30-year retirement, you would have lived through only one of those periods.

It might have been one with a 6.7% real return, or it might have been the one with a whopping 11.2% annual return on the right of the chart above. Then again, it might have been the one with the 1.9% annual return on the left. The average doesn't imply as much with a one-time event like an individual retirement. If you lived several hundred lifetimes, 6.7% would be a good bet (but retirement planning would be a bear).

As I showed in recent posts on the topic of sequence of returns risk, a retiree might earn 3% annually and successfully fund thirty years of retirement. But she can also earn an average 7% and go broke in less time. The order of the market returns can be even more important than the average of those returns if you choose to spend down a stock portfolio after you retire.

Lastly, no one earns market index returns over the long run. You will undoubtedly experience lower returns than “the market average”.

If your retirement plan is based solely on expected market return averages, you should probably give it a second look.

Imagine a punch bowl with 1,332 little pieces of folded paper, each with one of those market returns. You get to reach in and pull out a number to decide your fate. 650 of the papers represent returns of 6.5% or greater but 682 are less. 78 are less than 4% and 9 are less than 3%.

You get one turn.

But is investing for retirement really as random as pulling a piece of paper out of a punch bowl?

Yup.

It mostly depends on when you were born.

When to Stop Betting

I have a friend who keeps asking me if the stock market is going up or down. My answer is always, “Yes, it is.”  But he keeps asking.

He never asks in the same way twice. One time it’s, “Should I wait to sell my stocks until after the government shutdown?” Another time it’s, “Should I wait to sell stocks until my portfolio reaches a million dollars?”

I have answered in several different ways, each time explaining that no one knows whether the market is going up or down. No one. Ever.

Oh, everyone guesses and some of them will be right, but no one prognosticator is right consistently. As my grandfather used to say, even a blind chicken finds a kernel of corn now and then.

Once I reminded him that our mutual friend lost his entire savings, four million dollars, a few years before retiring by trying to eke out a few more dollars from his tech stock.

I’ve told him I knew dozens of paper millionaires at AOL who rode their stock options from $102 a share to worthless, convinced the entire way that the stock would recover if they just hung on long enough.

This is probably the most important thing to understand about investing. No one knows where the market is going.

Behavioral finance tells us that we want to believe that we are all above-average investors, like the children in fictional Lake Wobegon. Studies show us that most investors’ returns actually lag the returns of the funds they invest in and no fund consistently beats market averages.

To quote Morningstar, “In fact, in every diversified stock-fund category and all but a handful of sector categories, funds' 10-year investor returns lagged their total returns. The divergence was, in several cases, quite striking.”

The problem, as Morningstar notes, is that investors pick poor times to buy and sell. Fund return averages look better because they never sell.

So, most fund managers under-perform market indices and most investors under-perform the funds they purchase. Yet, we still want to plan retirement based on historical market index returns.

Another thing we want to believe is that there is an intrinsic 8% (or 10% or 12%) return to be had in the market if we just find the right system. Dollar cost averaging, buy and hold, systematic withdrawals. If we believe in the fairy dust, in time we’ll get our 8%.

An analysis by Business Insider, however, shows that since 1871, the stock market has returned an 8% or more annual CGR in only 21% of the 240-month (20-year) periods.

The idea behind dollar cost averaging is that making smaller sales or purchases over time might be safer than making one large bet immediately. That theory was debunked ages ago. You’re better off taking the plunge.

So, will waiting to buy or sell result in a loss or a gain? 

Yes, it will. I just can’t tell you which.

What I keep telling my friend is that the only answerable question is whether he is ready to stop betting.

And only you can answer that.

When You Have Less Money, You Probably Ought to Spend Less

In the late nineties I read about safe withdrawal rates (SWR) and became fascinated by the concept, since I was planning to retire in the next five to ten years at the time.

SWR strategies are the ones you read about in financial magazines, like Money, that say you can invest your retirement portfolio in stocks and safely spend 4.5% of your portfolio’s initial balance annually after you retire. If you retire with $100,000, for example, they say you can safely spend $4,500 every year and your money is likely to last 30 years.

It was an attractive proposition. You could have thirty years of annuity-like payouts and still leave a huge portfolio to your heirs — in a few hypothetical scenarios, at least.

SWR advocates say you can keep spending $4,500 a year even if your stock portfolio plunges in value when the market crashes. (After crashes, they usually say, “Well, we didn’t mean that literally.”)

I think they’re a bad idea, but like dollar-cost averaging, SWR strategies continue to be popular despite loads of studies showing them inferior. Both approaches generate a lot of stock and mutual fund business, so I’ll leave it to you to figure out why Wall Street pushes them.

I not only read about the strategies, I built my own models and monte carlo simulators (I began my career in computer science). I got to know every picky little detail of how they work and, consequently, began to understand the problems with constant-dollar spending strategies.

Soon, I abandoned them. They looked like a dead end to me.

I understood, statistically, how retirement portfolios in the spending phase could reach a tipping point with the SWR strategy and then begin a downward death spiral. As even SWR advocates will tell you, it happens about 5% of the time with constant-dollar withdrawals of 4.5% of the initial portfolio balance.

I never really thought about models that would spend a fixed percentage of remaining portfolio balances each year instead of a constant-dollar amount, but lately I had the opportunity. I was comparing withdrawals of $45,000 a year from a million dollar portfolio (4.5% of initial balance) to withdrawing 4.5% of each year’s remaining portfolio balance.

I used real S&P 500 returns from Robert Shiller’s website to generate rolling 30-year sequences from 1871 to 2008. Nine of these 108 scenarios ran out of money in less than 30 years, for a failure rate of 8.3%, but one lasted 28 years and one 29 years, so let’s round it down to a 6% failure rate and toss a crumb to the SWR crowd.

The thing that surprised me was what happens to percentage-withdrawal portfolios in the scenarios where constant-dollar portfolios fail, the nine in this example.

I guess I always assumed that percentage-withdrawal strategies would also fail, but that they would just keep paying out insignificant percentages of smaller and smaller portfolios. I expected them to fail, just without a clear point of demarcation like you have with constant-dollar strategies. If the economy were bad enough to decimate a constant-withdrawal portfolio, could any other strategy be that much better?

But when I looked at the nine failed scenarios, that isn’t what happened.

Sure, bad stretches of market returns generated lower annual payouts, but making smaller withdrawals when the portfolio was under pressure eased that pressure enough to allow those portfolios to recover. In fact, only one of the portfolios ended up with a value less that $1M after thirty years (see table below) and it held over $870,000.

Strategies that spend a constant amount every year from a stock portfolio, such as the safe withdrawal rates strategy, are quite binary. You either get lucky and fund your entire retirement with a steady stream of income, or you go broke in your dotage.

Percentage-withdrawal strategies don’t provide consistent payouts, but you’re far less likely to end up in the poorhouse. In fact, your chances of leaving that big check for your heirs are better.

Percentage-withdrawal strategies, unlike constant-dollar withdrawal strategies, work on the time-proven financial principle that, after you lose a lot of money, you probably ought to spend less.


Table 1. TPV of 9 Scenarios that
Failed with Fixed Withdrawals

4.5% Withdrawals	$45,000 Withdrawals
$1,251,877	$0
$1,871,837	$0
$1,015,742	$0
$870,190	$0
$1,041,979	$0
$1,447,398	$0
$1,632,138	$0
$2,005,257	$0
$1,254,348	$0

Sequence of Returns Risk: What's That Mean?

My favorite video logo belongs to Far Field Productions and shows up at the end of episodes of the TV series Bones.



After several posts on the subject of sequence of returns (SOR) risk, it's time to tie this subject up in a nice bundle that a normal person (and by that I mean someone who doesn't play around with Mathematica all afternoon for fun) might understand, and to answer the kid's question.

The first thing to know about SOR risk is that you don't have it unless you try to spend down a portfolio of stocks after your retire. (OK, you have it when you're saving to a 401(k) account, too, but it isn't as damaging and there isn't a lot to be done about it). Fixed annuities aren't exposed to SOR risk, and less volatile portfolios that hold bonds, for example, don't have much. A buy-and-hold stock strategy has none.

Assuming you are (or will) try to spend down a stock portfolio after you retire, the thing that you need to know about SOR risk is that average market returns don't tell you everything you need to know about retirement investing. You also need to know the order those market returns will occur.

Here's an example. Looking again at real S&P 500 market returns from 1871 to 2008 provides 108 rolling 30-year scenarios. If we assume a retiree started each of those periods with a million dollars and withdrew $45,000 every year, he or she would go broke in less than thirty years 9 times (8.33% failure rate).

If we graph annualized market returns for those 108 periods against terminal portfolio values (TPV), we find a correlation of only 0.8. (I say "only" because intuition might tell you that average market returns would explain all of the outcome.)

At the bottom left of the chart, you will see that three periods successfully funded 30 years of retirement while averaging only about 3% market return per year. You will also see a portfolio for the period beginning in 1974 that generated a 6.8% annualized market return and failed. (Both circled in red.)

You can win with a 3% average return and lose with a nearly a 7% average. There's no magic here, it's just that the compound growth rate doesn't contain all the information you need to determine if a sequence of returns will lead to successfully funding retirement. 

Look directly above any market return, like 6.8%, and you will find a huge range of terminal portfolio values that resulted from the same average return (one failed and one reached a TPV of $4.6M).

When you are spending down a volatile stock portfolio after retiring, in many cases the annual return doesn't predict whether or not you will succeed (7% and above always worked in this limited sample of 108 periods). The sequence of those returns has a large impact.

If you insist on funding retirement by spending down a stock portfolio, your spending strategy will be based on a constant percentage of remaining portfolio balance or something else. If it's based on "something else", like a constant-dollar spending strategy, your terminal portfolio value will be exposed to SOR risk and you might go broke before you die. This includes SWR strategies.

If you base withdrawals on a percentage of remaining portfolio value, you are less likely to go broke, but your annual payouts will be variable.

If you choose to implement a Safe Withdrawal Rates or other constant-dollar spending strategy, my advice would be the same as in the old joke about the man who tells his doctor, "It hurts when I do this."

Constant-dollar strategies have been repeatedly shown to underperform. Don't do that.

If your advisor tells you that you can withdraw a constant amount from your portfolio after you retire, regardless of how the market performs, get a second opinion. And a third, if necessary.

I suspect that if it weren't for SWR strategies, sequence of return risk would seldom come up. But, when it results in a retiree going broke in old age, as it does with SWR strategies, it gets more attention. 

Best way to avoid the risk? Don't do that.

If you do base spending on a percentage of remaining portfolio balance, you will have varied annual payouts, but you are far less likely to go broke.

No matter what spending strategy you choose, a huge market loss early in retirement will decimate your retirement finances. You should begin to reduce your stock allocation at about age 55 until about age 75 to something like 20% or 30%.

Having read my last few posts on this topic, it would be reasonable to assume that I would advise retirees to spend down stock portfolios based on a percentage of remaining portfolio balance and not one based on constant-dollar withdrawals. But I don't.

I advise retirees to set aside the capital they need to generate enough income to cover non-discretionary spending in a safe TIPs bond ladder or fixed annuities. Then you will have some certainty that you can pay the bills. If you have cash left over, then invest that amount in stocks. None of the three (fixed annuities, TIPs ladders, or buy-and-hold stock portfolios) are exposed to SOR risk.

If you simply must spend down a stock portfolio, then percentage withdrawals of remaining balance are far less expensive and risky.

But, seriously. Don't do that.