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.

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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.

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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.

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.

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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.

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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."

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.

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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.

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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.

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.

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.

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REFERENCES

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

Lessons from 2018

Retirement finance is my hobby. I find it has two great rewards: helping people who can’t find affordable retirement advice and learning new stuff.

OK, sometimes there are other rewards. A retiring college professor insisted on paying me for her retirement plan so I negotiated dinner with her at a new pizza place I had wanted to try. (Yes, I work for pizza.) A podcast producer interviewed me and afterward sent a really nice set of engraved kitchen knives. My wife is an amazing cook. She is also an MBA but opening those knives was the first time in two decades that she has shown any interest whatsoever in my retirement planning hobby.

Back to learning stuff, I’ll wrap up the year by sharing a few of the things I learned in 2018 that you might find useful.

I spent most of this year co-authoring research with Neville Frances, a UNC econometrician. The first thing I learned was that a research project can take four times as long as you expect and dramatically impact the amount of time you have to write blog posts. I hope to do much better next year.

I learned that a lot of poor research is published. I was already aware that a lot of excellent research is available in the retirement finance field but also a lot that is questionable. When I discussed this with my co-author, he shrugged and told me that’s true of all of economics. So, I checked with my son, a medical researcher. He confirmed that he runs across a lot of junk in that field, too.

If you read something in a peer-reviewed journal, be skeptical. If you read it elsewhere, be very skeptical. I’m planning a column on the topic for early next year but Francois Gadenne has already published his thoughts.[1]

Most papers are essentially arguments. I find one of the problems with reading papers is that many people can’t logically deconstruct an argument. I read a paper this year, for example, that made several claims but provided no evidence to support any of them. If the basic argument is flawed then discount the research.

If you’re interested in analyzing arguments, my friend, Dr. Walter Sinnott-Armstrong, created an excellent, free video class at Duke University[2] and he has written a couple of books on the topic with Think Again perhaps the more readable.[3,4]

I learned the extent to which sustainable withdrawal rate (SWR) is explained by sequence of returns as opposed to the portfolio returns, themselves. "Big Ern" at EarlyRetirementNow.com found a convincing way to explain it.[5] He found that "knowing only the average returns over the next 30 years is not very informative."

But he also found that for a 30-year retirement, nearly all (close to 96%) of the variation in the sustainable withdrawal rate is explained by the average returns of six five-year windows. The average return for years 0 to 5 explains about 29% of SWR variance and the average return for years 5 to 10 explains another 19%. Explanatory power declines further in subsequent windows and totals about 0.96.

(If terms like "regression testing" and "R-squared" don't frighten you away, I highly recommend the post or any other on his blog.)

The simple takeaway here is that when you spend from a volatile portfolio, the long-term returns matter very little compared to the sequence of those returns. Don't worry about whether your portfolio will earn an average 8% a year but about when the bad years will occur. (Later is better.)

This doesn't mean, however, that once we survive the first five years of retirement sequence risk goes away.

I used Ern’s spreadsheet to estimate that returns for the first four years of a retirement with 20 years remaining have about the same explanatory power as the returns for the first five years when 30 years remain. The explanatory power of the returns for the first two years of a retirement with 10 years remaining is about the same as these. Sequence risk becomes “compressed” but it never goes away entirely.

If we successfully navigate the first five years of portfolio returns then we still have to negotiate the next five and eventually the next two. There's no reason to expect that if you make it through the first 5 years of retirement that your risk will simply disappear.

I learned that many Monte Carlo models are poorly designed. I also learned that many advisors who use them don’t really understand the technique and by the time they explain the results to the typical client, most of its value is lost. Although I still consider MC an extremely valuable tool, I'm now cautious about recommending it because I'm not confident that it will be used and interpreted correctly.

I learned from Zvi Bodie that probability of ruin (or probability of shortfall) is a problematic metric not only because it measures the probability of a shortfall while ignoring the magnitude of the loss but also because it ignores utility. He explained this in terms of Arrow-Debreu contingent claim state prices, which probably makes as much sense to my readers as it did to me when I first read his explanation.[6] I had to learn about Arrow-Debreu before I could even have a discussion. A-D won't interest normal people but I found it pretty exciting. It even gave me some insight into the Black-Scholes model.

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Having less confidence when I retired would have served me well.

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Simultaneously, I was learning a great deal about MC from my econometrician co-author and it became clear from our work that using MC to measure probability of ruin has even more problems than using the historical probability of ruin. (Probability of ruin isn't a "robust" model metric.)  We don't understand the process that determines the sequences and we don't have enough independent 30-year historical sequences to provide insight, so we don't really know how to model sequence of returns. In turn, I no longer have confidence in analyses that measure Monte Carlo model results using probability of ruin as the metric.

I learned that there is no consensus among economists as to whether stock returns mean-revert or, even if they do, if that would imply that stocks become safer the longer we hold them. (See Mean Reversion of Equity Returns and Retirement Planning.)

Lastly, I learned that I'm not the only one concerned about retirement planning for unwealthy households. Wade Pfau, Steve Vernon and Joe Tomlinson addressed this problem in a hefty tome entitled, "Optimizing Retirement Income by Integrating Retirement Plans, IRAs and Home Equity." You might want to read Vernon's shorter discussion of part of this work referred to as the "Spend Safely in Retirement Strategy" here[7] in which he concludes:

The "Spend Safely in Retirement" strategy represents a straightforward way for middle-income workers with between $100,000 and $1 million in savings to generate a stream of lifetime retirement income without purchasing an annuity and without significant involvement from financial advisers. This group might represent as many as half of all workers age 55 and older.  

This is hardly an ideal retirement finance strategy but retirees with limited resources and no access to a good financial adviser might have difficulty finding a better one and I think that was the goal.

So, that's some of the important stuff I learned in 2018. Ironically, the more I learn about retirement finance the less certain I become about what I thought I knew. Being less confident back when I retired would have served me well.

Wishing you a happy and enlightening 2019!

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REFERENCES

[1] How to Read Research Papers With a Discerning Eye: Take the Best and Leave the Rest by Francois Gadenne.



[2] Think Again I: How to Understand Arguments, Coursera.



[3] Understanding Arguments by Walter Sinnott-Armstrong.



[4] Think Again by Walter Sinnott-Armstrong.



[5] The Ultimate Guide to Safe Withdrawal Rates – Part 15: More Thoughts on Sequence of Return Risk, EarlyRetirementNow.com



[6] An Analysis of Investment Advice to Retirement Plan Participants by Zvi Bodie. (see footnote 10)



[7] Meet the "Safe Spending in Retirement Strategy" by Steve Vernon.

My Year-End Review and Planning Regime

I am frequently asked how I manage my own retirement finances. Retired households can have dramatically different financial situations so my regime won’t work for everyone but it does demonstrate some of my retirement finance philosophies.

It amazes me to learn how often some people check their portfolio balance. Weekly or even daily? Are you just looking for something to stress about?

I check my portfolio balance about once a year, usually in December. I have a 40% equity allocation, so if the market declines 10%, my portfolio declines about 3% or 4%. For me, that's clearly in the “who cares” zone.

(My portfolio fell 15% during the Great Recession. I cared, but I never considered selling.)

About 70% of my wealth is contained in my portfolio, so a 4% decline in my portfolio value represents about 2.8% of my wealth, which crosses the line into “why did I bother looking” territory. I check my net worth a lot more often than my portfolio value, maybe once every couple of months. (You can link accounts at Yodlee.com or most large investment service websites, like Vanguard, to check your net worth in less than a minute.)

Viewing portfolio losses as a percentage of your net worth can be a lot less scary than looking at portfolio losses in absolute dollars.

Frequent portfolio checking may be a sign of an equity allocation that exceeds your risk tolerance.

When I do check my portfolio balance I also check my asset allocation, though I rarely do anything about it. In thirteen years of retirement, I have rebalanced perhaps three times. One of those times was a year in which I paid off a large mortgage balance, significantly changing my asset allocation. The other two times were years in which I took advantage of some tax-harvesting opportunities. I only "tax harvest" when I have equities I no longer want to own.

Given all the studies and advice regarding the advantages of rebalancing, why am I so nonchalant about my asset allocation? First, I recall reading a William Bernstein post that said there’s a good argument for never rebalancing.

Second, I am cognizant of my short-term risk tolerance. Were I told that my optimal asset allocation was 80% equities, for example, I would ignore that advice because I know that I can’t stomach the short-term volatility of an 80% equity portfolio.

Third, I have a strong safety-net, or "floor", so market crashes are less likely to lower my standard of living.

Lastly, let’s talk about “optimal asset allocation.” Gordon Irlam published a study[1] in which he noted that, while it would be tremendously helpful to know the optimal allocation, his estimate of the 95th percentile confidence interval for equity allocation was roughly between 10% and 80%. Based on that analysis, I can’t know with any certainty at all whether rebalancing would move me closer or farther from optimal. Tweaking an asset allocation within 5% tolerance is, I believe, an example of the massive overconfidence prevalent in many areas of retirement planning. We feel certain about things that aren’t certain, at all.

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My year-end review and planning regime.

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Another important part of my end-of-year regime is reviewing my overall expenses and comparing them to my previous year’s budget. I do this largely to check for trends but I don’t believe expenses in retirement are very predictable.

Recurring expenses are somewhat predictable, though David Blanchett, who publishes extensive research on retirement spending, tells me that there is significant volatility in year-to-year retirement spending. Include spending shocks and expenses aren’t predictable at all.

Spending shocks are by definition low-probability events. Nassem Taleb tells us (and, in fact, told Congress[2]) that low-probability events are simply unpredictable. Last December, for example, I didn’t expect to have to replace two HVAC systems and a car this year. I expected to paint my house but wasn’t prepared for the extensive carpentry repairs that painters would find I needed. I didn’t expect to have substantial uninsured medical bills.

I have learned to expect significant unplanned expenses. Those who think they can predict retirement spending are, again, overconfident.

Once I review previous year spending, planned spending for the coming year, and my portfolio allocation, I recalculate a  budgetary spending amount for the coming year, knowing that if a storm takes off my roof I will have it repaired and if a child has uninsured medical expenses I will pay them, budgeted or not.

This annual recalculation of spending risk is a basic concept. Regardless of what the 4% Rule suggests that you can spend every year of retirement, the actual "safe-spending" amount varies up and down, often significantly, depending on your market returns, unexpected expenses, marital status, and age. There is no reasonable fixed amount that you can safely spend throughout retirement from a volatile portfolio.

Unfortunately, this notion has been accepted by many retirees. I overheard two college profs discussing retirement one morning at my local coffee shop. One declared that she simply had no idea how much of her retirement savings she could spend. The other replied, “It’s simple. Just spend 4%.”

It’s simple but wrong. Retirement finance has no cruise control.

Mention end-of-year planning and most people immediately think of taxes. I have always found tax-planning to be more tactical than strategic because you never know when Congress will make major changes to the tax code, as they did in 2017, and destroy your plans.

In the past, I have used excess deductions to generate tax-free or low-tax Roth conversions in December. After my taxes were calculated the following spring, I would recharacterize any part of the conversion that generated more tax. Recharacterization is no longer allowed but the rest of the tactic is still viable if you are careful not to "over-convert." You can no longer put money back into your IRA the following year.

I estimate my taxes with a calculator called “TAXSIM” provided by NBER.[3]

That’s basically my end-of-year regime. It isn’t very complicated but it works for me. I also record my data to compare to next year’s results.

I don't spend hours and hours on my year-end reviews and planning because I know that any answer I produce will be at best an educated guess that will need to be updated next December. The critical factors of my plan are largely unpredictable – how long I will live, my health, market returns, and expenses.

I don't lose sleep over market declines or check my portfolio balance excessively because my portfolio reflects my risk tolerance.

If any of these are problems for you, then you might need a more suitable retirement plan.

Either way, enjoy the holidays!

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REFERENCES

[1] Asset Allocation Confidence Intervals in Retirement, by Gordon Irlam.



[2] 2011 Congressional Testimony, Nassem Taleb.



[3] Internet TAXSIM Version 27, National Bureau of Economic Research.

Mean Reversion of Equity Returns and Retirement Planning

Do stock returns exhibit long-term mean reversion? That's an economist's way of asking if stocks get safer the longer we hold them.

Long-term mean reversion would act like a spring returning prices back to a trend line when they advance above that trend or fall below it. The strength of this spring is referred to as its "half-life", the time it would take to recover half of a loss or — often conveniently overlooked — how long it would take to lose half of a gain.

A Society of Actuaries report[6] from 2014 states:

"In a survey by Ivo Welch (UCLA and Yale) in 2000, only 36 of 102 surveyed financial economists said that they believed in long-term mean reversion for stock returns (17 had no opinion and 49 did not believe). "

Among those economists who believe mean-reversion exists, a common half-life is believed to be about 17 years. The longer the half-life, the weaker the effect.

This is an important question for investors because, if stock returns do mean-revert in the long run then stocks are a little less volatile on an annualized basis than a random walk would imply.

As retirees, we have to ask some follow-up questions beyond whether stock returns mean-revert. Does mean reversion equate to less risk? If we believe they do mean-revert, what impact would that process have on retirement plans? How would its impact compare to other factors of retirement planning? How should a retiree bet on mean reversion?

Let's look at the big question first. Do stock returns exhibit long-term mean reversion? Despite extensive research for decades, there is no consensus among economists.

Daniel Mayost of the Office of the Superintendent of Financial Institutions Canada wrote a nice review[1] of the seminal research on the topic in which he concludes,

"The claim that equity returns revert to the mean over the long term is not completely unfounded, and cannot be dismissed out of hand. However, there is at least as much evidence to refute this claim as there is to support it, and there is certainly no consensus answer within the economics profession."

Well said. So, a definite "maybe."

Despite the lack of consensus, many stock traders have developed strategies to attempt to profit from mean reversion of equity returns. Do the strategies work? They probably do, sometimes, if for no other reason than because nearly all strategies will work sometimes.

James Davis, VP of Research at Dimensional, studied the prospects for trading strategies and found that "Evidence of mean reversion is weak, and 780 simulated trading strategies show very limited evidence of reliably positive abnormal returns [profits]."[2]

If we assume that equity returns do mean-revert, how would that impact a retirement plan?

Many have the impression that the mean-reversion "spring" only pushes below-average returns back up toward the underlying average after a market decline. If you read my explanation above carefully, however, you will note that it would also push higher-than-average returns back down toward the average in the future.

That means that long-term mean-reversion might help or hurt retirement finances depending on initial conditions. When returns have been low for a long time, we would expect mean-reversion to slowly lift returns in the future back toward a growth trend line. But if they have been high for a long time, we should expect it to slowly push them lower toward that trend line. It would help when we're below the line and hurt when we're above it, keeping in mind that we don't really know where the line is or, more importantly, where it will be. (In the example below, the red line was added by the author.)

  Created at MacroTrends

Commenting on the CAPE 10 equity valuation measure's level of 34, Larry Swedroe recently wrote[3],

"The concern about future returns is justified by the fact that, while the academic research shows valuations are an extremely poor forecaster of stock returns in the short term, they are the best predictor of long-term returns. A CAPE 10 of 34 translates into a real-return forecast for U.S. stocks of just less than 3%. Add in 2 percentage points for expected inflation and you get a nominal return of about 5%, half the size of the historical return."

If the market is currently highly valued, as the CAPE 10 seems to suggest, mean-reversion implies that future returns are more likely to trend downward back to the mean. So, presently, mean reversion suggests less annualized uncertainty (risk) about an expected return that is likely to be smaller — less risk but a lower expected return. Mean-reversion isn't always a winner.

The popularity of the concept of stock risk declining with time grew with Jeremy Siegel's Stocks for the Long Run[4]. Siegel noted that over long periods of time, stocks do seem to be safer than a random walk would imply.

Economist, Zvi Bodie argues vehemently that stocks are risky no matter how long we hold them. He demonstrates with the following charts that the annual compound risk measured by variance of returns does, in fact, decline with time, as statistics predicts.

But Bodie argues that annual volatility is less a concern for retirees than the uncertainty of terminal portfolio values, which continues to increase with time.

Bodie further argues that if stocks become safer with longer holding times, then the cost of insuring against a loss should also decline. (Please see Dr. Bodie's further qualification in the first comment below.) We can insure against stock losses by purchasing a put option but puts become more expensive as their expiration date extends into the future, not cheaper.

(If you are unfamiliar with options, a put option, or "put", is a contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time frame. If you want to ensure that you will be able to sell a stock or index for at least some price in the future, for instance, you may be able to purchase a put to do just that. Be forewarned, however, that this insurance can be quite expensive. An excellent chapter on options can be found in Bodie and Merton's Financial Economics, 2e[8].)

Bodie and Siegel are brilliant economists and each score a point or two, but like the broader population of economists, they ultimately disagree. (Here is a transcript of a fun debate between Bodie and Siegel on the topic.[5])

You can also find papers that argue that one or the other's argument is flawed. These aren't arguments about the existence of mean reversion, however. They're arguments about the quality of the arguments about the existence of mean reversion in equity returns. You can chase the issue all over the Internet and you will always end up with "there is some evidence it exists." The problem is that we have too little historical data to argue with any certainty.

There is also a behavioral aspect that could affect retirement plans. Retirees who choose to believe that stocks get safer with holding time might choose a higher equity allocation with little actual evidence to support that decision.

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Mean reversion and retirement plans — don't be so sure.

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Next, let's consider how mean reversion of equity prices might impact retirement plans compared to other factors of retirement planning.

Retirement plans entail massive uncertainty. The greatest risk is longevity, in that nearly everyone could fund a one-year retirement but far fewer of us could fund one of thirty-five years. I'd rank expense risk second, as a catastrophic expense would destroy most plans. Market returns are extremely unpredictable, as are interest rates but, of course, that's only important to retirees heavily dependent upon stock investments for retirement income.

The amount of retirement risk explained by long-term mean reversion would likely be quite small compared to these. I've read postings from other researchers who played around with mean reversion in their retirement models until they realized that any risk-reducing effects were swamped by the huge remaining retirement risks. That's one of the reasons I don't bother modeling long-term mean reversion — along with the fact that I don't know if it exists or how powerful it might be, so I'm not sure what I would model. (Regardless of what you've read, Monte Carlo models can be built with mean-reverting processes.)

My final question is "how should a retiree bet on mean reversion of equity prices?"

Mayost addresses this point for the bank when he states,

"Given the large reduction in segregated fund guarantee reserve and capital requirements that would result from assuming mean reversion in equity returns, it would not be prudent for OSFI to approve equity return models that are based on the assumption of mean reversion without strong evidence that mean reversion actually occurs in the market and is likely to continue in the future. The current state of research does not provide such evidence to a sufficiently high degree of certainty.

That's a long way of saying, "No one seems to know but it would be imprudent to bet that equity returns mean-revert without stronger evidence."

I believe retirement planners have little to gain by betting that mean reversion exists unless and until research resolves the issue. (The issue has been around for a long time and it could be a thousand years before we have enough data.) There is significantly more downside to incorrectly guessing there is less risk than there is to incorrectly guessing there is more risk.

To summarize for those of you planning retirement who aren't interested in reading dozens of papers on long-term mean reversion of equity prices that come to significantly different conclusions with no consensus, I suggest the following.

As DeNiro said in Donnie Brasco, "Fuggedaboutit."

Do stocks get safer the longer you own them? There is some evidence that they might and some evidence that they don't. Do you want to bet your retirement on that?

As a retirement planner, I care far less about whether or not equity returns may mean-revert over a couple of decades than I care about how mean reversion, whether or not it exists, might affect my retirement plan. In other words, is it something I need to worry about?

There is no consensus among economists regarding how powerful mean-reversion of equity returns might be or if it even exists.  The only thing you can know for sure is that whether you believe stocks mean-revert or not, there is a really good argument that you are wrong.

(Note the lack of consensus among economists compared to the number of retirees and advisors who claim to know with certainty that it does exist.)

The evidence supporting mean-reversion of equity prices is somewhat weak, as the mean-reversion force also appears to be.

It is debatable (literally[5]) whether mean-reverting equity prices would actually mean that stocks get safer with holding time. It depends on whether you define "safer" as less annualized portfolio volatility or as a narrower range of possible wealth-generation.

Whether or not stocks get a little safer on an annualized basis the longer you hold them is unlikely to have a large impact on your retirement plan. Your plan contains far more risk than mean-reversion would explain and those risks are where you should spend your planning time.

There are actually two larger issues here. First is how much of our planning efforts we should spend on factors that will probably have little impact on our retirement plans. And second, there is a real risk in feeling "certain" about assumptions that actually have limited supporting evidence.

The most important thing I have learned from two decades of studying retirement finance is how little I know for certain. Unfortunately, overconfidence extends to many retirement planning assumptions beyond the nature of mean reversion of equity returns.

I once had a conversation with a healthy 60-year old client about claiming Social Security benefits and he assured me with great confidence that he would never see age 80.



REFERENCES

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[1] Evidence for Mean Reversion in Equity Prices, Mayost, D., 2012.



[2] Mean Reversion in the Dimensions of Expected Stock Returns, James Davis, Dimensional.



[3] Seeing Valuations Clearly, Larry Swedroe.



[4] Stocks for the Long Run, Jeremy Siegel.



[5] The Great Debate, Siegel and Bodie.



[6] Simulation of Long-Term Stock Returns: Fat-Tails and Mean Reversion, Rowland Davis.




[7] Are Stocks Really Less Volatile in the Long Run?, Pastor and Stambaugh. See also, video interview with Lubos Pastor.



[8] Financial Economics, Bodie and Merton.

HITBLITS: Charles Barkley and Saving for Retirement

"I'm a HITBLIT", Charles Barkley, in the waning days of his NBA career, told his interviewer.

"A HITBLIT?" the reporter asked.

"Yes, that stands for had it. . . but lost it", the aging Round Mound of Rebound explained with a laugh.

Having it and losing it seems to be heavy on the minds of many near-retirees who see record equity prices and who have lived long enough to know that bull markets don't last forever. They can end very badly. Severe bear markets near a retirement date can delay retirement plans and even permanently lower a standard of living in retirement.

Robert Powell recently wrote at The Street[1] regarding a subscriber who asked, "What is the best thing to do with a 401(k) if the market keeps crashing or we go into another recession when I only have a few more years to go before retiring? I need to minimize losses at this point."

Two things we can be relatively sure about are that the market will keep crashing and that there will be another recession. Bear markets often overlap with recessions but not always, as the following chart from Capital Economics[4] shows.

Powell responded to the question with answers from a number of retirement advisers (including yours truly). It's a nice piece and you can read it at the link below but I can distill the essence of the advice.

Don't gamble more than you can afford to lose.

"Once you win the game, stop playing", William Bernstein advised about saving for retirement. I don't believe, as some have suggested, that he means that you should stop investing in stocks once you've funded retirement. I think he's making a more subtle point about utility, a measure of the satisfaction we receive from consuming goods and services.

If you have an income of $1,000 and you receive an additional $100, the additional consumption that a hundred bucks enables would probably make you happy. It would probably make you much happier than if you had an income of $100,000 and received an extra $100. The "utility" of an extra $100 becomes less as income grows.

There is a similar utility issue when we consider how much to invest in the stock market as we approach retirement because investing more means we might earn more but also that we might lose precious capital. For most of us, losing capital after we have "won the game" would generate a lot more pain than increasing our savings by that same amount would generate happiness.

Earlier in our careers, the scenario is reversed. We don't have much financial capital to lose and we have decades to make up for any losses. We have lots of "human capital", the ability to earn money from our labor. The losses are less painful because we expect to win in the long run and we don't need the money for decades. We can better afford losses because we have lots of two key ingredients: time and the ability to work. Both diminish with age.

The solution is to gradually shift the game away from growth of capital and toward preservation of capital, though not entirely. We'll probably still need some growth. After decades of saving for retirement, many of us have difficulty making that shift from accumulation to spending. It's a different game.

Sadly, I have much more experience with HITBLITS than most. During the Tech Crash, I personally knew dozens of 20- and 30-somethings who had amassed 5 or 10 millions dollars or more in tech stock options but refused to sell them and rode them all the way back to zero. It happened quickly. From zero to millions to HITBLIT in about ten years. The crash was over in months.

A close friend in his early 60s sat atop $4M of vested MCI stock options only to see his boss, Bernie Ebbers, convicted of the largest accounting fraud in U.S. history, at least until a different Bernie stole that record. At least the 30-somethings had a few decades to recover, though they were very unlikely to see such wealth again as they once had. My friend had a handful of working years left and a bankrupt employer.

Just after the Great Recession, the national press was replete with stories of near-retirees who were looking at postponing retirement for years in hopes of getting back to where they were in early 2007 with no certainty of ever reattaining that level of wealth. They had simply had too much equity exposure.

These experiences probably left me with a different perspective than most have regarding the need to protect your savings when you have little time left to recover from losing them.

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HITBLITS: Charles Barkley and saving for retirement.

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Why not just accept bear market losses with the confidence that a higher equity allocation will help you recover quickly? That works fine in early stages of the accumulation phase but the calculus is quite different as one approaches retirement.

Younger households still have careers that let them buy more equities at bargain prices after a crash. As a result, their portfolios will recover even faster than the market. Near-retirees, on the other hand, have far less time to recover and most of their wealth growth comes from their base of capital and not new savings.

Not long ago, a reader pointed out to me that when dividends are included, the U.S. market recovered from the Great Depression relatively quickly. There are some markets that have never recovered, though, and Japan's recovery has exceeded 20 years and counting.

But, my reply to the reader was "you are not that guy." Someone beginning a career right after the Great Depression would probably have had little to lose in the market crash but years to work and save money to invest in a recovering market. By investing periodically in stocks, his portfolio would have grown even faster than the market.

For someone retiring around the time of the Great Depression, however, the crash would have devastated her savings just when she needed to begin spending them. Instead of adding new investments like the early-career guy, she would be spending from a depleted portfolio. Her portfolio would recover much more slowly than the market and, in fact, would likely never recover. Large market losses in our youth are far less dangerous than losses when we approach retirement.

I often receive comments saying something like, "but the market recovered in just 5 years after the Great Recession!" True, but if you were paying bills for those 5 years by selling investments, your portfolio didn't.

I think anxiety is an excellent metric for asset allocation. Bernstein agrees. In The Intelligent Asset Allocator[2], he recommends first allocating one's portfolio between stocks and bonds based on the greatest bear market loss we believe we could stomach without being tempted to bail out at market-bottom prices.

There are other factors to consider beyond the equity allocation of our portfolio, including total wealth and our floor of safe (not market-based) investments.

Very wealthy households may spend only a small percentage from their portfolios each year. They can afford to take more equity risk with limited risk to their standard of living. They have the luxury of riding out market declines and waiting for the recovery. If you only spend a percent or so of your investment portfolio each year, a bear market shouldn't bring on an anxiety attack.

Households without large savings but with significant safe income from Social Security benefits, annuities and pensions also have a more secure standard of living. I've helped clients whose safe income could completely cover their standard of living. They, too, have the luxury of riding out market declines and waiting for the recovery.

Retirees and near-retirees who lose sleep over the next bear market are likely to be largely dependent upon market returns to fund their desired standard of living. The problem may not be their portfolio's exposure to equity risk but a lack of income from non-market sources.

For these households, purchasing annuities can ensure more of their standard of living and allow them to take more risk — and potentially enjoy more gains — with a smaller equity portfolio.

Sleep loss and anxiety attacks aren't the only symptoms of a retirement plan that might not be right for you. Frequently checking your portfolio balance or regularly checking market levels can also be a red flag.

I check my portfolio balance (or more often my net worth) once or twice a year. I have felt the need to rebalance perhaps three times in thirteen years of retirement. Admittedly, I check more often in a severe bear market (I'm not immune to anxiety) and I suspect most retirees check more frequently than I do. Nonetheless, if you feel the need to check on your stocks more than monthly (or anxiously await your daily dose of Mad Money), it's probably worthwhile asking yourself why.

If your current retirement plan has you on edge like The Street subscriber, then your concern is likely more about losing your standard of living than seeing your savings balance abruptly (and hopefully temporarily) decline. Maybe you have too much equity exposure for your risk tolerance and risk capacity but maybe your plan is too dependent on market returns.

One of my favorite quotes about retirement planning is a comment from Michael Finke to financial advisors:

"Your goal is to make [clients] as happy as they can be in retirement and it may make them happier to have less anxiety about their investment portfolio.[3]

If your retirement plan makes you overly anxious about bear markets, maybe you need a plan that makes you happier.

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REFERENCES

[1] What to Do With Your Retirement Portfolio in This Volatile Market, The Street.



[2] The Intelligent Asset Allocator, William F. Bernstein, Chapter 8.



[3] What Makes Us Happy, The Retirement Cafe.



[4] Bear Markets and Recessions, Capital Economics via Business Insider.

Two Tweets and a Comment: Spending in Retirement

The inspirations for this week’s post are two tweets and a reader comment, which could be the title of a movie about retirement planning if anyone were ever desperate enough to film one.

Retirement planner and researcher, Larry Frank[1] tweeted a link from a Wall Street Journal article by Dan Ariely, a professor of psychology and behavioral economics. The article, entitled “How Much Money Will You Really Spend in Retirement? Probably a Lot More than you Think”[2] suggests that the conventional wisdom that we will need to replace 70% to 80% of our pre-retirement income may be vastly optimistic and the real number could be as high as 130%. That will require workers to save twice as much as they expect, according to Ariely.

Before you throw up your hands and give up on ever saving enough, let me explain that these two numbers, 70% and 130%, don’t measure the same thing.

The leader in estimating “replacement ratios”, the income needed for the first year of retirement as a percent of the income needed to buy the same standard of living as the year before retirement, is AON Consulting.[3] AON doesn’t calculate a single replacement ratio but notes, for example, that it is higher for lower-income households than higher-income households. Over time, “conventional wisdom” settled on about 70% for a replacement ratio no matter what your circumstances, which is obviously a poor rule of thumb, however widely accepted.

Beware the Ides of March and rules of thumb.

For my two cents, from some unrelated research I'm doing using the Health and Retirement Survey data from 1992 to 2014, I find that about 550 one-person, retired households experienced a median replacement ratio of about 107% and about 850 two-person households experienced a replacement ratio of about 112%. I don't yet know how long those increases continued. As I mentioned, replacement ratios are about the first year of retirement. Furthermore, these are medians — your mileage may vary.

To be perfectly clear, I'm not a fan of replacement ratios as a planning device.

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Two Tweets and a Comment: Spending in Retirement.

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Ariely’s calculations are the results of an experiment in which people were asked what they hope to do after they retire. Of course, many would hope to travel the world, eat all their meals in fancy restaurants, take the grandchildren to Disney World annually or retire to a golf resort. That will cost a bit more than simply staying home from the office, living in the same place and doing the same things as before without the commute, which is closer to the AON calculations.

The important points I learned from the Ariely column were more behavioral than economic. Here's one. I’ll bet if you ask most workers whether retirement will cost more or less than pre-retirement, most would answer, “Less, of course!” Ariely shows that really depends on what you plan to do after retirement and where you plan to do it.

The WSJ column provides a link[4] to Ariely's spreadsheet to calculate replacement costs based on your own retirement dreams. If you calculate that replacement ratio and then compare it to the AON Consulting replacement ratios specific to your financial circumstances, you may find numbers that differ significantly from 70%. Both numbers may help your planning by providing a range of estimated spending and they might also provide a warning flag that your expectations of what you can afford in retirement may be overly optimistic.

I found the behavioral aspects of the column more compelling than the economic perspective. First, replacement ratios compare costs for the first year of retirement to the year before. Hopefully, your retirement will last longer than a year and it is unlikely that if you decide to travel the world at age 65, for example, you will still be flying at 85. (Airlines statistics show that retirees tend to stop traveling internationally in their 70s.)

Even if the retirement you envision requires a 130% replacement ratio, that increase won’t last forever and probably won’t require doubling your pre-retirement savings target, though it will increase it. If an early-retirement spending increase were to actually be sustained for your entire retirement then your savings needs might double but I doubt that it will.

Ariely states that in retirement "Every day becomes just like the weekend. And on the weekend, we have all kinds of time and opportunities to spend money. We shop, travel, buy tickets for events and eat out." As a retiree of 13 years, I don't know any retirees who would agree that retirement is like that, at least not moreso than when we worked, and I will repeat my assertion that we need more researchers with retirement experience (a personal peeve).

My second inspiration was a tweet from a financial planner who didn’t understand why estimating retirement spending is difficult. He suggested basing it on the past four months of current expenses. Calculating current spending is indeed relatively simple and estimating spending for the first few years of retirement isn’t a stretch; the challenge is estimating spending 10, 20 or 30 years into the future.

Will your retirement spending go up or down after you retire? I think the best research on this question comes from David Blanchett[5] and Sudipto Banerjee[6]. Blanchett concludes that a household’s spending trajectory is a function of the ratio of retirement savings to the desired standard of living or said differently, a function of whether the retired household has saved appropriately for the desired standard of living, under-saved, or over-saved.

Blanchett found that households with appropriate savings tend to see a 1.5% to 2% annual reduction in the cost of retirement (spending), though it isn’t a smooth decline. He found that households that “over-save” tend to realize they can spend more after a few years and do. At the other extreme, households that haven’t saved enough tend to notice their savings are declining too fast and reduce spending.

Some have interpreted Blanchett’s findings to suggest that spending declines for the "first half" of retirement and increases for the second half. That’s really only true if you live to 100 or so. Most households won’t and their spending trajectory will look a lot like Banerjee’s chart, which is to say that spending will tend to decline throughout retirement and even large end-of-life costs will likely be smaller on an inflation-adjusted basis than first-year spending.

Which direction your spending will head is unknowable. It’s important to understand that these projections are made for the population of retirees and there is no way of knowing if your household's unique retirement spending will be like any of these averages. Your retirement spending will be determined not only by your wealth and income but also by how much life decides to charge you and for how long.

My final inspiration was a reader asking how much money she will need to spend annually throughout retirement. You can see my response in the comments section at The Critical Factors of Portfolio Ruin Aren't Predictable but there is one inescapable reality — no one can predict how much wealth and income an individual household will have or how much it will need with any accuracy for more than a few years.

To summarize this information about retirement spending, I would say we have some good research on population averages but they can’t predict the future of a single household. Ariely tells us that the retirement we want might be more expensive than the one we can afford and perhaps more expensive than our pre-retirement standard of living. Blanchett and Banerjee tell us that retirees who have saved enough and those who have saved too little tend to experience spending declines throughout retirement. The airlines tell us that we become less adventurous in our 70s.

No one can tell you how much your household will need to spend or be able to spend for more than a few future years. The only realistic solution is to plan for the long term but adjust often.

Retirement finance has no cruise control.


REFERENCES

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[1] You can follow Larry Frank on Twitter at @LarryFrankSr and you can follow me at @Retirement_Cafe.

[2] How Much Money Will You Really Spend in Retirement? Probably a Lot More than you Think, Wall Street Journal.

(I frequently have problems with the WSJ paywall but you should be able to read this by clicking "sign in" if you don't subscribe. If not, I found that I could read it by Googling "How Much Money Will You Really Spend in Retirement? Probably a Lot More Than You Think" and clicking the link on the Google search page.)



[3] AON Consulting Replacement Ratio study, AON Consulting.



[4] Retirement Spending spreadsheet, Dan Ariely.



[5] The True Cost of Retirement, David Blanchett.



[6] Expenditure Patterns of Older Americans, 2001-2009, Sudipto Banerjee.

Probability of Ruin in Pictures

William Bengen calculated sustainable withdrawal rates (SWR) using historical S&P500 market returns since 1928 leading to the “4% Rule.”[1] More recently, Robert Shiller published stock market  returns data back to 1871 using the S&P Composite Index[2]. In this post, I’ll explore the “probability of ruin” using the more extensive Shiller data.

Probability of ruin is typically used in retirement planning to estimate the probability that a retiree will outlive her portfolio based on some set of assumptions such as a fixed planning horizon (often 30 years), market return expectations and a constant-dollar spending strategy.  Bengen studied rolling 10-, 20- and 30-year retirements using historical S&P500 market returns and a constant-dollar spending strategy[3].

He found that assuming a fixed 30-year retirement and annual withdrawals of 4% of the retiree’s portfolio value at retirement the worst-case historical scenario (someone retiring for 30 years beginning in 1966) would have depleted a portfolio in less than 30 years for about 5% of the rolling periods. Hence, the “4% Rule.”

The following chart shows the terminal portfolio value (TPV) after 30 years for a retiree spending $42,000 (4.2%)  annually from an initial portfolio valued at $1M for 110 overlapping thirty-year periods from 1872 to 1982. (Shiller’s data ends in 2012 so the last 30-year period began in 1982.) The red bars indicate years of retirement that funded less than 30 years.

(Click on the charts to zoom in.)

Six of the 110 periods (5.5%, the historical “probability of ruin”) were depleted in fewer than 30 years. TPV charts typically and reasonably assume a retiree’s portfolio can’t drop below zero but I continued withdrawals for the full 30 years to show the extent to which they failed. Another way to read this is that the deeper the red column, the sooner the portfolio was depleted.

Take a longing glance at those tall columns, the ones with really large terminal portfolio values. Then, compare them to the little stubby blue guys. Both are probability of ruin “successes”.

Probability of ruin assumes that you’ll be happy simply not retiring in one of those red years. You’re either in the 5% of scenarios that start a losing period or the 95% of winners and so as long as your bar turns out blue, you’re good, right?

Not really. Wouldn’t you be at least a little happier with a tall blue bar than a short, stubby blue bar, even though both avoid portfolio depletion? I would. Probability of ruin assumes that you’ll be just as happy successfully funding retirement and leaving a hundred bucks to your heirs as you would be leaving them a million. And, that you’d be as dissatisfied with a portfolio that funds 29 years as with one that only funds 15. 

I wouldn’t. If a planner said, “Hey, great news! Your retirement is funded 95% of the time”, my response would be, “That sounds great but how well does it turn out when it is completely funded and how badly when it isn’t?”

Sequence risk affects all outcomes, sometimes positively and sometimes negatively. Probability of ruin flags only the worst outcomes. Probability of ruin is sort of an upside-down “tip of the iceberg” in that most of the information is hidden from view by condensing all that information into a single data point, the percentage of failures.

(For a better iceberg effect, turn your phone upside down while you view the chart below. If you’re reading this on an iMac or PC, probably better to just use your imagination.)

In Figure 2 below, I increased spending from 4.2% of initial portfolio value to 4.75% which, of course, creates more red bars indicating more depleted portfolios.

Note that the red bars appear in four distinct clusters in both Figures 1 and 2. A “95% probability of ruin” might suggest that ruin appears sporadically about every 20 years (5% of periods). It does not, although that is how sequence risk is most often (incorrectly) modeled. 

When I increase spending to 5.5%, the result is even more red bars, as expected, but they’re still all within those four clusters. Ruin isn’t a uniformly-distributed event. Probability of ruin is quite high in certain periods of economic distress but relatively low any other time. 

Here's an analogy. Kentucky averages about 12 snowfall days per year but we don’t predict snowfall in July. It’s more likely to snow in winter in Kentucky and high sequence risk is more likely to deplete a portfolio when spending starts in an "economic winter". Many models of sequence risk predict snow in July.

Unless you retired just prior to the Panic of 1910, the Great Depression, a bad 1937 bear market (squeezed between two really good market years, by the way) or during the inflationary 1965 to 1975 period, the 4% Rule would not have depleted your portfolio. Unfortunately, these periods are not predictable. The jury is still out on the 2000s.

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Probability of ruin in pictures via @Retirement_Cafe.

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In the next chart, Figure 3, the y-axis scale changes from $M to $K so we can better see the near misses. I arbitrarily set the definition of success in this test to include TPVs greater than $150,0000 and the definition of failures to include TPVs worse than -$150,000. My reasoning is that given the margin of error in a 30-year retirement plan these scenarios might have gone either way IRL (in real life, as Millennials say). This is arbitrary but so is drawing the failure line at precisely zero dollars and this definition factors in more of the uncertainty of the analysis.

Note the number of portfolios that barely avoided depletion (3) and the number that very nearly avoided depletion (2). If we omit these five scenarios from the calculation because they are too close to call, the probability of ruin becomes 3.8% instead of 5.5%. That’s more than a 30% change in the estimate of ruin and represents a big change in sustainable spending.

I'm not advocating ignoring these data but simply viewing them in three categories instead of two: probably succeeded, probably failed and too-close-to-call, based on our degree of confidence in the outcomes.

When you have only a few failures, a few close calls make a large difference in probability of ruin.  Portfolio’s that come up just a little short probably aren’t losers and a small bequest left to heirs is probably too close to call a winner, as well. Thinking we can predict a 30-year retirement much more accurately than plus or minus a few years is overconfidence.

Why do I question “near misses”? Because they probably would have funded most of the 30 years. Only 6% of men and 13% of women aged 65 live another 30 years and all of those who died sooner would have successfully funded their retirements in these scenarios. 

The following chart, Figure 4, brings bear markets (the yellow bars) into the picture. 

Retirees are often told that retiring into a bear market is deadly, but bear markets don’t appear to be particularly highly correlated with failing portfolio periods. Robert Shiller doesn’t even consider the 1960’s and 1970’s to be bear markets because they were so gradual[4]. Paint those bars blue and the correlation of bear markets to portfolio ruin is even less obvious.

If portfolio depletion isn’t necessarily caused by bear markets, what does cause it? The EarlyRetirementNow.com website found that the sustainable withdrawal rate is nearly completely explained by portfolio returns for the first five and first ten years of 30-year periods.[5] This explains SWR but not ruin — portfolio depletion is completely explained by sequence risk. 

Nonetheless, a chart of SWRs is informative. Figure 5 shows the SWRs that would have depleted a portfolio in precisely 30 years from 1872 to 1982.

This is the view of the iceberg below the surface. Sustainable withdrawal rates that deplete portfolios in precisely 30 years are unpredictable and vary widely from 3.8% to 12.6% historically. 

Figure 5 above provides a visual explanation of the “4% Rule” probabilist school of retirement finance. That approach recommends spending the amount that would only fail in no more than 5% of retirement periods. Using the Shiller data, that amount of spending would be about 4.2% of initial portfolio value.

There are two potential risks with this strategy. The obvious one is that you might fall into the unlucky 5% (one in twenty) and outlive your savings but an equally important concern is that you would almost always underspend. All of the blue bars above the red line represent underspending. You would have spent 4.2% if you retired in 1950, planning to live 30 years, for example, when you could have spent 11.8%. Of course, you couldn’t have known that in 1950.

Some planners have suggested that sequence risk goes away after 10 years. Alas, it does not. The following chart shows the value of portfolios at the end of the first 10 years for historical data.

The smallest TPV after 10 years was $340,000 (retirement in 1973) and the largest was $3.8M (1949). Surely the latter has less sequence risk ten years into retirement.

If both scenarios are assumed to complete the remaining 20 years of a 30-year retirement and both continue to spend the $42,000 they calculated as sustainable back in year one, the larger portfolio would have survived all rolling 20-year historical periods with continued annual spending of 1.1% (42,000 / 3,800,000), while the smaller portfolio would have failed nearly all of those periods with 12.4% annual spending (42,000 / 340,000). 

Sequence risk might appear to go away after 10 years from the perspective of the start of a 30-year period but after 10 years much will have changed. Sequence risk will change accordingly and become greater or smaller. We can’t know which.

As I mentioned above, the EarlyRetirementNow blog found that the returns for the first 5 years of a 30-year retirement best explain the sustainable withdrawal rate.  Figure 7a shows 5-year annualized market growth rates with the same time period on the x-axis. The panel below, Figure 7b, shows 30-year TPV with portfolio failures in red in the top chart. Note how well very low growth rates for the next five years align with portfolio depletion.[6]

Portfolio failures are caused by poor market returns early in a series of returns. The low returns can result from a quick, precipitous shock like The Crash of October 1929, from a single terrible year of returns like 1937, or from a long, gradual sideways series of mediocre real returns like 1966 to 1975.

These growth rates are explanatory, not predictive. In these charts we are explaining the past, not predicting the future. We have no idea what the next five years of market returns will bring but we can see that low early returns — sequence risk — are not a good way to start.

To summarize, probability of ruin is an interesting rule of thumb with severe limitations. Sequence risk affects all portfolios from which the retiree periodically spends but probability of ruin only measures the extreme outcomes, those that result in premature portfolio depletion. It treats all failures alike and all success alike, ignoring the extent of the success or failure. The thin line separating success from failure is arbitrary. It hides the extent of success and the extent of failure.

Portfolio ruin isn’t sporadic and doesn’t uniformly occur once every 20 years or so as a 5% failure rate might imply. Most of the time, sequence risk is quite low but during major economic upheavals, it occurs in bouts.

Models of probability of ruin are not robust. They provide a significantly different answer every time they are run even when nothing changes except the Monte Carlo random number draw.

Probability of ruin is based on some strange assumptions about human behavior, like assuming we will continue to spend the same amount when ruin becomes apparent or that we don’t care how much wealth we have as long as it’s more than zero. It’s also based on less than five unique sequences of 30-year historical returns, a truly small sample.

Put all this together and probability of ruin looks like a very poor metric by which to predict, model, or manage retirement finances. 

REFERENCES

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[1] Conserving Client Portfolios During Retirement, William P. Bengen.

[2] Annual Data on US Stock Market, Robert. J. Shiller.

[3] This analysis uses the S&P Composite Index, data from 1871 to 2012, and 100% equity allocation.

[4] [The U.S. stock market looks like it did before most of the previous 13 bear markets, Robert J. Shiller, MarketWatch.

[5] The Ultimate Guide to Safe Withdrawal Rates – Part 15, Early Retirement Now blog.



[6] The market grew about 0% from 1927 to 1931 as shown in the bottom panel, for example, and portfolios with spending beginning in 1927 failed sooner than 30 years with 4.75% spending, as the top chart shows.