You're Responsible for Your Own Online Security

Credit cards, debit cards, ATMs, and electronic fund transfers (EFTs) offer excellent fraud protection but your bank, credit union and investment company's online protections aren't as strong.

In response to my post, The Best Inflation Protection You Never Heard Of, a reader commented that he/she avoids I Bonds due to security concerns with TreasuryDirect.^® It didn't take long to find several threads on the topic. The primary concern seems to be this statement from the Code of Federal Regulations:

§363.17   Who is liable if someone else accesses my TreasuryDirect^® account using my password? You are solely responsible for the confidentiality and use of your account number, password, and any other form(s) of authentication we may require. We will treat any transactions conducted using your password as having been authorized by you. We are not liable for any loss, liability, cost, or expense that you may incur as a result of transactions made using your password.[72 FR 30978, June 5, 2007]

Should you be concerned about security issues at TreasuryDirect,^® the only place where you can purchase I Bonds? I think you should be concerned about the security of online access to your holdings at all financial services companies and I think your security is largely up to you.

Having your financial services company hacked is different than having your individual account hacked using Internet access. I'm addressing the latter but the former happens with amazing frequency and you will be protected from those breaches. You probably won't even know it happened to your company until you read about it in the paper.[1]

You will probably find wording similar to that of the TreasuryDirect^® statement above at the websites of all of your banks, credit unions, investments companies, and other financial services.

First, let's look at where we are protected.

Electronic Fund Transfers.

According to the Federal Reserve, "Regulation E provides a basic framework that establishes the rights, liabilities, and responsibilities of participants in electronic fund transfer systems such as automated teller machine transfers, telephone bill-payment services, point-of-sale (POS) terminal transfers in stores, and preauthorized transfers from or to a consumer's account (such as direct deposit and social security payments). The term "electronic fund transfer" (EFT) generally refers to a transaction initiated through an electronic terminal, telephone, computer, or magnetic tape that instructs a financial institution either to credit or to debit a consumer's asset account."[2]

Section 205.6 of Regulation E states the liability of [the] consumer for unauthorized transfers, "[Regulation E] limits a consumer's liability for unauthorized electronic fund transfers, such as those arising from loss or theft of an access device, to $50; if the consumer fails to notify the depository institution in a timely fashion, the amount may be $500 or unlimited."

At first glance that would appear to cover online access to your account at a bank or credit union — they are both subject to Regulation E and it specifically mentions computers — but that does not appear to be the case. The catch seems to be in how your bank or credit union defines "unauthorized access."

Credit Cards.

According to NOLO.com[3],

"Under the Fair Credit Billing Act, your liability for unauthorized charges depends on whether the thief personally presented your card to make the purchase, or just stole the number.

• If the thief personally presents your card to make the purchase, the card issuer can't hold you liable for more than $50 in fraudulent charges. (12 C.F.R. § 1026.12). Many card issuers waive this $50.
• If the thief stole the number, but not the card, you have no liability.

In either of the above situations, however, it's important to notify the card issuer as soon as you know of the theft—by phone and in writing.

Additional information regarding how to report fraud is also available at the NOLO link.[3]

ATM and Debit Cards.

Also from NOLO.com,

"With ATM or debit cards, you must act quickly in order to avoid full liability for unauthorized charges when your card is lost or stolen. Under the federal Electronic Fund Transfer Act, your liability is:

• $0 if you report the loss or theft of the card immediately and the card has not been used
• up to $50 if you notify the bank within two business days after you realize the card is missing
• up to $500 if you fail to notify the bank within two business days after you realize the card is missing, but do notify the bank within 60 days after your bank statement is mailed to you listing the unauthorized withdrawals, or
• unlimited if you fail to notify the bank within 60 days after your bank statement is mailed to you listing the unauthorized withdrawals. (15 U.S. Code § 1693g).

If you can convince the bank that your notification failure was due to extenuating circumstances, it must extend the notification timeline for a "reasonable period."

If your card wasn't lost or stolen, but the number is used for unauthorized transactions, you aren't liable for those transactions so long as you report them within 60 days of the statement being sent to you.

In response to consumer complaints about the possibility of unlimited liability, some card issuers cap the liability on debit cards at $50. And some banks don't charge anything if unauthorized withdrawals appear on your statement. Also, some states have capped the liability for unauthorized withdrawals on an ATM or debit card at $50."

So, for ETFs, credit cards, debit cards, and ATMs, the fraud protections are pretty strong but what is the extent of our protection for accounts with other financial services?

Banks and Credit Unions.

As I previously mentioned, banks and credit unions are subject to Regulation E and that regulation seems to protect online access to your account. A review of a few online-fraud policies, however, reveals a loophole that limits their guarantees of "100% fund recovery" if you "share" your login credentials or don't "adequately" protect them.

My credit union states in its "Zero Liability Guarantee for Online Fraud" policy, "You should not share your UserID and/or password with anyone. If you share this information with anyone, any actions they perform on your accounts online are considered to be authorized by you."

I found similar statements at bank websites. Wells Fargo's states, "To qualify for the protections provided by the Online Security Guarantee, you must. . . Never disclose your personal account information to others (including your Personal Identification Number (PIN), online username, password, one time passcodes, RSA SecurID® token, or any other security credential you may use to access your accounts)"[4]

Wells Fargo's statement goes on to warn that, "If your device allows access to anyone other than you via fingerprint, that person will also be able to access your Wells Fargo Mobile downloadable applications on the same device when Touch ID^® or fingerprint is enabled, and their transactions will be considered authorized."

So, if your phone's fingerprint access feature fails, allowing someone to gain access to your login credentials, Wells Fargo treats that as your authorization for that person to make transactions in your account. And, those fingerprint readers may not be as secure as you think.[5]

You can find your investment company's online-fraud protection policies, well. . . online.[6,7,8] Most of the investment companies I researched do offer full protection against fraud except for fraud committed when you share your login credentials. The problem is that most have a very broad definition of "sharing." Fidelity Investments states, for example,[6]

"What are examples of where I won't be covered?

If you grant authority to, or share your Fidelity account access credentials or information with, any persons or entities, their activity will be considered authorized by you. Losses of cash or securities transferred to outside accounts that are beneficially owned by you are not covered by this guarantee. Also not covered is any activity by an employer/plan administrator, financial intermediary, or third-party who is authorized by you to access your data (or who received your data as a result of that access), or with whom you've shared your username, password, or account number, or from malware or a breach of security that affects the systems of any of those parties."

Fidelity also lists some types of assets that aren't protected:

"What assets may not be covered?

Assets including certain annuities and insurance products, Fidelity Advisor Fund accounts, and Fidelity Advisor 529 accounts are not covered because they are held away from or maintained by someone other than Fidelity."

In a timely email, Charles Schwab just this week sent me the following information:

"We want you to have the highest level of confidence when you do business with Schwab. That's why we offer you this simple guarantee: Schwab will cover 100% of any losses in any of your Schwab accounts due to unauthorized activity. Read more about our Security Guarantee at schwab.com/guarantee."[7]

That sounds excellent until you click on that link and see the limitations of the guarantee:

"Does the guarantee apply to my account if I use a financial application ("app") or program that retrieves my account data from Schwab for things like financial planning or to help me manage my finances?

Yes, with some conditions. You must not share your Schwab login credentials with anyone or through a non-Schwab app. A firm that retrieves, aggregates, and presents account information to a customer for financial activities is known as an "aggregator." When you authorize an aggregator and instruct Schwab to allow the aggregator access to your account information, the aggregator as well as its employees, agents and financial apps and companies the aggregator does business with who receive your Schwab account information ("aggregator third parties") are considered your authorized persons. The guarantee only applies to unauthorized activity in your account. What an aggregator or an aggregator third party does in connection with your account and your information is authorized, so the guarantee does not apply to their actions."

Sharing login credentials typically invalidates that "100% guarantee" that your loss will be recovered. How broad can a financial service company's definition of "sharing" be?

• Providing your login credentials to any other person, such as a financial advisor, is generally considered sharing. One company's website suggested that giving your login credentials to your spouse is sharing and recommended that spouses submit paperwork to give one another access to their accounts, instead.
• Providing login credentials to a third-party aggregator is typically considered sharing. Popular third-party aggregators include Mint.com, Vanguard's Portfolio Watch, and Fidelity Investments Fullview.
• As mentioned above, Wells Fargo assumes that you have shared your login credentials with anyone who can fool your smartphone's fingerprint ID feature.
• Fidelity Investments assumes that someone who learns your login credentials by a security breach or malware is authorized to access your account.
• TreasuryDirect^®'s statement above appears to state that anyone who has your login credentials is authorized to make transactions in your account regardless of how the credentials were obtained.

The message is quite clear: if you want a guarantee against online fraud, don't share your login credentials with anyone or anything and don't let them be stolen. Some recurring themes run through these policies.

• You have no fraud protection guarantee at any investment company I have researched if you share your login credentials,
• The company's definition of "sharing" can be quite broad,
• Investment companies can have vastly different descriptions of what they consider "adequate" protection of your credentials, and
• Some company's don't protect all types of accounts.

When I began research for this post, I had hoped to be able to provide some general guidelines for all banks, credit unions and investment companies regarding their online fraud protection. Unfortunately, I found that they vary so much that I needed to read every policy for every financial services company that I use to understand my protections and what I am required to do to be eligible for their "100% online guarantees." I changed my passwords at each one, in part so I no longer run afoul of "third-party-aggregator sharing" rules and to be completely honest, in part because the protections weren't as ironclad as I had assumed. I strongly suggest that you do the same.

So, bottom line, fraud protection at investment companies, banks and credit unions is significantly weaker than for credit cards, debit cards, ETFs, and ATMs.

But what about SIPC, you ask? Isn't it the equivalent of FDIC for banks? No, SIPC offers protection of assets at failed brokerage firms. According to their website[9], "SIPC protects against the loss of cash and securities – such as stocks and bonds – held by a customer at a financially-troubled SIPC-member brokerage firm. The limit of SIPC protection is $500,000, which includes a $250,000 limit for cash. Most customers of failed brokerage firms are protected when assets are missing from customer accounts."

Unless it is failing, your investment company backs your brokerage accounts, not SIPC.

Having read this post, extremely risk-averse investors might be tempted to try to find financial services companies with no Internet access. They may be surprised by how difficult that has become. This is the world we live in: we're forced online but not adequately protected from online security problems. Security is largely in our own hands.

Fortunately, there are steps we can take to secure our accounts. Unfortunately, none is perfect.

Here's my advice. Google "online fraud protection company name" for every bank, credit union, investment company or other financial services company you use online. (Links to a few are provided below in REFERENCES.) Search their websites for the following information:

1. Is there an online fraud guarantee?
2. Under what conditions are you not covered?
3. What types of accounts are covered?
4. What actions does the company require on your part to ensure that your login credentials are "adequately" secured?

Here's a tech hint that will help when they play the fine-print game. Command+ on a Mac or CTRL+ on Windows will usually increase that tiny font as much as you'd like. (I'm looking at you, Fidelity.)

Because this post is already, as my grandfather would say, longer than a horse's face, I have posted  some recommend security measures you should implement with all of your financial accounts, including TreasuryDirect^® at How to Secure Your Online Financial Accounts.

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REFERENCES

[1] For Big Banks, It’s an Endless Fight With Hackers, New York Times.



[2] Regulation E, federalreserve.



[3] Your Liability for Unauthorized Credit and Debit Card Charges, NOLO.com.



[4] Wells Fargo online fraud policy.



[5] That Fingerprint Sensor on Your Phone Is Not as Safe as You Think, New York Times.



[6] Fidelity Investments online fraud policy.



[7] Charles Schwab fraud policy.



[8] Vanguard Investments Online Fraud Policy



[9] Securities Investor Protection Corporation (SIPC) website.

Navigating the TreasuryDirect® Maze

In a previous post, The Best Inflation Protection You Never Heard Of, I wrote about U.S Series I Savings Bonds. Like Treasury Inflation-Protected Securities (TIPS), I Bond returns compensate for inflation, as measured by the CPI-I Index.

I like Series I Bonds but the TreasuryDirect^® website, not so much.

The two types of bonds (I Bonds and TIPS) are otherwise significantly different. I Bonds have some unique features as I previously explained, but they also have significant maximum purchase restrictions that make them cumbersome for wealthy retirees to accumulate.

Those maximum purchase restrictions were one of two issues raised by readers of that post, the other being difficulty in navigating the TreasuryDirect^® website to purchase the bonds.

Individuals can purchase up to $10,000 of I Bonds per social security number per (calendar) year, which means a couple can purchase $20,000 annually. A single, retired friend complained that it would take decades to buy enough I Bonds at $10,000 per year to fill his bond portfolio. I suppose I can somewhat sympathize with that "problem" except that I know a lot of people who would love to have it.

I, too, need to own TIPS in addition to the I Bonds I purchase but I don't think of my inability to buy as many I Bonds as I'd like as a reason not to purchase any. Other than the maximum purchase limitation, they have some very attractive features.

TreasuryDirect^® e-commerce capabilities could use some work. I just spent two weeks working with a couple of well-educated clients who struggled mightily but were ultimately successful in purchasing I Bonds for both spouses. I will offer some tips that might help you navigate the TreasuryDirect.gov website (and therein lies the first tip: don't go to TreasuryDirect.com or Treasury.gov).

The first step to purchase I Bonds at TreasuryDirect^® will be to open an account for yourself and one for your spouse if you are married. You can submit your application(s) online by clicking here and then click the "Go" button. But, there is some prep work you will need to complete first.

For each account that you will open at TreasuryDirect^® you will be required to submit a TreasuryDirect^® Account Authorization Form, FS Form 5444, and snail-mail those completed forms to the Treasury Retail Securities Service address on the form. The form requires a bank's signature guarantee or a brokerage's signature guarantee or Medallion Guarantee. Certification by a notary isn't acceptable. Do not fill out the form until you are in the presence of the guarantor.

You will need a source of funds to purchase the bonds, of course, and you have two options. Typically you will want to purchase bonds using an account at a bank that accepts Automated Clearing House debits and credits. (There is a second way using a "Zero-Percent Bond" to make payroll purchases or a recurring bank debit.) You will provide your banking information when you create the TreasuryDirect^® account, so have check(s) available to provide the routing and account numbers.

One of the clients I helped was notified that his account application "needed further security checks." About a week later, he was informed that his application had been accepted, though he was unable to find out why additional checks had been necessary.

You may also need to move funds into the bank account before the bond purchase. If you need to sell stocks or funds, for example, to purchase I Bonds, then be aware that it may take a few days for the brokerage sale to clear and another few days to transfer the sale proceeds to the bank account. There are sometimes ways to link bank accounts and brokerage accounts to make this work faster in subsequent years.

As I pointed out in the aforementioned post, you will normally want to purchase I Bonds from a taxable account. If you withdraw retirement account funds, the transaction will be taxable at ordinary income rates and may be subject to penalties. TreasuryDirect^® accounts cannot be retirement accounts.

TreasuryDirect^® sells several different types of bonds. Once you reach the purchase page, be sure to select "Series I", the second radio button from the bottom of the page.

To summarize the steps:

1. Collect social security numbers for each of the spouses.
2. Find a check for each of the bank accounts(s) from which you will make the purchase of I Bonds.
3. Go to TreasuryDirect^® Open Individual Accounts and open an account for each spouse. Set up strong passwords for the accounts, write them down and store them safely (A strong password is very important so please don't ignore.) Save copies of all confirmations for a paper trail.
4. If you are asked to submit FS Form 5444, download it and take the blank form(s) to your bank or brokerage for signature guarantee(s). Mail the completed form(s) to the address stated on the form. (Update: I edited this after a reader comment below. Though I was unable to find a definitive statement online, it appears that this form is only required if 1) your submission can't be validated online or 2) you are randomly selected to submit it. Regardless, you will be instructed to submit it as part of the application submission process if it is required.)
5. If you will use funds from a brokerage account instead of a bank, sell the appropriate amount of assets. Use funds from a taxable account — TreasuryDirect^® accounts cannot be registered as retirement accounts.
6. When the brokerage trade is completed and funds are available, transfer those funds to the bank account(s) that you registered during the TreasuryDirect^® account creation process in step 4.
7. When the bank deposits are available, log onto your TreasuryDirect^® account(s), click the red "BuyDirect" tab, select "Series I Bonds" from the options, and enter your purchase. Your registered bank account number from which funds will be drawn will be in a drop-down box.

When you return to purchase more I Bonds next calendar year, you will be able to skip steps 1, 2, and 3.  TreasuryDirect^® e-commerce software and paperwork requirements are a bit of a maze but the steps are necessary to protect your account. These instructions should help and you can console yourself with the thought that next year's purchases should be a lot easier.

My Preferred Planning Software is MaxiFi

I've been working on a research paper with UNC econometrician, Neville Francis for the past year and that has given me the opportunity to look at several free online retirement planners. Overall, I have to say that most were disappointing.

I have also worked for several years with another online retirement planning tool that is not free but is quite affordable, economist Laurence Kotlikoff's MaxiFi.[1] I recently asked Dr. Kotlikoff some questions about his product.

Dr. Kotlikoff, you say that MaxiFi is based on "consumption smoothing", the "proposition that households want to have a stable standard of living through time as well as across good times and bad times." What does that mean to a retiree or to someone saving for retirement?

Consumption smoothing is at the heart of economics-based financial planning. It's firmly anchored in human physiology. None of us wants to splurge today and starve tomorrow. Nor do we seek the opposite. Whether retired or still working, rich or poor, we're after the same thing — a highly stable living standard. Leaving aside issues of investment risk, the core financial planning question is how much to save each year to achieve a smooth consumption ride. MaxiFi calculates this directly based on your lifetime resources net of future taxes and gross of future Social Security benefits. In so doing, MaxiFi eliminates the guesswork in planning your retirement finances. It also helps you find investment strategies that limit your investment risk. In contrast, conventional financial planning asks you to set a goal for annual retirement spending. My goal is $1 billion.

A retirement planner recently commented to me that retirees don't all want "smooth consumption"; some want to spend more early in retirement. But spending more at some ages than others isn't inconsistent with "smooth" consumption, is it?  

MaxiFi has a Standard of Living Index that lets you tell the program you'd like to have a higher living standard earlier in life and a lower one later on. The tool will recommend discretionary spending that follows your desired living standard path as closely as possible subject to not putting you in debt. You can also specify special expenditures, like a major trip when you reach 70. MaxiFi will budget for this and have you pay for it by spending less ever year before and after the trip.

Most retirement planning tools measure success with "probability of ruin", or the percentage of simulated future scenarios in which a retiree can expect to not outlive their savings. Please explain why you prefer consumption smoothing.

Conventional planning is built on three mistakes. First, it asks people their retirement spending targets. Mine is $1 billion a week. So right away I've made a mistake. But even if I guess a "reasonable" number, I'm going to be miles off the level that MaxiFi will calculate. Second, conventional planning assumes you'll keep saving what you are now saving. That's mistake number 2. What you are now saving is surely wrong. The third mistake is assuming you'll spend your targeted amount year after year in retirement whether your assets go through the roof or fall through the floor.

Conventional planning's "probability of ruin" Monte Carlo simulations calculate the chance you'll run out of money if you make all three mistakes, i.e., if you a) save the wrong amount each year before retirement, b) spend the wrong amount year after year after retirement, and c) never adjust your annual spending once you retire. I can't fathom why anyone would wish to know the probability of financial survival in the context of making three major financial mistakes. Financial planning is supposed to help us make the right financial decisions, not tell us something we don't want to know about something we shouldn't be doing.

I can find lots of free "single-purpose" planning tools on the internet, tax planners, sustainable withdrawal rate calculators, life expectancy calculators, Social Security optimizers, RMD calculators, asset allocators, etc. Is there an advantage to incorporating them into a single program like MaxiFi?

All our financial decisions are interconnected. Take life insurance. You can't decide how much to buy until you know the living standard you need to insure. But your sustainable living standard (if no one dies) depends on the amount of insurance premiums you'll be paying. So, your living standard and life insurance needs must be jointly calculated. MaxiFi does this. It jointly handles all the factors you mention and more. The advantage of MaxiFi's integrated financial planning is that all its suggestions and calculations, including federal and state taxes, are absolutely internally consistent. If you use piecemeal calculators you'll get a set of suggestions that don't add up.

MaxiFi asks for only a few of my expenses as input. Why is that?

MaxiFi asks you to specify your "off the top" expenses on housing and other must-spend items, like alimony payments, out-of-pocket medical expenses, or college tuition. These expenditures are like negative income. Your other resources less a) these off-the-top expenses and b) your lifetime taxes determine your lifetime budget — what you can spend on a discretionary basis over the rest of your life. MaxiFi then smooths this spending. If we were to ask you to specify everything you were going to spend each year, year in and year out, you'd give us amounts that were either a) unaffordable or b) left some of your lifetime budget on the table.

Is MaxiFi a "Monte Carlo" simulator?

MaxiFi does Monte Carlo simulations on your living standard. It calculates 500 living standard trajectories you might experience based on how you are investing. It then compares these 500 trajectories with 500 based on investing more safely and 500 based on investing at greater risk. These trajectories take into account that you'll adjust your spending annually in light of how well your investments fare, always with the goal of having a stable living standard. Best yet, MaxiFi combines all of the 500 trajectories in a single index of your average lifetime happiness — what economists call your Expected Lifetime Utility. This index, which takes into account your tolerance for risk, lets you compare in terms of three numbers (one for each of the three sets of 500 trajectories) how your current investment strategy stacks up against investing at less or more risk. Lifetime expected utility maximization is the gold standard of economics-based portfolio guidance.

Can MaxiFi tell me if I should purchase life insurance or an annuity?

Absolutely. It calculates how much term life insurance you need to hold each year to ensure survivors have the same living standard to the dollar had you not died. It also shows you how much higher or lower your living standard will be if you purchase an annuity.

Can I perform what-if analyses with MaxiFi? What kinds of things can I test?

You can set up as many alternative profiles as you'd like and compare them against your base case in terms of their lifetime discretionary spending. For example, you can easily learn how much more you'll get to spend if you downsize or if you go back to work or if you switch jobs or if you annuitize your retirement accounts or if you wait to take your Social Security benefits.

But MaxiFi also does its own what-ifs for you. Once you run your base plan, MaxiFi asks you to MaxiFi It. When you run this report, MaxiFi looks for safe ways to raise your living standard by maximizing your lifetime Social Security benefits and finding the retirement account withdrawal strategy that will reduce your lifetime taxes.

Where can I learn more about how MaxiFi works?

Go to www.maxifi.com. Check out the videos, the case studies, and other descriptions posted there. And then try it! I promise, you'll get hooked on its ability to safely raise your living standard and finally take the guess work out of financial planning.

(Note: If you prefer video instruction, I have added two links below to recent MaxiFi Webinars.)[2,3]

Those are some of the reasons Dr. Kotlikoff believes MaxiFi's economics-based approach is best. Now, here's why I like it.

At $99 per year with $70 renewals, it's quite affordable for the do-it-yourselfer.

Dr. Kotlikoff and his team have steadily improved and refined the product, beginning with E$Planner, for over 25 years. That leaves the others with a lot of catching up to do with both the economics and the technology.

As a computer scientist, I know from experience that Dr. Kotlikoff has a top-notch technical staff and their help desk has always been available when I needed it with real people who know their product.

MaxiFi completely avoids the limitations of probability-of-ruin estimation. Instead, it incorporates consumption smoothing and maximizies the utility of achievable spending.

Many retirement planning tools address only the decumulation phase, when we retire and begin spending down our wealth. MaxiFi is a life-cycle planner and is useful at any stage.

Lastly, as Dr. Kotlikoff mentions, MaxFi integrates many calculations into a single model. Most free online simulators handle only a part of the problem, like maximizing Social Security benefits or modeling investment returns. Retirement planning isn't a problem that can be solved by solving many individual sub-problems independently.

If you're interested in financial planning software, give MaxiFi a try. You can use it to build a retirement plan or to create a "second opinion" of one you already have. It's also a good tool for your annual retirement plan checkup.

I rarely promote products at my blog but I know that many of my readers are do-it-yourselfers and many have expressed interest in software tools. I have a lot of confidence in MaxiFi. A multi-client version called MaxiFi Pro is available for advisors.

There are a number of new entrants into the online retirement planning field and I'll keep looking for free or affordable, unbiased, comprehensive planning tools. If you are especially fond of another tool that shares these attributes, please add a comment below.

To be clear, I don't believe that software can effectively replace a good human retirement planner given the current state of the technology, though the latter will no doubt cost more. I think you'd be way better off using a good human planner who uses good planning software. But for now, at least, I prefer MaxiFi for the do-it-yourselfer.

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OTHER RESOURCES

Economist, Zvi Bodie now links to his "trusted sources" at https://zvibodie.com/trusted-resources/. I find the entire website very useful and particularly the videos.

NewRetirement.com provides a wealth of retirement planning software. I encourage you to take a look. Full disclosure, I act as an advisor to NewRetirement.

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REFERENCES

[1] MaxiFi web-based planner, website.



[2] MaxiFi Webinar, June 26, 2019, VIDEO.



[3] MaxiFi Webinar, June 13, 2019,VIDEO.

The Best Inflation Protection You Never Heard Of

In a recent post, I discussed inflation's potential impact on your retirement income (see Remember Inflation?) and I warned against letting three decades of low inflation lull us to sleep.

Inflation rates are low right now, about 1.9% per year according to the U.S. Department of Labor. Even at that rate, a 2019 dollar in 2049 would purchase only $0.56 worth of goods and services in constant dollars of 2019 by the end of a 30-year retirement. Assuming the long-term average inflation rate of 3.15%, that dollar in 2049 would be worth only $0.38 in 2019 dollars.

Of course, there isn't a strong argument that inflation rates won't be significantly worse than average sometime in the next thirty years as they have been in four of the past eleven decades. The reality is that no can predict future inflation, mean or worst-case, with any certainty.

It is nearly certain that we will see some level of inflation over several years of retirement and even low levels will erode the purchasing power of nominal annuities and pensions. The only real question is how much.

Economist, Zvi Bodie and I recently published a paper[1] recommending that retirees consider purchasing CPI-adjusted annuities and CPI-adjusted bonds (TIPS)[2] instead of their nominal alternatives.

Retirees with pensions rarely enjoy inflation protection and when they do it is limited. I have several friends and family members covered by the Kentucky Teachers' Retirement System, for example. According to their website, their pensions currently offer a 1.5% cost of living adjustment which is much better than nothing but won't adequately compensate for historical average inflation or even today's low rate.

Annuities, whether CPI-adjusted or nominal, aren't the best solution for every household but there are other inflation-protecting alternatives to consider. TIPS are another choice for consideration but for this post I'll suggest U.S. Treasury Series I Savings bonds, or I Bonds.[3]

I Bonds are meant to be used as inflation protection for individual households and can only be purchased online at TreasuryDirect.gov^®.[4] The interest rate they pay consists of a fixed rate, currently 0.5% plus a variable inflation rate, currently 1.4% per year, that is recalculated twice a year. The fixed rate has been as high as 3.4% in 1998. These components constitute a "composite rate" that is currently 1.9% per year. Before you lose interest in a 1.9% return, consider several additional features of I Bonds that distinguish them from CDs or money market funds that don't compensate for inflation.

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The best inflation protection you never heard of.

[Tweet this]

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CD's typically can be purchased with terms up to five years. I Bonds pay interest for 30 years.

The early withdrawal penalty for a CD depends on its term. A 5-year CD, if redeemed before the end of its term, will typically incur a penalty of about nine months of interest and a 1-year CD typically three months. I Bonds can't be redeemed for one year after purchase but there is no penalty for redemption after five years and only a 3-month penalty for redemptions between one and five years.

If I Bond interest rates decline, you have locked in your rate for up to 30 years. If rates increase, you can sell your old bonds and buy new ones, subject to annual purchase limits described below.

According to Dr. Bodie, "...another advantage of I Bonds is that [should interest rates rise,] investors could then cash out their existing I Bonds (and keep principal plus accrued interest) and buy new ones at the higher rate of interest. In other words, whether interest rates go up or down, the investor is protected. (But note that if you buy new I Bonds you would be subject to the $10,000 limit.) If you have the money, you would have to be nuts not to invest in I Bonds up to the limit."

I Bonds can never yield less than zero, so in the worst case your investment will maintain its purchasing power. In the event of deflation, I Bonds would increase in value.

From a tax perspective, according to TreasuryDirect.gov^®.[4], I Bonds are somewhat similar to a non-deductible IRA in that tax on interest can be deferred. You don't have to pay taxes on earnings until the bonds are redeemed, though you can choose to pay annually if that benefits you. I Bonds are subject to federal income taxes but not state or local income taxes. CD and money market fund interest can be subject to all three if held in a taxable account and interest is taxed as it accrues annually.

I Bonds do have some drawbacks. A household can purchase a maximum of $10,000 per Social Security number per year. Still, that's $20,000 per year for a couple. Additional purchases can be made up to $5,000 per Social Security number per year if the purchase is made from a federal tax refund.

Some advisors suggest that the maximum annual purchase limitations mean I Bonds will be less interesting to households with a lot of savings. Perhaps, but I find them too good a deal to pass up even if I'd like to buy more (and I would).

I Bonds can't be purchased in a retirement account. Certain entities in addition to individuals, however, are permitted to open TreasuryDirect.gov^®.[4] accounts including a personal trust, such as a revocable or "living trust."[5]

The real interest rate on I Bonds will be relatively low because they are extremely safe, backed by the U.S. Treasury and protected from inflation.

With the very low early-withdrawal penalties, I Bonds can be an excellent solution for investing an emergency fund or for any other future liability beyond one year and for protecting that investment against inflation. They are accessible by retirees with limited resources in denominations as low as $25. Even households with large retirement savings may want to max out I Bond purchases before buying TIPS.[6]

It's a struggle to find retirement strategies for under-saved households but I Bonds provide one. Households that are able to save some of their early-retirement income from pensions and Social Security benefits could use those savings to purchase I-bonds that would then provide inflation-protected consumption later in retirement.

To find out more about Series I Savings Bonds and how to purchase them, go to TreasuryDirect.gov^®.[4]. Creating an online account at TreasuryDirect.gov^®.[4] is currently the only way you can purchase them. If you prefer video explanations, please see the links below.

TIPS: (the old-fashioned kind) TreasuryDirect.gov^®.[4] is an excellent informational website but it could be a better e-commerce site. Don't enter "TreasuryDirect.com" into your browser (it's "TreasuryDirect.gov"). Likewise, don't enter "Treasury.gov", that's a different website. To purchase I bonds, go to the homepage "TreasuryDirect.gov" and click on the green "Open an Account" link toward the upper right.

For more help creating an account and funding it, see Navigating the TreasuryDirect.gov^®.[4] Maze.

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REFERENCES

[1] Hedging Against Inflation with Real Annuities, Zvi Bodie and Dirk Cotton.



[2] TIPS in Depth, TreasuryDirect.gov.



[3] Series I Savings Bonds, TreasuryDirect.gov.



[4] America’s Best Kept Financial Secret: I Bonds, Zvi Bodie on PBS.



[5] How To Transfer I Bonds to an Entity Account, TreasuryDirect.gov.



[6] Comparing I Bonds to TIPS, TreasuryDirect.gov.



[7] How to Buy Digital Savings Bonds Online, VIDEO.



[8] How to Buy Digital Savings Bonds as Gifts, VIDEO.



[9] How to Protect Your Nest Egg from Inflation, Zvi Bodie, VIDEO.



[10] Guided Tour for Opening an Individual Treasury Direct account, TreasuryDirect.gov.

The Real Cost of Nominal Annuities

There are a number of ways that a retiree could speculate on the direction of future inflation but I doubt that many would want to. I imagine that most retirees would prefer to "inflation-proof" their retirement plan to the extent possible, instead. It’s possible to speculate on inflation, however, without even being aware that you are.

My last post, Remember Inflation?, was intended as preparation for this one and I recommend you read it first unless you feel you have a good understanding of the topic.

I recently co-authored a paper entitled, “Hedging Against Inflation Risk with Real Annuities” with economist, Zvi Bodie. Dr. Bodie has made key contributions to Life-Cycle economics and pension planning. If you’re studying retirement finance and are unfamiliar with his work, then you need to remedy that. I’ll provide links in the references below to get you started but the obvious places would be his website[1] and two of his books, “Risk Less and Prosper”[2] and “Worry-Free Investing.”[3]

Here's the crucial point of the paper in a nutshell. We obtained annuity quotes recently for a nominal (no inflation protection) income annuity, a nominal income annuity with a 3% annual cost-of-living adjustments, and a "real" annuity with no caps that is adjusted annually for inflation based on the Consumer Price Index for All Urban Consumers (CPI-U).[4]

Table 1.

I can purchase a nominal annuity that pays out $6,440 a year but because I can't predict future inflation, I have no idea how much purchasing power it will have in the future. Its future purchasing power might be a lot more or a lot less than $4,550 will purchase today in 2019 (see the first row of Table 1).

The rightmost two columns of Table 1 show the purchasing power in today's dollars twenty years from now if future inflation should mimic the high inflation of the 1970s and 1980s (column 5) and the same if future inflation looks like the low-inflation 1950s and 1960s (column 6). Both real payouts, $,1723 and $4,109, would have been significantly lower after twenty years than the initial $6,440 payment of the nominal annuity.

I can purchase a nominal "graduated-payment" income annuity that pays out $4,670 for the first year with a payout that increases 3% each year thereafter regardless of the rate of future inflation. Like the level-payment nominal annuity in row one, I have no idea how much purchasing power it will have in the future.

I can purchase a CPI-adjusted annuity today that pays out $4,550 a year for as long as I live (row three). If I live for 30 years or more, it will still provide $4,550 of purchasing power in 2019 dollars. This is the only annuity I can purchase from among these three for which I can predict future purchasing power.

Which annuity will provide more lifetime purchasing power, the nominal annuity that pays $6,440 per year or the real annuity that pays $4,550?

That's a trick question. The correct answer is that we can't know until the end of retirement. Nominal and real dollars are apples and oranges so we can't compare them directly. We need to convert the nominal dollars to real dollars — their future purchasing power — to compare the two. That's easier said than done because it requires that we make a guess about unpredictable future inflation rates.

If future inflation is benign, as it was from 1950-1970, then both the nominal level-payment annuity and the nominal annuity with a 3% COLA seen in Chart 4 would end up purchasing more at today's annuity prices than the CPI-adjusted annuity.

On the other hand, if future inflation is historically high, as shown in Chart 3 of the 1970s and 1980s, then the CPI-adjusted annuity would end up purchasing more than either of the two nominal annuities.

Charts 3 and 4 represent historically high and low inflation rates for 20-year periods since 1913 so other periods would have shown results of inflation ranging between those two.

The question this raises is whether that potentially large difference in a nominal annuity or bond's future purchasing power is a risk you want to take. Do you prefer a lifetime of $4,550 of near-certain 2019 purchasing power or would you be happier with a lifetime of 2019 purchasing power that ends up somewhere, unpredictably, between $2,257 and $5,381 after 20 years for the COLA annuity or between $1,723 and $4,109 for the nominal level-payment annuity?

Do you purchase an annuity to provide guaranteed purchasing power for life, or to provide a fixed number of dollar bills whose future purchasing power is unknowable? Is this something you want to speculate on?

The CPI-adjusted annuity has no inflation risk. It is a true inflation hedge. Purchasing a nominal annuity (or a nominal bond) is a bet on future inflation that you probably don't want to make.

Where does the graduated-payment (COLA) annuity fit in? The annual increases are chosen when you purchase the annuity. Adjustments are not linked to inflation but increasing income would offset some inflation, though it would provide a lower initial payment.

Joe Tomlinson did an analysis for the Journal of Retirement Income and concluded that "An inflation-indexed SPIA would be ideal. A COLA-SPIA may be the next best alternative.'[6]

In a separate analysis, Tomlinson found that at today's annuity prices, inflation needs to average 3.57% for the real annuity to outperform the level-payment nominal annuity. Inflation averaged 7.3% in the 1970s, 5.8% in the 1980s, 4.9% in the 1940s, and nearly 10% in the 1910s. All are significantly higher than the long-term average rate of inflation of 3.15%.

I have two concerns regarding inflation. First, even today's low inflation rate of around 2% will roughly halve a retiree's purchasing power over a 30-year retirement. Every retirement plan should consider inflation risk but after three decades of low inflation, it may not get the attention it deserves.

My second concern, also expressed by Tomlinson at Advisor Perspectives, is not the risk that inflation runs a little more than average but that it substantially exceeds average inflation for a prolonged period, as it has done in four of the last eleven decades (see Chart 1), and decimates the purchasing power of a nominal pension or a nominal annuity with or without a COLA. This is a potentially catastrophic outcome that isn't adequately addressed by nominal annuities even with a COLA. As I have often said, I believe retirement plans should take unacceptable outcomes off the table.

If you don't want to buy a CPI-adjusted annuity, have already purchased a nominal annuity, or have a pension without inflation protection, it's important to understand your inflation risk exposure and to try to mitigate it in other ways. You can do this by stress-testing your retirement plan to make sure you would retain minimum-acceptable income even in a period like the 1970s and 1980s. If you would not, you then need to look for other ways to mitigate inflation risk.

You can stress test this easily with planning software like Maxifi Planner[7] or ask your planner to run a high-inflation scenario for you.

The risk of purchasing a nominal annuity or owning a nominal pension has to be considered within the context of the rest of your retirement plan. For example, if a severe loss of the purchasing power of the pension or annuity would not compromise your standard of living because they represent a small portion of your income-producing assets, then they pose less risk to your plan. A nominal annuity or pension that is a major source of your plan's income would obviously be riskier. Purchasing a nominal annuity can be a rational choice in some scenarios and the best way to see that is to run the stress test.

Social Security benefits have historically been adjusted for inflation but most pensions are not. If you have a nominal pension or annuity then its purchasing power will almost certainly decline significantly over a long retirement.

The key takeaways are these. Express your retirement plan in real dollars or insist that your planner do so. Understand your retirement plan's exposure to inflation risk. Consider the possibility and ramifications of not enjoying three more decades of low inflation. Decide if you're willing to speculate on future inflation rates.

So, which annuity has the largest payout, the nominal or the CPI-adjusted? Unfortunately, only time will tell. The only meaningful comparison is based on purchasing power, not first-year payments. You can only be sure about the real annuity's purchasing power.

Unless you're a gambler, why bet on low future inflation? You can completely hedge inflation risk with a no-cap, CPI-U-adjusted annuity. The same logic applies to TIPS and I Bonds instead of nominal bonds.

I'll describe U.S. Series I Savings Bonds in my next post.

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REFERENCES

[1] ZviBodie.com, Dr. Bodie's website.


[2] Worry-Free Investing at Amazon, by Zvi Bodie.


[3] Risk Less and Prosper at Amazon, by Zvi Bodie.


[4] We obtained recent quotes for income annuities for an unmarried 65-year old male. The nominal annuity quotes were provided by New York Life and the CPI-adjusted annuity quote was obtained from The Principal. The Principal is currently the only U.S. provider of CPI-adjusted annuities. (We found one additional provider that only sells to its group members.) The Principal sells a "real" annuity through the purchase of a CPI rider for a single payment income annuity (SPIA). Quotes for these annuities are available through ImmediateAnnuities.com and BlueprintIncome.com.


[6] Making the Case for a COLA-SPIA, Kerry Prechter, The Retirement Income Journal.


[7] Maxifi Planner  online planning tool.

Remember Inflation?

I've noticed lately that our country is highly polarized.

No, I'm not referring to social media or cable news. I'm thinking about the great divide between Baby Boomers and every other younger cohort on the topic of inflation risk.

Baby Boomers worry about inflation.

Many of us graduated college into the jaws of 1970s "stagflation" (a terrible-sounding word describing a stagnant economy with high inflation) and watched our grandparents' pensions, paid in nominal dollars, slowly disappear over two decades as they aged. It was common to hear them say, "We're living on a fixed income" but they were not — they were living on a disappearing income in terms of purchasing power.

Fast forward to 2019 and a GenX'er recently suggested that we "old-timers" have too much fear of the "big bad inflation wolf."

I have no idea whether inflation rates the likes of which we experienced in the 1970s and 1980s will reappear anytime soon. Long-term inflation is unpredictable. I hope the GenX'er is right but I'm not willing to bet my retirement that he is. High inflation can be catastrophic and when we plan for retirement we should take catastrophic outcomes off the table when we can.

Inflation peaked at over 13% in 1980. I had a 14% mortgage.  Inflation rates were even higher in earlier decades. But annual inflation is a snapshot. Prolonged inflation is the real monster.

I stumbled across the following chart recently at inflationdata.com[1]. It shows historical annualized inflation rates by decade. Inflation for the decades of the 1970s and 1980s averaged 7.25% and 5.8% per year, respectively. Again, much lower than the annual peak in 1980 but destructive in its persistence.

We can now update inflation from 2010-2019 to 1.78%.

Notice that periods of high inflation come and go with no regularity. Also, notice that the high inflation of the 1970s and 1980s was immediately preceded by very low inflation in the 1950s and 1960s. No one saw it coming.

We sometimes speak of high inflation rates as "tail risk" but four of the previous eleven decades experienced average annualized inflation significantly higher than the long-term average of 3%. We haven't seen high inflation since the 1980s so we're probably experiencing recency bias.

There are a number of ways a household can mitigate inflation risk. I will write about one, CPI-adjusted annuities, soon. In the meanwhile, you can read a paper that economist, Zvi Bodie and I recently co-authored on that topic[2].

Buying TIPS bonds instead of nominal bonds is a near-perfect inflation hedge that transfers inflation risk to the U.S. Treasury. Your home equity might keep up with inflation. Social Security benefits are inflation-adjusted.

Although stocks are commonly referred to as an inflation hedge, they are not truly a hedge because real equity returns are not correlated with inflation. Stocks typically perform poorly in times of high inflation. Rather than "protect" against inflation they more or less "eventually outrun it", which is fine if both you and your portfolio survive long enough.

Economist, William Sharpe was recently quoted on this great divide. "I realize that it is hard to make the point that inflation can get out of control with the generations that grew up after the early 1980s, but perhaps we can point to other countries in more recent times, then ask them whether they think we are virtually guaranteed to have low and relatively steady rates of increases in prices for the rest of their lives.”

It's a good question to ask yourself or your advisor.

Don't forget inflation.

In my next post, The Real Cost of Nominal Annuities, I'll share some thoughts on hedging inflation with CPI-adjusted annuities.

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REFERENCES

[1] inflationdata.com.



[2] Hedging Inflation Risk with Real Annuities, Zvi Bodie and Dirk Cotton.

Going it Alone with Retirement Planning Software

I love models. I build and research models almost every day and have for almost two decades. For the past year, I have explored online retirement models while co-authoring a paper with an econometrician. Modeling is pretty much all econometricians do.

I don't like bad models, or models used for the wrong reason, or models used by people who don't understand them, especially when people who don't understand them try to explain them to other people who don't understand them.

It also concerns me that many people attribute mystical powers to computers. A computer model is no better than the human that programs it. It's just a whole lot faster and doesn't get complacent or bored.

So, I certainly don't like all models.

If you're going to use computer models to help plan your retirement, there are many things to consider.

First, economic models can be very useful to study your retirement prospects and figure out the best bets but they in no way predict your future. As the saying goes, all models are wrong but some are useful.

A Monte Carlo model, for example, can test thousands of possible future scenarios for your household but your retirement is a one-time event. There is no way to know which one of a multitude of simulated scenarios might be similar to the future you will experience or if any of them will. The tendency is to guess that your retirement will be like the median model outcome but that means you will be overly optimistic half the time.

The output that models create is only as realistic as the assumptions we feed them. Unfortunately, we can't estimate with any precision what future market returns will be, how long we will live or even how much we will need to spend over the coming decades. These are some of the key assumptions that drive models and we are, for the most part, guessing at what they might be.

In computer science there is an old saying, garbage in, garbage out. What we mean is that the output of a program is only as good as the input. Make a wild guess at the input and the output will be a wild guess. Unfortunately, many of our guesses, or "assumptions", are by necessity fairly wild.

A reader recently commented that "retirement planning is an unsolvable problem with unlimited variables." You could say that about chess, too, but some players clearly solve it better than others.

Retirement finance is unsolvable if your definition of "solvable" is finding a single, optimal solution in advance for your individual household. But, there are lots of "games" in economics that are probabilistic — retirement planning can be considered a "stochastic game against nature" in game theory parlance — for which we can determine the best strategies even though we can't be guaranteed to win.

We should never expect a model to provide a single, optimal solution to the retirement planning "game", nor should we expect that from a human advisor. The optimal solution can only be identified with certainty after retirement is over and that isn't very helpful for planning purposes.

Our goal, like that of the chess player, should be to find and implement strategies that produce the outcomes we want and avoid the ones we fear more often than alternative strategies do.

Many so-called retirement models concentrate almost solely on investment results. Those are investment models, not retirement models. A comprehensive retirement plan will consider many factors including Social Security maximization, annuitization, life insurance, estate planning, taxes, and others.

It is possible to use multiple models (perhaps an investment model, a Social Security model, and a tax program) to solve these problems individually but a comprehensive plan needs to also consider the interplay of these factors. (See a sample list of free limited-purpose models below.) Change any of these factors and other factors will be impacted. We would pay a big price in the planning process if we didn't consider that. A comprehensive retirement planning model is a much better tool.

A major benefit of Monte Carlo models is that we can test changes to many factors and see how they interact in one model run.

Assume, for example, that we are planning retirement with a spreadsheet model, such as the Bogleheads spreadsheet below, that considers many retirement-funding options. Let's say that I want to run the spreadsheet to consider all possible combinations of market returns ranging from 4% to 10% in 1% increments, asset allocations from 0% to 100% equities in 10% increments, and annuitization from 0% to 50% in 10% increments. Considering just those three factors, I would need 462 runs to capture the combined effects with a spreadsheet model or I could capture them and many more with one run of a Monte Carlo model. There are actually several other factors I should include and note that the spreadsheet is not modeling sequence risk.

It is unlikely that a retirement toolkit provided by an investment firm will give annuities, life insurance or reverse mortgages consideration equal to equities and vice versa. Better to find a model with no agenda.

It's also important to know who built the model and their qualifications. I have a lot of confidence in the Bogleheads and more in Laurence Kotlikoff, who created MaxiFi. Wealthfront identifies the developer of their retirement model. But, unless you know the qualifications of the model builder, I'd steer clear. Anyone can build a model and post it on the Internet.

Building a retirement model requires an understanding of finance, modeling skills, expertise in the computer language used (even if it is only Excel), and a sound understanding of statistics and probabilities. If you don't have all four, then building your own model is a very bad idea.

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Retirement planning software can answer a lot of questions but you have to know what to ask.

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Models can answer a lot of questions but you have to know what to ask. A model is unlikely to suggest that Roth conversions might be profitable, for example, or that you should consider a combination of annuities, whole life insurance, and equities, as Wade Pfau and Michael Finke have suggested.[1] A good human retirement planner knows what to ask.

I am wary of models that use probability of ruin as their metric of success.[2] Probability of ruin measures the probability of portfolio failures but does not measure the magnitude of losses. For example, it will count a strategy that funds 29 out of 30 years an unequivocal failure. It will count a retirement strategy that successfully funds 30 years as a success but no more successful than one that funds 50 years.

As Zvi Bodie points out, probability of ruin doesn't consider utility. Presumably, retirees will be less satisfied coming up $100 short of paying the bills than they will be satisfied with a $100 surplus. Paying the bills is a necessity; having a little extra is a nicety.

Probability of ruin is a particularly bad metric for Monte Carlo models because, among other reasons, results can change significantly by changing nothing but the random number draw. If you use such a model, try running it several times with the same input and see if you get nearly identical results each time. If the results change a lot for each run and never converge then the model is problematic. If the results are precisely the same for each run with the same input it may be because the model always uses the same set of random numbers for every run to speed up computation, so we still can't say for sure that the model is properly constructed.

If you are going to plan with a "retirement toolkit", I recommend the following:

• Be aware that today's retirement models are not a replacement for a human advisor. If you plan your own retirement with these models then you and not the model will be replacing the advisor.
• Understand that no model can predict your future, certainly not for 30 years. You will need to recalculate periodically.
• Know the credentials of the model builder.
• Use models to explore the possible outcomes and better understand the economic forces at play. When you see bad outcomes, try to come up with a way to mitigate them.
• Be aware that a model is only as good as the input we provide and the assumptions we make and that we can't make very precise assumptions. That means we won't get very precise results.
• Understand that a model is not a retirement plan. It is one tool to help build a plan.
• Find a model from a provider that won't profit from the sale of retirement-funding products.
• Find a comprehensive retirement model that tests several key factors — spending rules, taxes, Social Security claiming, pensions, annuities, life insurance, asset allocation, etc. — and their interactions instead of trying to combine the results of single-purpose models.

I think the best and most comprehensive retirement planning software with a reasonable price tag for consumers at present is Laurence Kotlikoff's MaxiFi.com. It's not free but it is affordable. It can be tricky to use and, again, the more you know about retirement finance, the better the results you can expect. MaxiFi provides all the capabilities that I mentioned above and more and it completely avoids probability-of-ruin issues by maximizing lifetime consumption, instead.

What should you do with this information?

Use all "toolkits" with caution. I have a toolkit in my garage that contains all the tools needed to perform most household plumbing chores but for some reason, my wife still insists that I call a professional plumber.

Given that finding a great retirement planner can be challenging and expensive and that many of this blog's readers tend to do their own planning, it's easy to see the allure of finding a great software package and doing it yourself. Today's software, however, is much closer to a toolkit than to a "robo-advisor." Those who choose this path should avoid being overconfident in the results and should build plenty of safety margin into their plan.

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Sample List of Free Limited-Purpose Retirement Planning Tools

• Estimate a budgetary amount to spend from savings for the current year: Ken Steiner's How Much Can I spend in Retirement Spreadsheet. Note: Ken Steiner mentioned to me that my original wording here, "safe amount to spend" should instead say "budgetary amount to spend", as we agree there is no way to predict a "safe" spending amount. Ken's goal is to provide a budgetary spending estimate based on sound actuarial principles.

• Comprehensive retirement planning spreadsheet: Bogleheads
• Social Security optimization: Mike Piper's Open Social Security
• Tax estimation: National Bureau of Economic Research's: TAXSIM
• Immediate annuity quotes: ImmediateAnnuities.com, CANNEX. CPI-adjusted annuities: Principal
• Life expectancy: Vanguard Plan for a Long Retirement

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REFERENCES

[1]Improving Retirement Outcomes with Investments, Life Insurance, and Income Annuities, Wade Pfau and Michael Finke.



[2] Toward Determining the Optimal Investment Strategy for Retirement, Javier Estrada.

Black Holes, the Higgs Boson and Retirement Planning

The first image of a black hole. Credit: Event Horizon Telescope collaboration et al.

What do relativity theory, quantum mechanics and retirement planning have in common? Not a lot and that's actually an important point.

Black holes were implied by Einstein's work on general relativity in 1915 but the first one wasn't discovered until 1971[1]. Physics was able to predict the existence of one of the largest elements of the universe 56 years before one was discovered.

At the other extreme, on the quantum scale, Peter Higgs and five other scientists proposed the existence of the Higgs boson in 1964. Its existence was confirmed in 2012 based on collisions in the Large Hadron Collider at CERN. The existence of the Higgs boson was predicted 48 years before it could be confirmed.

In retirement planning, we do well to predict finances somewhat accurately more than a year or two in advance. Retirement planning is clearly not rocket science.

Physical sciences and their predictions are based on physical laws of the universe. Acceleration due to gravity on Earth is about 9.8 meters/second², or about 32 feet per second per second as we Boomers learned in high school physics back when a meter in the U.S. was something one paid a quarter to park. On Mars, it's about 3.7 m/s². Light travels at about 300,000 kilometers/second.

Drop an object from a height of 10 meters on earth and we can predict that it will reach the ground in 1.43 seconds traveling at 14 meters/second at impact. We can build models that predict such things with great accuracy.

Economics, however, is a social science, not a physical science. Finances can be modeled mathematically but actual outcomes are highly dependent upon the behavior of the humans involved. That makes the models far less predictive.

Unlike the universal laws of physics, the inputs for financial models are often unknown, so we make our best guesses. The most important factor of retirement finance, how long you and your spouse will live, is largely unknowable. Half of a group of people like you may live another 18 years but you might live twice that long or get hit by a bus tomorrow.

We know that stock markets have returned about 9% a year over the past 150 years but you won't be retired for 150 years. The geometric rate of market return you would have historically experienced over any single 30-year retirement during those 150 years could have been less than 3% per year or more than 10%, depending on the year you retired. The range of returns is broader for shorter periods.

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Black Holes, the Higgs Boson and Retirement Planning.

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Retirement models, whether mathematical, spreadsheet, or Monte Carlo simulation, can't predict the future the way models do in the physical sciences. Monte Carlo simulation was developed for the Manhattan project and was accurate enough to help develop the atomic bomb when the world had minuscule computing power. MC could predict how atoms would behave but it can't predict your retirement finances.

In 2001, William Bernstein published a blog post entitled, "Of Math and History" noting that "it’s the engineers who most often give me the willies."[2]

"The trouble is, markets are not circuits, airfoils, or bridges—they do not react the same way each time to a given input. (To say nothing of the fact that inputs are never even nearly the same.) The market, though, does have a memory, albeit a highly defective kind, as we’ll see shortly. Its response to given circumstances tends to be modified by its most recent behavior. An investment strategy based solely on historical data is a prescription for disaster."

(It's a great read, by the way, as is just about everything at EfficientFrontier.com.)

There is huge risk in believing that we can accurately predict our financial future, market risk or returns, a safe amount to spend annually from our savings portfolio, our optimal asset allocation, our probability of successfully funding retirement, or any such metric with any degree of accuracy for any period beyond perhaps a couple of years, let alone for a retirement that could last 30 to 40 years.

I recently told an audience at a retirement finance conference that the greatest risk of retirement is overconfidence. Believing you can accurately predict the things in the previous paragraph is a prime example.

You might rightly ask, given my perspective of uncertainty, why I spend much of my retirement days building simulation models. The answer is that I don't use the models to predict probability of ruin or to predict anything, for that matter. I use them to study many possible outcomes for hints for improving my retirement plan. I readily admit that I have no idea which simulated scenario, if any, ultimately will be similar to mine. I just want to find the bad outcomes and say, "Whoa! How can I avoid those?"

I was once asked what I think is wrong with spreadsheet models of retirement. My answer is that they only consider a single possible scenario and not a realistic one, at that. It is highly unlikely that you will live precisely 30 years in retirement, for example, and there is an infinitesimal probability that your market returns or expenses will be the same each of those years.

(You could run a spreadsheet model several times with different assumptions, of course, but you can generate tens of thousands of different scenarios in a few seconds with MC.)

The tools we use in the physical sciences can be useful in social sciences like economics but they cannot be as predictive because people, unlike atoms, are unpredictable. Computerized retirement models can look impressive when a computer spits out thirty pages of Monte Carlo simulated data but less so when one considers the huge assumptions that have been input into the program. Computers and simulation cannot remove risk from your retirement but they can help identify and understand it.

In an earlier post, I suggested that the most important retirement decision you will make is how much of your wealth to allocate to safer income assets and how much to risk in the market. Don't be overconfident in your ability to predict the risk and returns of the latter. Have a backup plan (a floor of safe income) in case of portfolio failure. Retirement models are simply the best estimates we can make of a largely unknowable future.

And, if someone tells you that you will die with $5.3M in your investment portfolio or that you can spend 4.27% of your portfolio balance annually with a 95% probability of not outliving your savings for at least 30 years, consider that with a large dollop of skepticism.

Remember when you're considering your retirement plan that all models are wrong but some are useful.

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Zvi Bodie explains "America's best-kept secret", I bonds for inflation protection.


The American College of Financial Services has created a wonderful collection of brief video interviews with Rick Miller on topics of personal financial planning.

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REFERENCES

[1] Who Really Discovered Black Holes?, BBC Science Focus Magazine.



[2] Of Math and History, William Bernstein.

The Mystery Of Dividend Preference And The 'Spend Dividends Only' Strategy

A good many retirees seem to be enamored with the "Spend Interest and Dividends Only" strategy for spending down their retirement savings. The foundation of this strategy is a preference for the value of a dollar generated from dividends over the value of a dollar generated from the sale of stock, or capital gains.

This preference has long been recognized but never quite understood.

The reason for this preference for dividends is so confounding that economists in the field of behavioral finance find it an interesting research topic. One of those researchers is Samuel Hartzmark, an Associate Professor of Finance at the University of Chicago's Booth School of Business.

Hartzmark thinks dividends fall under the category of mental accounting. He describes a "free dividend fallacy", in which investors view dividends as a source of return that is independent of the price of the stock when in reality the price of the stock is immediately reduced by the value of the dividend when it is paid. This fosters the mistaken belief that dividends are the same as bond interest.

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Samuel Hartzmark describes a "free dividend fallacy" in which investors view dividends as a source of return that is independent of the price of the stock.

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This false equivalence of bond interest and dividends probably influences some investors to turn to high-dividend stocks when bond interest is low without considering the additional risk that equities bring. They are not the same, of course. When a $10,000 bond pays out $300 in interest, the bondholder is still owed $10,000 in principal at the bond's maturity date. When $10,000 of stock pays out $300 in dividends, the value of the remaining stock immediately drops to $9,700 at payout. Unlike bonds, there is no "maturity date" or any promise of the stock's value at some future date.

In fact, there are tax advantages to generating income with capital gains in a taxable account, despite the fact that qualified dividends and capital gains are currently taxed at the same rate. The investor can postpone capital gains tax until the funds are actually needed whereas a cash dividend (the most common type) will be immediately taxable when the company decides to issue it. An added bonus of capital gains is the ability to minimize taxes by selling specific lots.

In a post entitled, "Buffett: You Want a Dividend? Go Make Your Own,"[1] Motley Fool describes Warren Buffett's explanation for Berkshire Hathaway's refusal to pay dividends and how it is actually more efficient for both Berkshire and their shareholders if shareholders "create their own dividends" by selling shares.

In "Vanguard Debunks Dividend Myth"[2], financial researcher Larry Swedroe notes,

"But this preference isn’t entirely new; it has long been known many investors have a preference for cash dividends. From the perspective of classical financial theory, this behavior is an anomaly. It’s an anomaly because dividend policy should be irrelevant to stock returns, as Merton Miller and Franco Modigliani famously established in their 1961 paper 'Dividend Policy, Growth, and the Valuation of Shares.'"

Swedroe further notes that concentrating on dividend-producing stocks reduces diversification benefits. Concentrating is a key word here because adding some dividend-producing stocks to a portfolio can increase diversification. Said differently, there is nothing wrong with dividend-producing stocks but investing in only those stocks can be hazardous to your portfolio's health. As is often the case, too much of a good thing is too much.

Swedroe concludes that "both theory and historical evidence demonstrate there isn’t anything unique about dividends."

Strategies have been proposed to eliminate sequence of returns risk with high-dividend stocks. This wouldn't have occurred to me because sequence risk is caused by systematically selling stocks when prices are low. Cash dividends don't avoid sales at low prices; they are effectively a forced sale that will occur regardless of the stock's price and with timing decided by the company.

A recent series of three posts at the EarlyRetirementNow blog entitled "The Yield Illusion: How Can a High-Dividend Portfolio Exacerbate Sequence Risk?,"[3] shows that a high dividend yielding portfolio doesn't mitigate sequence risk and can, in fact, exacerbate it.

As always, the bottom line is what a retiree should do with this knowledge. My advising philosophy is that so long as a household understands a strategy and its alternatives, they should do what makes them comfortable.

I once had a client say, "I know I am behaving irrationally but this is what I am most comfortable doing." I don't know how I can argue with that or even if I should. As Michael Finke says, our job as advisors is to make clients happy.

Furthermore, there is no way to prove that even a poor strategy won't turn out well or a good one poorly for an individual household. We can only say what is probably a good or poor bet.

But, if you plan to spend down retirement savings with a strategy based on preferring a dollar of dividends to a dollar of capital gains, you are betting against economic theory, portfolio theory, historical evidence, tax law, behavioral finance and the wisdom of Warren Buffett.

Then again, maybe you will be lucky.

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REFERENCES

[1] Buffett: You Want a Dividend? Go Make Your Own, Motley Fool.



[2] Vanguard Debunks Dividend Myth, Larry Swedroe.



[3]  The Yield Illusion: How Can a High-Dividend Portfolio Exacerbate Sequence Risk?, EarlyRetirementNow blog.