Assume Your Social Security Number Is Already Out There

I’m going to briefly depart from my typical retirement finance post to talk about ID theft and retirees, who are frequent targets of this crime.

A few weeks ago, the IRS informed me that someone had filed a federal tax return for last year in my name and claimed a tax refund. In my case, the fraud have been discovered and IRS had not yet paid the bogus refund, as they apparently have for several hundred thousand or so other fraudulent filings. My real tax refund, tiny though it was, arrived unimpeded a few days later.

The way the scam basically works is that the criminal gathers enough of your personal financial data to electronically file a 1040-EZ and claim a tax return. The IRS is working with the electronic tax return filing industry to put better safeguards in place.

My wife freaked out when she heard. I didn’t. The difference was in our expectations.

“Some criminal has our Social Security number!” she pleaded.

“True,” I replied, “but it’s safe to assume that it’s been out there for quite a while."

News stories appear almost daily about massive security breaches. This one at the IRS. A few weeks ago it was the bank that issued my credit card. Target’s database was compromised by criminals gaining access through their HVAC service company. There’s a really good chance that your financial data has also been compromised and, at any rate, it’s safest to assume that it has been.

If ID thieves had rubbed a magic lamp in the mid-twentieth century and had been offered one wish, it would have been "tie every individual American's sensitive financial information to their Social Security number forever." Unfortunately for the rest of us, they didn't need a lamp.

A website called Information is Beautiful justifies its claim by organizing a history of major breaches in this fabulous display. See any merchants or websites there that you have used?

This brings up an important point. We worry that someone will access our home computers, tablets or smart phones and steal our financial data. While that is possible, it’s a lot easier to get our financial data by stealing millions at a time from Target than it is to sit around a coffee shop waiting for someone to log onto their bank account. The latter is actually a lot easier to protect against, and why pick up crumbs when the entire delicious cake is right there for the taking?

While the IRS works on ways to prevent fraudulent returns, there are some steps that retirees (or anyone, really) can take to secure their credit. I placed a freeze on credit reports at the three credit agencies, Experian, Trans Union and Equifax. Now, no one can use these agencies to approve loans or open new credit accounts in my name or my wife’s without my knowledge. The cost of placing, removing and replacing a credit freeze varies by state law, but there are exceptions for free credit freezes for seniors, minors, documented ID theft victims, etc.

The Federal Trade Commission explains how to place a freeze here.

Be sure to freeze the credit of both spouses!

There are valid considerations for not freezing your credit, as explained in this post by Consumer Reports.  If you take out new car loans or apply for credit cards, you will need to remove the freeze and that can take several days. As the Consumer Reports article mentions, it may be easiest to find out which credit agency your car dealer uses and temporarily lift the freeze at only that agency for only that dealer (or a few).

My household's days of applying for new credit cards is long past and unfreezing my credit a few days before I buy a car every few years isn’t a burden compared to the peace of mind the freeze brings. And if having to unfreeze credit a few days before buying a car stops one of my relatives (you know who you are) from continuing to trade cars on impulse so he or she can later wallow in buyer's remorse, all the better.

Freezing our accounts included the unexpected opportunity to request that the agencies never again allow my credit history to be accessed by someone offering pre-authorized credit cards. This should cut by junk mail problem in half.

Another possible solution is to use an “Identity Theft Protection Plan” like the ones reviewed in this Huffington Post article entitled, "Do Identity Theft Protection Services Work?"

Most are not free, although when major breaches occur like the one at Target, the breached company frequently offers a year of such a service free to their customers who may have been exposed. To make my point, I currently have three such services monitoring my credit paid for by three different companies that "may" have offered up my personal credit information to hackers.

A credit freeze protects us from thieves opening new accounts but it doesn’t protect existing accounts. ID Theft services supposedly cover both. Fortunately, most credit cards and debit cards don’t hold us responsible for fraud if we report it in a timely manner. Debit cards, however, can handle the response to fraud claims in a less convenient manner than credit cards. 

The conversion of American credit cards to chip-and-pin technology is largely underway and offers a higher level of credit card fraud protection that has been available for a decade or more in Europe and Asia. You may already have a card or two with the embedded computer chip. Now, we have to wait for a zillion American merchants to convert to chip-and-pin readers and systems that actually use the chip. Then, as a side benefit, when we travel to Europe, we won't have to look like someone out of the 1980's whipping out a stack of traveler's checks.

My recommendation to retirees, given the likelihood of fewer new credit accounts to be opened, is to implement a credit freeze at all three major credit agencies. Again, instructions on how to do so can be found here. For younger households that need more frequent access to credit reports, a credit freeze may be more burdensome, but possibly worth the extra effort. 

And, of course, take advantage of your free annual credit report and review it carefully. To avoid free credit report website offers with strings attached, use the official one promoted by the FTC. It's free, as in free.

And lastly, I recommend that you assume your private and sensitive financial information has already been hacked.  Even if it hasn’t been, you’re safer assuming that is has. Check out my next post, "Have You Already Been Hacked?"

The Risk of Retiring (or Being Retired) Early

Financial journalist, Mark Miller, recently asked me to provide input on a piece he is doing about retiring early. Early retirement is clearly out of reach for most American workers, but as I was working on the article with him, I realized that early retirement issues provide important insights into "normal age" retirements, say from age 65 to 70, and also into the risks faced by the roughly 50% of workers who retire early because they have to. (PDF from Employee Benefits Research Institute. See Figure 34.)

The writer suggested that his research into the topic showed that the answer, more often than not, is "don't do it." That's probably correct, "more often than not", but maybe a better way to say it is that retiring early is probably riskier than most people realize.

There are at least three major financial challenges of retiring early. First, although no healthy person knows how long he or she will live, retiring early increases the expected length of retirement and the number of years we spend in retirement is the greatest unpredictable determinant of retirement cost. (The amount we spend can be a greater factor, but unlike life expectancy and other key factors, spending is at least somewhat within our control.)

It is also a major factor in determining a sustainable withdrawal rate.

When you retire early, you add more years of retirement expenses and, as a result, you add more financial risk. You have to spend a smaller percentage of your retirement savings portfolio annually to mitigate that risk.

Second, retiring early ends savings contributions when they will typically be greatest. Third, retiring early means drawing down savings until Social Security benefits or pension income kicks in. This places additional stress on savings early in retirement that increases the risk of outliving your savings.

Let's look at longevity and sustainable withdrawal rates first.

Longevity risk is the risk that a retired household will outlive their retirement savings. The major factors contributing to longevity risk are how long retirement lasts, how much we spend each year of retirement and how aggressively we invest.

We predict how long retirement might last using life expectancy calculations at our retirement age. We can predict a median life expectancy, and we can also calculate the probability that we will live to some advanced age, such as 95 or 100. A 65-year old American male retiring today, for example, has a median life expectancy of 83 years (86 for a female) and a 6% chance of living to age 95 (13% for a female).

A retiree who decides to retire early increases the risk of a long, costly retirement. The 60-year old male in this example has a 6% chance of surviving a retirement of 30 years or more. Deciding to retire five years early at age 60, however, creates a 6% chance of a 35-year retirement and more than triples the risk of a 30-year retirement from 6% to 19%.

Retiring early has an obvious upside. A retiree who doesn’t live long after retiring will enjoy a longer retirement by doing so. The longevity risk of early retirement is that the retiree might turn what would have been a long and expensive retirement into one that is even longer and more expensive. Turning a 5-year retirement into a 10-year retirement by retiring five years early probably won't cause problems, because the retiree should have planned for an even longer retirement. But, turning a 30-year retirement into a 35-year retirement just might. Of course, the retiree has no way of knowing how long retirement is actually going to last. 

The table below shows the cost of retirement to age 95 with spending of $80,000 annually and discounted at a rate of 2% per year. Column three shows the percent increase of the cost incurred by retiring 5 years earlier than the previous row's retirement age and column 5 shows the probability that an American male retiring at that age would survive to age 95 or beyond. For example, retiring at age 65 would cost 14.7% more than retiring at age 70 and retiring at age 60 would cost 11.6% more than postponing retirement to age 65, assuming both retirees survive to age 95.

The table above shows near-worst case cost, a retirement to age 95. For comparison, the table below shows similar costs assuming the retiree lives to the median life expectancy for a U.S. male at that retirement age in 2015. For example, retiring at age 60 would cost 16.7% more than postponing retirement until age 65, assuming the person lived to his median life expectancy at the retirement age.

Notice that the costs of retirement are lower than in the previous table because expected years in retirement is smaller, but the percent increase in cost from earlier retirement is greater. The chart below shows the probability of a retiree experiencing a long and costly retirement as a function of retirement age. For example, an American male retiring at age 60 has about a 19% chance of a retirement lasting 30 years or more, but that probability for the same person retiring at age 65 is only about 6%.

Reducing the amount of annual spending that is sustainable increases the amount you need to save for retirement. The annual sustainable spending rate grows quadratically as the length of retirement becomes shorter. (All sustainable withdrawal calculations in this post use Milevsky's formula for sustainable spending without simulation (PDF) and assume a maximum 5% portfolio failure rate and a 40% equity portfolio with real mean return of 4.6% and standard deviation of 7%.)

That means that target retirement savings decay quadratically as the length of retirement becomes shorter.

An American male retiring at age 60 has a life expectancy of about 22 years and can spend about 3.6% of his retirement savings portfolio annually. Retiring at 70, he has a life expectancy of about 14 more years and can spend about 4.3% of savings annually, about 20% more. To support $50,000 annual spending from savings, the retiree at age 60 would need to save about $1.39M, while the retiree at 70 would need to save $1.163M, or 16% less.

So, those are the first couple of challenges with retiring early, whether voluntary or not. You risk adding years to a retirement that you couldn't have known in advance was going to be a long, expensive one and with that increased longevity risk, you need to save more before retirement or spend less after. Expected retirement costs more because it lasts longer, but also because it is riskier.

This is a consideration for fortunate workers who have a realistic option of retiring early, but it is a severe penalty for workers who have not adequately saved and find themselves leaving the workforce before they had planned. For workers between these two extremes, this demonstrates the value of working even a few extra years.

Next, I'll look at the second factor,  Retiring Early: Lost Savings.

Retirement Expectations: A Reality Check

I got into an interesting discussion with some friends on FaceBook the other day about what Americans can reasonably expect from retirement. It made me think about what my own expectations had been and I realized that I had never really had many.

(Embarrassing full disclosure: I never thought much about retirement at all until I was about 50.)

Oh, I saved a lot of money in defined contribution plans over the years, but not because I was thinking about the future. I had a high-paying career and the tax deferrals were instant gratification. I knew down deep that I would have to pay those taxes someday, that they were merely deferred and not avoided, but I didn't give that much thought. I was interested in the current year's tax savings.

Surely everyone knows by now that a large majority of Americans under-save for retirement. Baby Boomers haven't saved enough and they get most of the venom from the press, but younger cohorts are in even worse shape.

How badly prepared are we?

The Employment Benefits Research Institute (EBRI) has prepared a "Retirement Readiness" report since 2003. A recent report (download PDF) from 2012 states,

"EBRI’s updated 2012 Retirement Security Projection Model® finds that for Early Baby Boomers (individuals born between 1948–1954), Late Baby Boomers (born between 1955–1964) and Generation Xers (born between 1965–1974), roughly 44 percent of the simulated lifepaths were projected to lack adequate retirement income for basic retirement expenses plus uninsured health care costs."

How do we compare to the rest of the world?

Natixi Global Asset Management produces a ranking of retiree welfare by country (PDF). In 2015, they rank U.S. retirees 19^th in the world, slightly worse than France, slightly better than Slovenia, and four rungs below the Czech Republic.

A critical factor in the cost of retirement, of course, is longevity. The longer we live after we retire, the more our retirement costs. I suppose there is some "good news" in our world rankings, in a morbid sort of way. The CIA Fact Book ranks the U.S. 49^th in life expectancy, slightly worse than Portugal, slightly better than Taiwan. (You can find the full ranking here.)

At least we don't have to fund Japan's retirements, with life expectancies of 84 years, let alone Monaco's nearly 90.

So, the problem that has evolved, for both Baby Boomers and younger cohorts, is that advances in medicine have extended our life expectancies significantly since World War II (though not as far as Portugal's, let alone Monaco's) and that has significantly increased the possible cost of retirement. Unfortunately, longer life spans increase the number of years at the end of our lives, while our earning years still end around age 65. We have the same length careers to fund potentially much longer lives.

For someone who lives to 95, that means perhaps 70 years of adulthood will have to be funded by about 40 years of working career. We get some help from Social Security retirement benefits, a few of us have pensions, and we can leverage time and our investments if we start saving early. But that's still a pretty tall order.

Wade Pfau wrote a paper in 2011 entitled, "Safe Savings Rates: A New Approach to Retirement Planning over the Lifecycle." (PDF) He calculated that the amount of our paychecks that we needed to save historically sometimes approached 25% for a household that needed to replace 70% of pre-retirement income with 30 years to accumulate savings. That's a lot when a household is doing all they can to raise a couple of kids and put them through college. (For some periods, the saving requirement was significantly less, but we can't know that in advance.)

That brings me around to how to think about retirement savings. We shouldn't think about retirement savings as this year's tax break, as they were marketed to Baby Boomers, or as a way to make our retirement years a little more golden.

We should think about retirement savings as transferring some of the wealth from those 40 working years to fund the last 30 after retirement. It isn't fun to think about the fact that in addition to supporting our families before we retire – which probably seems like an enormous challenge on its own – we need to earn enough to also support ourselves and our spouses for what could be a very long retirement.

If I were giving my twenty-something children retirement saving advice, that's what I would tell them. Save like you understand that the money you earn today has to pay the bills today and the bills after you retire. Because it does.

I would also tell them that funding a decent retirement in the U.S. is an extreme challenge that requires sacrifice while they are working and a great deal of good luck throughout their lifetimes.

Many households simply won't earn that much, or be that lucky, and that is the reality that ERBI is reporting. It's not the prettiest picture, and it's one you can't wish away.

Retirement Expenditures and Costs of Retirement

Some great questions and comments about my previous posts on spending in retirement, beginning with Spending Typically Declines as We Age, suggest that I should add a bit more to my explanation. Or as Ricky Ricardo might have said, "I got some 'splainin to do."

Will the cost of retirement decline as you age?

The fact is I don't have any idea how much you will spend late in retirement, nor does anyone else. I can't predict what a household's finances will look like in two or three decades (which is why glide path discussions don't much interest me). My arguments about declining expenses as we age and dynamic updating are about how much you can spend now based on what you now know, not about how much you will spend later in life.

(Reminder to readers: Hover your mouse pointer over yellow text for further explanation. Double-click any chart to see a larger version. Orange text is a hyperlink. "PDF" denotes that clicking will download a PDF of the referenced document.)

The Banerjee and Blanchett studies show that retirement expenditures typically decline with age. Expenditures, however, are not the same as the generally accepted definition of “cost". Think of expenditures as consisting of non-discretionary spending (“basic costs") and discretionary expenses (“lifestyle costs”). In fact, Blanchett showed that the group of retirees with high net worth and low spending are the ones most likely to experience an increase in expenditures, not because their costs go up in many cases, but because at some point they realize they can safely spend more money on their lifestyle than they have been.

No one knows if your spending or your costs will decline as you age, but these studies (and many others) show they are very likely to. Banerjee shows that expenditures decline for two out of three retired households. That is the best initial assumption until experience with your actual retirement results indicates that you are on a different track. (You can refine that initial assumption, as I explained in Retirement Spending Assumptions and Net Worth.)

Is it dangerous to assume that costs will decline?

Not really, and for two reasons. Theoretically, using this approach, if we assume costs will decline and they don’t, we will spend money early in retirement that we might come to need late in retirement. That’s a risk.

It's important to note that the risk of overspending early in retirement isn't exclusive to a plan that assumes decreasing spending. 

But, Banerjee showed that spending declines for about 66% of retirees and increases for about 16% in real dollars. If many of the 16% of retirees who eventually spend more do so because they realize they can afford to, then the danger zone is the 18% chance that spending will remain flat.

However, assuming declining costs in order to provide the most accurate assessment of how much money a retiree can spend today isn’t a one-time calculation, at least it shouldn't be. These calculations should be made annually (see Dominated Strategies and Dynamic Spending). A retiree who initially assumes declining expenditures but ends up in the 18% or so of retirees who don’t see declines in spending should quickly notice the divergence from plan and correct spending within a few years. Annually adjusting spending and assumptions about future spending should should provide for a quick and relatively smooth correction. This is the first way we hedge the risk of assuming declining expenditures.

The second hedge is control of our discretionary spending. We can budget discretionary spending to target a planned decline in spending as we age to increase the probability that our spending does, in fact, decline as we assumed it would. In other words, we have some control over those spending declines. As Blanchett shows, the larger the portion of our budget that consists of discretionary expenses, the more our spending is likely to decline with age. If your spending is largely non-discretionary, then your expectations for spending declines should be modest from the beginning.

There are other arguments for assuming flat spending, including building in a margin of error and having the excess available to pass to heirs. Perhaps the first argument is a matter of personal choice, but I prefer to make the best prediction that I can of future expenses and allow for a margin of error separately. I like to understand both the expected costs and the risk, and not have risk tossed in as an afterthought.

Assuming flat spending as a safety margin is, after all, quite arbitrary. Why not assume a half-percent annual increase in spending, instead of flat spending? Without studies like Banerjee and Blanchett, most retirees and planners couldn’t identify the magnitude of that margin, let alone determine if that is the correct safety margin. Regardless, in my opinion, the risk of running out of savings should be addressed in the floor portfolio, not as additional margin in the risky portfolio.

I have a similar concern with planning legacies as an afterthought of spending, first because I believe that any serious concern about a legacy deserves its own plan and, second, because Scott, Sharpe and Watson (PDF) have shown that planning with “reserves” (hedging sequence of returns risk with over-saving) can be very costly.

In my next post, Retirement Expectations: A Reality Check, I'll write about what we should hold as reasonable expectations of retirement. Hope to see you there.

Spending Rules That Fit the Patterns of Retirement, and Some That Don't

I noted in a recent blog post that Spending Typically Declines with Age after we retire. In a follow-up post, Retirement Spending Assumptions and Net Worth, I explored two recent papers on retirement expenditures that suggest how much spending might decline for you based on how much you plan to spend annually on non-discretionary expenses and your net worth.

I also pointed out that spending rules typically assume that spending will be flat throughout retirement, contrary to what Blanchett, Banerjee and several other researchers have found in studies of data for actual reported retirement spending.

The question most of these spending rules answer is, "how much can I safely spend from savings this year assuming I will spend that same amount every remaining year of retirement?", when the question retirees actually mean to ask is "how much can I safely spend from savings this year given what I assume I will need to spend in the future?"

The difference can be substantial. Quoting Blanchett from Estimating the True Cost of Retirement (PDF), 

"When combined, these findings have important implications for retirees, especially when estimating the amount that must be saved to fund retirement. While many retirement income models use a fixed time period (e.g., 30 years) to estimate the duration of retirement, modeling the cost over the expected lifetime of the household, along with incorporating the actual spending curve, result in a required account balance at retirement that can be 20% less than the amount required using traditional models."

Sustainable withdrawal rate models make this flat-spending assumption, though it isn't difficult to change the models to fit a different spending assumption. I ran my own Monte Carlo model assuming a 50% equity allocation with constant spending and estimated a 95^th-percentile safe withdrawal rate of 4.1%. Then I modified the model to spend 1.5% less in real dollars for each year of ten thousand 30-year scenarios. The second model estimated a 95^th-percentile safe withdrawal rate of 5%. That's 22% more annual spending, or $9,000 a year more "sustainable" spending than the SWR model suggests for a $1M initial portfolio balance.

Looked at from the wealth accumulation perspective, a retiree would need to save 18% less to generate the same annual spending if she expected expenditures to decrease 1.5% a year on average rather than assuming expenses would remain flat throughout retirement as most spending rules assume.

The ARVA (PDF) spending strategy model, or annually recalculated virtual annuity, is more problematic. ARVA assumes that the correct sustainable amount to spend in the current year is the amount that an inflation-protected life annuity purchased in the current year would pay out. The retiree doesn't actually need to buy the annuity, she can simply base spending on what would happen if she did. An inflation-protected annuity will pay out the same amount throughout retirement and it isn't clear to me how ARVA could be adapted to predicted declines in spending needs as we age.

This problem extends to life annuity strategies, in general. Inflation-protected life annuities will pay out a flat rate throughout your lifetime in real dollars that will not match declining expenditures. From that perspective, nominal life annuities may not be quite as bad as they seem, since inflation will eat away at the real annual payouts, but expenditures will probably decline, too. The problem is that even "normal" inflation of 2% to 3% is greater than the estimates of expenditure declines, so this is a poor way to match income and expenses. Runaway inflation could be devastating.

Moshe Milevsky's formula for calculating sustainable withdrawal rates without simulation also seems problematic, as it, too, assumes the sustainable spending that it calculates will continue to be spent throughout retirement. It isn't clear to me that regularly rising or declining spending could be incorporated into his probability models, let alone irregular net spending, but his math is well above my pay grade. Milevsky's formula doesn't accommodate the loss of a first spouse except under the assumption that spending doesn't decline. Based on his responses to similar questions in the past, I would guess he would tell us that these scenarios would have to be calculated individually with numerical analysis if we want to avoid simulation.

As I mentioned in Retirement Spending Assumptions and Net Worth, it is probably more common for a retiring household to experience irregular spending throughout retirement, and the SWR model can easily be modified to accommodate that expenditure, as well. I repeat that chart here for your convenience. The red columns show irregular spending. Your spending in retirement is much more likely to resemble this than a straight line.

Bond ladders work well with any spending pattern including irregular ones. It is simple enough to match bond purchases to different amounts of future spending.

If spending increases as we age in retirement, most spending rules will overestimate the safe amount to spend in the current year. It is more likely that your spending will decline over time, in which case these models will provide current-year safe spending amounts that are too conservative. With irregular spending, it's hard to know where to begin with most spending rules.

My last three posts have followed a theme. First, spending is more likely to decline as we age than to remain flat.

Second, by looking at our own non-discretionary spending and net worth, we may be able to determine a more accurate assumption for our own retirement expenditures.

And, third, most spending rules aren't based on a realistic financial model of actual retirement. They assume flat spending, fixed lifetimes (e.g., 30 years), constant risk aversion, and average market returns and they make other spherical cow assumptions that simplify the math but can lead to inefficient saving and spending.

I suggest modeling your expected expenses and income to consider expected market returns, life expectancy and expected expenditures. They are all "stochastic variables", which means they have a random probability distribution that can be analyzed statistically, but can't be predicted precisely.

Retirement Spending Assumptions and Net Worth

In my last post, Spending Typically Declines as We Age, I reviewed the results of research by David Blanchett (PDF) and Sudipto Banerjee (PDF) that shows expenditures in retirement typically decline as we age. Most retirement spending strategies assume, as I noted in that post, that future real spending will remain constant throughout retirement.

The amount that we can safely spend from retirement savings in the current year depends heavily on the assumptions we make about future spending trends. If our future spending needs will decline, spending rules that assume constant real spending will be unnecessarily conservative and, of course, if future spending will increase, those spending rules will recommend spending that may not be sustainable.

What assumptions should our retirement plan make about future spending? The two papers I reference offer some clues.

First, Banerjee reports that spending in retirement increased for only 16% of the households in the data he studied, while it declined for 66% of them. It is significantly more likely that your expenditures will decline as you age, but they might not, so our retirement plans should also consider worst case outcomes.

We could assume a worst case, that expenditures will increase perhaps 1% per year on average, but that would significantly increase the predicted cost of retirement. If we assume we will live 30 years or more, that our market returns will be quite conservative by historical standards and that our expenses will grow in retirement, we will quickly realize that hardly anyone could afford that retirement. Making lots of conservative assumptions doesn't make a very good plan.

Blanchett offers additional insights by segmenting the data based on the level of annual spending relative to net worth. He creates four categories of consumption: low spenders with high net worth, low spenders with low net worth, high spenders with high net worth and high spenders with low net worth. By figuring out into which group you best fit, you may be able to narrow the field of spending assumptions for your plan.

The dividing line for high and low spenders was $30,000 per year and the hurdle for high net worth was $400,000 in Blanchett's study. These are the median values for his data sample, not for the population of retirees. In other words, more than $30,000 of annual spending made households in the data sample high spenders relative to other households in the sample, but that amount wouldn't make you a high spender relative to all other retirees in the U.S. today. The breakpoints for the larger population of retirees would likely be much higher. Blanchett is showing that expenditures in retirement depend on the relationship between annual spending and net worth; he is not claiming that these are the dividing lines for all retirees.

Blanchett notes that two of these groups, Low Spending, Low Net Worth and High Spending, High Net Worth retirees, consume efficiently (green), while the other two groups consume too much (red) or too little (yellow).

Following is a diagram from Blanchett's paper plotting these four segments. Please note the very important point, as I explained in Spending Typically Declines as We Age, that these graphs show annual rate of change in spending and not annual spending, itself. With the exception of Low Spending, High Net Worth households (the red squares on Panel B) almost all of the annual changes in expenditures are negative, meaning spending declines throughout retirement for the other three groups. (Double-click the chart for a larger image.)

Notice that the following graphs of annual spending are quite different than Blanchett's graphs of annual spending change above. Because some readers have mistaken the Blanchett "smile" rate-of-annual-change graphs for annual expenditures graphs, I provide both in the examples below.

In fact, Blanchett's paper shows this in his Figure 7, though most of that paper addresses annual spending change and not annual real dollar spending. My graphs will show typical real dollar annual spending that is derived from the rate-of-change graph to its right. I place the spending function on the left because I believe that information will be more meaningful to most of my readers, and I switched Panels A and B in Blanchett's Figure 7 for consistency – the charts on the left always show annual spending.

Let me be very clear about this. The Blanchett smile curves, like Panel A above, show how quickly typical spending changes each year. The spending curves, like Panel B above, show how much spending changes in real dollars and, in most cases, spending goes steadily downward throughout retirement, like the curves in Panel B.

Now, let's look at Blanchett's four spending/net worth classifications.

Low Spending, Low Net Worth households likely spend a large portion of their budget on non-discretionary expenses with little opportunity for reducing expenses later in retirement. We usually give up some discretionary items later in retirement, like extensive travel and sports, and these households have fewer of those to eliminate, so expenditures don't decline a lot with age.

High Spending, High Net Worth households also consume efficiently and will likely see greater declines in spending than Low Spending, Low Net Worth households, because they will have more discretionary spending to eliminate as they age.

Low Spending, High Net Worth households appear to have the highest probability of increased expenditures throughout retirement, but they can afford it. They are underspending. A likely cause for such an increase in expenditures, in fact, is recognition over time that they have the resources to spend more.

This graph also demonstrates the key point that increasing expenditures don't necessarily mean that retirement is getting more expensive and decreasing expenditures don't mean it is getting less expensive. They mean that retirees are spending more or less. Expenditures, the subject of this analysis, are not the same as expenses. Sometimes expenditures change because retirees have to spend less and sometimes it is because they can spend more.

High Spending, Low Net Worth households also consume inefficiently and they are likely to recognize as they age that their level of spending is unsustainable. This realization will eventually lead to declining expenditures later in retirement, as can be seen in the following chart.

The next chart combines all four annual spending curves for comparison. The two curves in the middle result from efficient consumption. Inefficient consumption produces the two extremes.

Your personal ratio of annual spending to net worth should suggest whether your own spending is more likely to rise, fall, or remain somewhat constant throughout retirement.

To summarize this information, Banerjee tells us that two-thirds of retirees will experience declining expenditures as they age and only 16% will see increased spending. Blanchett tells us that spending will likely increase for Low Spending, High Net Worth households as they realize they are able to spend more as they age, as it will likely decrease for High Spending, Low Net Worth households as they realize they are running out of savings. Among households that consume efficiently, those with High Spending and High Net Worth are more likely to spend less later in retirement because they will have more discretionary expenses to "age out of" than will Low Spending, Low Net Worth households.

Some expenditures change for reasons that have little to do with how much annual spending a retiree targets or how wealthy they are. Some changes are the result of aging. Health care expenses tend to increase as we get older but we also become less active and other expenses decline. I recently read that international air travel declines among septuagenarians and domestic air travel declines among octogenarians. I suspect the sales of bungee-jumping and rock-climbing gear decline in those market segments, as well. I spend less on hair care expenses.

These two studies deal with typical retiree spending patterns and assume that expenditures will follow some trend, rising, constant or declining, throughout retirement. They don't, however, deal with the most likely scenario for an individual household, irregular net spending.

Both income and expenses in retirement are likely to vary significantly over time. Income will vary, for instance, as Social Security benefits ramp up for retired couples and more income needs to be withdrawn from savings early in retirement. There may also be large planned expenses later in retirement, like college for a child or grandchild. Net spending is the important consideration, the difference between annual income and annual expenses. Irregular net spending from savings might look like the red bars in the following chart:

These irregular net spending years, whether they are caused by changing income or changing expenses, must be considered when calculating a sustainable amount to spend in the current year. Like steadily rising or steadily declining expenditures, spending rules assume flat future spending and don't accommodate irregular net spending very well.

It is helpful to know that expenses typically decline in real terms throughout retirement, but yours may not. You need to plan for expected spending declines but be prepared for a worse case. Like portfolio returns, total expenditures in retirement are unpredictable.

So, most retirement income strategies assume constant spending throughout retirement and most retirement expenditure studies show that constant spending isn't the norm. What's a retiree supposed to do with that?

In my next post, Spending Rules That Fit the Patterns of Retirement, and Some That Don't, I'll explore spending strategies in light of future spending expectations.

2015 RIIA Practitioner Thought Leadership Award

The Retirement Income Industry Association® (RIIA) today announced that Financial Planner Dirk Cotton, author of The Retirement Café blog and founder of JDC Planning, LLC, is the winner of its 2015 RIIA Practitioner Thought Leadership Award. The Award recognizes his paper, “Sequence of Return Risks: A New Way of Looking at Spending or Saving Scenarios with Path Dependence,” for contributions to retirement thought leadership and RIIA’s Body of Knowledge. The paper appears in the Spring issue of RIIA’s peer reviewed industry publication, the Retirement Management Journal®.

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Spending Typically Declines as We Age

The most common assumption of retirement spending strategies is that real (inflation-adjusted) spending from savings will be flat throughout retirement, yet most studies of actual retiree household expenditures show that constant real spending is atypical. For most retirees, expenditures decline pretty consistently as we age.

Two of my favorite studies on this topic are David Blanchett's Estimating the True Cost of Retirement (2013, PDF) and Sudipto Banerjee's Expenditure Patterns of Older Americans, 2001-2009 (2012, PDF). The results of the studies are quite similar – not surprising since they used the same databases – but each provides unique information.

Blanchett christened his findings the "retirement spending smile", though be forewarned that if you Google "Blanchett smile", you will find a multitude of photos of Cate Blanchett's lovely face with poor David nowhere to be found. (It wasn't a terrible disappointment.)

Following is a chart of the "smile" from Blanchett (2013). (A quick note: you can double-click any chart in my posts to see a larger version. Also, while burnt orange text indicates a link to another website, yellow text indicates a mouse-over. Hover your mouse over the link for more information.)

There are three things I should note about the chart. First, the term "Experience" labeling the y-axis is an "auto-incorrect" for "Expenditures." Second, the smaller smile was added because of limited sample sizes for some tests. Pay more attention to the 30-year smile. My third point is a larger issue.

I suspect that some readers interpret the spending smile as showing that spending is high in early retirement, becomes lower until age 75 and then returns to nearly the level of early retirement near age 90, but this is not a graph of total annual spending. It is a graph of the annual real change in consumption for a typical retiree. In other words, it shows a decrease (and very rarely an increase) in spending at say, age 61 compared to age 60. It shows not the change of spending, but the rate of that change.

The rate of the decrease changes throughout retirement, but because these rates are nearly always negative (below the zero percent line on the y-axis in Blanchett's chart above), spending constantly decreases, but at different speeds. Banerjee shows the data in terms of total spending instead of the rate of annual change in spending and this point is more clear in his chart:

Reconstructing annual total expenditures from Blanchett's annual rate of change data for a retiree with a $100K annual spending target, we see a chart below that is similar to Banerjee's.

Mathematically speaking, the Banerjee curve is an annual spending function and the Blanchett smile curve is the derivative of the spending function. Banerjee shows the spending curve for a typical retiree while Blanchett shows the acceleration of that curve. Both show that expenditures generally decline with age, as have earlier studies. Blanchett additionally shows that expenditures drop more rapidly each year of early retirement and drop more slowly each year of late retirement, but both show that the amount of spending almost always declines.

Medical expenses late in life can increase expenditures significantly, but both studies appear to show that even when medical expenses do increase expenditures at older ages, they are lower than early retirement spending in real dollars.

The Banerjee chart and the Blanchett annual expenditure chart are not identical. Banerjee shows a steeper decline. Part of the reason for this may be, as Blanchett suggests, that he scrubbed the data to eliminate data points that seemed unreasonable, while Banerjee appears to have used the entire dataset.

Another reason is that Blanchett shows that rates of spending decline vary for undersavers and oversavers, while Banerjee provides a single rate of decline for all households.  Regardless, both studies find that typical retiree expenditures decline as we age. They do not remain constant in real dollars as spending strategies generally assume.

Why is this important? It should be obvious that when we try to estimate an amount of our savings that we can safely spend in the current year we must make some assumption about our future spending patterns. Spending strategies assume that our expenditures in real dollars will remain flat throughout retirement. If our actual spending will increase over time, we can safely spend less in the current year than these strategies predict, and the reverse is true if our expenditures will actually decline after we retire.

A 30-year retirement with level real spending of $100,000 a year would cost about $2.4M if we discount future expenses at 2%. Assuming Blanchett's findings for a retiree with a spending target of $100,000 a year, the same retirement would cost about $2.1M. Using the Banerjee 2012 finding that expenditures tend to decline about 2% annually, that retirement would cost only about $1.8M.

The following chart shows the expected annual spending and cost of an initial $100K annual retirement using all three assumptions:

Future spending is difficult to predict with any accuracy, but a spending strategy that assumes flat real spending throughout retirement, as nearly all do, will underspend early in retirement if the retiree's expenditures decline over time as Blanchett, Banerjee and several other researchers believe they commonly do. In these examples, Blanchett predicts a 12.5% less expensive retirement and Banerjee forecasts 25% less. From another perspective, that means a worker would need to save 12.5% or 25% less to fund retirement.

To quote Blanchett, "While many retirement income models use a fixed time period (e.g., 30 years) to estimate the duration of retirement, modeling the cost over the expected lifetime of the household, along with incorporating the actual spending curve, results in a required account balance at retirement that can be 20% less than the amount required using traditional models."

How does this impact our retirement plan? Clearly our future spending trend assumption has a significant impact on both how much we need to save and how much we can "safely" spend in the current year. Unfortunately, like assuming many other critical retirement unknowns such as future market returns and the length of our own retirement, choosing a future spending assumption is both critical and challenging.

In my next post, Retirement Spending Assumptions and Net Worth, I'll explore these two papers to see what they tell us about how we should choose.

Time to Retire the Probability of Ruin?

The following post originally appeared on Advisor Perspectives, a blog for financial planners, in April 2015.

Perhaps no other retirement finance concept has gotten more ink than the "probability of ruin", which is interesting because few other economic concepts model the real world as poorly. The gist is that a retiree who spends a constant dollar amount throughout retirement is exposed to the risk of outliving her savings. The problem with the economic model is that no one would actually do that.

A constant-dollar spending assumption served us well when William Bengen formalized the notion of path dependence, but it seems that even he didn't anticipate that planners might implement the strategy by rote. In Conserving Client Portfolios During Retirement, Bengen states, ". . . the adviser should examine the projected current withdrawal rate through the entire time horizon of the clients, not just the first year of retirement." He even put it in italics.

Probability of ruin is largely an artifact of those constant-dollar SWR studies.

(Note: You can hover over yellow terms.)

Once constant-dollar SWR escaped the lab, though, the mainstream press and popular retirement newsletters latched onto the belief that constant-dollar spending was OK. These same publications softened their stances quite a bit after retirements were destroyed in the Great Recession, but I recently received a Kiplinger retirement newsletter still espousing the constant-dollar strategy.

Nearly all retirement income strategies avoid the probability of ruin issue in theory by spreading spending thinner and thinner as savings decline – a rational rationing strategy. Annual Recalculated Virtual Annuity (ARVA download PDF), RMD,  Milevsky's formula for sustainable withdrawals without simulation, and the 3D dynamic updating strategy (download PDF) of Frank, Mitchell and Blanchett all spread spending over remaining life expectancy. Constant-percentage SWR doesn't, but won't deplete a portfolio in theory, either.

Unfortunately, these strategies reduce the probability of ruin by reducing spending, our "standard of living."

Life annuities are different because they augment their payouts with a mortality premium and both guarantee a standard of living and provide longevity protection.

I was rereading a study recently about evaluating retirement strategies and noticed the author suggested that retiree's want an income strategy that guarantees they will not outlive their savings. While this is no doubt true, what we really want is an income strategy that guarantees we won't lose our standard of living. That's a bigger ask than avoiding ruin. A strategy that ignores standard of living but guarantees the retiree won't go broke is easy to develop, though perhaps not very useful.

Probability of ruin analyses are not good models of rational human behavior. Michael Kitces has often argued that no one actually implements a constant-dollar SWR strategy. If a retiree's portfolio grows significantly after retirement, any rational person would begin to spend a bit more and surely the reverse is true. What rational person would lose a large portion of their savings and believe they wouldn't need to spend less?

Wade Pfau says it a little differently: constant-dollar SWR is a research technique, not a retirement strategy.

Following this line of reasoning to its logical end, I have calculated the true probability of ruin resulting from consistent overspending with sequence of returns risk for nearly all retirees under nearly all economic conditions.

Zero.

That's the probability I estimate that an actual retiree will just keep spending the same amount every year as she faces clear prospects of ruin. She will, instead, reduce spending and face the prospects of a diminished standard of living. This is a more rational model and the risk that we should be discussing. The probability of a reduced standard of living is more difficult to quantify than probability of ruin with constant-dollar spending, which is why we use the latter in the first place, but ease of calculation doesn't make it a useful metric. 

I have given this question a great deal of thought relative to my own retirement finances and I cannot imagine the impact of outliving my savings, nor can I assign a probability of doing so that I would consider "acceptable." I can say that my number is far closer to zero than to 5%. 

A small probability of a catastrophic outcome is not something that most of us can internalize. We only know that we want to avoid it.

Probability of ruin is a useful research technique that can allow us to compare the relevant benefit of two strategies, but translating that to real-life benefit isn't straightforward. The concept can rarely be communicated with a retiree, unless that retiree has an unusually strong understanding of probabilities, and even then an acceptable probability for losing one's savings late in life is just too big an ask.

I wonder if it's time to retire the probability of ruin, or at least drive it back into the lab. It's not clear to me that we are helping retirees by focusing on it.

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Michael Kitces has posted two outstanding columns (more, actually) on Social Security benefits at his blog, Nerd's Eye View. The first, Valuing Social Security Benefits As An Asset On The Household Balance Sheet, was posted April 8, 2015. This led me to a 2014 post, How Delaying Social Security Can Be The Best Long-Term Investment Or Annuity Money Can Buy.  I highly recommend them, and Nerd's Eye View, in general.

Variable Spending Strategies: Variations on a Theme

We could easily name ten or twelve retirement income strategies but several of them are really just variations on a theme. When you're trying to choose one, it may help to visualize them that way.

In a recent post, Dominated Strategies and Dynamic Spending, I showed that fixed-dollar sustainable withdrawal rates (SWR-Fixed), fixed-percentage rate SWR (SWR-Variable), and Required Minimum Distribution strategies are all dominated by a dynamic updating strategy. Game theory tells us that dominated strategies should never be played and that guideline should narrow the field of choices.

In A Second Look at Time Segmentation, I argued that the benefits of time segmentation strategies may be largely behavioral. Holding large allocations of cash will reduce expected returns and Moshe Milevsky has shown (download Word doc) that the strategy cannot be counted on to bail us out of a bad sequence of returns, though it sometimes will. 

Nevertheless, many retirees appear to find comfort in time segmentation strategies, knowing that any spending problems are at least five years into the future. I'm always in favor of sacrificing a little economic efficiency if it helps the retiree sleep at night.

I’m now going to argue that these are actually the same strategy applied to different degrees.

A dynamic updating strategy, or dynamic spending strategy as I have sometimes referred to it, tells us to modify our spending periodically (typically annually), to reflect our ever-changing portfolio value, diminishing life expectancy, new expectations about market returns and risk, and any changes to our personal risk tolerance and risk capacity.

If we calculate a sustainable spending amount once at the beginning of retirement, we have an SWR-Fixed strategy. This strategy's attraction lies in its simplicity of implementation and maintenance, but it condemns the retiree to spend based on conditions that might have existed two or three decades earlier. In other words, it ignores any new information after retirement begins – a foolhardy approach.

Michael Kitces argues that no one really implements SWR-Fixed because retirees eventually realize they must spend less or can spend more and do so, and he has an excellent point. Wade Pfau argues that SWR-Fixed is a research technique and never was a retirement income strategy. I think he’s right, too. Yet, I don't completely buy the idea that no one tries to use the SWR-Fixed strategy by rote.

For a decade or more, Money magazine touted the SWR-Fixed strategy, relenting only after many retirements were trashed in the 2008 market crash. I recently received a sample Kiplinger newsletter suggesting the strategy. With so much ink in the popular press for so long, it’s hard for me to accept that no one believes it. I hope Pfau and Kitces are correct, but I have a nagging suspicion that they are not entirely. If you’re implementing a SWR strategy by rote, please stop.

In a post entitled, Sequence of Returns Risk and Payouts, I showed that an SWR-Variable strategy, in which a retiree spends a fixed percentage (like 4%) of remaining savings portfolio balance each year, eliminates the possibility of ruin inherent in an SWR-Fixed strategy. It provides variable annual spending but a more constant risk of failure than SWR-Fixed. SWR-Variable moves risk from longevity (running out of money) to payouts (perhaps needing to spend less), where it seems to do less harm.

SWR-Variable reduces sequence of returns (SOR) risk by reducing spending when portfolio value declines. If we recalculate a sustainable spending amount annually, instead of once at the beginning of retirement like SWR-Fixed, and only update portfolio balance, we have an SWR-Variable strategy. Because it uses more new information, it dominates SWR-Fixed, but because it doesn’t update life expectancy, market return expectations and risk tolerance and capacity changes, it is dominated by dynamic updating.

So, calculate spending once at the beginning of retirement and you have SWR-Fixed. Apply it annually, updating only your savings balance, and you have SWR-Variable.

Basing spending on IRA Required Minimum Distributions (RMDs) also exposes us to less SOR risk than SWR-Fixed because spending will be reduced when portfolio values decline. RMD bases spending on an annual updating of portfolio balance and remaining life expectancy (updated annual spending is roughly current portfolio balance divided by remaining life expectancy), but ignores changes to expected market returns and changes to risk tolerance and capacity. As a result, it is also dominated by dynamic updating.

Still, studies show that the RMD strategy is a reasonable approximation of dynamic updating strategies and a lot simpler. To quote David Blanchett, et. al. from a 2012 paper entitled, Optimal Withdrawal Strategy for Retirement Income Portfolios, "As a practical matter, for retirees who can’t replicate the results presented here or don’t have access to them, the RMD method emerges as a reasonable alternative to the more common constant dollar and constant percentage of assets withdrawal strategies."

Dynamic updating strategies calculate a new sustainable spending rate each year incorporating all critical factors of the probability of ruin: current savings balance, remaining life expectancy, market return expectations and current risk tolerance and risk capacity. Spending is no longer tied to your personal financial situation as it existed at the beginning of retirement, or even the previous year.

Lastly, let's look at time segmentation strategies. Time segmentation strategies hold four or five years of expenses in cash, the next five to seven years of expected spending in intermediate bonds, and the remainder in stocks to cover long term spending.

As I argued in A Second Look at Time Segmentation, this strategy is largely an SWR strategy with perhaps too large an allocation to cash for its own good. It could be an SWR-Fixed strategy if the retiree calculates spending once, an SWR-Variable strategy if the retiree recalculates spending periodically based on a current portfolio balance alone, or a dynamic updating strategy if the retiree updates all critical variables periodically. If we look at the portfolio holdings alone, it may be impossible to distinguish an SWR strategy from a time segmentation strategy. (A larger than expected cash holding tips us off that it is probably the former.)

The more critical parameters we consider in our retirement income strategy, the better the approximation of sustainable spending.

The following table summarizes the variables considered by each strategy. Time segmentation is not included because it dictates an asset allocation but can use any of these spending strategies.

How does this help a retiree? It should help by simplifying the broad array of retirement income strategies available. A retiree will always be better off updating her spending as her financial situation changes and the more critical information she updates in the process the better. 

SWR-Fixed, SWR-Variable and RMD strategies simplify sustainable spending calculations by ignoring critical new information. Time segmentation can be added to any of these strategies, but the financial justification for it is much weaker than the behavioral justification.

What is the benefit of ignoring relevant new information? Only that it simplifies the math and reduces the management process a tiny bit – spending is recalculated just once a year in any case, except for SWR-Fixed, of course.

Retirees unwilling to do that little bit of extra work will likely be better off with a set-and-forget strategy like TIPS bond ladders and life annuities.

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The sidebar shows a link to a recent post by Wade Pfau at Advisor Perspectives entitled, The Hidden Peril of Sequence of Returns Risk. SOR risk is complicated and nuanced. In several ways, it is unlike any other form of retirement financial risk, and certainly different than investment risk. No retirement income strategy is perfect, but the risks of SWR strategies are more difficult to understand than the rest. A great read.

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