Positive Feedback Loops: The Other Roads to Ruin

Positive feedback like, “Nice post!” is always welcome, but positive feedback that gets stuck in a loop can have catastrophic results.

The most memorable experience of positive feedback is the head-splitting screech that fills an auditorium when the PA system experiences feedback. Someone speaks into the microphone and the sound is amplified. Amplified sound from the speakers is picked up by the microphone and amplified again through the speakers and back to the microphone and . . . well, by about the fifth cycle through the amp everyone in the room is holding their hands over their ears and mouthing silent profanities.

The most common experience of a negative feedback loop is your home thermostat that reduces heat when the temperature gets higher. You’d think that a screeching PA system would be negative and a thermostat controlling your home heating and cooling would be positive, but that isn’t how feedback loops are named.

According to one website, a more formal explanation of the difference is this:

“Positive feedback loops enhance or amplify changes; this tends to move a system away from its equilibrium state and make it more unstable. Negative feedback loops tend to dampen or buffer changes; this tends to hold a system to some equilibrium state, making it more stable."

So, when does a retirement income system “tend to move away from its equilibrium state and become unstable”?

To answer that, I'll tell a story about a retired couple in 2007, because I was raised in the South where every question is answered with a story. My story is not strictly true (a long-standing tradition of Southern stories). I will build a composite retired household from personal observations of multiple actual households from that time, some of whom weren't really even retired but, as my grandfather would’ve said with a grin if he were telling this story, “they might'a been.”

Jim and Linda retired in Omaha in 2005. The family seemed well-to-do, but they lived in a large, heavily mortgaged home. Jim had built a small fortune over his working career investing in rental homes, also heavily mortgaged, and most of their retirement income came from those properties. They both had retirement accounts invested in index funds worth about $200,000 and significant income from several CD’s and a money market fund.

Life went pretty much as planned until late 2007 when the stock market began a 50%, 18-month drop, interest paid on safe investments dropped to zero and, worse for Jim and Linda, the real estate market tanked, all simultaneously. Though most people would eventually recover from these crises, Jim and Linda wouldn't – a financial crisis can be a very personal thing.

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Market losses aren't the only road to ruin in retirement.

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With the rental income gone and the CD's and money market funds now paying a pitiful fraction of one percent, Jim could no longer afford the mortgage on his home plus the mortgages on fifty or so rental properties so he let the unprofitable rentals go. There were no buyers, so “letting go” meant skipping mortgage payments until the banks foreclosed.

The family’s rental business had drifted into a positive feedback loop wherein foreclosed properties reduced income, which reduced their ability to pay other mortgages, which resulted in more foreclosures, which resulted in even less income. It didn't stop until all the properties, including their home, were foreclosed. In less than a year, Jim and Linda's once-shiny finances looked like PA system feedback sounds.

The couple’s plan had assumed that their portfolio of rental properties was well diversified. Sure, a few of the fifty properties might fail from time to time, but what were the odds that a catastrophic number of them would fail in short order? Incidentally, this is the same assumption that led to the Wall Street collateralized mortgage obligations crisis on a much grander scale and as Jim, Linda and several Wall Street giants soon learned, the correlations had been much higher than they had believed.

Jim needed to sell their stocks, intended to fund decades of retirement, at lower and lower prices as the stock market continued its collapse. The stock market would recover years later, as stock brokers promise it always will, but Jim and Linda wouldn't participate in that recovery. Their stocks had long been sold. The stock market had also entered a positive feedback loop with selling encouraging more selling for a year and a half.

Their retirement planner had told them that they could safely spend 4% of their portfolio value each year, or about $8,000. There was a small chance, around 5%, that a series of poor returns early in retirement would result in their outliving their savings, but an even smaller chance if they spent less when their portfolio declined in value. Unfortunately, they did realize that unlikely poor performance right after they retired.

Jim, Linda and their planner had assumed that spending might need to be reduced during a bad market spell. (We say “spell” in this context a lot in Southern stories. It’s a very versatile word. We can sit for a spell, Uncle Howard can have one of his spells, or in Louisiana we might even cast one.) What they hadn’t considered is that forces other than market volatility – like expense surprises and lost income, for example – might preclude their ability to make those needed spending cuts.

Each year that Jim and Linda spent more than planned from their portfolio increased their probability of ruin. The continual shrinking of their portfolio value as the market fell increased it even more. Soon that probability of ruin was a lot more than the original 5%. An example is provided in the table below.

Their portfolio spending strategy had drifted into a positive feedback loop (that's three if you're keeping score), wherein every year that they overspent from their savings they increased the risk of portfolio ruin, reduced their capacity to recover when the market did, and decreased the amount of spending that would be considered safe the following year, increasing the probability that they would need to overspend yet again. The way to escape this loop would have been to reduce spending from their portfolio. Without the rental income and fixed income interest, they couldn’t.

The good (and coincidentally true) ending to this story is that today, eight years later, all of the households in this composite have recovered to some degree, though one middle-aged couple divorced under the strain. The investment portfolio is gone, as is the real estate wealth, but they have a "spell" to recover because, as I said, none of them were actually retired. The outcome would have been worse had they been. Younger people have more risk capacity and remaining human capital.

Most people survived and completely recovered from these simultaneous stock, interest rate and real estate crashes, but Jim and Linda did not. Had their investment properties not simultaneously tanked, they would have easily survived the bear market and kept their home.

What types of spending shocks can initiate a positive feedback loop? There are several candidates. A late-life divorce can be financially devastating and, though you may imagine them rare, they are not. I am aware of three among my circle of acquaintances over the past five years. (One gentleman was 80 and he married again within a year.)

Unexpected medical expenses, particularly onerous with dementia (see Costs for Dementia Care Far Exceeding Other Diseases), aren't uncommon. Two families within my circle of acquaintances are retired and financially stressed by the high support costs of their grown children who have medical problems. A combination of small underestimates of spending, expected market returns, and longevity could also do the trick in an otherwise survivable economic downturn. (As I showed in 100% Certain That We're Not Sure, there is no certainty that you picked the correct portfolio spending rate to begin with. You may already be overspending.)

Research shows that well-diversified retirement portfolios are unlikely to completely fail as a result of market volatility. (See, for example, Larry Frank.) The portion of the portfolio that is unlikely to disappear is sometimes referred to as a “soft floor.” Stout and Mitchell (download PDF) showed that retirees who reduce spending when their portfolio is stressed can reduce the risk of ruin by 30% to 40%.

These studies don't address spending volatility, however, so they don't predict what happens if retirees, like Jim and Linda, are unable to make the needed spending reductions. Mean reversion and diversification won't save those who can't due to divorce, dementia, debt or dependents.

The positive feedback loops are present in these studies if you look for them carefully. Observe what happens to a portfolio in a constant-dollar spending model and you will see that when a portfolio declines in value and the retiree keeps spending a constant-dollar amount, she increases the risk of portfolio ruin going forward. When this happens several years in a row, the probability of ruin grows quite quickly. In the following table, a 65-year old couple in 1974 with a 50% equity portfolio wishing to spend $52,000 from a $1M portfolio each year would see their probability of ruin nearly triple in five years. (Probability of ruin calculated using Milevsky formula.)

Year	Return on 50% Equity Portfolio	Portfolio Balance	Withdrawal Rate for $52k Spending	Probability of Ruin
Initial		1,000,000		5.0%
1974	-8%	872,160	6.0%	5.2%
1975	-11%	729,942	7.1%	8.5%
1976	18.5%	803,362	6.5%	14.4%
1977	6.5%	800,200	6.5%	10.6%
1978	-4%	718,272	7.2%	14.4%

The table above demonstrates a positive feedback loop that would have developed had the retiree felt it was safe to continue the same amount of spending yearly as the market declined (it isn't), but it would also have developed if the retiree hadn't been able to reduce spending.

Positive feedback loops disappear in dynamic-updating models that assume that the retiree will be able to cut spending when necessary. Since there are no unmet liabilities (overspending) in these models, there are no positive feedback loops. The difference between probabilities of ruin between the two types of models offers an estimate of the risk of not being able to reduce spending.

Stout and Mitchell found that adjusting spending reduces risk of ruin 30% to 40% compared to constant-dollar spending, so we can infer that not adjusting spending is about 43% to 67% riskier than adjusting it. The risk that we will deplete our portfolio because we can't adjust our spending is that 43% to 67% probability times the probability that we won't be able to reduce spending. The probability that we can't is far more difficult to estimate.

We can, however, ballpark that probability by considering our financial risk capacity. If we have lots of money saved relative to our spending needs, we have lots of risk capacity and the odds are better that we won't find ourselves unable to reduce spending from our portfolio when needed. The less savings we have relative to our spending, the greater the likelihood that we may be unable to reduce spending when necessary and the greater the chances that we will trigger a positive feedback loop that ends in ruin.

(Another way to look at risk capacity is your portfolio spending rate. If you only need to spend 1% to 2% annually, you're far safer from spending crises than if you need to spend 4% or more annually.)

Most Southern stories have a moral and this one is no exception. Market volatility isn't the only road to portfolio depletion. Studies that ignore spending risk understate the probability that a retiree will outlive savings.

Here's my intuition: retirees are more likely to outlive their savings as the result of a spending crisis that triggers a downward, self-feeding spiral than they are to outlive their savings as a result of slowly overspending 4% a year instead of 3.5%, especially if they dynamically update their plans. I readily admit I don't have data to back that up, so take it for what it is. I also suspect that long-term persistent overspending and sequence risk are far more likely to result in a permanent loss of standard of living than outright ruin.

Retirement income systems are vulnerable to positive feedback loops that can preclude the option to reduce spending in times of portfolio stress. Nor is retirement uniquely the domain of positive feedback loops. My personal experience with pre-retirement households that ended in personal bankruptcy displayed evidence of loops. Long bouts of unemployment or disability trigger them; consumer debt, divorce and foreclosure combine to finish them, in good stock markets and bad.

Another impression I have is that most of us have far more confidence in retirement models than our understanding of them merits, and "us" includes financial planners. I appreciate models as research and learning tools and as tools that can support a good retirement plan, but I've been building and studying them for perhaps 20 years and the list of their weaknesses is long. They can't predict an individual household's future and they are not by themselves a retirement plan (see Michael Kitces' recent post.)

Positive feedback loops are a characteristic of chaos theory. Is our retirement income system a chaotic system that is normally in equilibrium but can unpredictably be drawn into the influence of a point attractor like ruin? I'm not certain, but I have been doing some research and having some interesting discussions. Check out Retirement Income and Chaos Theory.

100% Certain That We’re Not Sure

In my previous post, Uncertainty Denial, I promised to suggest a way to accept and plan for the uncertainty of future market returns rather than to deny it. Future market returns, future expenses and how long a healthy person will live are critical to your retirement plan and all are uncertain. The uncertainty is inescapable. Relying solely on averages or likelihoods in a retirement plan is risky.

In this post, I’ll talk about the uncertainty of market returns and the impact that has on our ability to optimize the financial parameters of a retirement plan, like spending rates, equity allocations and how much we need to fund a safe floor of income.

Let’s say you decide to base your plan on the assumption that your portfolio will return 5% annually in real dollars with a standard deviation of 11% over the remainder of your lifetime. You should have very little confidence that this prediction is in any way accurate, but let’s stick a pin in that for now and pretend that we’re pretty sure of our prediction.

That 11% standard deviation quantifies the uncertainty of our estimate. It means that roughly two-thirds of the annual returns will fall between a 6% loss and a 16% gain, a pretty broad range. About 95% of those returns will fall between a 17% loss and a 27% gain.

The following chart shows terminal portfolio values (wealth at death) from a Monte Carlo simulation for a retiree spending $40,000 a year from a $1M initial portfolio balance (the 4% rule) and living exactly 30 years in retirement. The red dots are scenarios that ended in ruin before 30 years. The lighter blue dots represent scenarios that survived 30 years but ended up with less than the $1M the scenarios began with. The dark blue dots represent scenarios that funded thirty years and ended up with more than the portfolio’s initial value. The probability of ruin is 6.7% for all scenarios.

(I fudged a bit on the TPV of the red dots by continuing spending after the portfolio was depleted for the sake of visual clarity. The values of these failed portfolios should all be precisely zero, but that places all the red dots on the x-axis and it is impossible to see how many there are.)

Figure 1 above shows a lot of uncertainty. About 14% of the scenarios had annual returns less than 2.5%, or half the expected return. About 11% had returns greater than 7.5%, or 50% greater than the expected 5%. Figure 2 below shows the same simulation as above, but adds life expectancy modeled from mortality tables for a 65-year old couple.

There are several points of interest regarding Figure 2. First, the points are more scattered than the first graph, showing the degree of uncertainty that life expectancy adds. That means real retirement outcomes are less predictable than studies assuming a 30-year retirement. Second, there are fewer red dots in this chart than in Figure 1 because many retirees who would have run out of money had they lived 30 years would die before going broke in real life. (Only about 6% of 65-year old males will live another 30 years or more.)

The probability of ruin drops from 6.7% to 3% for all scenarios when we include life expectancy in the model. This is consistent with a study by Stout and Mitchell that found that considering life expectancy in the sustainable withdrawals rate (SWR) model lowers the probability of ruin by about half. That’s another way of saying that fixed-length retirement models overstate the probability of ruin.

While 3% of the 10,000 scenarios ended with failed portfolios before death, 82% of those failures (1,400/1,700) occurred when returns were worst, 18% occurred with below average returns, and 0.01% occurred when returns were greater than the expected 5%.

Shorter lifetimes than 30 years means less time to grow those big terminal portfolios found in the upper right quadrant of both figures, and when joint lifetimes for a couple are considered instead of assuming they always retire for 30 years, the median terminal portfolio value falls 22% in this example.

Those huge terminal portfolio values from SWR studies that leave us starry-eyed are possible, but they require all four of these pieces of good luck: excellent market returns, a long life, a fortunate sequence of those returns, and no spending shocks. On the other hand, any one of poor market returns, an unfortunate sequence of returns, or spending shocks combined with a long life can be financially catastrophic.

Third, notice the dots (scenario outcomes) in Figure 2 near the 5% annual return line. The outcomes range from a couple of failed scenarios (red dots) to one leaving about $3M to heirs. Outcomes range from portfolio failure to a huge success even though they all experienced a 5% average annual return on investments. Or look at the outcomes with an annual average 10% return that range from $1M to $8M. These examples illustrate sequence of returns risk.

Next, notice that there is one lonely failed scenario in the Above Average Returns range and none in the Best Returns range. Had I increased the number of simulations from say, 10,000 to 100,000, more failures would show up in all ranges and a few would appear in the Best Returns range. These additional failures are improbable, but not impossible. The best range of returns is not immune to portfolio failure; failures there are just less likely.

Lastly – and perhaps most importantly, if you retired 10,000 times then your history of terminal portfolio balances might look a lot like Figure 2. But unless you're Dr. Who, you only get one retirement and one of those dots.

(If you are Dr. Who, please call me. I need to know if Clara is permanently dead. The suspense is killing me.)

Table 1 below shows the statistics for the simulation that includes joint life expectancy.

Table 1. Portfolio Return Scenarios Including Joint Life Expectancy
Outcome	Worst Returns	Below Average Returns	Above Average Returns	Best Returns
Range of Returns	<= 2.5%	2.5% to 5%	5% to 7.5%	> 7.5%
% of Scenarios	14%	33%	34%	18%
Median Successful TPV ($)	441,160	905,200	1,883,960	3,314,862
% Failed Scenarios	14%	3%	0%	0%

Next, let’s add rows to Table 2 for the 95^th-percentile sustainable spending rate using Milevsky’s formula and the recommended asset allocation using the AACalc website. Those last two rows of Table 2 show the spending rate and asset allocation we would have chosen had we known we would end up with those returns instead of the 5% average return that we assumed.

Table 2. SWR and Equity Allocation Recommendations
Outcome	Worst Returns	Below Average Returns	Above Average Returns	Best Returns
Range of Returns	<= 2.5%	2.5% to 5%	5% to 7.5%	> 7.5%
% of Scenarios	14%	33%	34%	18%
Mean Annual Return	1.0%	3.9%	6.1%	9.3%
% Failed Scenarios	14%	3%	0%	0%
Sustainable Spending Rate	1.1%	2.6%	3.9%	5.9%
Equity Allocation	15%	55%	100%	95%

And herein lies the planning predicament. Although 5% returns with an 11% standard deviation sounded precise, it actually provides a 1-in-7 possibility of a terrible outcome and nearly a 1-in-5 possibility of a really great outcome. For which scenario do we plan? Worst Returns with 1.1% annual spending and a 15% equity allocation? Best Returns with a 5.9% spending rate and 95% equity allocation? Somewhere in the middle?

A lot of plans will focus on the middle, but a good plan will consider them all.

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"Looks like we’re 100% certain that we’re not sure." — Jerry Horn, Twin Peaks.

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Here’s my thinking. The first order of business is to eliminate catastrophes – those red dots. We can’t avoid red dots when we fund retirement with an equity portfolio because even good returns on average can fall victim to an unfortunate sequence of returns. We can, however, make red dots non-catastrophic by building a floor of safe income with TIPS bond ladders, Social Security benefits, fixed annuities and the like to insure that we can meet our non-discretionary spending needs. Then, even if our equity portfolio becomes a red dot, we don’t lose our standard of living.

Do this step first because most American households will find that once they allocate their assets to the floor and set aside some cash for liquidity, there won’t be much left to invest for upside. Floors are expensive, especially in the current low-interest rate environment. Most households won’t even be able to build an adequate floor. For those who can, the cost of the floor is likely to significantly change the size of the upside equity portfolio.

If you end up in Above Average Returns or Best Returns, you won’t have many money problems. I would hope for those outcomes, but not plan on them. We should plan for somewhere between Worst Returns and Below Average Returns, but this is still a broad range of equity allocations and spending rates. By doing so, we reduce the upside potential of better returns, but that is the cost of safety.

Many retirement income plans appear to make assumptions about these parameters that are far more certain than we can actually calculate. If the right answer is somewhere between 15% and 55%, tweaking an allocation by 5% seems hard to defend.

Whether I would choose closer to the Worst Returns or to the Below Average Returns parameters would depend largely on my capacity to build a floor. With a larger floor, I can take more equity risk and lean toward Below Average Returns. I also consider short-term volatility in setting my equity allocation, as I explained in The Role of Xanax in Asset Allocations. That might overrule these recommended allocations.

Regardless, retirees should revisit this decision annually because some uncertainty is reduced with time. As we age, for example, our remaining lifetime becomes more certain and the range of possible TPV's becomes more clear.

Now, I have to return to my earlier statement above that these calculations are based on the assumption that we are pretty confident in our prediction of 5% future returns with an 11% standard deviation – and that we have no reason to be.

To quote a recent study by Pastor and Stambaugh entitled, “Are Stocks Really Less Volatile in the Long Run?” (they aren’t, by the way):

“Expected return is notoriously hard to estimate. . . “estimation risk” . . .  reflects the fact that, after observing the available data, an investor remains uncertain about the parameters of the joint process generating returns, expected returns, and the observed predictors. That parameter uncertainty adds to the overall variance of returns [risk] assessed by an investor.”

In other words, we are adding to the uncertainty quantified by an 11% standard deviation for our 5% return assumption the uncertainty that 5% and 11% were the right guesses in the first place. My calculations above, for example, only show the uncertainty assuming we were certain about our return assumption. Were 4% a better estimate of future returns, for example, sustainable spending rates would have ranged from 0.7% to 5.2% and equity allocation recommendations from 0% to 95%, a sizable difference from the 5% guesstimate.

The process I suggest may seem pointless given the amount of uncertainty involved, but a plan that results from our best efforts to quantify that uncertainty is better than no plan at all. If we can’t identify a plan that will work with certainty, we can at least rule out plans that probably won’t work and identify plans that are more likely to work. But, we have to recognize that uncertainty, even in the latter.

I suspect that most planners put way more faith in expected outcomes than is prudent. The unexpected outcomes are the ones to worry about.

The best strategy is to "buy insurance" to avoid catastrophic outcomes and invest what’s left. We buy portfolio failure insurance by building a floor of Social Security and pension benefits, TIPS bond ladders, and fixed annuities and we maximize that floor by delaying Social Security benefits as long as we can.

If we’re lucky, our wealth will grow. If we’re unlucky, we’ll still have a roof over our heads.

Don’t confuse precise probability calculations with certainty. As Jerry Horne said to his evil brother, Ben, after torching their lumber mill for insurance fraud in the second season of Twin Peaks, “Looks like we’re 100% certain that we’re not sure.”

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Please check out my next post in this series, Positive Feedback Loops: The Other Roads to Ruin.

Uncertainty Denial

Joe Tomlinson wrote an excellent piece at Advisor Perspectives last week entitled, “The Most Critical Planning Assumption – and How to Choose It.” The piece is primarily a warning to advisers who rely on a single estimate of future market returns for retirement plans, or who use planning software that limits them to a single estimate, but there is a lot of good insight in the piece for all of us.

The assumption Joe has in mind is the equity risk premium, or ERP, but to simplify the explanation, I’ll substitute a related and more familiar term, the expected market return.

We need to estimate future market returns and volatility to make a number of calculations, including how much we need to save, how much we can spend each year, and what an ideal asset allocation would be. We may also use this estimate of future returns and volatility to determine how much to allocate to a floor portfolio. If we think future equity returns will be quite high, we’ll probably feel less need for a large floor portfolio and vice versa.

Since so many plan parameters are dependent upon this estimate of market returns and volatility, Joe rightly calls it the most critical assumption. (I think there's a strong argument that life expectancy is the most critical assumption, but I'm sure Joe and I agree it's best to assume a long life.)

The issue Joe describes is that there isn’t a single spending rate, savings rate, asset allocation and floor allocation that are optimal across the broad range of possible returns suggested by such a mean and standard deviation. Picking the optimal parameters from the average (and most likely) scenario may be wildly incorrect if your retirement ends up significantly better or worse than the average case you predicted.

Plan results are very sensitive to the market return and volatility assumptions. A small change in a plan's market return assumption can make a large difference in what we calculate as optimal spending rates and asset allocations. The error in our estimate of future market returns gets magnified.

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"Pretending we can accurately predict a critical assumption like future market returns is dangerous overconfidence. "

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Tomlinson provides an example using Professor Aswath Damodaran’s estimated ERP of 6.25% with a standard error of 2.32% for the period 1928-2014. He assumes a 65-year old retiree with a 4% spending rate and $1M savings portfolio at retirement. He finds that depending upon where the returns actually fall within that broad range of potential outcomes, a retiree would have a portfolio failure rate ranging from 2% to 42%, a median bequest of $127,000 to $2M, and an optimal stock allocation ranging from 10% to 90%.

I ran those estimates through Moshe Milevsky's formula for lifetime probability of ruin (download PDF) and found 95^th percentile sustainable withdrawal rates ranging from 2.35% to 8.5%. Here's a chart with data from the Tomlinson piece and my own SWR calculations.

Source: data from the Tomlinson post plus author's calculations.

To quote Joe's post, a completely forthcoming (though, likely unacceptable) discussion with a client should go something like this:

“Your results will be heavily dependent on the extra return of stocks over bonds. Unfortunately, we have limited statistical evidence and don’t know what to expect. The best I can do is tell you that I’m 95% confident that you can expect a bequest in the $100,000 to $2 million range and that the probability of plan failure is somewhere between 2% and 40%. For an asset allocation recommendation, it could be anything from 10% to 90% stocks.”

I actually believe Joe is optimistic about our prospects here because even if we could accurately predict future returns with a relatively small variance (we can’t) we need to consider sequence of returns risk when we save to or spend from a volatile portfolio. Sequence risk is unpredictable and an unfortunate sequence of returns can ruin even a good average return. We need to know the return, the variance and the sequence of those returns.

The gist of Joe's post is that retirement plans entail a great deal of uncertainty and that pretending we can accurately predict a critical assumption like future market returns is dangerous overconfidence. (Please read his column – I don't do it justice.)

We tend to think that the estimates of our optimal asset allocation, floor allocation, safe spending rate and required savings can only be as good as our estimate of future market returns. I think it's correct that they won't be more predictable. The problem is that our plans are highly sensitive to market return assumptions, so those optimal parameter estimates can actually be a lot less predictable than our market return estimate.

Generally speaking, I think most of us understand that retirement finance, and investing in particular, is risky, but I also think we are overconfident in our ability to manage that risk. We pretend that we can accurately (or accurately enough) predict future market returns. Many of us seem to believe we know whether we will live long lives. We believe we can identify a precise sustainable withdrawal rate when that rate is a function of both the rate of return we can't predict and how long we will live, also unpredictable. We believe we can avoid stock market risk by simply holding stocks a very long time.

This is overconfidence. There are ways to manage this financial risk but even if we do the best job possible there will still be much uncertainty.

You're likely overconfident when you think, "I'm really not sure what my investments will return in the future, but I probably oughta' tweak my asset allocation by 5%."

Next post, I'll suggest an approach to accept and plan for this uncertainty in 100% Certain That We're Not Sure.

The Role of Xanax in Asset Allocations

It's amazing how often this happens. I publish a post and within 24 hours something pops up in the news that would have worked beautifully with it. The most recent post in this case is Homo Economicus and the something-in-the-news that works with it is an opinion piece I read in the New York Times online this morning by J.L. Cowles entitled “Defeating My Anxiety.”

Mr. Cowles' piece is actually about dealing with his anxiety. Investment results are just one cause of his angst (see his second paragraph below for a more complete inventory) but those results illustrate quite well the concepts of risk tolerance towards short-term portfolio volatility that I discussed in Homo Economicus compared to risk tolerance towards long-term volatility. The first two paragraphs from that Times piece are relevant to retirement:

When the stock market crashed in 2008, my wife and I were 70. And we saw half of our retirement funds disappear. Before the crash, we felt secure in the belief that we had enough money to last as long as we lived; after the crash, we feared that we would not, and I worried about it a great deal. I had a hard time going to sleep and an even harder time going back to sleep after getting up to go to the bathroom in the middle of the night. I came to hate going into that bathroom because I knew my demons resided there and would invade my consciousness immediately.

By the time the stock market began to recover and our savings were again at a comfortable level, I had become conditioned to associate my nightly bathroom trips with “worry time.” I would worry about everything: home repairs, trip planning, medical issues and all the vicissitudes of old age, fears of infirmity, dying and seeing my friends and loved ones die.

It was probably not Cowles' intent that my first thought after reading his article would be that his stock allocation had been too high, but it was. The stock market fell a little more than 50% from late 2007 to early 2009, so the Cowles must have been fully invested in equities. They had laid a lot of chips on the table.

I'm not a doctor, but if you can't sleep at night because you're worried about losing your retirement standard of living in a market crash, you have too much of those savings invested in stocks. If you can't sleep and need anti-anxiety medications because you're worried about your portfolio, you have way too much invested in stocks.

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"When the stock market crashed in 2008, my wife and I were 70. And we saw half of our retirement funds disappear."

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Cowles notes that “the stock market began to recover and our savings were again at a comfortable level,” though he doesn't say they fully recovered. His portfolio will probably eventually recover, assuming he didn't bail out at the bottom of the crash, but that's the big risk.

If Cowles decided near the bottom of the crash that in addition to finding anti-anxiety meds, religion, and meditation he needed to eliminate a source of the anxiety, he might have chosen to reduce his equity allocation (sell stocks). A lot of research shows that investors tend to buy at the top and sell at the bottom. With a lower allocation to stocks after the fall, the climb back uphill becomes even harder. Your equity allocation will already be lower because your stocks will have fallen faster than your bonds. Selling more stocks makes it worse.

As I mentioned in Homo Economicus, it's important to understand your risk tolerance before you retire. If you guess that your tolerance to short-term volatility is higher than it turns out to be, you are faced with two unattractive options near the end of your first bear market after retiring. You can sell equities to stop the bleeding, increase the sleeping, change your asset allocation to where it should have been all along, and severely hamper your prospects for fully recovering.

Or, you can fight through the pain and convince yourself, as your stockbroker tried to do, that the market always recovers. Keep in mind, of course, that your savings portfolio isn't the market.

The Cowles say they saw half their retirement savings disappear in 2008 at age 70. That's a lot of stress when you have no career to return to.

Insuring that you have a solid floor of income from assets not tied to the stock market may ease the pain of a bear market.

Perhaps you're one of the 14% of respondents to my informal survey (bottom of that page) who eats risk for breakfast, sleeps well and never takes anything stronger than vitamin C. In that case, your asset allocation should be based on factors other than short-term volatility. But if you're one of the 84% of respondents who need some bonds to help you sleep, or the 2% who want nothing to do with stocks in retirement, your tolerance to short-term volatility should be a factor in your asset allocation. That stock allocation may be smaller, for example, than one that would optimize a safe withdrawal rate over the long run.

I apologize that this post and the previous are somewhat redundant, but it's an important point and sometimes a real-life scenario is more convincing.

Homo Economicus

William Bernstein is my favorite financial writer. I have followed him since his early days at the Efficient Frontiers blog when hardly anyone without a neurological disorder had heard of him. I like him because he is brilliant; I love him because he writes wonderfully.

One of my favorite Bernstein lines came from Efficient Frontiers in reference to the 1999 book Dow 36,000. The argument put forth by the book's authors was probably based on a not-uncommon misreading of Jeremy Siegel's Stocks for the Long Run. Siegel had noted that over long periods of time, stocks nearly always outperform bonds and the authors of Dow 36,000 apparently understood that to mean that stocks are ultimately safer than bonds. If that were true, then stocks would have been tremendously underpriced in 1999. One day, investors would wake up to just how safe stocks are and the Dow would soar to 36,000 or higher.

Unfortunately for the authors of that ill-fated tome, and for all of us who invested in equities back then I suppose, sixteen years later the Dow is around half that value. Siegel's argument that stocks outperform bonds over the long run does not equate to stocks being safer than bonds. Stocks can and do take stomach-churning dives along the way and bonds don't. The short-term volatility of stocks is much greater than that of bonds and as Siegel and Zvi Bodie agreed in a famous interview (download PDF), stocks are risky no matter how long you hold them.

To quote Professor Siegel from that interview, “In other words, [stocks] are relatively safer in the long run than random walk theory would predict. Doesn’t mean they’re safe. . . Well, they’re not safer in the long run—that’s definitely not true.”

The Bernstein comment I have always remembered is “James Glassman and Kevin Hassett . . . in Dow 36,000 postulated a new species of homo economus [sic] impervious to short-term volatility.”

I suspect that the vast majority of us retirees are keenly aware of short term volatility, even if we firmly believe that the market will always recover, eventually. I haven't found research that specifically addresses this issue, so I recently conducted a simple survey to determine if at least some retirees care about short term volatility.

In that survey, I asked retirees and near-retirees if they would invest their portfolio totally in equities if their non-discretionary expenses were securely covered by a floor, noting that such a portfolio might have fallen 50% or more in value during the 2007-2009 bear market. The survey should not be confused with science – it's merely the thoughts of about a hundred and fifty or so readers of my blog – but the results do suggest that a lot of retirees care about short term volatility even when their living expenses are secure.

About 84% of respondents indicated that they would prefer to reduce portfolio volatility, presumably through a bond allocation, even with a secure floor. About 14% said they would go full bore with equities if their non-discretionary living expenses were safely covered, and 2% implied that they'd rather shave their head with a cheese grater than allocate any of their retirement savings to the stock market.

OK, not precisely in those words.

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84% of respondents to an informal survey say they would want to manage portfolio risk even with a solid floor of income.

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My take from this informal, unscientific survey is that there are at least some retirees who would need an allocation to bonds in order to sleep at night even with a bedrock-solid floor. (No one wants to sleep on the floor, but some are willing to risk it.) Whether the numbers are as dramatic as my informal survey suggests, I cannot say. My goal was simply to find out if I'm the only retiree who cares if his portfolio occasionally crashes.

To assume that retirees with a secure floor would not care about short term volatility is to recreate the Dow 36,000-postulated homo economicus, a retiree impervious to short term volatility. My standard of living was not threatened by the 2007-2009 crash because I had a sizable allocation to cash and bonds, but it was not a fun ride even so. I suspect that most retirees see a portfolio crash as the evaporation of wealth that can no longer be replaced by human capital and that they find that worrisome.

Some will be quick to point out that the market as measured by the S&P 500 index recovered to it's 2007 high by January 2013, but as I explained in this post, retiree portfolios don't recover as quickly as the market. The market doesn't take annual withdrawals to cover its living expenses.

Your tolerance toward market volatility, even when your floor is secure, is something you want to understand up front. Getting it wrong has consequences. If you believe you can tolerate the high-equity allocation roller coaster and find out after your first big bear market after retiring that you can't, your response will probably be to reduce your equity allocation at the worst possible time – after your portfolio has crashed and before it recovers.

It's tough to keep investing largely in equities, especially for a retiree, while you are watching your wealth vaporize day by day. For a real-life example, read my next post, The Role of Xanax in the Asset Allocation.

End of File-and-Suspend and the Breathtaking Medicare Spike that Wasn’t

Last week, Congress passed the Bipartisan Budget Act of 2015, the compromise deal that President Obama has said he will sign as early as Monday, November 2, 2015. Part of the bill effectively ends so-called “file-and-suspend” Social Security claiming strategies and mostly fixes a feared spike in 2016 Medicare Part B premium costs.

File-and-suspend is (was) one of several “claim now, claim more later” strategies for maximizing Social Security benefits, primarily beneficial for married couples. It typically involved having one spouse claim spousal benefits for up to four years between ages 66 and 70 before switching to his or her own larger retirement benefit. This allowed the higher-earning spouse to delay claiming and increase future benefits while the spouse received a smaller benefit for a few years.

That’s an over-simplification, but unless your household is grandfathered in, the details of a now-defunct strategy probably aren’t important to you. According to Michael Kitces, “restricted applications. . . to receive just spousal benefits and not individual retirement benefits” are grandfathered in for those born in 1953 or earlier, but “the new rules limiting suspended benefits will apply to anyone who tries to file-and-suspend after a 6 month grace period beyond the effective date of the legislation.” In other words, unless you’re at least 65 ½ years old Monday (assuming the bill is signed into law then as expected), file-and-suspend is no longer an option for you.

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The end of the “file-and-suspend” Social Security claiming strategies won’t affect most households.

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The press had raised alarms recently over an expected huge increase in Medicare Part B premiums for 2016 as reported, for example, in a recent article at AARP. The increase would have resulted from an obscure part of Medicare law that ties COLA increases to Part B premiums, combined with the lack of a Social Security COLA increase announced for 2016.

The Washington Post reports that the "Budget deal blunts, but doesn’t erase, increase in Medicare premium". Prior to the new law, about one in three older Americans would have seen a premium increase just north of 50% in 2016, but that increase will now be about 17%. According to the Post, the group subject to the increase includes "people who do not collect Social Security, will be enrolling in Medicare’s Part B next year for the first time, have incomes great enough that they are charged higher premiums, or are poor enough that they also qualify for Medicaid." Again, two-thirds of recipients won't be affected either way.

What does all this mean for the typical retiree? The changes to Social Security rules mean that, unless you are grandfathered in by your age, strategies like file-and-suspend are no longer available to you. If that was part of your retirement plan, you need to revise it. If you were worried about a Medicare Part B premium spike next year, it won’t be as breathtaking as the press has led us to believe, but that doesn’t guarantee there won’t be dramatic premium increases in future years. Remember, the spike was related to the fact that there was no Social Security COLA adjustment for 2016.

It also means that books and software about Social Security benefits optimization are now outdated. Mike Piper says he plans to update his book, Social Security Made Simple, very soon. Laurence Kotlikoff’s MaximizeMySocialSecurity website currently posts a warning on the site’s opening page saying, “Alert! Major SS Benefit Changes Pending!” Kotlikoff has also promised updates to his software as soon as possible.

In the meanwhile, if you are interested in the fine print, Wade Pfau, Mike Piper and Michael Kitces are my go-to guys for Social Security issues. Kitces has an excellent post at his Nerd’s Eye View blog. I also recommend Piper’s post  at the outstanding ObliviousInvestor blog and the excellent discussion at this Boglehead’s forum. Robert Powell has a very readable column on the topic at MarketWatch.

Sometimes the early reads on law changes gain clarity over the following days and weeks, so waiting until the dust settles and the books and software have been updated to see the law’s impact on your own retirement plan might be the best approach.

The end of the “file-and-suspend” Social Security claiming strategies won’t affect most households. Nearly half claim benefits at age 62, the earliest possible age, probably because they can’t afford to delay the income according to Motley Fool. U.S. News reports that only about 5% delay claiming until after full retirement age to maximize their longevity insurance. About 2% claim maximum longevity insurance at age 70.

The file-and-suspend strategy required the lower earning spouse to delay claims until full retirement age (currently 66 for those born between 1943 and 1954) and the higher-earning spouse to delay even longer (to 70 for maximum benefit).

No huge Medicare premium spike is good news for retirees and no more file-and-suspend is maybe not so good. This week's news illustrates a reality of retirement financial planning: good news or bad, very little is cast in stone.

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On a related note, see the sidebar for three timely pieces on Social Security written by Wade Pfau at the Retirement Researcher blog.

Second, thanks to those of you who responded to my survey regarding retiree attitudes toward investment portfolio volatility when non-discretionary expenses are safely covered by Social Security benefits, pensions and annuities. I promised to share the results here and, based on the first 100 responses, they are as follows:

• 15% would take maximum risk with their investment portfolio if they knew non-discretionary expenses were safe,


• 2% said they wouldn't invest retirement savings in stocks even if non-discretionary expense were covered,


• 83% said that, even if they felt non-discretionary expenses were safely covered, they wouldn't risk a huge loss such as they might have seen in the 2007-2009 bear market with an all-stock portfolio.

Please don't confuse this with a scientific poll – it is far from it – but it does suggest that many retirees still worry about portfolio volatility even when the rent and grocery bill are safe.

Basing Your Allocation on Half Your Assets

Although we tend to focus on our investment portfolios, Social Security benefits, and annuities when we think about retirement, these aren't the only sources of household wealth. In fact, they may not even be the largest sources of wealth. For young people just starting a career, human capital (the capacity to exchange labor for wages over their career) is likely their greatest asset. In many older households home equity is the largest component. By focusing solely on our portfolios, we may overlook much, perhaps even most, of the household wealth at our disposal to fund retirement.

A recent paper by David Blanchett and Philip Straehl entitled, “No Portfolio is an Island” (download PDF) separates household wealth into real estate, financial capital, pension wealth and human capital. Real estate wealth is home equity and other real estate investments. Financial capital includes our savings and pension wealth is the present value of Social Security benefits and pensions.

This is not a new concept – the Retirement Income Industry Association (RIIA), for example, has advised us for quite some time to plan retirement using the “entire household balance sheet” – but Blanchett and Straehl take the research to a new level by studying the correlations between these components of wealth. More on that later. First, let's look at a chart from the paper that shows a hypothetical life cycle of these components of wealth. (Click to enlarge.)

A young person beginning her career may have an abundance of human capital, or the present value of a future lifetime of paychecks, and a small amount of pension wealth, the present value of future Social Security benefits. She will likely own no real estate and have limited savings. Financial wealth will typically peak around retirement age when she stops saving and begins spending those savings, and her human capital all but disappears. By the end of life, her wealth may largely consist of home equity, unless she uses it to fund retirement. This represents typical wealth changes and yours might be quite different, but the hypothetical illustration is informative.

The diagram suggests that focusing solely on financial wealth poses the biggest disconnect for young savers, who have mostly human capital, but it also illustrates for retirees and those approaching retirement how dramatic the change can be once the paychecks end.

As the authors point out, previous research has shown that other household wealth investments may exceed investment capital. In 1993, Nobel laureate, Gary Becker, found that human capital made up four times the value of all other wealth combined. In 2000, Heaton and Lucas found that human capital makes up nearly half of household wealth while financial assets constitute less than 7%.

In the above diagram, granted hypothetical, financial assets never exceed 50% of wealth so, the authors ask, how can an asset allocation based on less than half your assets be optimal?

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How can an asset allocation based on less than half your assets be optimal? –Blanchett and Straehl [Tweet this]

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Primarily, Blanchett and Straehl recommend that we broaden our focus from the narrower investment portfolio to the entire household balance sheet and recognize that some of these components of wealth can be highly correlated, which means “risky”, in the sense that that some might tank simultaneously. In 2007, for example, both the stock market and the real estate market crashed.

The Tech Bubble provides a historical (perhaps even historic) example. Many Enron employees held a lot of Enron stock in their retirement portfolios, so their human capital (their paychecks from Enron) were highly correlated with their retirement savings. When Enron went under, employees lost both their jobs and their retirement savings. Enron succumbed to accounting fraud, but the employees of many legitimate high-tech companies found themselves in a similar situation. Blanchett and Straehl recommend that if we work in the tech industry, for example, there are highly correlated stock sectors to which we should reduce our exposure.

The authors draw on modern portfolio theory (MPT) for their analysis. MPT shows that we can combine uncorrelated assets to create an optimum return for a given level of risk or vice versa. While MPT optimizes stock and bond allocations to find the least risky way to earn an expected rate of return at a point in time (or the maximum return for a given level of risk), Blanchett and Straehl apply the same thinking to their four categories of household wealth over a life cycle, pointing out that these broader asset classes can be correlated, as well. The result can have a significant impact on our portfolio allocation. The authors find differences of up to 20% for optimal portfolios.

Viewed independently, we might conclude that a 50% stock allocation is appropriate for our investment portfolio. For those of us whose career is more “bond-like”, or who have a lot of pension wealth, a higher stock allocation might be appropriate when we consider total household wealth.

If you are unfamiliar with the concept of having a career that is either stock-like or bond-like, it comes from the work of economist, Zvi Bodie. Moshe Milevsky published a book on the topic. Here’s an example of the concept.

In the late nineties, I left a job at Cable & Wireless, a British phone company founded in 1866. I had a very nice and very dependable salary and even earned a small pension, but I owned no company stock. I traded this bond-like, relatively safe job with limited upside for a position at America Online with no guarantee that the company would even survive. I accepted a significant pay cut in exchange for stock options that would pay off nicely if the company thrived. I traded a bond-like job for a stock-like job.

(Michael Kitces provides a bit more thorough description of the concept in this piece.)

Many of the young employees I knew at AOL held nearly all their wealth in AOL stock options yet, in the heady days of the Tech Boom, invested everything they could in more tech stocks. Some even bought more AOL stock. Those that got out before 2000 won big. Many of those that held on lost everything. Bodie, Milevsky, Blanchett, Straehl and others would recommend that they should have invested outside money in safe bonds, instead.

If you lack a basic understanding of MPT, you might find the Blanchett and Straehl paper dense. Michael Kitces wrote an excellent review of the paper that is more accessible, but still a bit challenging.

It’s probably impractical for most people to perform mean-variance optimization on their choice of careers, regional real estate prices, Social Security benefits and portfolio allocation as Blanchett and Straehl did. There are some general conclusions, however, that we can take away from the research and apply to our own retirement plans. Make sure your retirement plan considers all of your resources, not just your savings. If your job is bond-like, invest a little more in stocks and vice versa.

Think about how the various components of your wealth might be correlated. Not investing most of your retirement savings in the company that hands you a paycheck should be a no-brainer after Enron, but real estate prices might also be highly correlated with your career.

If you take this approach, you need to be aware that your investment portfolio will be allocated to optimize risk and return for your total household wealth. You may be disappointed in your investment returns if you use those alone as the benchmark for your financial success instead of your total wealth.

What Academics Say

I've meant to write a post about academic papers for some time and I received an email recently that gives me a great opportunity.

“I generally think highly of [Dr. Redacted’s] work. . . But I’ve been puzzled by why his results sometimes weren’t more thorough – they are sometimes like abstract points . . . They can’t be applied without significantly more refinement and sometimes can lead to a wrong conclusion.”

Exactly.

But the problem, I believe, is not with the academic research – which is as it should be – but with our expectations and our over-reading of the conclusions. Sometimes, we just miss the point. Other times, we try too hard to convert theory into practical advice. And lastly, we're not the intended audience.

Let's look at those one point at a time.

It seems that many people unfamiliar with how academic research works are looking for a study that shows the one way to plan for retirement that is better than all previous recommendations and is the single best way to plan. As they say on police dramas, that ain't gonna happen.

Research is often an “experiment” that provides new information that we should consider and perhaps use to modify our previous beliefs to some extent. Or as someone said, “science is the process of continually improving your answer.” If you expect the next big academic paper to provide “the answer” that supersedes everything we used to think that we knew was correct, your expectations are too high. A good piece of research simply improves on the previous answer. It rarely replaces it.

So, is research sometimes "like abstract points"? Yes, often. One definition of abstract is “theoretical” and most academic research is theoretical, that is “concerned with or involving the theory of a subject or area of study rather than its practical application.”

Molding theory into practical application is the next challenge. Sustainable withdrawal rates research is, I think, an excellent example. Most studies use constant-dollar withdrawals, a spherical cow that is useful for research but problematic in practical application. No rational retiree is going to continue to spend the same amount every year once she observes that she is going broke. The technique is useful to understand the process of sequence of returns risk, but it is way too simple a model to predict outcomes for an actual retiree.

As a highly-respected retirement researcher once told me, “Bengen did an outstanding job showing that sequence risk exists, but then trying to identify a safe withdrawal rate was a fool's errand.”

Unfortunately, Money magazine and other popular media outlets translated this research directly into practical advice for several years before the 2007-2009 market crash convinced them that people really need to spend less money when they become less wealthy. The risk is not so much that you will deplete your savings with SWR as that you will irretrievably lose your lifestyle.

The comment above that research papers can sometimes lead to wrong conclusions is spot on but, again, this is more a problem with our conclusions than with the research. Here's an example. Wade Pfau and Michael Kitces caused a stir (a sign of good research) by writing a paper entitled, Reducing Retirement Risk with a Rising Equity Glide Path. Their research suggests that “rising equity glide paths from conservative starting points can achieve superior results.” One well-known retirement expert immediately tweeted something to the effect of, “Great idea - let's put all 95-year olds 100% in stocks.”

That wasn't the point of the research, but the effects were predictable. Clients asked if I thought they should be following a rising glide path and invest more in equities when they are older. I told them that they should decide that when they are older – I have no idea what their financial situation will be when they are 95.

Wade Pfau agreed, telling me that a custom asset allocation will always be better. He believed their findings simply suggest that if we knew nothing about a client other than his or her age, or if the retiree were only willing to do the absolute minimum of planning, a rising glide path would be the best bet.

He added that this is probably the best strategy for a target-date mutual fund that needs to serve a broad range of retirement investing needs. He also felt that the most interesting finding of the research is that you can sometimes “reduce both the probability of failure and the magnitude of failure for client portfolios” by increasing market risk. Not that everyone should adopt a rising glide path upon retirement and stick with it come what may, though this is what many concluded.

Sometimes, we just miss the point. David Blanchett wrote a paper that inspired the term “the Blanchett Smile” (download PDF). Many readers understood his findings to suggest that expenses begin to decline at retirement, bottom out about the mid-point, and then increase until death, in the shape of a smile. The “smile” Blanchett found, however, showed the acceleration of spending, not the amount of spending. The amount always trended downward, at about 2% or so per year for appropriately-spending retirees, throughout retirement. Only the acceleration of the downward trend (it's first derivative) eventually turned upward.

Misreading academic papers isn't a problem only among do-it-yourself retirees. After I wrote about this at Advisor Perspectives, a top-notch retirement adviser privately thanked me. He said that he had been present when Blanchett presented the paper and that he completely missed this point, as did, he believed, everyone sitting near him.

My last point is an important one: we are not the intended audience for academic papers. They are written primarily for other academics, who will review the papers before publication. Consequently, they tend to make modest claims that can be strongly supported by the evidence provided. Claims more like “increasing portfolio risk has the potential to actually reduce both the probability of failure and the magnitude of failure for client portfolios” rather than “everyone should follow a rising glide path.”

(Be even more cautious of "pseudo-academic papers" that are not peer-reviewed and thoroughly cited.)

I'm not suggesting that you stop reading academic papers on retirement finance. I am suggesting that you understand their intent and use considerable care in trying to apply their findings to your own personal situation. Treat them as another piece of evidence and weigh them accordingly.

(Interestingly, I've found that the retirement field is not the only one where academic research has a strong following among lay readers. I found a website where non-scientists express great interest in cosmic physics. I find that encouraging.)

While academic papers aren't intended for a broad audience, the authors of those papers often write books, blogs and columns for the press that are. Wade Pfau, for example, does an excellent job of explaining his research to a broader audience of advisers and even do-it-yourselfers at several places, including newsletters to which you can subscribe, the Advisor Perspectives website, and his own Retirement Researcher blog. William Bernstein has written many brilliant books and over the years has intentionally made them more and more accessible.

Dr. Moshe Milevsky is another excellent writer. While I don't recommend most people tackle his papers about lifetime probability of ruin and the reciprocal gamma distribution (it kept me up nights until my tenth reading), I just finished the second edition of Pensionize Your Nest Egg, co-written by Milevsky and certified financial planner, Alexandra Macqueen, and find it quite readable. (Macqueen clearly helps balance Milevsky's inner quant.) It provides a strong argument for the circumstances under which and to what extent one should employ annuities. Spoiler: if you have a lot of wealth or a little, they may be less effective than for those in between.

Why Retirees Let LTC Insurance Lapse

A reader recently asked my opinion on long-term care (LTC) insurance policies. My position is that many retired households, perhaps most, will not be able to afford LTC premiums and will have no decision to make. Wealthy households will be able to self-insure. That leaves the households in between with a decision to make. For those households, purchasing a long-term care insurance policy can be the lesser of two evils.

The problems with LTC insurance are well known (see An Economist Explains the Dangers of Long-Term Care Insurance). Many carriers have found the policies unprofitable and have simply gotten out of the business. According to a recent Wall Street Journal article, five of the 10 largest LTC policy sellers, including MetLife and Prudential Financial, have sharply reduced or discontinued sales entirely since 2010. Buying insurance when many insurers are abandoning the market for that insurance is risky.

Some Boomers have been encouraged to buy LTC policies because they worked well for their parents, but this is not your father’s LTC policy. Rates increased substantially after insurers realized they had initially underpriced policies and would need to raise rates substantially if they were to make a profit. You're unlikely to get the deal your parents got.

Perhaps the greatest problem with LTC insurance is the possibility that an insured retiree will let his or her policy lapse and, after making large premium payments for years or even decades, not be covered when LTC insurance is actually needed.

While insurers can't increase premiums for a specific policy, they can increase premiums for classes of policyholders. Jane Gross, a retired correspondent for the New York Times and author of the excellent blog on aging, NextAvenue, recently wrote in a post entitled, " Reasons to Worry – and Agitate – About Your Financial Security", 

"Next up is my long-term care insurance policy, which now costs $1,357.85 a year but, this letter tells me, is raising its premiums by 48 percent — unsurprising but still breath-taking.

It would be way more than that, the MetLife representative told me by phone, but for the fact that New York State has one of the nation’s most stringent insurance commissions. . .
In 2019, MetLife told me, the state commission will again allow the insurer to raise its prices. When that happens I’ll reduce my benefit duration from three years to two. Is there a point when I’d flush down the toilet 13 years of premiums already paid? I haven’t a clue."

Although the probability that a retiree will need some amount of long-term care is significant, the probability of a financially catastrophic stay in a long-term care facility is relatively small, as I described in an earlier post. Many stays will be quite brief and some can be paid out-of-pocket.

Long-term care expenses can range from informal care in the home to expensive nursing facilities, from short stays that can be paid out-of-pocket to lengthy stays with catastrophic costs.

The following table (click to enlarge) is from a study entitled, "Long-term care over an uncertain future: what can current retirees expect?" Notice that while 69% of people over age 65 required some form of long-term care, 31% required none at all. Another 29% required stays of two years or less. The scary number is the 14% that required more than 5 years of in-facility care. The odds of that happening are somewhat low, but the magnitude of the risk can be financially catastrophic and that's what we need to prepare for in some way.

Medicare does not cover most long-term care costs. Medicaid may, but only after most of the retiree's financial resources have been spent. It is intended to cover indigents. To use it for long-term care, you must become one.

A recent brief published by the Center for Retirement Research at Boston College entitled, “ Why Do People Lapse Their Long-Term Care Insurance?”, researches this important issue. According to the report, “At current lapse rates, men and women age 65 have, respectively, a 32- and 38-percent chance of lapsing prior to death, assuming that lapse rates remain at the same levels observed for recent cohorts.”

Let me repeat that. About 30% to 40% of 65-year old's will eventually allow their LTC policy to lapse, forfeiting all benefits after having paid years of premiums. Insurers bemoan low lapse rates of 1% to 2% for these policies as a justification for rate increases, suggesting they are on the hook for underpriced policies issued years ago that buyers are unwilling to relinquish. This is an annual lapse rate, however, and a 1.5% annual lapse rate over a 30-year retirement results in about a third of policies lapsing over a 30-year retirement.

The brief's other key findings are:

1. Lapses could be due to the burden of insurance premiums, a strategic calculation that care use is less likely, or poor decisions due to declining cognitive ability.

Why do retirees allow their LTC coverage to lapse? Insurance premiums could increase and render the policy unaffordable, or they could remain the same while the retiree's ability to pay declines. That doesn't mean the premiums would have been spent totally in vain, because risk was protected prior to the lapse and that has value. But it does mean that the retiree has a potentially huge uninsured risk going forward. It would be a poor outcome, indeed, to pay premiums for decades and then suffer devastating long-term care costs after the policy lapsed.

2. The analysis finds support for both the “financial burden” and “cognitive decline” explanations.

The research finds that many LTC policy lapses are the result of either premiums that the retiree can no longer afford, or the retiree losing the mental acuity needed to maintain the policy. They might forget to make premium payments or simply decide, incorrectly, that they no longer need the policy.

3. The consequences of lapsing are significant, as lapsers are actually more likely than non-lapsers to use care in the future, partly due to cognitive decline.

Interestingly, the study found that retirees who let their policies lapse are more likely to need long-term care in the future than those who don't lapse. This is partly explained by the fact than impaired retirees are more likely to let policies lapse and impaired retirees are also more likely to need long-term care.

4. Thus, for some lapsers, having insurance could be counterproductive as they buy it to protect against risk but drop it just when the risk becomes more likely.

In other words, if you’re going to allow the policy to lapse, you’re probably better off not buying it in the first place. Of course, when you buy the policy, it is probably your intention to keep it in force.

Joe Tomlinson, whose opinion I respect most on retirement insurance issues, suggests that purchasing the policies, despite their known faults, is the lesser of two evils. In AdvisorPerspectives, Joe expressed his preference for standard LTC policies over hybrid policies (life insurance or an annuity with an LTC rider) or self-insurance.

Retirement advisor, Dana Anspach, wrote a nice piece, "What Happens When You Don’t Have Long Term Care Insurance?", explaining the downside of not purchasing LTC insurance. I agree with all of it, perhaps with the exception of identifying "the worst case scenario [as] where one spouse remains healthy and retains most of the ongoing costs of living independently and the other spouse needs care in assisted living or nursing home." I think paying premiums for decades and then letting a policy lapse just prior to incurring huge end-of-life costs has a strong claim on that title.

I believe that you should forego these policies if you can’t afford the premiums, and potentially large future premium increases, or if you are wealthy enough to self-insure.

If you fall in between, I don’t believe there is a single clear winner in the numbers. There are several strong arguments in favor, and several against. Your decision will largely depend on your unique financial situation and your risk tolerance. For some, insuring the risk of catastrophic end-of-life medical expenses is worth a lot. It lets them sleep at night.

I hope that explaining the issues involved will help with your very difficult decision.

Protecting Your Family from Elder Fraud

     I have a client who was defrauded by an unscrupulous financial adviser. He was caught and found guilty and forced to make reparations. She won't completely recover her losses, but this is a far better outcome than most victims of elder fraud will experience.

     I have posted on this topic before. Because elder fraud is so pervasive, so devastating and growing, I felt it was time to write another. The November 2015 Consumer Reports magazine notes that a recent study by the Journal of Internal Medicine found that about 1 in 20 elderly Americans has been financially exploited. If you're a fan of the 4% Rule (I'm not), then perhaps you think you should have no more than a 5% chance of outliving your money. The chances of losing your savings to elder fraud, instead, are about the same.

     Quoting again from that C.R. article, "The Federal Trade Commission says that fraud complaints to its offices by individuals 60 and older rose at least 47% between 2012 and 2014."

     I strongly recommend that if you are in or approaching retirement, or you have parents who are, that you read the article. Those who don't subscribe to Consumer Reports can read it here.

     Elder fraud can destroy retirements when victims are older and unable to recover financially. Aside from getting lucky, as my client partially did, the only recourse may be the possible deduction of those losses on a tax return, but many retirees won't have enough income to fully use the deduction even if it is available. There are several limits on deductibility.

     Ken Fisher's book, How to Smell a Rat: The Five Signs of Financial Fraud, has long been a favorite of mine. It's an easy read and provides simple rules to greatly reduce the risk of fraud. One of those suggestions, never give custody of your money to your financial planner, might have protected my client's savings.

     Financial planners can manage your money without having custody of it. Granting them custody opens the opportunity for your planner and your money to end up in an unidentified Central American country together with no forwarding address.

     Please be careful with your hard-earned retirement savings  – a bear market isn't the only way to lose them. You may be equally likely to lose your savings to fraud. And if you have an older parent, please watch out for them, too. Reading Fisher's book and this Consumer Reports article are a great way to start.

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I added a "Follow Me on Twitter" button at the top right to make it easy for you to follow @Retirement_Cafe. Sometimes, I find important information that's too concise to warrant a blog post – interesting papers to read, other bloggers' posts, or tweets from researchers like Wade Pfau, Moshe Milevsky, Michael Kitces and others – and I will post these on Twitter.

If you're not familiar with Twitter, check out this starter's guide. It's very easy to use and a source of a lot of timely information. As you find "Tweeters" you like, you can follow them, as well. Twitter apps are available for your smart phone, tablet and desktop, or you can simply use the twitter.com website.

As I mentioned previously, I have also acquired the domain name for TheRetirementCafe.com  to make it easier to reach and share my blog.

As always, thanks for reading! 

Investing and Insuring Are Not the Same Thing

Wade Pfau's Retirement Researcher blog received a disquieting question from a reader last week. The reader asked Wade how he, the reader, would have done had he invested his FICA payments over the years in the stock market instead of paying into Social Security. We assume the reader knew that wasn't legally possible.

Wade researched the question because well. . . because he's a researcher, and responded along the lines that in the reader's personal situation it would have been roughly a draw, but that investing in the market would have exposed him to far more risk to achieve similar results. In other words, the reader would have done about as well with investments but largely because he had chosen a good time to be born. (He was lucky.)

Wade later noted that his analysis didn't include spousal benefits. Spousal, survival, and other Social Security benefits are huge, so if the reader is married then he would have been worse off investing his FICA taxes. Significantly worse off.

The question is disquieting because it suggests that the reader may not appreciate the difference between insurance, like Social Security Retirement Benefits, and investments. They aren't apples and apples.

Social Security retirement benefits, officially named Old Age and Survivors Insurance (OASI), are insurance against longevity, or living a very long time and running out of wealth. It was passed into law in the 1930's because Americans felt that old people who couldn't work any longer shouldn't live in poverty. We pay the premiums for this insurance with FICA taxes. OASI is available not only to Americans but to anyone who works legally in the U.S. and pays FICA taxes. Benefits are based on how much we pay in FICA taxes over the years.

Insurance is a contract that pays us when bad things happen in our lives but typically pays nothing if we don't suffer a loss. An investment is something we buy with the hope of selling at a higher price in the future.

If you live a long time after retiring, you will be better off buying insurance like fixed annuities or more Social Security benefits, which you can effectively do by delaying claiming. If you live less than an average lifespan, you may well be better off investing – or maybe not, since investments can lose as well as gain. Investing seeks to maximize spending in retirement but guarantees nothing, while insurance guarantees that you will have at least some income no matter how long you live. If you are healthy, you cannot predict how long you will live, which makes it a lot harder to choose between the two. Theirs are two very different promises.

When you buy stocks and bonds you “sell cash and buy risk.” Cash includes things like actual cash and short- to intermediate-term Treasury bonds. Risk means risky assets, like stocks and riskier bonds. When you buy an annuity or increase Social Security longevity insurance by delaying your claiming age, you are buying safety from longevity risk. Another way to say this is that you are paying an insurer to accept your longevity risk.

Your total household balance sheet, as RIIA likes to say (download PDF, should include all social, financial and human capital.

The risk you buy when you invest in stocks and bonds is market risk, or capital market risk, and this is a risk to your financial capital. When you buy an annuity, increase Social Security benefits by delaying claiming age, or buy disability or life insurance, you're protecting your human capital.

Claiming Social Security benefits early and investing them would mean accepting more longevity risk in addition to increasing market risk. Investing FICA taxes in the market would mean increasing your financial risk in hopes of mitigating your human capital risk, which is all perfectly fine if your overall financial situation in retirement calls for more risk. If you have a huge private pension and little savings to invest, for example, that might be the case.

Increasing your Social Security benefits by delaying claiming them would decrease both your financial risk, because you would be investing less, and your longevity risk by making sure that you or a surviving spouse will have more income guaranteed if one of you lives a long time.

When we ask if we would be better off with stock investments than Social Security benefits, we're asking if it is better to gamble that our investments will do well and we won't live a long time or to buy insurance that will increase our income if we do live a long time. The ideal answer is to have enough wealth to do some of each. This is the basis for a floor-and-upside income strategy.

When I read the question, my first thought was why not invest my homeowners insurance premiums in the market instead of handing them over to an insurance company? If my investments do well and my house never floods or burns down, I'll be way ahead of an insurance policy. (Please don't try this at home.)

But what if it does? What if my house burns down? What if I live to an old age? What if  my widow lives to a very old age? Some risks, like long-term care costs, home insurance, and living to 95 are, as my cousin in the insurance industry likes to say, not easy to out-save. When there is a low-probability, high-magnitude risk and insurance is affordable to protect against it, then insurance is the most effective way to deal with that risk.

The next question might be, “I’m wealthy and don’t need Social Security, so why should I have to participate?”

The answer is adverse selection. If only people who really need insurance buy insurance, any kind of insurance, that insurance is doomed to failure. Successful insurance only works when claims are random and uncommon.

Adverse selection increases the price of life annuities (SPIAs and DIAs), as well. People who don’t expect to live long buy life insurance, not annuities. Those who buy annuities are those who think they will live longer, so the price goes up. If only poor people or old people enrolled in Social Security, it couldn’t work.

So, why am I bothered by someone asking if investing is better than insuring? Because they are not the same thing, so “better” depends on what you are trying to achieve. Is an umbrella better than sunscreen? It is if it rains.

Investing and buying insurance are two very different propositions. Even if your personal preference is to bet everything on the market, you should do so understanding this difference.

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