A Mission Statement for Retirement, Part 5

Let's take a quick review of the story so far. Retirement finance is, in game theory terminology, a sequential game against nature (see A Random Walk, A Sequential Game, Part 3), nature being a "fictitious player having no known objective and no known strategy." We place our bets, as in a game of roulette, and nature spins the wheel. Then it's our turn again and we reassess our situation and place the next set of bets.

Our wealth throughout retirement will look like a random walk because most of the key factors of retirement are probabilistic (see A Model of Retirement Planning, Part 1). Wealth will meander from its initial value at the beginning of retirement between increased wealth and insolvency.

Our wealth at all states (ages) of retirement will look like a time-discrete Markov chain because our wealth at our next age depends only on our current wealth and what happens in the coming year. In other words, if we have $1 million today, it doesn't matter if we got here beginning with $2 million or beginning with half a million. Our past finances are largely irrelevant.

Retirement finance also appears to act like or to be a chaotic system and whether it can be mathematically proven to be chaotic probably doesn't matter. (If it looks that much like a duck, it's wise to cover your head when it flies directly over you, see Retirement Income and Chaos Theory.) Our finances can enter positive feedback loops that will end in bankruptcy for about one in two hundred retirees, insolvency being a far worse outcome than the depletion of our savings portfolio alone (see Why Retirees Go Broke).

In simpler terms than those of statistics and probabilities, game theory and chaos theory, retirement finance is highly uncertain (risky), requires periodic adjustments and the bottom can fall out frighteningly fast.

This brings us to my last post, What Would a Good Retirement Plan Look Like?, in which I suggested that a good retirement plan is one that has a high probability of successfully meeting a retiring household's achievable objectives. If we accept this as the definition of a good retirement plan, then the next obvious question becomes how we define and integrate the goals of the household into the retirement planning process.

Goals and objectives can be strategic or tactical. Strategic goals are what we want to achieve. Tactics are how we will achieve our goals.

Successfully funding our standard of living for the remainder of our lifetimes is a strategic objective. Maximizing the household's inheritance might also be a strategic objective. Selecting an optimal withdrawal rate or asset allocation are tactical objectives.

One way to distinguish between the two is to consider whether you would measure retirement success by achieving that objective. If you were to constantly maintain the optimal sustainable withdrawal rate throughout your retirement but fail to maintain your standard of living, you would probably not consider retirement a success – it would fail the "Saint Peter test”, a thought experiment I described in What Would a Good Retirement Plan Look Like? Maintaining an optimal sustainable withdrawal rate throughout your retirement, then, is not a strategic objective but maintaining your standard of living is.

I expect that most people wouldn't consider owning a life annuity as an objective in itself, though it can be an excellent tactic for achieving the strategic objective of not running out of income before you die. Likewise, implementing a floor-and-upside strategy is not a strategic objective, but a tactic to achieve a broader goal. The point of all this is that a retirement plan should aim to meet our strategic objectives and that tactics are just a way to get there. Tactical objectives should follow from strategic objectives.

The best model I have found for a strategic retirement planning process is the one used by businesses. Although there are significant differences between developing a strategic plan for a business and developing one for a household's retirement, the overall process for the former seems a good model for the latter.

(Spoiler alert: the strategic planning process for businesses, as explained in the venerable MBA textbook, Strategic Management, Pearce and Robinson, will play a key role in future posts in this series.)

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A good retirement plan should begin with a mission statement explaining what you hope to achieve.

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The strategic planning process for businesses begins with a mission statement. That seems like an ideal place to begin a strategic retirement planning process, as well.

While businesses use the mission statement, according to Pearce and Robinson, "to describe the firm's product, market and technological areas of emphasis . . . in a way that reflects the values and priorities of the firm's strategic decision makers", retiring households can employ a mission statement to identify their strategic objectives, or those things that, at retirement's end, they would need to have achieved in order to consider their retirement to have been successful.

While we are primarily discussing retirement finance, a mission statement should also include important strategic objectives that may impact our finances, like wanting to travel or earn a Ph.D. In fact, once we achieve the required state of intense pondering required to create a mission statement, it wouldn't hurt to throw in some non-financial but important goals like figuring out the true meaning of life or becoming a blogger.

Here's an example of a retirement mission statement.

• We hope to maintain our current standard of living throughout both our lives, though we recognize our spending desires will likely decline some with age.
• We don't want to be a burden to our children.
• We plan to pay for our children's education as far as they are willing to pursue it, but we have no fixed plan for an inheritance.
• We are not willing to risk our current standard of living to improve it or to increase our terminal wealth. Our standard of living is our priority.
• We want to travel abroad every year until our mid-70's.
• We prefer to downsize our home by age 75 to reduce maintenance.

Your statement can be longer or shorter, but it should at least encompass your feelings about risk, standard of living, plans for your home, and bequests. Notice it doesn't mention sustainable withdrawal rates, asset allocations, annuities or floor-and-upside strategies because those are tactics and not strategic objectives.

If you are setting out to develop a retirement plan, I recommend you create such a mission statement as the starting point. Satisfying this mission statement is the goal of your retirement plan. If you are about to pay someone else to develop a plan for you, the mission statement is a great way to communicate what you expect from the plan. A mission statement can help you and your spouse make sure you're on the same page. And if you already have a plan, I recommend you develop a mission statement, anyway, and compare it to the plan you have. Make sure your existing plan is set up to achieve your strategic goals.

Your first draft of the mission statement may not be your last. You may remember from a previous post that we amended the definition of a good retirement plan to define goals as reasonable (attainable). During the planning process, we may discover that some of the goals of our mission statement aren't achievable given our resources, in which case the mission statement must be revised.

On the plus side, we may discover that there are resources available to enhance the goals in the mission statement. But, figuring that out comes next at The Intersection of What's Desired and What's Possible, Part 6.

What Would A Good Retirement Plan Look Like?, Part 4

In my three previous posts, beginning with A Model of Retirement Planning, Part 1, I laid out a high-level model of retirement finance. The high-level model essentially describes the problem we are trying to solve. But, my ultimate goal is to define a good way to develop retirement plans to solve the problem.

Surprisingly, I have been able to find very little literature that addresses the best way to develop a retirement plan. As I have mentioned before, RIIA’s approach is the best I’ve seen but it is still a little too tactical for me.

A good place to start, I think, would be to decide what a good plan should look like in broadest terms.

When answering questions like this, I try to imagine myself at the future endpoint looking backward. For example, when I make a major decision, I imagine that it has turned out badly and that I have asked myself what I would decide if I could have a do-over. Would I ask myself why I had taken such a bad risk and vow never to make that mistake again? Or, would I believe I had made the best bet and just been very unlucky? In the latter case, I’d make the same decision again. I try to avoid the what-was-I-thinking outcomes.

I find this approach especially helpful when I’m considering a bet with a low probability of a really bad outcome. It's so tempting to imagine that low-probability outcomes, especially the awful ones, just won't happen. But, improbable doesn't mean impossible. Since most of retirement finance is probabilistic, a retirement plan is essentially a bet. I try to avoid having to one day think, “That bet was a huge mistake, but it seemed so unlikely that I’d lose it.” Going broke late in life is one such bet.

When I look at the retirement plan bet, I imagine that I am standing at the pearly gates and St. Peter asks, “So, how did that retirement plan work out for you?”

My first thought was that we should evaluate our plan by how well it met our individual household goals (past tense – remember, we’re standing at the gates), but that doesn’t take risk into consideration. A retiree who successfully funds retirement by investing 100% of her savings in penny stocks didn’t have a good plan, she was just extremely lucky. Lots of people successfully fund retirement with no plan, at all. So, retirement plans can’t be measured solely by the eventual extent of their success.

A good retirement plan, viewed in retrospect, would be one that had a high probability of achieving the individual household’s retirement goals. In other words, it was a good bet. Retirement finance is a stochastic (probabilistic) game, so retirees can win with a bad plan and lose with a good one, though we would expect that to be less likely than the reverse. A good plan is a good plan whether it succeeds or fails. A bad plan (or no plan) is a bad plan even when it succeeds.

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A good retirement plan, viewed in retrospect, would be one that was a good bet.

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If my plan succeeded, I would want to tell St. Peter that I had a good plan and I got lucky. Were it to fail, I would want to be able to say that I had a good plan but poor luck and that if I had it to do over again for a hundred lifetimes, I would choose the same plan. Ideally, we should have no regrets if the plan fails, because it had a high probability of succeeding.

Now that we know how to define a good plan, how do we actually measure that? Michael Kitces posted a timely piece addressing this question at Advisor Perspectives recently. He came to a similar conclusion:

“Thus, in framing different retirement income strategies – and the trade-offs they entail – it’s important to scrutinize the measuring stick used to evaluate the outcomes. The best retirement income strategy will depend on whether you measure based on wealth, spending, probabilities of success, magnitudes of failure or utility functions that weigh both the upside and downside risks!”

Kitces also lists several metrics that are often used to compare plans, including:

• Terminal wealth
• Total cumulative spending
• Probability of ruin
• Magnitudes of failure and adjustments
• Utility functions and risk aversion

I have only a couple of quibbles with the list. First, I don’t believe the probability of ruin is a good way to measure retirement success, even though it is the most commonly used metric. I argued this at my post at Advisor Perspectives and Moshe Milevsky subsequently wrote a better argument.

Second, Laurence Kotlikoff and other economists prefer maximum smoothed consumption to total consumption because it smooths consumption over time and provides more spending when it is needed. A plan that maximizes total consumption but provides most of the spending when we are very old and desire less isn’t a good plan.

Consistent with Kitces’ assertion, I don’t believe that any of these measurements is “best.” In fact, we might employ two or more in a retirement plan to estimate the probability of achieving the household’s retirement goals.

Of course, the highest probability of success might not be very high, as in the case wherein a retiree’s goals are beyond their means. Even the best plan will have little chance of success in this scenario, but this is a problem with the goals and not the plan. Still, to cover our bases, let’s expand the definition of a good retirement plan to one that will have a high probability of achieving the individual household’s reasonable retirement goals.

Notice I said, "one that will have a high probability" of success. There will likely be multiple plans that have a higher probability of achieving household goals than other plans under consideration. Among the group of better plans, the retiree will need to make the selection based on his or her other preferences, because all of them will be rational choices. You might find a plan with a high probability of meeting your goals with an annuity and another that avoids annuities and prefer one over the other, for example.

Now we know basically how retirement finance works (nearly everything important is unpredictable and probabilistic and changes as retirement progresses) and how to choose a good retirement plan (pick one that has a high probability of achieving your household's individual reasonable retirement goals). We even know the rational way to cope with that uncertainty and change (update the plan periodically as new information presents itself).

Next time I’ll talk about incorporating those individual household goals into a retirement plan and why this should be the first step in developing a plan.

Webinar: Why Retirees Go Broke

I'll be hosting a free webinar at noon EDT tomorrow, May 4, sponsored by the Retirement Income Industry Association. I'll also be discussing some research that will be published in the fall entitled, "Competing Risks: Death and Ruin."

Hope to see you there!

A Random Walk, A Sequential Game, Part 3

In A Model of Retirement Planning, Part 1, I wrote that the challenge of retirement income planning is to best position ourselves to maintain our desired standard of living throughout an unpredictable length of retirement with somewhat-predictable future income but largely unpredictable future expenses. A mighty challenge.

In Adding Risk to the Model, Part 2, I added to the model tolerance toward the risk of losing standard of living, because within a fairly small range of expected income and expenses, some households will choose to spend more early in retirement at the risk of having less to spend late in retirement, and some households will choose the opposite. Some can live with more risk than others.

We need to add one last important characteristic to the top-level model of retirement finance, its “chained state” nature. Retirement finance is not a “set-and-forget” decision that we implement and never revisit. It's a series of moves in a sequential game.

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Retirement finance is not a “set-and-forget” decision that we implement and never revisit. It's a series of moves in a sequential game.

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I often use the sailing metaphor. At the end of a day of sailing – or a year of retirement – we will find that we have drifted off course and we need to correct our heading. We can't just continue using the heading we set at the start.

Game theorists refer to this as a sequential game against nature, meaning that the game is a series of alternating moves in which Player 1 (your household) makes a move and nature (defined in game theory as "a fictitious player having no known objective and no known strategy") responds.

Although personal finances are practically time-continuous, it is easier to think of them as a series of years, or “discrete-time states”, so that’s how we plan. The age of death for a healthy person is unpredictable, but we often think of people retiring around age 65 and living until age 100, or so. In that case, retirement would consist of one to 36 discrete time states representing ages 65 through 100.

 Following is a simple state diagram for a retiree who retires at age 65 and turns out to live to age 76. Of course, life span is unpredictable for a healthy retiree, so we don’t know beforehand if our own chain will contain one state or dozens.

An individual state can be identified by the age of the retiree, so we can use the terms “state” and “age” synonymously in this example. Each state has associated with it information about income, expenses, net worth, remaining lifetime, portfolio balance, desired standard of living, risk tolerance and other critical financial information.

This information is known with the most certainty in the state that is current, in other words, at our present age. For example, we can know our current portfolio balance, interest rates, current desired standard of living, and current risk tolerance fairly well. We can't know with as much confidence what these values will be for next year, and the uncertainty increases every future year.

For example, if state zero represented 2007, the market crash in October of that year might significantly change all future expectations for portfolio balance, portfolio spending, and net worth and it might even affect our decision to delay Social Security benefits. For some households, it postponed the planned retirement date.

The following table illustrates some of the plan's forecasted financial data for each year in the diagram above as of the starting state (age 65). Age 66 data is less certain when predicted at age 65, age 67 data predicted at age 65 is even less certain, etc. (Click to enlarge.)

Large changes in expectations might also result from out-sized market gains, unexpected medical expenses or the loss of a spouse. Our view of the future can change significantly in a short time. In 2006, our forecast for 2008 would not have included a 55% market crash and a housing crash.

Also, note that the state data we are forecasting are moving targets. Income changes when we claim Social Security benefits. Life expectancy decreases at each new state. Spending, our desired standard of living, tends to decline with age. The sustainable withdrawal percentage from our savings portfolio increases with age. The purchasing power of a dollar changes. Our forecasts constantly change, but so do our targets. We can't simply say we're going to spend $50,000 a year in retirement or receive $50,000 of income annually in retirement because those numbers change over time.

What about the past?

This series or “chain” of discrete states (ages) has the characteristic that the values of next year's state are dependent only upon the information provided in the current state and what happens this year. Anything that happened before reaching the current state is no longer relevant. (Mathematicians refer to this as a discrete-time Markov chain.)

A Monopoly board provides a simpler example of a Markov chain. If your race car or thimble is currently parked on Illinois Avenue, where you will end up next depends solely on where your thimble or race car currently sits and the next roll of the dice. It doesn't matter if you got to Illinois Avenue by sitting on New York Avenue and rolling a five or States Avenue and rolling eleven. That won't affect where you will move next.

This is an important concept that points out, for example, the absurdity of a fixed sustainable withdrawal strategy basing how much you can spend in year 12 of retirement on how much savings you had at the beginning of retirement. If you reach year 12 of retirement with a half million dollars in your savings portfolio, it doesn't matter if you got there by starting retirement with $1M and depleting half of it, or by starting retirement with $250,000 and doubling it. All that matters is where you are now and what happens next.

This is also an important concept in retirement planning because the states you “land on” will be a random walk through retirement-wealth “state space” resulting from those unpredictable incomes, expenses, market returns, and lifetimes, etc.

(State-space is simply the set of all possible future states of a dynamic system – or all possible states of retiree wealth in this explanation. In the simple game of tic-tac-toe, for instance, there are 765 essentially different states that can be reached. The state space for a coin-toss consists of only a head and a tail. There are only two possible future states. In reality, there are an infinite number of possible wealth states for a retiree and time is continuous. It simplifies the explanation, however, if we imagine time in discrete years (snapshots) and a finite number of essentially-different wealth states.)

The state diagram above shows the path moving forward in a straight line, but your path will actually wander through wealth “state space” depending on the draws from those random variables, incomes, expenses, market returns, etc., as illustrated in the following diagram.

When you reach the darker-blue state at age 67 in the above diagram, for example, it won't matter how much or how little wealth you had at ages 65 or 66. Those gray states and the information they contained will no longer be relevant. At age 67, we can only guess the future positions of the light blue states and when we reach age 68 and gray-out age 67, our predictions of the position of future light blue states may change then, perhaps dramatically.

This Markov-chain, or "Markovian", nature of retirement finance has a number of implications for the retirement model. First, since year three's finances depend solely on year two's financial state plus some unpredictable events, and year two's finances are also unpredictable, predicting our future finances with any accuracy quickly becomes untenable. We are trying to predict where we will be in the future by moving an unpredictable distance and direction from an unknown starting point.

Our ability to predict future states decays quickly. We can perhaps predict a year in advance with a little accuracy, but this foresight decreases with each year beyond that and quickly becomes unpredictable. No one predicted the 2008 financial disaster in 2006.

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Our ability to predict our financial future decays quickly. No one predicted the 2008 financial disaster in 2006.

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Second, thinking of retirement as a Markov chain that renders past information irrelevant means each new year of retirement becomes a new puzzle to solve, possibly quite different than the one we faced the previous year, so dynamically updating our plans becomes an obvious necessity. It also rids us of the notion that our financial situation years ago remains relevant.

The top-level model for retirement finance, then, should look something like this.

"Retirement finance is a random walk of unpredictable length ranging from one year to several decades. At a given age, only the present financial data are known with any certainty. Data from previous years can be known but are irrelevant. The reliability of forecasts of data for future states decays rapidly with time and forecasts beyond five years are probably sheer conjecture. The key determinants of retirement wealth are random variables: income, expenses, life span, and risk tolerance. Retirees can choose to spend more or less, within a reasonable range, depending on their risk tolerance. Retirees with high risk tolerance can increase spending early in retirement and consequently increase the risk of a lower standard of living in late retirement while more risk-averse retirees can decrease spending early in retirement and consequently decrease the risk of a lower standard of living in late retirement.”

Retirement finance is a random walk along a Markov chain, or to a game theorist, a sequential game against nature. Each year we make forecasts based on what we know (our current financial status and the financial environment), what we expect to happen in the future, and what unexpected outcomes we believe we might experience in the future (risks). We make our move based on this analysis and our risk tolerance. Then nature takes its turn and we repeat.

Once we have a high-level model of retirement finance, we can start to think about how to plan for it. Surprisingly, I have been able to find very little literature that addresses the best way to develop a plan. A good place to start, I think, would be to answer this question: How can you know a good plan when you see one?

Adding Risk to the Model, Part 2

In my last post, A Model of Retirement Planning, Part 1, I suggested that “The challenge of retirement income planning is to best position our available resources to maintain our desired standard of living throughout an unpredictable length of retirement with somewhat-predictable future income but largely unpredictable future expenses.” 

Let me break that down. "Best positioning our available resources" means placing our best bets because retirement is unpredictable and we can't know in advance which strategy will outperform the others. "Maintaining our desired standard of living throughout retirement" is typically the retiree's first goal, but it may not be the only one.

I began building a high-level view of retirement finance and the main point of that post was that the three most critical factors of retirement finance are lifespan, income, and spending and all three are largely unpredictable.

Once we lay out an estimate of the cost of the standard of living we desire in retirement (the expenses), estimate the amount of income we might be able to generate from all available wealth resources, and choose a life expectancy for planning purposes, there will be a large range of potential retirement strategies still at our disposal. Different households with virtually the same expected income, expenses, and lifetimes may plan very differently because their risk tolerances differ. We need to add risk tolerance to the model.

The primary risk of retirement is that of losing our standard of living. (Notice I didn’t say the primary risk is depleting our savings. It’s possible to deplete our savings – or even to not have savings –  and still maintain our standard of living. The latter is more important.)

Risk tolerance refers to how much risk we can tolerate emotionally and psychologically. Nearly everyone is risk-averse, meaning that, when exposed to uncertainty, we attempt to reduce that uncertainty. But, some of us are more risk-averse than others, and some are more risk-tolerant, so we tend to choose whatever strategy “lets us sleep at night.”

Given identical expectations of future expenses and income, two households might choose very different retirement strategies because one household is significantly more worried about the prospects of losing their standard of living than the other. Generally, the higher standard of living one chooses, the greater the risk of outliving savings.

Because income can be a range and not a single amount and expenses are a range and not a single amount, there is a budget range within which we can plan. Say we expect annual expenses to range from $30,000 to $35,000 and income to range from $40,000 to $42,000. We can take some risk and plan on $42,000 of income and $30,000 of expenses, be conservative and plan on $40,000 of income and $35,000 of expenses, or choose something in between.

The amount a household will spend in retirement depends somewhat on how much risk they are willing to accept that they will run short of money late in life. Consequently, risk tolerance is a key factor in the basic retirement finance model.

A household that finds that it doesn't have enough expected income to pay for the expected cost of their desired standard of living has three levers to pull in any combination. The household can reduce expenses, increase income, or take more risk of a lower standard of living late in life.

First, we can lower our expenses, reducing discretionary expenses like travel for example, or accept a lower standard of living. We might relocate to someplace where our desired standard of living is less expensive. We can also lower expenses in retirement by working longer and thereby shortening the length of our retirement.

Second, we can increase income by delaying retirement and working and saving longer (the most effective strategy). We may also be able to increase income through part-time employment. We can increase income by delaying the claiming of our Social Security benefits. We may even increase it by changing our funding strategy. A life annuity, for instance, might generate more lifetime consumption than investing in stocks and bonds.

Third, we can spend more early in retirement if we are willing to accept more risk of a lower standard of living at the end of retirement. One way to do this is to bet a lot on the stock market. If the market performs very well during our retirement, we will have more money to spend. Unfortunately, if the market performs only moderately well or poorly, we will have less to spend later in retirement. Many people seem willing to make that bet.

We can also take risk with our life expectancy. Some people bet that they won't live a long life and they increase spending accordingly. That seems like a risky bet for a healthy person, the downside being a low standard of living in old age, but people tell me frequently that they “won't live past 80.” I have no idea how they know that. Once again, this allows us to increase spending in early retirement at the risk of a lower standard of living late in retirement.

Regardless, if you are willing to take more risk of a lower standard of living in late retirement, of not reaching late retirement, or of not encountering many large, unexpected expenses, you can increase your spending in early retirement. Spending won’t depend solely on your income and expenses, it will also depend on your risk tolerance.

Imagine two married households with identical financial resources on the eve of retirement, but with vastly different risk tolerances.

The risk-tolerant household can assume that they won’t live much past median life expectancy, that they won’t need long-term care or have other large unexpected living expenses and that the market will return 8% after inflation throughout their retirement, so they invest most of their savings in a stock and bond portfolio and spend 4% of it each year.

The more risk-averse household will assume the husband will live to age 90 and the wife to 100. They will work as long as they are able and delay claiming Social Security benefits. They will purchase long-term care insurance and use their savings to purchase a life annuity so they maximize consumption and avoid market risk entirely. They will relocate to an area with a lower cost of living. They will spend less early in retirement and hold some back for a possibly long retirement.

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Risk tolerance is critical to retirement planning, but can vary over time with risk capacity and risk perception.

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The risk-tolerant household will feel comfortable spending significantly more in early retirement than the more risk-averse household, which is to say that they will choose a higher standard of living with a greater risk of dying broke. If the more risk-tolerant household is too conservative, they will have a lower standard of living than they would have otherwise had. If the more risk-tolerant household loses the bet, they will have a higher standard of living in early retirement than in late retirement.

One last important point about risk tolerance should be considered. We might imagine that risk tolerance is constant for a given retiree, but that isn't always the case. Like most other key factors of retirement planning, risk tolerance can be unpredictable. It can change situationally or with age.

William Bernstein has written often about investors who feel quite risk tolerant during a bull market only to find during a market crash that they fear losses much more than they expected. He recently wrote that investors who take measure of their risk tolerance during good times should probably halve it. It is difficult to predict how you will feel in a gut-wrenching crash like 2007 until you have lived through one or two.

Research differs on the correlation between age and risk tolerance. This 1997 study (download PDF) concluded that “Risk tolerance increases with age when other variables are controlled”, while a 2010 study reports that “Risk tolerance generally decreased as people age.” In both cases risk tolerance changed significantly with age, but the direction of the change differed.

Interestingly, the study that showed older people become more risk tolerant concluded during the Tech boom and the study reporting that risk tolerance generally declines with age concluded just after the Great Recession, consistent with Bernstein's observation.

Regardless, the important point for a retirement model is that risk tolerance is critical to planning but it can vary over time as our risk capacity and perception of risk change. Like most critical factors of retirement finance, it isn’t something we can establish at the beginning of retirement and assume will remain unchanged. And, because we frequently can’t predict our future risk capacity with any certainty, nor our future perception of risk, our risk tolerance over time can be somewhat unpredictable.

To plan for retirement, we need to estimate future expenses, estimate future income, establish a life expectancy for planning purposes and understand how much risk we are willing to take with those estimates. We add the risk of losing our standard of living to the basic retirement model as follows.

“The challenge of retirement income planning is to best position our available resources to maintain our desired standard of living throughout an unpredictable length of retirement with somewhat-predictable future income but largely unpredictable future expenses. Retirees can choose to spend more or less, within the range of available resources, depending on their risk tolerance. Retirees with high risk tolerance can increase spending in early retirement and consequently increase the risk of a lower standard of living in late retirement while more risk-averse retirees can decrease spending in early retirement and consequently reduce the risk of a lower standard of living in late retirement.”

Once we have an estimate of expected retirement income and expenses, choose a “comfortable” level of the risk of losing our standard of living late in life, and choose a life expectancy parameter for planning, we have gone a long way toward bounding a set of retirement finance strategies appropriate for our household. Choices of details like asset allocations, withdrawal rates, construction of a safe floor portfolio, and annuity considerations will flow from these basic decisions.

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Retirement planning should be a top-down process, rather than choosing from a menu of strategies.

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The previous paragraph has significant implications for retirement planning. It suggests that planning should be a top-down process driven by the choices identified initially within the high-level model, rather than a process of choosing from among a menu of all possible strategies. By identifying the key factors first, we immediately eliminate many inappropriate or irrelevant strategies from consideration.

There is at least one more important top-level characteristic of retirement finances our high-level model must incorporate – retirement's “chained state” nature. Retirement planning isn't a one-time decision.  It's a series of moves in a sequential financial game.  (A sequential game against nature, in the vernacular, and a little more game theory.)

I'll get to that in A Random Walk, A Sequential Game, Part 3.

A Model of Retirement Planning, Part 1

The details of retirement financial planning are easier to understand once you imagine the big picture and can see what the pieces are and how they fit together. It's easy to get stuck in the weeds.

Most retirement literature, unfortunately, doesn’t start with the big picture. It often jumps right into asset allocations or sustainable withdrawal rates. So, let’s take a step back and build a basic model of retirement finance, starting with how much the bills will be and how we will pay them.

Funding retirement begins with the simple observation that after one retires, the bills keep coming but the paychecks stop.

We then need to find the “best” way to pay the bills, with “best” being defined from an individual household's perspective. The plan one household considers best might be completely unacceptable to a different, even quite similar household. Given two households with identical finances, for example, one might find a life annuity to be "the best" solution while the other might not trust insurance companies and refuse to even consider annuities.

Paying for the expenses of retirement is the basic problem, so let's start with the cost. Expenses are also sometimes referred to in a retirement planning context as spending or consumption. I'll use them synonymously here.

One way to estimate retirement expenses is to assume that we will maintain our pre-retirement standard of living after we retire. We can subtract FICA taxes and retirement savings amounts from our pre-retirement paychecks because those are two items we will certainly not need to pay after retirement. The result is an estimate of the amount of retirement income needed assuming no changes to our standard of living. But, it isn’t a very good estimate for two reasons. First, our spending will change as we age (it typically declines). Second, living expenses aren’t entirely predictable.

Some living expenses are fairly predictable but some are random. I can predict that I will have a grocery bill, a housing bill and a Netflix bill next month and I can predict the amounts fairly accurately.

When my son needed $500 a while back to repair his car's ignition switch, we didn't see that coming. When my daughter needed an emergency appendectomy, that wasn’t in the plan. Living expenses have both unpredictable and predictable components, which means that your total annual living expenses are unpredictable.

The predictable part is simply the minimum. I can be pretty sure that my living expenses will be $50,000 next year, but I might also have a large unpredictable expense or two next year. So, my total expenses next year will actually be somewhere between $50,000 and some amount that could be much larger but is unpredictable.

This “expense risk” is the fallacy in looking at retirement planning simply as an income problem, such as a sustainable withdrawal amount from a portfolio of volatile investments.

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Retiring for an unpredictable number of years with unpredictable expenses and somewhat-predictable income.

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Let’s say a planner (or an online calculator) tells you that you can spend 4% of your savings each year and your savings will likely last at least 30 years. That 4% provides you with a nice standard of living when added to your Social Security benefits until one day someone in your family becomes quite ill and you have $100,000 of uninsured medical bills or your adult child becomes unemployed and moves back home. Your retirement plan – and perhaps your retirement – is destroyed.

What went wrong? Your planner (or that online calculator) promised that you could spend 4% of your portfolio balance annually and your savings probably wouldn’t be depleted for at least 30 years. He (it) didn’t say what would happen if you should need to spend more than the 4% you planned. You thought 4% spending was safe, but how can you know that your retirement finances are “safe” without knowing how much you might have to spend? The income side of the equation alone doesn't show all the risk.

How long you will live in retirement is more critical than spending. If your desired standard of living costs $60,000 a year, you retire at 65 and die at 66, your entire retirement will cost about $60,000. If you live to 100, retirement will cost about $2.1M. (Those totals don’t include the aforementioned unpredictable expenses and the longer you live, the more likely you are to be hit with them.) A healthy person can't predict how long he or she will live and that means the total cost of retirement is highly unpredictable even without large, unexpected costs.

Life expectancy and spending are the two largest determinants of retirement cost and, as I have pointed out, both are unpredictable. So, when someone asks how much money they will need to retire or how much retirement will cost, the correct answer is, “We can't say with any certainty, at all. We can tell you what typically happens, but your retirement may not be typical.” That rules out waiting until you're certain you can afford it to retire. Certainty is absurd.

This doesn't imply that because retirement is largely unpredictable retirement planning has no value. We can't say with certainty that it won't rain June 2nd of next year but we can plan an outdoor wedding that has a better chance of success than simply hoping for nice weather.

Where will we find the income to pay our bills after we retire? It typically comes from Social Security benefits, pensions, part-time employment, and personal savings invested in income-producing assets like stocks, bonds, and real estate.

Income is more predictable than expenses or it can be if retirement is funded appropriately. Spending from pensions, life annuities, TIPS bond ladders and Social Security benefits is pretty predictable. Investments are less predictable, but the most you can lose from your investment portfolio is its total balance. Unexpected expenses can cost much more than your savings.

Imagine, for example, that you have saved $100,000 and have it invested in stocks and bonds. The most you can possibly lose in the market is $100,000 and it is extremely unlikely that you will lose all of it. On the other hand, it’s easy to imagine a medical bill exceeding $100,000.

This large amount of risk inherent in retirement finance is an unavoidable reality. Even if you fund retirement entirely with Social Security benefits and life annuities, making your expected income more predictable, retirement will still be very uncertain because some expenses are highly unpredictable. If you are very wealthy relative to your spending, of course, this matters much less.

Here, then is the first part of a retirement finance model:

The challenge of retirement income planning is to best position our available resources to maintain our desired standard of living throughout an unpredictable length of retirement with somewhat-predictable future income but largely unpredictable future expenses.

Note that the primary goal is to maintain a desired standard of living throughout retirement and not to maximize wealth, income or an inheritance. Once the standard of living goal is achieved– itself alone a massive challenge for most households – any uncommitted resources can be applied to the other goals.

Standard of living, by the way, is also a moving target. We naturally become less active and spend less as we age. As David Blanchett showed, however, spending typically declines as retirees age when they spend appropriately for their savings level. Retirees who under-save tend to spend less over time and retirees who over-save tend to spend more as they age. The latter two tend to "correct" spending as they recognize that they are depleting savings too quickly or have more money to spend.

This is the beginning of the “big picture” and one of the reasons questions like “how much money do I need to retire” and “when can I retire?” are so difficult to answer and why retirement planning is so challenging. It also points out that most retirement planning focuses too narrowly on investment results.

Lastly, it points out just how risky retirement is. As financial planner, Larry Frank, frequently reminds me, “everything is stochastic.” By stochastic he means random or unpredictable. And, by everything he means the market, interest rates, inflation, expenses, taxes, Social Security benefits, how long we will live and most other significant factors of retirement financial success.

But, unpredictable life spans, income, and expenses aren’t the entire “big picture” of the retirement finance model. I'll expand the model in future posts, starting with Adding Risk to the Model, Part 2.

Certainty is Absurd

Sometimes I read an excellent column somewhere and refer my readers to it while trying to build on the author's ideas a bit. I read a column today by Adam Butler posted at Advisor Perspectives that is such a column, but it is so well written that I don't find much to add.

The information in Adam's column isn't new research. It is, instead, a well-laid-out argument consisting of prior research showing that no one, not even those identified as experts, can reliably pick winning stocks or time the stock market, or predict the future in any of a broad range of disciplines, for that matter. He includes a wonderful quote from Voltaire, “Doubt is not a pleasant condition, but certainty is absurd.”

Adam suggests as an alternative to attempting to predict future market returns, advisers use “forecast-light methods.” In other words, if we can’t predict the future, our plans should minimize sensitivity to critical predictions.

Voltaire's quote is spot on. Accepting uncertainty in retirement planning is uncomfortable (Do I have enough savings to retire? Should I work another year just in case? What if I buy an annuity and only live a few more years?) but unavoidable. Retirement finances are so unpredictable that certainty is, indeed, an absurdity.

I find the framing of this argument intriguing. If a fortune teller told us he could predict the future, we would say, “Prove it.” In the investment world, people claim they can predict the future and say, “Prove I can't.”

It usually doesn't work that way and there is scarce credible evidence that anyone can outsmart the market for more than just a few years. (My favorite example is Bill Miller, see “Losing Money with the Best Mutual Fund Manager of All Time.”)

I'll stop talking now and send you to Adam Butler's post. Enjoy!

A Follow-Up on Confusing Issues

In a recent post, I asked, “What Do You Find Most Confusing About Retirement?” You can read the comments I received and my responses, as well as responses from other retirement planners and researchers, at that link. I also searched those comments for common threads and will consolidate my (our) responses in this post.

Social Security benefits are confusing, as is the process for identifying optimal claiming ages.

Amen. I have studied Social Security benefits extensively and have concluded that it is a topic with which most retirees and planners (including me) need help. Becoming an expert requires a lot of work and understanding the rules is only the first step. You then must apply the rules optimally for a given retiree's unique financial situation, life expectancy and tolerance toward longevity risk.

My favorite Social Security guru is Mike Piper at ObliviousInvestor.com. He has updated his book, Social Security Made Simple, to include recent changes regarding file-and-suspend and I recommend it. I am also quite fond of Laurence Kotlikoff's MaximizeMySocialSecurity software to identify optimal claiming strategies.

Trying to become a Social Security benefits expert on your own will be quite frustrating.

I have trouble finding a good retirement planner.

Join the club. I haven't found a lot of retirement planners I would trust with my money and the top planners and retirement researchers with whom I have discussed this challenge completely agree. But there are good ones out there, as I suggested in the previous post.

It isn't terribly difficult to become a Chartered Financial Analyst (CFA) or Certified Financial Planner (CFP), so those credentials alone don't guarantee you've found a good planner. I put a bit more stock in Retirement Management Analysts (RMAs) because I know their training process and I have met several of them, but it's still no guarantee. I would suggest you use such designations as a baseline starting point in your search. I really only trust financial planners I know, like Dana Anspach and Mike Lonier (see their comments on my previous post) or those referred by someone I trust.

I also suggest that you review a prospect's qualifications. You can usually tell when a CPA, insurance salesman, tax preparer or stock broker has added retirement planning to the quiver. Finding a planner with insurance or investment expertise, for example, can be a good thing unless it's merely a path to generate more insurance or stock sales.

Don't limit yourself to retirement planners who are located near you. Because there are relatively few good ones, you may have to search other cities or even states. Planning via telephone and internet is perfectly viable.

Lastly, and perhaps most importantly, I recommend a fee-only planner who has no monetary  incentive to sell you products. If the planner will manage your money or provide investment advice, confirm in writing that he or she assumes fiduciary responsibility for your account. And don’t give your adviser custody of your funds! (See A New Ponzi Scheme Every Week.)

To reiterate, most of us agree that good retirement planners are hard to find, but they're out there.

“Figuring out the most tax-efficient way to distribute from IRAs, Roth IRAs, and taxable accounts at the right time is just a few too many variables for me and Excel.”

Many planners recommend that you distribute from the taxable account first, then the traditional IRA, then the Roth last, but there will be situations that dictate otherwise. It may sometimes be optimal to withdraw from two or more types of accounts in the same year and the optimal withdrawal plan may change with time. The decision between Roth and Traditional IRA withdrawals will be affected by your opinion of future tax rates, which are impossible to predict. The outcome is also tied to your Social Security claiming strategy.

The problem is so complicated that at least one company, Retiree Inc., has been formed primarily to solve this problem for retirees. The company offers to develop an optimal withdrawal plan for a fee of $500.

I like Kotlikoff's E$Planner for this. It allows you to switch the order of withdrawal and measure the results by the consumption generated. It’s less expensive (currently $149) and is a more general purpose retirement planning tool. (I have used both Kotlikoff products, but I am unfamiliar with the Retiree Inc. product. I should also note that many find E$Planner confusing to use.)

It may not work well to decide on a withdrawal plan at the beginning of retirement and stick with it come hell or high water. Your situation may change as retirement progresses, suggesting an annual review and tweaks to your strategy may be warranted.

Another reason to dynamically manage this process is that tax laws change over time. Changes are nearly impossible to predict because they are political and they can have a significant impact on your plan. Stretch IRA's, for example, appear to be in present danger. A withdrawal plan you choose today might not make sense if tax laws change.

Retirement plan distribution choices also affect creditor protection of assets. Retirement plan assets are generally better protected than assets outside a plan. When you are spending retirement plan assets you are probably decreasing you pool of protected assets. (See Is My Retirement Plan Protected?)

Find a good retirement planner with tax expertise, or one who is willing to get help from a tax expert. If you insist on doing it yourself, try E$Planner. Optimizing your withdrawal strategy can provide significant improvements, but it is, in my opinion, a second-order problem. Getting it mostly right or a little wrong won’t make or break your plan. Spending from taxable accounts, then traditional IRAs, then Roth IRAs may get you most of the way there. The more important piece of the strategy is to adapt your plan as changes dictate.

The potential for early retirement.

I wrote a few posts on this previously beginning with The Risk of Retiring (or Being Retired) Early. Retiring early is far riskier than most people assume. We say the most important factor in the cost of retirement is how long you live, but what we really mean is "how long you live in retirement." Retiring early means increasing the largest risk factor in the cost of retirement.

Retirees who ask, “Do I have enough savings to retire?” are often frustrated when they can get a yes or no answer. The issue is far more complicated. A better question would be, “Do I have enough savings to retire and maintain my desired standard of living with an acceptable risk of not going broke before I die?”

Two of the critical pieces of that question can be answered by you alone. What is your desired standard of living? What do you consider an acceptable risk of going broke before you die?

Retiring earlier is significantly riskier than retiring later, so the correct answer to the question, "Can I retire early?" is "Maybe – we'll need to run the numbers – but it would probably be a lot safer not to."

A simple way to look at this problem is to add your expected annual Social Security benefits to the annual payout you could receive by purchasing a life annuity. According to Wade Pfau’s Retirement Researcher Dashboard, a 65-year old couple could currently receive a 3.85% pay-out, or about $3,850 a year for every $100,000 they have saved.

For example, a couple who has saved $250,000 and expects $30,000 a year in Social Security benefits could generate $39,625 of annual income.

Do you feel like the total you calculate would be adequate retirement income? Are you willing to accept the risk that this amount of income will cover future expenses including significant expense surprises? If so, you can probably retire.

Continuity of investment and household expense management if I die or become disabled and where to find emotional, decision making, and day-to-day support in very old age, when we're less sharp and mobile.

These are concerns I share, even though I am blessed with bright and reliable children who could help and a wife with an MBA. These issues are a bit outside my area of expertise, however.

Huffington Post recently provided a list of “10 Bloggers Who Make Aging A Whole Lot Easier.” Ted Carr and his wife were applauded in that article for providing excellent podcasts on a broad range of retirement issues.

When I asked Ted about the continuity issue, he told me that his “May podcast is with Professor Sharona Hoffman who has written Aging With a Plan. Her book contains a lot of information about different types of support to help with all sorts of issues. She too does not have children and shares similar concerns.” I downloaded the book to my Kindle but haven’t read it, yet. I suggest you take a look at the other nine recommendations, as well.

I thank my readers who posted their concerns. I will keep an eye out for additional concerns at that post and invite anyone to ask any retirement finance question at any time following any of my posts.

What Do You Find Most Confusing About Retirement Planning?

In response to my recent post, Retirement Savings and Annual Spending, a reader made the following comment.

"For older workers, I would say that the level of knowledge is generally a state of confusion unless they are working with a good RIA type of planner. The barrage of conflicting information from the financial industry has generally made it difficult for people to become well-informed, even if they put a modest amount of effort in."

We can start with a clarification of the term "RIA", an abbreviation of registered investment adviser. I think Investopedia says it well. 

"In general, only larger advisors that have at least $25 million in assets under management or that provide advice to investment company clients are permitted to register with the SEC, while smaller advisors are required to register with state securities authorities. Registration of an investment advisor is not meant to denote any form of recommendation or endorsement by the SEC or state securities regulators. It simply means that the investment advisor has fulfilled all the requirements for registration as an investment advisor."

RIA is not a certification, like CFA or CFP, but simply a required registration with the Securities Exchange Commission for large firms or the state for smaller firms. RIA does not speak to the skills or training of the adviser, it only denotes that the adviser has legally registered to provide advice, analysis or recommendations regarding securities for pay.

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What do you find most confusing about retirement planning?

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It is also possible that the reader meant to type "RIIA", an abbreviation for Retirement Income Industry Association. RIIA does offer a certification called a Retirement Management Analyst (RMA) Designation that involves "rigorous educational and ethics training curriculum."

I responded to this reader by saying that I try to resolve some of that confusion with my blog, but it occurred to me that I may not have a clear idea of what confuses people most about retirement finance. So, here's your chance to let me know.

If there are issues about retirement finance at any life stage that you find particularly confusing or conflicting, please let me know with a comment below. I'll do my best to respond to them all.

I'll summarize the results in my next post, Following Up on Confusing Issues.

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Is My Retirement Plan Protected?

In Why Retirees Go Broke, I explained that the risk of outliving your savings portfolio and the risk of insolvency are two very different risks. In Retirement Plan or Investment Plan?, I mentioned that a retirement plan should consider protection of your assets from creditors in the event of the worst-case outcome, i.e., bankruptcy becomes a consideration, and that most retirement plans are protected, at least to some extent.

To follow up, I thought it might be helpful to create an overview of asset protections for retirement accounts. It is, to say the least, a complicated subject, as legal issues tend to be, so I teamed up with Kim Steffan, an attorney from nearby Hillsborough, NC who writes the monthly “Ask the Lawyer” legal column for the News of Orange County.

We’re going to provide an overview but you really should discuss your specific situation with an estate attorney. Protection from creditors should be part of your retirement plan but if your planner is not also an estate attorney, insist that he or she consult one.

In broad strokes, different retirement plans are protected in different ways by the Employee Retirement Income Security Act of 1974 (ERISA, a federal law), the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA, also a federal law), and by your state laws.

ERISA is a federal law that “sets minimum standards for most voluntarily established pension and health plans in private industry to provide protection for individuals in these plans.” An employer, for example, might voluntarily set up an ERISA qualified retirement plan for its employees such as a 401(k), 403(b) or a defined benefit (DB) plan. ERISA protects individuals in these plans from creditors. Most employer plans are ERISA-qualified, but you should be able to confirm this with your plan administrator.

BAPCPA is a federal law passed in 2005 largely to limit debtor protections during bankruptcy, but that actually added protections for individual retirement plans not covered by ERISA, like traditional and Roth IRAs.

Debtors are allowed to exempt (protect) some amount of property in bankruptcy. BAPCPA defines exempt amounts at the federal level but allows states to “opt out” and define their own exemptions. Many states have chosen to opt out of the federal exemption scheme, so the laws of your state are likely to play a major role in protection of your individual retirement accounts.

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Most retirement plans are protected from creditors to some extent, but protection varies by state and creditor.

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Protection of our retirement plans may vary depending on whether or not we declare bankruptcy. Some creditor protections apply only during bankruptcy while others protect our IRAs from creditors without our having to file for bankruptcy. ERISA protects our employer plan benefits in both scenarios. BAPCPA protects individual plans only during bankruptcy. Creditor protection of individual retirement plans without declaring bankruptcy is dependent upon state law and varies widely.

Michael Kitces wrote an excellent piece soon after The Bankruptcy Abuse Protection and Consumer Protection Act (BAPCPA) changed the landscape in 2005. Kitces pointed out that “a client might actually need to file for bankruptcy to protect an IRA from creditors. On the other hand, if a client's other assets or income might be treated unfavorably during bankruptcy in the client's domicile, this might not necessarily be a desirable course of action.” In other words, your IRA might not be protected unless you declare bankruptcy and bankruptcy might have undesirable consequences for other assets.

Protections for non-ERISA plans like IRAs also need to be sorted depending upon whether they were created by a rollover. Rollovers from a qualified employer plan to an IRA inherit the unlimited protections of their former ERISA plan. SEP and Simple IRA plans are treated like employer plans, but if they are rolled over to an IRA they are then treated as individual plans and may have less protection from creditors.

According to the National Institute of Pension Administrators (download PDF),

“There are both federal and state exemptions that might apply to a debtor. States are permitted to opt out of federal exemptions and define their own. These state exemptions vary widely. The Bankruptcy Code allows debtors to claim certain property as exempt, using either exemptions allowed under state law, or exemptions provided in the Bankruptcy Code. While this choice is available in a few states, the majority of states mandate that debtors use only the exemptions provided under state law.”

When I searched for bankruptcy exemptions in my home state, North Carolina, I learned from NOLO that “North Carolina debtors must use state exemptions.” Also, IRAs and Roth IRAs have an unlimited exemption under NC state law. You need to check your state laws to see when state and federal law applies. Here’s a summary chart from The Tax Adviser of exemptions by state (download PDF), but it doesn’t provide everything you need to know.

Protection from creditors without declaring bankruptcy is a matter of state law. According to Kim Steffan’s website, for example,

“The good news [for North Carolinians] is that retirement accounts which you fund while you are working are generally safe from most creditors. N.C. General Statute section 1C-1601 covers what assets creditors can seize and sell to satisfy judgments – a topic which is entirely separate from filing bankruptcy, by the way. Under that statute, money in your 401(k), traditional IRA, Roth IRA, and/or 403(b) is protected . . . NC law doesn’t put a dollar limit on protection of retirement assets for those who do not file bankruptcy. Your contributions to your employer’s pension plan (like the N.C. State Retirement System) are also safe, but for a different reason – because they are held by the pension plan and are not assets in your name.”

Again, the key point is to check state law for your IRA protections from creditors both during and outside bankruptcy.

One relatively new development is that the Supreme Court ruled in 2014 that An Inherited IRA Is Not A “Retirement” Account For Bankruptcy Protection (another excellent summary by Kitces). The theory is that if you inherit your father’s retirement account, though it was a retirement account for him, it’s just a normal inheritance for you. Yet another development is the concern that “stretch IRA’s” are endangered, as described in this interview with IRA expert, Ed Slott.

My best shot at simplifying this morass is the following table.

Retirement Account Protection from Creditors

	During Bankruptcy		Outside Bankruptcy
Account Type	Federal Protections	North Carolina Protections [2]	Federal Protections	North Carolina Protections [2]
Qualified ERISA Plans
401(k), 403(b), Defined Benefit Plans, Profit Sharing Plans, Deferred Compensation Plans	Generally Unlimited [4,5]	Generally Unlimited [4,5]	Generally Unlimited [4,5]	Generally Unlimited [4,5]
IRA Plans Protected by BAPCPA
IRA (ERISA Plan Rollover)	Unlimited [4]	Unlimited per NC Law	Generally Unlimited [4]	Unlimited per NC Law
Traditional IRA	$1,245,475 [1]	Unlimited per NC Law	None	Unlimited per NC Law
Roth IRA	$1,245,475 [1]	Unlimited per NC Law	None	Unlimited per NC Law
Simple IRA	Generally Unlimited [4]	Unlimited per NC Law	None	Unlimited per NC Law
Simple IRA Rollover	$1,245,475 [1]	Unlimited per NC Law	None	Unlimited per NC Law
SEP IRA	Generally Unlimited [4]	Unlimited per NC Law	None	Unlimited per NC Law
SEP IRA Rollover	$1,245,475 [1]	Unlimited per NC Law	None	Unlimited per NC Law
Keough	Generally Unlimited [4]	Unlimited per NC Law	None	Unlimited per NC Law
Protection of Other Retirement Assets
Contribution to Employer Pension Plan	Unlimited [3]	Unlimited [3]	Unlimited [3]	Unlimited [3]
Distributions from Plans (incl. RMDs)	None	None	None	None
Inherited Plan	None	None	None	None

[1] This amount under BAPCPA ($1M) is adjusted every three years for inflation and was $1,245,475 as of 2013.   
[2] Protections vary widely by state.                   
[3] Contributions are safe because they are held by the pension plan and are not assets in your name.       
[4] There are some circumstances when a creditor can still get to your ERISA benefits. That includes seizure by: your ex-spouse under a Qualified Domestic Relations Order (QDRO), to the extent of your spouse's interest in those benefits as a marital asset or as part of a child support attachment.
[5] State law superseded by ERISA protections.


As you can imagine from the table above, it may be simpler to consider which retirement plans might be at risk, as opposed to identifying which are protected. Consider the following:

• Retirement accounts that you have inherited are not protected from creditors.
• Individual retirement accounts are protected under BAPCPA only to an aggregate amount of $1,245,475 (total balance of all your individual retirement accounts), but state law may provide more protection. For example, in NC, protection is unlimited by state law.
• SEP and Simple IRA accounts receive unlimited protection under BACCPA, but IRA’s from rolled-over SEP and Simple IRA accounts are protected under BAPCPA to an aggregate amount of $1,245,475. They may, however, have greater protection under your state law.
• Your retirement plan is not protected from claims from government creditors, or judgments needed for paying alimony or child support.
• Distributions from retirement plans, including Required Minimum Distributions, are not protected.
• Individual retirement plans are not protected outside of bankruptcy by federal law, but may be protected by your state law. Exception: IRA’s created from rollovers from ERISA plans are federally protected.
• Government and church retirement plans are not protected from creditors.

These issues are quite complicated, which is the point of this post. However, as I pointed out in recent posts, about half a percent of Americans over the age of 65 declare bankruptcy at some point, usually early in retirement. It’s important to consider protecting your retirement accounts from creditors.

Nor is bankruptcy the only concern. You may wish to protect assets from creditors and judgments without declaring bankruptcy. These protections are separate from those in bankruptcy.

What should a retiree do?

• Use the information in this post to better understand your asset protections and then discuss them with a qualified attorney and your financial planner.
• Several sources suggest that you create a separate account to receive your Social Security benefits payments to avoid commingling the funds and maintain their exemption. Similarly, several also suggest you create a separate IRA account to roll over an ERISA plan.
• Find out if your state has opted out of the federal exemption scheme. (Google, for example, “Kentucky Bankruptcy Exemptions NOLO.”) If your state has opted out, determine what protections your state provides for individual retirement accounts. Use this form to record the information.
• Develop a list of your retirement accounts, the type of plan (401(k), IRA, Roth IRA, etc.), and the balance of each for your accounts and your spouse's. Use the same form above to record the information.
• Discuss these accounts with a qualified estate attorney. Prepare yourself by studying your state’s bankruptcy laws regarding IRAs and other non-ERISA plans.
• Ask your attorney if those unprotected plans might be protected in some way.
• Don’t roll over your SEP and Simple IRA’s without determining the possible loss of protection from creditors in your state.
• Modify your retirement plan accordingly.

Check your state's retirement plan creditor protections and discuss them with a qualified attorney and your financial planner. About a half percent of Americans declare bankruptcy after reaching age 65. In the unlikely event it happens to you, or you are subject to a judgment, you’ll be happy that you did what you could to protect your assets.

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Retirement Savings and Annual Spending

The Motley Fool (TMF) recently published a column entitled, “The Average American Household Approaching Retirement Has This Much Saved Up.” It’s pretty discouraging.

TMF took data from a GAO report that includes the current financial status of households between the ages of 55 and 64. (A link to the report is provided in the TMF column.) They found that 41% of the households in the study had been unable to save for retirement directly though many of those have homes with paid-off mortgages and about a third have pensions.

TMF provided the following graph in that column, showing the distribution of retirement savings within that 55-64 age group. Keep in mind that some of the group have nearly reached retirement age while the youngest have another decade or more to save.

Ignoring the 41% of households with no savings and considering only the 59% with some savings, the Motley Fool produced the following chart showing median savings of just over $106,000.

Wade Pfau’s Retirement Researcher website includes a dashboard that shows the current payout of annuities, TIPs bonds, systematic withdrawals, and other distribution methods. It currently shows the payout for a 65-year old couple from a life annuity adjusted for CPI-U (inflation) with 100% survivor benefits to be about 3.85%. Wade's current estimate for the payout of a “4% Rule” spending regime is about 2.92% (the “4% Rule” is currently a little less than a “3% Rule”).

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Annual income implied by median retirement savings is only $4,085 from an annuity and $3,098 with 4% Rule.

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It's interesting to look at the savings in the Motley Fool chart in terms of the income that those amounts imply for a life annuity and for “4% Rule” spending. As the following chart shows, the median annual income implied by the TMF chart is only $4,085 for households that buy an annuity and $3,098 for households that go with the “4% Rule”. That’s not a lot of income. Of course, some of these families have pensions, some could borrow against the equity in their homes, perhaps through a reverse mortgage, and most will have Social Security benefits.

Realistically, families that have saved less than the median savings would probably be better off using the savings for emergencies rather than annuitizing them.

As for retirement savings, while saved amounts seem small for most households, the amount of annual income that could possibly be generated is even more discouraging for more than half of 55-64-year-old retirees today.

To get a quick estimate of your possible annual spending, divide the amount you hope to have saved by your retirement date by 34 if you plan to spend systematically from an investment portfolio, or by 26 if you plan to purchase an annuity.

If your calculated spending is disappointing, Wade Pfau has recently written extensively about reverse mortgages (download PDF) and their potential to bail out under-savers. He adds that "there is great value for clients to open a reverse mortgage line of credit at the earliest possible age."