Three Portfolios

After my last post on the sensitivity of retirement finance variables to asset allocation, Asset Allocation in Smidges and Dollops, a reader commented that it can be difficult to know what to include in retirement assets and, therefore, how to calculate asset allocation percentages.

And you know what? He's right. It can get complicated.

For a 40/60 portfolio, for example, do I allocate 40% of my total assets to equity or 40% of my liquid assets? Do I include my home equity? A pension or Social Security benefits? How about a fixed income annuity?

An often-asked variation of this question is whether home equity should be included when calculating "sustainable withdrawals".

I suggest the following to make it more clear. Divide all of your assets into three portfolios.

The first, which I'll call the non-retirement portfolio, will contain any investment assets that you choose not to be used to fund your retirement. Your home equity will probably go into this portfolio. If you plan to keep your house and leave it to the kids or to a charity in your will, it goes here.

The non-retirement portfolio will also include money you set aside for your heirs, antique cars, works of art, college savings and any other investment asset that you do not plan to convert to cash to pay for your retirement. Illiquid assets should go here unless and until you convert them to liquid assets. Liquid assets can go here if you don't plan to spend them to fund retirement.

Notice I say that assets go here that you choose not to use to fund retirement. Unless you put the assets in a trust, you can change your mind, move them to another portfolio and spend them later in retirement. This is little more than a "hands-off" sign for assets you hope you won't have to spend for retirement expenses, but that will be there if you need them.

The second portfolio, which I'll refer to as the "floor" portfolio, will contain any asset that will generate retirement income but is not exposed to either market risk or interest rate volatility. This will include Social Security benefits, pensions and fixed income annuities (and probably TIPS bond ladders, though they need further discussion). These sources will provide the same amount of retirement income whether the market sinks or rises and whether interest rates rise or fall. This portfolio will provide a relatively safe floor of retirement income no matter what happens to the stock and bond markets. (I wrote about floors in Unraveling Retirement Strategies: Floor-and-Upside.)

The third portfolio, which I'll refer to as the retirement income portfolio, will contain all assets that you intend to use to fund retirement and that are exposed to market risk and/or interest rate risk. The stream of spending created by the retirement income portfolio (due to the unfortunate acronym, I won't refer to it as the RIP) depends on stock and bond market returns and is risky. Diversifying among multiple stock and bond asset classes helps manage this risk.

I'll make one last point about portfolio contents regarding our homes because it is often a subject of confusion. I initially put the home in the non-retirement portfolio under the assumption that the retiree would keep the house throughout her lifetime. (Surveys show that's what most older American hope to do.)

But, as I mentioned above, these non-retirement assets can usually be accessed for retirement income if you need them.  The equity in a home can be transferred to the retirement income portfolio as cash if you sell the home. Also, the equity can be transferred to the floor portfolio if you take out a reverse mortgage. So, there are ways for your home to provide retirement funds that you can spend, but you have to sell your home or use it as collateral before that can happen.

If you have no plans to downsize or take a reverse mortgage, your home won't be a source of retirement income and should not be used in the sustainable withdrawal rate (SWR) or retirement income asset allocation calculations.

Back to our three portfolios, let's consider their very different natures.

The non-retirement portfolio has no retirement spending rate because you have chosen not to spend from it. The investment horizon may vary for each asset. A grandchild's college costs may need to be covered in three years while investments for heirs may not be spent for decades. Depending on its contents, the non-retirement portfolio may be exposed to market and interest rate risk. Unless the assets are in a trust, you can probably transfer their value to the retirement income or floor portfolios later in retirement. Asset diversification may be beneficial in the non-retirement portfolio, but it isn't linked directly to your retirement income portfolio allocation.

(The non-retirement portfolio isn't completely irrelevant to the retirement income plan. If you have a lot of non-retirement assets, you can take a little more risk with your retirement income strategy, knowing you have these other assets available as a backup in a crisis. If your non-retirement portfolio is empty, you need to be even more careful with your retirement income portfolio asset allocation.)

The floor portfolio, in contrast, provides income that is critical to our standard of living. The assets in this portfolio are not exposed to interest rate risk or market risk. (The exception to this is a bond ladder which I will discuss in a separate post.) Though diversifying among Social Security benefits, pensions and fixed annuities might be beneficial, it is rarely practical. The spending rates for these assets are fixed by the Federal government for Social Security benefits, our pension provider, or the insurance company that sold the fixed income annuity.

Lastly, the retirement income portfolio will have a spending rate, assuming the floor portfolio doesn't cover all of our expenses. It will typically be in the 3% to 4% range of remaining portfolio assets. The assets in this portfolio are exposed to interest rate risk and market risk. The investment horizon is laddered: we will have short term needs, long term needs until the end of our life, and everything in between.

The following chart summarizes the differences between the three portfolios.

So, back to our original questions, which assets are included in the percentages for calculating sustainable spending amounts and asset allocations? The answer is the total assets in the retirement income portfolio. If we move assets from one of the other portfolios (our home equity, for example) into the retirement-income portfolio in the future, we recalculate then.

Which portfolio assets can we move in the future? We can move non-retirement assets or retirement income assets into either of the other two portfolios, though we may have to convert the asset to a liquid form (usually meaning cash) before we do.

Moving out of the floor portfolio is more difficult. We can't move Social Security benefits. Moving a pension or an annuity would mean selling it for what is typically pennies on the dollar and is usually cost-prohibitive. Bonds can be moved to either of the other two portfolios, subject to interest rate risk.

These are important things to know when we are developing a plan. Some parts of the plan can be changed to adapt to changing circumstances over time, like our asset allocation, our spending rate and which assets we hope to bequeath to our heirs and which will we use to pay our own bills.

Other parts of the plan are very difficult to move once executed, typically prohibitive to undo, like changing a Social Security benefits claim or converting a pension or fixed income annuity into cash.

As an example of the asset allocation calculation, if we have $100,000 home equity in the non-retirement portfolio and $200,000 in the retirement income portfolio and would like a 40/60 retirement portfolio allocation, we would invest $80,000 in equities and $120,000 in bonds, ignoring the home equity. How would we allocate the $100,000 of non-retirement portfolio assets? That depends on our goals for those assets, but it may be very different than 40/60.

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Our Retirement System and Some Odds and Ends

I am un-retiring for the next month or so to attend some conferences. I'll be taking my first "business trip" in ten years this week. I hope they're more fun than I remember. I'll let you know.

On Wednesday, I will be joining MarketWatch Senior Columnist and Retirement Weekly Editor, Robert Powell, who will moderate a panel discussion in New York on retirement income. Wade Pfau, Joe Tomlinson and I will be on the panel. (Wade and Joe are brilliant retirement planners; I'm the token retiree.) For more information or to RSVP, please email MarketWatchevent@wsj.com by Monday, Oct. 13^th, i.e., today.

On October 23^rd, I will speak at the RIIA Conference in Charlotte on retirement planning from the retiree's perspective. I'll be doing a webinar on sequence of returns risk in November.

My regular stream-of-consciousness posts on retirement planning for the unwealthy may be somewhat disrupted for a few weeks (if it is possible to disrupt stream-of-consciousness), so here are a couple of links you might find interesting.

The New York Times printed a piece this morning on the retirement system in the Netherlands entitled, No Smoke, No Mirrors: The Dutch Pension Plan that I found interesting.

It's interesting to compare and contrast this with an older piece in the Times by Teresa Ghilarducci on the American retirement system entitled, Our Ridiculous Approach to Retirement. These won't help your individual retirement planning except to the extent that they provide global context, but I find them interesting.

Wade Pfau's excellent blog recently mentioned a Journal of Finance paper by Gordon Irlam. Irlam uses dynamic programming to explore dynamic asset allocation. The paper is rather dense, in other words, not targeted to do-it-yourself planners, but he has a Java-based asset allocation tool at https://www.aacalc.com/ that you might want to play with. If you do, please let me know what you think by commenting below. I'll be playing with it more after I wade through the paper sufficiently.

Asset Allocation in Smidges and Dollops

How important is it to precisely nail your asset allocation in retirement? You may be spending a lot more time than you need to fretting about investing 35% of your portfolio in equities instead of 40%.

Asset allocation affects a number of retirement plan factors including your portfolio’s exposure to a market crash, your long term expected portfolio return and volatility, and your sustainable withdrawal rate (and sequence of return risk). In this post, I'm primarily referring to your equity and bond allocations, which is the first allocation decision we make.

In his earlier books, The Intelligent Asset Allocator and The Four Pillars of Investing, William Bernstein suggested that the first step in choosing your asset allocation should be answering the question, “What is the biggest annual portfolio loss I am willing to tolerate in order to get the highest returns?"

Bernstein provided a table of asset allocations based on the answer to this question. I have included this table below alongside losses for the 2007 to 2009 market crash according to IFA.com. As you can see, Bernstein's recommendations were reasonable but were more optimistic than actual losses during that crash.

(This is a demonstration of the weakness inherent in using historical data to predict future market risk and returns. The Intelligent Asset Allocator was published in 2001 and a new low-water mark was set in 2009.)

Your individual risk tolerance – at least the risk tolerance you think you have – and your risk capacity are factors that will combine to suggest an appropriate asset allocation, according to Bernstein, and you will note that a 10% change in your portfolio’s equity exposure resulted in about a 6% change in the maximum loss you might have incurred during the 2007-09 crash.

(To clarify, a 5% increase in equity allocation here means increasing stocks from 30% of the portfolio to 35%, and not to 5% more of the original allocation, which would increase equities to 31.5%.)

How precisely you need to nail your asset allocation from the perspective of maximum loss in a market downturn depends, then, on how precisely you feel you need to limit those losses. If a 15% maximum loss versus a 20% loss feels significant to you, then a 10% change in equity exposure is important. If 20% and 30% maximum losses feel about equally acceptable, your equity allocation can vary by as much as 20%.

Asset allocation also affects the long term expected return and volatility of your portfolio. During a market crash, most asset classes tend to fall. This is referred to as “systematic risk" in modern portfolio theory (MPT) and it cannot be diversified away. Over the long term, however, asset diversification is a powerful tool.

Based on index portfolios from IFA.com, using data from 1964 to present, we can see the impact of increases in equity allocation at the conservative end (a 30% equity portfolio with the remainder in bonds and cash) and the more aggressive 70%-equity end of the spectrum.

You can see, for example, in the second row of data that increasing the equity allocation from 30% to 40% would increase the expected portfolio return from 8.01% to 8.9% and the risk from 7.13% to 9.2%.

How do you choose between a portfolio with an 11.15% expected return and a standard deviation of 15.67% and a portfolio with an 11.8% expected return and a 17.9% standard deviation? These are the parameters that would change for an investor contemplating an increase in her equity allocation from 70% to 80% (the fourth row of data in the table above). Although the expected return seems to increase significantly, so does the risk and there is actually very little difference between the two portfolios.

Using a tool provided by MD Anderson called Inequality Calculator, I compared probability density functions for the log-normal distributions of both portfolios. As the diagram below shows, even after increasing equity allocation from 70% to 80%, the probability of improving annual returns of your portfolio is only about 51%.

In other words, there isn't a lot of difference between the two portfolios. You haven't turned a low-risk portfolio into a high-risk one by increasing the equity allocation from 70% to 80%.

A small increase in returns can have a significant impact on terminal wealth after 30 years. Following is another graph from IFA.com showing the growth of $1,000 in their various index portfolios from 1984 through 2013, thirty years.

At the conservative end, an increase in equities from 30% to 35% resulted in a portfolio about 12% larger after 30 years. Increasing the asset allocation from 70% to 75%, on the other hand, increased the portfolio 9.7%. Those returns, however, are not guaranteed. The odds that your portfolio will end up larger with an 80% equity allocation than with a 70% allocation is still just a tad over 50/50.

A third factor influenced by your portfolio’s asset allocation, for those implementing a sustainable withdrawal rate (SWR) spending strategy, is the sustainable withdrawal rate itself. For a demonstration of the impact, let’s look at the original studies published in William Bengen’s Conserving Client Portfolios During Retirement. 

As his charts for both taxable and tax-deferred portfolios show with 30-year life expectancies, the SWR is essentially flat from about 30% to 80% equity allocations. Unless your portfolio has a very low equity allocation or a very high one, changing your equity allocation won’t have much affect on your sustainable withdrawal rate.

Even below 30% equities, the impact on SWR is on the order of a quarter- to a half-percent and it becomes less as retirement progresses. Of the three impacts we are considering, SWR is the least sensitive to asset allocation.

To summarize, you won't change your portfolio's volatility much by changing your equity allocation a 5% or 10% step up or down. You will improve the expected portfolio return, but the probability of improving your actual return or terminal wealth is roughly a coin toss. It won't have an impact on your sustainable withdrawal rate unless you move below about 30% equity or above about 80%.

The factor most sensitive to asset allocation seems to be maximum loss in a bear market. I personally pay the most attention to this dimension of risk because I am just finishing the first decade of retirement and sequence of return risk is front and center of my attention. Bernstein refers to this as "deep risk", a risk from which one might not recover, as opposed to long-term portfolio volatility risk. Antti Ilmanen refers to it as "bad returns in bad times".

Of course, the "best" equity allocation depends on what future market returns turn out to be, which is, of course, unpredictable. If 2007 found you woefully below the equity allocation most experts would recommend, you would've enjoyed the next three years much more than they did. We're trying to find a bet that will work more often than others, not the "best" bet.

Bernstein recommends portfolio allocations in "smidges of natural resources" and "dollops of Treasuries", which tells you what he thinks about our ability to make precise bets. In his words, "Once you’ve arrived at a prudent asset allocation, tweaking it in one direction or the other makes relatively little difference to your long-term results."

Risk and the Life Cycle

I think most retirees probably have a moment not long after calling it quits when the risk of their new endeavour fully dawns on them. I think mine occurred about twenty minutes after I left the building.

Most retirees seem to intuitively sense that they have entered a stage of life with increased risk, but probably few can articulate the issue as clearly as William Bernstein.

In his latest e-book, Rational Expectations, Bernstein compares a young person who has just begun to save for retirement, a 45-year old executive who has already saved enough for retirement, and a retired person all at the beginning of the 1929 market crash.

The 45-year old in Bernstein's example saw his portfolio fall 74% by the end of June 1932, recover a bit by 1937 and fall another 48% by March 1938. Fifteen years later at age 60, he had permanently regained his 1929 purchasing power. He would ultimately have been fine, assuming he had the courage to stick with stocks through that storm. Most didn't.

The Great Depression is ultimately a boon for the young worker because he will be able to buy stocks cheap and their value would have increased dramatically over his working career. Bernstein has long pointed out that volatility and even market crashes early in life are ultimately a huge advantage for the young stock accumulator.

The retired investor, however, found himself in the worst position of the three. Without the ability to work longer, delay spending from savings, or accumulate stocks cheaply, the typical retiree would never have recovered. He would have needed a 3.6% spending rate to nurse his portfolio along for 30 years. In Bernstein's words,

"The overarching lesson of these three men, then, is that the older you are, and the fewer working years you have ahead of you (or, to use a four-bit term, the less human capital you have), the riskier stocks are. For the young saver, stocks are not that risky. For those in the middle phase of their financial life, they are quite risky. For the retiree, they are as toxic as Three Mile Island."

The important difference among these investors of different ages is human capital, or one's ability to earn wealth in the labor market. The young worker has tons of human capital and little else. The mid-career worker has human capital remaining but the retiree has almost none.

The following chart, from a Wade Pfau column in Advisor Perspective, shows the trends of human capital and financial capital over a typical lifetime. Financial capital includes your portfolio and all other financial assets. Human capital actually has a complex definition and several dimensions, but think of it here simply as the present value of all the income you will earn in the future.

The mid-career worker can use remaining but limited human capital to postpone retirement, delay spending her retirement savings, rebuild her savings over time and reduce the number of retirement years she will need to support. Her primary loss will have been not being able to retire as young as she had hoped.

The retired investor has little or no remaining human capital and must continue to spend retirement savings to live after a crash. He will continue to spend down his stock portfolio by selling when equity prices are at their lowest. He will have no cash to buy cheap equities. If retirement has a three-edged sword, surely this is it.

It is sometimes argued — incorrectly — that stocks become less risky the longer you hold them. Actually, stocks are risky no matter how long you hold them.

Stocks generally do become riskier, however, the older you get. Until well into retirement, at least. Their volatility isn't affected by your age, of course, but the financial damage that volatility can create is helpful when you are young, troubling by mid-career, and "toxic" after retirement.

That sense of fear one gets after packing his or her photos and awards into a cardboard box and carrying it to the parking lot for the last time isn't just fear of the unknown.

The trepidation isn't uncommon and certainly isn't unwarranted.

There are real sharks in that water.

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Spreadsheets and SOR Risk

People planning retirement sometimes insert a minimum successful portfolio rate of return into a spreadsheet. The thought process goes like this. "If my spreadsheet of retirement finances works when I plug in say, a 2% average expected rate of return for my portfolio, then I know my plan is safe if I earn at least that much. Surely I can earn 2%."

But that strategy won't work when sequence of returns (SOR) risk is involved. Here's why.

The terminal value of a retirement portfolio (it's balance at the end of retirement) that we spend down using a sustainable withdrawals (SW) strategy isn't solely a function of the rate of portfolio return. It is a function of the withdrawal rate, investment returns, and the sequence of those returns.

For every average rate of portfolio return, there is some probability that the portfolio will be depleted prematurely and some probability that it will fund at least thirty years depending on the sequence of the returns. If the portfolio enjoys a high average rate of return over the 30-year period, the probability that it will be derailed by SOR risk is quite small. Likewise, if the average return is quite low over that period, the portfolio will probably fail, perhaps even without the nudge of a poor sequence of returns.

But in the range of average returns that you are most likely to experience, say between about 2% a year and 6%, SOR risk will often determine failure or success.

To illustrate, let's look at historical returns using the Robert Shiller data and the spreadsheet from the Retire Early Home Page and see what the historical results would have been for 2% real rates of return over past 30-year periods with a 4% withdrawal rate.

Historical stock market data is very limited. Shiller's data back to 1871 provides 142 years of data, but that is less than five unique 30-year periods. We try to stretch this number in a somewhat-flawed statistical manner by using rolling 30-year periods of historical data, but there are still only 112 of those. That is a relatively small sample for our purposes and no periods experienced 2% rates of return. Nonetheless, the terminal portfolio values for a $1,000 portfolio of 50% equities and using a 4.5% withdrawal rate with historical returns data can be shown as follows.

There were no periods with real 50% equity portfolio returns of only 2%, the rate of return I was hoping to investigate. There were so few periods in the sample, in fact, that I had to increase the withdrawal rate from 4% (the one I actually wanted to investigate) to 4.5% just to show a few more failures. Regardless, you can see that some portfolios historically failed with 4.5% rates of return while some successfully funded 30 years of retirement with only a 3.5% average return due to sequence of returns (SOR) risk. In fact, during this period of historical data, portfolios would have failed with real rates of return as high as 4.4% a year while others succeeded with returns as low as 2.8%.

Because there is such a small sample of historical data to work with, we sometimes use Monte Carlo simulation to test hypotheses. (A reader recently complained that I should use historical data more often, a strange complaint given that I very rarely use anything else, but this is an example of when we really need simulation to explain a point because the historical data is inadequate.)

I used the simulation from The Implications of Sequence of Return Risk to generate a similar graph. This simulation provided not only several scenarios with 2% portfolio returns, but produced a number of failed scenarios with a 4% withdrawal rate. The simulation provided 10,000 unique 30-year scenarios.

Notice in this graph that I rounded rates of return along the x-axis to the nearest one percent. Instead of producing a cloud of outcomes as in my previous post, this chart displays a vertical bar (actually a cluster of points) of the terminal portfolio values (TPV's) that demonstrate the range of outcomes for each rounded rate or return. (In effect, I scrunched all the outcomes from portfolio returns of 1.5% to 2.5% into a vertical bar above "2%", for example.)

Also note the yellow marker inside each vertical bar (double-click the chart to enlarge). That point marks the terminal portfolio value that would have resulted from a 30-year sequence of identical returns – in other words, it's the expected TPV with no SOR risk. This is the highly unrealistic scenario that would be generated by a spreadsheet or consumption-smoothing models that don't randomize returns.

Using spreadsheets and other tools that don't randomize returns, the yellow markers would seem to indicate that any return of 2% or greater would result in a retirement plan using the SW strategy successfully funding 30 years. But in reality, only 66% of the simulated scenarios with returns from 1.5% to 2.5% succeeded. The spreadsheet looks fine, but there is actually about a one in three chance of failure with this rate of return. And as we saw above, sometimes a lower return would have succeeded and sometimes a higher return would have failed.

What if I plug in 1% instead of 2% for my portfolio's rate of return and my spreadsheet still works? That's gotta be a good sign, right?

You've actually made the outcome less predictable.  Scenarios with 1% average returns in the simulation had about double the SOR risk of 2% returns. If you're looking for the lowest rate of return for your spreadsheet that will very likely be successful, insert a higher rate of return, not a lower one.

That's why we can't plug a low average rate of return into a spreadsheet or other planning tool that doesn't randomize returns and gain confidence from the results that our plan will definitely work.

Often it will. Sometimes it won't.

If you plan to implement a SW strategy, be aware that unless you randomize the returns in your spreadsheet, you won't see SOR risk. I'm not suggesting that you shouldn't plan for retirement using a spreadsheet or E$Planner, only that you should do so carefully.

The Implications of Sequence of Returns Risk

Some time ago, I wrote a series of posts on Sequence of Returns (SOR) risk. The focus of those posts was to explain what SOR risk is mathematically and where it comes from (periodically buying or selling from a volatile portfolio of stocks and bonds).

If you plan to fund retirement by selling off assets from such a portfolio, it is vital that you understand what SOR risk is, its source, and how it impacts your finances after you retire. I won't repeat the first two points about definition and source here, so you might want to review my earlier posts before proceeding, but I do want to expand the discussion regarding the implications of SOR risk.

As I mentioned, SOR risk is a result of periodically buying or selling from a volatile portfolio of stocks and bonds, as retirees do who implement a systematic withdrawals (SW) strategy. They're going to sell stocks every year for perhaps 30 years or more and with no idea what future stock prices will be when they eventually sell. That uncertainty is SOR risk.

In contrast, if they bought the exact same portfolio and held it intact for thirty years, the sequence of returns would make no difference in the portfolio's terminal value, whatsoever.

SOR risk is also present in the accumulation or "saving" phase of financing retirement, but its impact appears to be less severe than during the spending phase and it is more controllable. We sell assets in retirement because we have an urgent need to spend the money, even if we are forced to accept a low price, but we can easily postpone purchasing stocks during the accumulation phase when prices are high by leaving our savings in cash for a while.

Selling a constant dollar amount every year exacerbates SOR risk because it means that we will sell more shares when prices are low, which is, of course, the opposite of what we would prefer. Selling a percentage of remaining portfolio balance every year instead would help us sell fewer shares when prices are lower, but would leave us with an unpredictable income stream. (I still think that is the preferable approach. When you have less wealth, you should spend less.)

Bonds held to maturity, annuities, pensions and Social Security benefits, on the other hand, are not subject to SOR risk. The portion of our retirement spending provided by those sources is not affected by stock market price variance. In fact, even bond funds that do not hold their bonds to maturity but have low volatility will have only a little SOR risk.

So, the first way that SOR risk impacts retirement finances is that it is only present when we buy or sell from a volatile portfolio. Retirees with little or no stock exposure will have little or no SOR risk. The second way it impacts retirement finances is that it has a greater impact during spending than during accumulation. A poor sequence of returns when we are saving reduces our accumulated wealth, but during the spending phase a poor sequence can take us out of the game entirely.

In finance, risk is often defined as the uncertainty of outcomes. Unlike the everyday connotation of the term "risk", uncertainty can be both good and bad. A risky portfolio of stocks and bonds has greater potential for both gains and losses than a less-risky portfolio. Risk is where we make our money on investments. Risk-free investments do well to cover inflation.

In the same sense, sequence of returns risk can leave you with more wealth or less wealth. The most wealth during the spending phase comes when a sequence of returns is ordered from the best return first to the lowest return last. The least wealth comes when that same sequence is ordered from worst return first to best last.

In the saving phase, the opposite is true. We want the best returns later in life when our portfolios are larger, and we mind losing money less when we are young and have little to lose.

SOR risk is completely unpredictable. Diversifying your stock assets won't reduce this risk and the market cannot compensate you for it. In that sense, it's a "bad risk". A good risk would be one that we can be compensated for taking.

Much is made, and rightly so, of the fact that big portfolio losses early in retirement can devastate your portfolio. Wade Pfau estimates that your returns in the first decade of retirement explain about 80% of portfolio survival for thirty years. I have seen simulated scenarios with correlations near 90%. This is a result of SOR risk and is a direct result of my previous statement that "the least wealth comes when that same sequence is ordered from worst return first to best last."

An important consequence of sequence of returns risk is that our terminal portfolio value, what we have remaining to leave to heirs, can be dramatically different even with the same portfolio returns.

Following is a scatter plot of terminal portfolio values (TPV) versus portfolio returns. I created this from a simulation of 10,000 scenarios of annually spending 4% of initial portfolio value for 30 years from a 50% stock portfolio with a geometric mean return of 5.6% and a standard deviation of 11%. Each blue dot on the chart represents a scenario's TPV when the average return equalled amounts along the x-axis. (I let the portfolio values run negative, even though your broker won't, because cutting off the portfolio values at zero graphically hides some information.)

Notice that the very bottom of the blue crescent area of terminal portfolio values drops below the zero portfolio value line (x-axis). In the following chart, I zoomed in on the area between 1% and 6%, where portfolios both succeed and fail.

If you look directly above 4%, for example, you will see that many portfolios had TPV's greater than zero and many showed negative TPV's even though they all experienced 4% average growth annually without spending.

Again, SOR risk results in a broad range of outcomes even with the same market return.

SOR risk can exacerbate other risks, as well.

Imagine that you are retired and have a mortgage, so you have foreclosure risk. If your mortgage payment is paid from the sales of stocks in your retirement savings portfolio, then a poor sequence of returns could jeopardize your ability to make those payments. Your home is now subject to a greater risk of foreclosure than if your entire mortgage were paid from pension benefits or an annuity, for example.

The last thing I want to point out about SOR risk in this post is that, as the chart above shows, some portfolios failed with a 6% portfolio return, while others funded thirty years with portfolio returns of only 1% or 2%. The former had a poor sequence of annual returns while the latter had a fortunate sequence.

So, those are eight things you need to know about sequence of returns risk (I italicized them), and here's one more.

If stock investing weren't risky enough, once we start spending from a portfolio and exposing ourselves to sequence of returns risk, our financial success in retirement is not solely a function of the rate of return we earn. It also depends on the sequence of returns. An SW portfolio can fail when average returns from the market do relatively well and survive when average market returns are relatively modest.

I'll pick up there in my next post.

Wanna Pay a 50% Penalty on Your Retirement Account?

There are some things to know about your retirement accounts that are incredibly important, not the least of which is that the IRS can force you to pay a penalty of 50% in addition to any taxes you owe if you screw up required minimum distributions (RMDs) from certain types of those retirement accounts.

(If this is way more than you want to know about IRA's, please skip ahead to the last two paragraphs. If you don't even have a retirement account other than a Roth IRA and don't expect to, maybe just check out 10 Supplies You Always Need at the Gym over at Buzzfeed.)

According to the IRS website,

"The RMD rules apply to all employer sponsored retirement plans, including profit-sharing plans, 401(k) plans, 403(b) plans, and 457(b) plans. The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs. The RMD rules also apply to Roth 401(k) accounts. However, the RMD rules do not apply to Roth IRAs while the owner is alive."

(So, you get a break from the IRS if you're dead. Good to know.)

A 50% penalty. Surely that got your attention.

There are basically two individual retirement account deals offered by the IRS: a traditional IRA and a Roth IRA.

The IRS offers a tax deduction when you contribute funds to a traditional IRA. You contribute "pre-tax" dollars. Because Congress didn't want wealthy people to be able to avoid taxation on those funds forever, they mandated required minimum distributions (RMDs). The effect of RMDs is that after age 70½, retirees must withdraw at least a certain percentage of their current traditional IRA balances and pay taxes on those withdrawals.

That's the bad news —  you'll have to pay taxes on your traditional IRA's when you withdraw and you will eventually have to make withdrawals. The worse news is that it will all be taxed as ordinary income, even if you earned the money with long-held stock investments. Preferred capital gains rates don't apply to holdings in an IRA.

Roth IRA's are the other, different deal. You don't get a tax deduction for contributions up front. You contribute after-tax dollars. The good news is that there are no taxable required distributions from individual Roth accounts (there are from Roth 401(k) accounts, though) and the contributions and any earnings on those contributions are never taxed.

Which is the better deal? That depends on whether your taxes are higher when you contribute or when you withdraw. And, that's fairly unpredictable.

The IRS enforces the RMD penalty if you don't withdraw the required minimum amount each year after age 70½. (The penalty may be waived if the account owner establishes that the shortfall in distributions was due to reasonable error and that reasonable steps are being taken to remedy the shortfall.) You will not only have to pay taxes on the correct amount of the withdrawal you didn't make on time, you will have to pay a 50% penalty on the shortfall and you will still have to withdraw the funds from your IRA.

This is a costly mistake you don't want to make.

The calculations look complicated (see Form 5329), but there are calculators on the web to help, and your investment company may even offer a service for free to remind you and calculate your RMD for you. Vanguard offers such a service, for example, though you have to be 69½ to enroll.

The minimum amount to withdraw is based on your life expectancy as calculated by one of three tables provided by the IRS. (Here's an easier-to-read version from Forbes magazine than IRS Publication 590 provides.)

If you are 72, for instance, the uniform table calculates your life expectancy as 25.6 years and that year you must withdraw the total of your IRA Account balances divided by 25.6. That's about 3.9%. At age 82, that will grow to 5.85% of whatever you have left in those accounts.

Recently, I received a couple of questions regarding RMD's and sustainable withdrawal rates. The common thread of the queries was, "What do I do when the IRS requires that I make withdrawals that are larger than my 4% safe withdrawal rate? Won't I deplete my portfolio too fast?"

(RMDs exceed 4%, for example, after age 73.)

The first thing to realize is that they're two very different things. SWR withdrawals are spent while RMDs are only taxed. The assumption is that if you didn't need the entire 4% SWR withdrawal in a given year, you would leave what you didn't spend in your portfolio.

IRA RMD's are withdrawn so that you a) must pay taxes on them and b) you stop any future tax deferrals on the withdrawal amount. The IRS doesn't say you have to spend the withdrawal. Just reinvest the balance after taxes into a taxable account. Heck, put it into the same mutual fund you took it out of, if you like, just do it in a taxable account.

The second thing to be aware of is that safe withdrawal rates also increase with time. According to William Bengen's original work, "SAFEMAX" is about 4.4% when you have 30 years left in retirement, 5.2% with 20 years remaining and 8.9% with 10 years remaining. Other studies show similar results (with the caveat that I don't trust any of them.)

Lastly, we can't assume that all of a retiree's portfolio resides in traditional IRA accounts. If half the portfolio is in taxable accounts, for instance, and half is in IRA's, a 3.9% RMD from the IRA's would only equate to a 1.95% portfolio withdrawal.

So, required minimum distributions shouldn't destroy your retirement spending plan unless it was developed with the incorrect assumption that you would never have to pay taxes on any of your retirement accounts.

To sum it all up, it is very important that you understand that there are certain amounts of your traditional IRA's and similar retirement accounts that must be withdrawn and taxed after age 70½. The rules are complex and violating them can cost you a bundle in penalties.

If tax gibberish is just beyond your attention span (in other words, you are normal), then I suggest the following. Make a note to call your tax professional or your mutual fund customer service department on your 70th birthday and ask what you need to do about required minimum distributions or "RMDs". Or call that customer service department today and ask if they offer a reminder service.

A potential 50% penalty should be plenty of incentive.

A New Ponzi Scheme Every Week

I interrupt this blog stream for a public service announcement. One of the biggest risks to your retirement finances is fraud. Some call it “elder fraud”, but the fact is that Bernie Madoff destroyed the futures of a lot of people who were by no means elderly.

I was reminded of this topic by a New York Times column this morning written by Elizabeth Olson and entitled, "Despite Exposure of Madoff Fraud, New Ponzi Schemes Emerge" that noted that a new Ponzi scheme is uncovered nearly every week.

Ponzi schemes aren’t new. Charles Ponzi created his in the 1920’s, but Charles Dickens wrote about such a scheme in his novel, Martin Chuzzlewit, in 1844.

In, How to Smell a Rat, Ken Fisher does an excellent job of describing how to protect yourself (and your retirement) from fraud. I recommend the book. It’s a quick read that could save your savings.

I think the two most important points in Ken’s book are to expect reasonable returns on your investments and not to give your money away.

A gentleman called me not long ago to discuss retirement planning. He argued that he was currently investing in a financial product with a “safe” return of 9%. I could not convince him that the investment was risky. His arguments sounded like they came straight from a very good salesman.

I knew nothing about the investment, so why did I find it so suspicious? Safe investments today return about a percent or so. Any investment that needs to pay you 9% is not safe. Thinking you can earn a high rate of return with little risk gets you into trouble every time.

But, do people really freely give their money away to fraudsters? All the time.

Fisher recommends you never give your money to your financial planner. You can trust your money to a safe third-party like Smith Barney, Fidelity, Schwab or Vanguard and enter into an agreement whereby your financial adviser can trade in your account but cannot withdraw your money.

I used Ken Fisher's company to manage my portfolio for a while. They never asked for custody of my funds. Instead, they offered two companies for me to choose from and we went with Smith Barney. I opened a brokerage account at SB, deposited my funds there and entered into a contract for Ken to provide investment instructions to my broker. Ken instructed SB on what to buy and sell within my account but his company never had control of my money.

A scam artist can send you investment reports that look real while stealing your money. A trusted third-party will send you reports that you can trust and will be responsible for your money.

You have to be very careful with this one. Madoff clients thought they were leaving their money with a trusted third-party, but it turned out that Madoff controlled that company, too.

I said two key points, but here’s a third. Never let an investment salesman convince you that you’re getting in on an investment opportunity that most people don’t have access to. The suggestion that you are somehow being admitted to an exclusive club is a red flag.

You can go a long way toward protecting your life savings with those three rules. Never believe that you can make lots of money while taking little risk. Never give custody of your funds to anyone except a trusted, well-known financial firm. And don’t let anyone convince you that you’re getting in on something special and exclusive.

If you have any doubts, don't invest until you're confident. 

You worked hard for your money. Don’t give it away.

Half Right

One way to look at retirement planning is with a spreadsheet. We make some assumptions, like 5% portfolio returns and 3% inflation and we build 30 rows representing as many years, with the same average assumptions plugged into each row.

The world doesn't actually unfold that neatly, of course. We get returns that can vary widely each year, and if you're buying and selling along the way, it isn't nearly the same thing. This variance of returns introduces sequence of returns risk when we are accumulating or spending from a volatile portfolio and the spreadsheet doesn't capture that.

Market crashes can cause wealth-destroying panic selling and high portfolio variance can increase longevity risk. The typical spreadsheet analysis doesn't account for any of that.

Most importantly, half the time your return will be more than the average and half the time it will be less, so if you assume an average return of 5%, for example, and need at least 5%, you will fail half the time. (Technically, that's the median and not the average, but I'm assuming they're pretty close in this situation.)

This chart shows a probability density function of portfolio returns with a mean of 5% and standard deviation of 11%. Your actual returns can fall anywhere along the x-axis, but most will fall somewhere close to the average return of 5% in the middle.

Your actual return could fall to the right of the average and exceed 5%, or to the left and be less than 5%. The dotted line shows the average, which tries to represent all of that data in a single number in a spreadsheet. But there's a 50/50 chance that your return will be less than 5%. A 50% chance of being wrong is more risk than a conservative retiree might want to take.

To address these problems, many planners and nearly all academics prefer to use Monte Carlo simulation, instead. Monte Carlo generates many outcomes and, unlike the spreadsheet approach, shows the distribution of outcomes, like this graph, and the probabilities of each occurring. It also simulates sequence of returns risk and creates some "market crash" scenarios.

Instead of simply using an average that we will under-perform half the time, Monte Carlo can also tell us what rates we are likely to outperform 80% or 90% of the time, for example.

Is there a way to use a spreadsheet and incorporate this volatility risk that would typically remain hidden? Wade Pfau recently published a column in Advisor Perspectives entitled "New Research on How to Choose Portfolio Return Assumptions" attempting to answer that question. I won't repeat his findings in detail — I hope you will read his analysis — but I will summarize the results.

In simplest terms, Wade performed a Monte Carlo analysis to generate a random variable with a median return of 5% (the same as the spreadsheet answer that is exceeded 50% of the time) and standard deviation of 11% and then calculated what the returns would be with more conservative assumptions, like the return that would be exceeded 90% of the time, also known as the 10^th percentile.

Wade confirmed some guidelines suggested by financial planner, Daniel Flanscha, who noted that when he uses a fixed return assumption (a spreadsheet analysis), he subtracts 1.0% to 2.5% from the return during the accumulation phase and 2.5% to 4.0% from the return during the distribution phase to account for the effects of randomness.

Wade found that compared to performing Monte Carlo simulation of a retirement spending scenario with a median geometric return of 5% (arithmetic mean of 5.6%) and volatility of 11%, a return you could expect to meet or exceed 50% of the time, you could provide a reasonably conservative result, one that might be met or exceeded in 90% of cases, with a spreadsheet by using an expected return of 1.9%.

Here's our portfolio returns probability density function chart with the dotted line now showing the more conservative 10^th-percentile figure of 1.9%.

There are several important take-aways from this analysis, the most important of which is that volatility costs a lot. Subtracting 1.0% to 2.5% from your return assumption during the accumulation phase and 2.5% to 4.0% from the return assumption during the retirement phase of planning eats a lot of your expected portfolio return.

Second, it shows that sequence of returns risk is greater during the spending phase than during the accumulation phase. In Wade's example scenario, you would subtract 2% during the accumulation phase, but 3.7% during the retirement spending phase. I think I showed that with my discussion of sequence of returns risk, too.

Lastly, as an anonymous commenter to the column noted, conservative stock returns start to look a lot like bond returns:

"Given the 1.9-2.5% real projected returns at the 10^th percentile that you use for the example, by the time you subtract any management fees, transaction costs, and/or fund expenses, the real returns would be in the range that's quite attainable with a carefully laddered long bond-only income portfolio where the bonds are held to maturity. Even if the 50/50 portfolio at the 10^th percentile might do slightly better than the bond ladder, the difference in real return might not be worth the risk. . ."

To which Wade added:

"this is an important point about how a conservative rate of return assumption starts getting close to the internal rate of return from a bond ladder. There is one important difference, however: the bond ladder will not have upside potential, while the diversified portfolio could perform better. Remember, this is a conservative return assumption."

The diversified portfolio could also perform worse; there's a 10% chance of that happening. In fact, Wade's analysis assumes that the individual earns market returns, which is a big assumption. Most don't. Underperform those stock market index returns with your own investments and you do have bond returns.

Still, there is a much better chance that you will do better than worse at the 10^th percentile.

Be careful with tools other than your own spreadsheets, as well. E$Planner, for instance, used to use spreadsheet-like calculations until it began to incorporate a Monte Carlo function. Monte Carlo is still optional. (You can implement Monte Carlo simulation in a spreadsheet, just know whether or not you are.)

It was spreadsheet-like thinking that led Peter Lynch to infamously suggest that 7% should be a sustainable withdrawal rate and many people to think you can always make a profit earning an average market return that is higher than your mortgage cost.

It's half right.

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Defending Systematic Withdrawals

Jonathan Guyton and Michael Kitces are both leading advocates of systematic withdrawal strategies for retirement, as Wade Pfau pointed out in a recent post. Pfau observes that "it is somewhat uncommon to hear rigorous intellectual defenses of systematic withdrawals." Most academics prefer other strategies with greater downside protection.

The video is informative and I suggest you watch it regardless of how you feel about "safe withdrawal rates." Guyton and Kitces are two very bright people, but I am not a fan of systematic withdrawals except for households who have a lot of savings.

When I say "a lot", I'm referring to those over-savers who need to spend perhaps 3% or less of their savings every year in retirement. They probably have adequate risk capacity to manage the downside of SW.

As I watched this interview, I realized that I am perhaps not as far from Michael's position as I had thought. If you're wealthy enough, I have no problem with SW, and that is the target market for most financial planners. I focus my attention more toward retirees who are not over-savers, for whom I believe SW is often a very risky approach.

Risk tolerance, or how much risk lets you sleep at night, is different than risk capacity, or how much risk you can afford to take. (Here's a cute analogy to explain the difference.) Risk capacity is the limiting factor when choosing a retirement strategy and the more wealth you have relative to your annual spending, the greater your risk capacity.

Kitces notes in the video that in many cases the overall portfolio constructed with a floor-and-upside strategy (or "discretionary - non-discretionary strategy", as it is called in the video) is practically identical to what would be required for a SW strategy. This is technically accurate, but omits important points.

First, a major purpose of floor-and-upside and time-segmentation strategies is to make retirement finances more transparent and manageable. We could, using the same logic, organize our household budget into just two categories: "income" and "stuff I need to pay for". That wouldn't provide much transparency into our budget, however, so we create subcategories for food, rent, transportation and the like.

In this same way, floor-and-upside and time-segmentation strategies create subcategories, or "buckets", to help us visualize where the money will come from to pay our living expenses in future years, or whether a shortfall will jeopardize groceries and housing, or just the cable bill.

In other words, these strategies help us manage our retirement plan.

Time-segmentation attempts to minimize the risk of needing to sell assets when they are cheap and to provide a safe source for near-term spending. Floor-and-upside tries to ensure that in the worst case we can still pay for non-discretionary expenses. SW lumps them all into one large "total return" bucket, much like the "stuff I need to pay for" category.

The second important but unmentioned point is that SW recommends a spending rate that some might consider safe or sustainable. Life annuities also determine a spending rate based on the payout rate of the annuity we purchase. The SW rate is probabilistic while the annuity payout is contractual.

Time-segmentation and floor-and-upside strategies, to the contrary, do not inherently calculate a spending rate. SW rules of thumb and consumption-smoothing are two ways one could establish such a rate for these strategies.

Lastly, these strategies rebalance asset classes differently. The asset allocations may start out being quite similar, but they will most likely drift apart over time.

These are important differences  — the strategies provide different spending, different risks and different asset allocations over time. The initial portfolio allocations may be "practically identical", but the strategies are not.

I find comfort in the observation that the strategies frequently have similar initial portfolio allocations because I would have a hard time explaining why they wouldn't.

One of them will perform best for you over your lifetime. Unfortunately, we can't predict which one that will be. That's the bet you have to make.

Kitces also mentions in the interview his personal quandary, which he has stated before, that a retiree who expects a wonderful retirement might consider it a failure if that retirement only turns out to be OK. This is the tradeoff one makes when forgoing the possible upside standard of living with the SW strategy in order to mitigate the risk of going broke in old age with a floor-and-upside strategy.

Personally, I don't understand the quandary. If I were offered the opportunity to take the worst-case scenario off the table (dying broke) by giving up the possibility of more trips to Europe and a second home, I'd jump at it.

But, that's a decision retirees with a lot of wealth will get to make for themselves.

Retiring with Children

Some of us have children at an early age and they are self-supporting when we enter retirement.

Many of us don’t.

For us late starters, having children who are young adults when we enter retirement is a substantial financial risk. I was reminded of that fact by an article written by Adam Davidson in the New York Times Magazine entitled “It’s Official: The Boomerang Kids Won’t Leave”.

Davidson writes, "One in five people in their 20s and early 30s is currently living with his or her parents. And 60 percent of all young adults receive financial support from them. That’s a significant increase from a generation ago, when only one in 10 young adults moved back home and few received financial support."

Davidson goes on to argue that this isn't a temporary financial blip, but may be a longer term trend.

I am also reminded by clients who plan on their children graduating from college in four years. Good luck with that one.

A Time magazine article from 2013 entitled, “The Myth of the Four-Year College Degree”  reports that, "According to the Department of Education, fewer than 40% of students who enter college each year graduate within four years, while almost 60% of students graduate in six years. At public schools, less than a third of students graduate on time.”

Each additional year that child remains in college means not only more tuition and books, but more rent and groceries and another year of not earning income. Losing early years of income can have a significant impact on your child's lifetime earnings, so it’s not exactly a bonus for  him or her, but tens of thousands of dollars for unplanned college expenses may be difficult for many retirees to deal with.

The surprises may not be college-related and, in fact, may appear long after your child's college years. I have spoken with several retired couples whose children (or grandchildren) had their own financial crisis. Not helping wasn’t an option.

Retirees with middle-aged children are often called upon to help after a health crisis, a substance abuse crisis, or extended unemployment.

Additional unplanned years of college and parental support don’t always happen when something goes wrong. They can also happen when something goes right.

My oldest son decided to go to med school and, after his third year, elected to take leave for two years to earn a masters degree. I’m very proud of my son and don’t regret one penny that I have spent on his education, but it wasn’t in my retirement plan.

The point is that those of us with children will retire with greater financial risk than will childless couples. When I think about the major risks of retirement, I think longevity risk, market risk, healthcare risk and long term care risk, but our children also represent a major financial risk that our plans need to consider.

I would start by planning for at least five years of college, if your kids haven’t already graduated. Then, I’d recommend reading the Davidson article and considering the distinct possibility that your children won’t simply go to college for four years, get a job right away, and become largely self-supporting.

Maybe you and I did it that way, but nowadays it isn’t that common.

A Summer Break

I'm taking a few weeks away from musing about distribution strategies and risk tolerance to celebrate a most amazing week that I recently enjoyed. I'd like to take this opportunity to remind us all that there is more to life than money.

(I will hastily add that the more money you have, the easier it is to say that.)

A couple of weeks ago, within a seven-day span, my daughter was married, my wife and I celebrated our fortieth wedding anniversary and . . . OK, maybe a little about finance . . . I paid off the mortgage. We spent last week in Paris, a place we last visited not long after our wedding, celebrating our time together.

Some things money can't buy, like finding the love of your life at a young age and getting to live with her for a very long time.

Before long, I'll be writing again from my favorite neighborhood coffee shop, though I'll probably be daydreaming about those along Paris boulevards.

I wish you all the joys life can bring and I suppose I could drop one piece of retirement advice while I'm at it.

If you're looking for a place to retire with a reasonable cost of living. . . Paris ain't it.

 

 

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Is Inflation Tame?

I suppose the answer to that question is relative. I bought a house in 1980 with a mortgage rate of 13.875%. That priced in a lot of expected future inflation.

About that same time, I bought a 5-year CD from a bank in Rockville, MD that yielded 14%. That's right, a 5-year bank certificate of deposit paying 14%. Today's CD rates probably make you wonder if I got the decimal point in the right place.

Inflation expectations declined rapidly during that five years and when I went back to the bank on Rockville Pike to cash it in, the banker took one look and shook his head.

"Is something wrong?" I asked.

"No," he replied. "I just can't imagine that we were ever willing to do this."

Those of us who lived through 70's and 80's inflation know how it can wreck your finances. Some of us learned to deal with it and even to profit from dis-inflation. I bought that house cheap because not many buyers were willing to take out a mortgage then and I refinanced several times over the next twelve years as mortgage rates declined precipitously. The price of that house more than doubled and my mortgage payment just kept getting smaller. It worked out nicely.

Compared to those decades, inflation since 2000 has been a relatively tame 2.73% a year. The long-term average since 1913 has been 3.22% a year. So, for those who retired around 2000, inflation hasn't been much of a problem, right?

Actually, it has.

Robert Powell's Retirement Weekly newsletter this week pointed out the results of an analysis entitled Annual Survey of Senior Costs released by The Senior Citizens League (TSCL) that shows inflation has reduced the buying power of retirees by nearly a third since 2000.

How is that possible if the Consumer Price Index (CPI) has increased only 2.3% a year in that time according to the Bureau of Labor Statistics? There are two reasons.

First, Nixon-Carter era inflation ran from 8% to over 10% and hit our buying power in Katrina-like fashion. Inflation over the last 14 years, however, ate into our wealth more gently but more persistently, sort of like the Colorado River eating into the Colorada Plateau. Give rivers or moderate inflation enough time and you will end up with a really big hole like the Grand Canyon somewhere.

Second, the TSCL study calculates inflation in a way that is more representative of the spending of retirees, weighing medical and other expenses more heavily than does the CPI. This "retiree's inflation" averaged 2.6% a year from 2000-2014 while the widely-use CPI averaged a smaller 2.3% a year increase.

How can a retiree hedge against "retiree inflation"?

It isn't easy. TIPs bonds and inflation-protected fixed annuities are based on the CPI. They won't hedge for price inflation of products and services more heavily purchased by retirees.

Social Security benefits are adjusted for inflation under present law. Since 2000, the Social Security Cost of Living Adjustment (COLA) has increased benefits just 41 percent while typical senior expenses have jumped 84 percent, more than twice as fast, according to The Senior Citizens League. It's those faster growing "senior expenses" that increased inflation from 2.3% to 2.6% for retirees.

Investing more in stocks is probably the only way to outpace retiree inflation and stocks do so only indirectly. Over time, stocks do tend to earn more than the rate of inflation, but they don't typically do so when the inflation occurs. Stocks don't do well when inflation is high, but their subsequent returns might help you catch up later if you have time to wait.

On the positive side, the typical spending of retirees tends to decline about 3% a year over the long run, which is conveniently near the long-term rate of inflation in the U.S.

My recommendation to retirees would be that they not just worry about 80's-style hyperinflation. Be aware that even a little inflation will eventually cause a big problem.

Because you can't completely hedge against inflation doesn't mean that you can't plan for it. Plan for less spending power as you age. Adjust your spending to reflect your inflation expectations and the natural tendency for spending to decline as you age, anyway. E$Planner is a good tool for this.

Make sure that inflation, tame or not, is a risk that your retirement plan addresses.

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