Basing Your Allocation on Half Your Assets

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What Academics Say

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

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

Exactly.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why Retirees Let LTC Insurance Lapse

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

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

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

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

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

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

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

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

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

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

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

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

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

The brief's other key findings are:

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

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

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

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

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

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

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

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

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

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

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

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

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

Protecting Your Family from Elder Fraud

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

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

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

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

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

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

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

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

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

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

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

As always, thanks for reading! 

Investing and Insuring Are Not the Same Thing

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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All the Stock Investors Are Above Average

Some time ago, I wrote a piece entitled The Chicken and the Pig explaining how a worker experiences a paradigm shift upon retiring, and another that I called Think Like a Bayesian Pig. Suddenly, upon retiring, conserving our wealth becomes far more important in our personal perspective than building more. I spoke on the topic at the RIIA conference in Charlotte last year.

The Retirement Income Industry Association was founded by Francios Gadenne. The first time I met Francois, we discovered that we had come to retirement planning in the same way. Both from the tech industry, we had found ourselves able to retire early, but couldn't find a retirement planner with whom we were comfortable. We each set out to improve that situation, Francois by creating RIIA, and me by blogging. Francois has probably reached more people more effectively, but I'm funnier.

My goal is to have the funniest, most entertaining retirement finance blog on the web, which is, as you might imagine, a very low hurdle.

I attended the RIIA conference in Indianapolis last week to receive an award for a paper I had written. At a dinner the night before, I sat across from a young lady who had seen my presentation in Charlotte. After a few minutes, her face lit up with recognition. “Oh, I remember you now. You're the Think Like a Pig man!”

It's good to have a brand. I guess.

For those of you who, like me, haven't been to Indiana in decades, I can report that it is still very flat, but I learned things last week that are more relevant to a retirement blog and I'll share them with you.

Dr. Moshe Milevsky gave a fascinating presentation on tontines, a medieval predecessor of life annuities. (Who knew it was even possible to give a fascinating presentation on annuities?) Moshe has written a book, King William's Tontine, which I have not yet read, but if it's anything like his presentation, I will love it.

A typical fact from his presentation: when England’s King William used a tontine to fund a war with the French, several shares were bought by Frenchmen. Now, that’s what I call a hedge.

I did read Milevsky’s “The 7 Most Important Equations for Your Retirement: The Fascinating People and Ideas Behind Planning Your Retirement Income” over the weekend and found it fascinating, as well. But, that's me. Unless you love reading about the history of mathematicians, you probably won't enjoy either as much as I did. I concede that I may be in the minority on this. (If you do love this sort of thing, David Berlinski’s A Tour of the Calculus is still one of my favorites.)

Dr. Milevsky (@RetirementQuant on Twitter) gave us another of his books, co-authored with  Alexandra Macqueen, CFP, entitled Pensionize Your Nest Egg. I haven't read it, yet, but I did give it a thorough skimming. I found the following table (double-click to enlarge) that I thought you might find interesting. Look at the percentage of our budgets that Americans spend on Health compared to other countries. Scary stuff, and getting worse, but not at all surprising to me after my own ten years of retirement.

I have asked @RetirementQuant questions on Twitter and promptly received very valuable and insightful responses. (That alone is an impressive accomplishment – by the time he finishes saying “reciprocal gamma distribution”, he's already used his 140 characters.)

As with all conferences, some of the things we learn come from the attendees. One attendee pointed out that enough insurance companies that offer annuities have been bought out by private equity to alarm New York state's insurance regulators. The dramatic number of acquisitions has raised alarms in some circles about the safety of life annuities. There doesn't seem to be enough evidence to suggest that annuities are now at risk, but it's a topic we should all probably keep an eye on.

Another informal discussion I found interesting was the collapse of the number of fund managers who now outperform their benchmarks. Here’s a recent quote from Larry Swedroe at Advisor Perspectives:

“But the bottom line is that 20 years ago about 20% of active funds were beating their risk-adjusted benchmarks on pre-tax basis (much lower percentage on AT basis). But today that figure is about 2% even on pre-tax, making it likely it's maybe 1% on AT basis as taxes are often the greatest expense for active managers.”

There is just very little hard evidence that more than a thimbleful of stock pickers and market timers (think Dodd and Buffet) can outperform. In my experience, contrary to the evidence, many individual retirees feel certain that they are in that thimble or that they can find a magical advisor, blogger or investment club that is.

Swedroe wrote a book on this topic entitled The Incredible Shrinking Alpha, which I also downloaded to my Kindle and plan to read soon. For a shortcut, read Michael Kitces' outstanding summary.

Dr. Steven Huxley of Asset Dedication, and his co-founder, Brent Burns, discussed their company's strategy of implementing floors with individual bonds (they prefer agency and other Treasury bonds). When asked their reasons for eschewing annuities in the floor, they replied that their major objection to life annuities is cost (they optimize safety and cost) and added that the constant cash flows of annuities don't match the variable spending requirements of most retirees. I would add that annuities and bonds aren't an “either-or” decision and that variable cash flows can be achieved with a combination of the two.

They also agreed with my argument (Funds and Ladders) that individual bonds held to maturity are not identical to bond funds with the same duration. I think the argument that they are the same is quite flawed. (Dr. Milevsky had previously agreed with my argument indirectly, via Twitter, by suggesting that the fund and the ladder could perform similarly – but only if they have the same duration and convexity, i.e., both hold essentially the same bonds.)

Bond funds have sequence risk. Ladders of individual bonds held to maturity have future guaranteed redemption prices and dates that we know precisely. There is no sequence risk. A ladder of TIPS bonds held to maturity is cash. I asked Dr. Pfau his position on this argument and he simply replied, “I don't see much use for bond funds in a retirement plan.”

Finally, Dr. Brigitte Madrian also received an award at RIIA’s Fall Conference. Fortunately for me, my award was presented first. If I had to follow her presentation on her research, I would've feigned illness and hidden out in my room. Dr. Madrian's research on how we use 401(k)'s changed the industry and Federal regulations. Essentially, she uncovered the total irrationality with which most workers make decisions about their 401(k).

The scary part is that her sample was comprised solely of Harvard students, graduates, faculty and staff. So, if you invest your 401(k) in all cash, or all in your own company's stock, or you pick your savings withdrawals in 5% increments (“no one picks 7% or 13%”), you’re making poor choices but you're in well-educated company.

Wade Pfau, Michael Finke and several other retirement researchers of note also attended. Here are some of Wade's thoughts on the conference.

To paraphrase Garrison Keillor. . . that's the news from Lake Wobegon, where all the women are strong, all the men are good-looking, and all the stock returns are above average.

Maslow's Internet Service Provider

I recently explained to a commenter on my blog that he need not apologize for a “diversion” because we thrive on diversion here at the Retirement Cafe´. This is, after all, my hobby. To prove my point, I'll devote today's post to psychology and the “dismal science.”

In 1943, Abraham Maslow introduced the “hierarchy of human needs” in which he more or less noted that people dying of thirst don't focus much on hamburgers, while even thirst tends to get moved to the back burner by people whose air supply has suddenly been cut off. There's a lot more to the theory, of course, and my college professors would have suggested long ago a bit of independent study at the library (a large building where physical copies of books were organized by index cards and stored), but which nowadays entails an effortless hop over to Wikipedia.

We studied Maslow in business school to understand discretionary and non-discretionary products and services, a concept that is also quite important to retirement planning. The idea was that in bad times some businesses do better than others because they fill genuine needs (food, water, medical care and the latest iPhone, for example) rather than discretionary desires like marble tile in the bathroom.

The scope of this theory was driven home to me several years ago when I visited my sister, who lived in Honolulu at the time. A hurricane had devastated Kauai and volunteers were loading emergency supplies onto a boat headed for that island. A KHON TV reporter interviewed one of the volunteers as he loaded the boat.

“What supplies are you taking them?”, she asked with the keen insight of a veteran journalist.

“Beer, rice. . . just the essentials,” he answered with absolute solemnity as he lifted another case of Primo onto the boat.

(Alcoholic beverage manufacturers are, in fact, considered non-cyclical, “defensive” stocks.)

This concept is important in retirement planning because in the worst possible outcome, you want to make sure that you can afford food, shelter and the latest iPhone. That's why we recommend that you carefully protect your non-discretionary spending.

You may be asking what any of this has to do with Internet Service Providers and I will now reveal that my Time Warner Cable internet service was knocked out by a storm last Thursday. Had I led with that, I would've lost you by the second paragraph because – let's face it – a Time Warner Cable service outage isn't exactly a rare, newsworthy event.

Despite much yelling and screaming at some poor customer support representative speaking to me from Bangalore in the middle of the Indian night (the wrong person for me to blame, for sure), I was informed that the earliest a repairman could possibly visit would be Tuesday, which would mean a nearly 5-day outage.

TWC's monopoly here is quickly eroding. AT&T offers fiber service to my neighborhood, but when I tried to get it installed a year ago, the installers couldn't figure a way to avoid running a cable up the outside of my house and drilling a hole through the brick into my kitchen. I told the guy to come down from the ladder and go away until he could figure out a better solution. Though he never came back, despite my making two more appointments, AT&T began billing me a few weeks later for the service they were never able to install. I somehow felt better paying for TWC service that sometimes works than for faster AT&T Internet service that couldn't be installed.

The other option is Google Fiber, which will soon be available in my Chapel Hill neighborhood. A few months back, Google promised to send me a free #FiberIsComing T-shirt if I signed up to receive occasional updates on their progress by email. Not only did I sign up for the T, I offered to help them dig up my street and lay the fiber. “Just paint a spot on the pavement,” I told them. “I'll bring my own shovel.”

So, where does Internet service fit on my personal version of Maslow's pyramid? The past few days have been enlightening.

TiVo sort of works in that we have stored several hours of TV shows that will easily hold us over for  4 or 5 days, but many features don't work. The guide is now outdated and we can't, of course, use TiVo to download Hulu or Nextflix without an Internet connection. My Nest thermostats are limping along but performing adequately, if not optimally, in their current “dark” mode. My Dropcams are frequently and annoyingly pinging my iPhone to tell me that they have no Internet connection. They are useless without it.

Our cell phones text and make voice calls easily, but don't have adequate signal to download email unless I walk upstairs to the northeast corner of the house. My son's bedroom, on the other hand, is in that corner and he has downloaded videos onto his iPhone non-stop for the past three days. I received a text message warning last night from Verizon telling me that he has used three fourth's of our entire family's monthly cellular data allocation in just three days and the month isn't half over.

(Exceeding our data plan will soon fix the problem with all those annoying apps telling me they can't access the Internet. I won't pay for more data so I can get more messages telling me that my Internet service is down.)

My son's online college class will require him to drive down to the library on Monday (the index cards have been replaced by Wi-Fi to download Kindles) to upload a paper that I hope he has written. Why they still call them "papers" is a mystery to me.

Without Internet service, I was able to finish an excellent novel with paper pages, an upside, of course, but my retirement research has been dramatically curtailed by the lack of collaboration tools. I found myself describing graphs over the phone to a co-author (my older son). “The three curves kinda goes straight for a while and then shoot upward and the lines split apart, ya' know what I mean?” I could print the graphs and mail them to him. USPS would deliver the letter before the TWC guy shows up.

I had forgotten that you have to turn book pages manually. I kept touching the right margin without result. Oh, and remember that you don't have to turn off hardcover books. Apparently, they time out and turn themselves off after you've gone to sleep. Battery life is amazing.

My wife sheepishly admitted yesterday that, without access to her weather app, she had needed to step outside to realize that fall temperatures had arrived.

What does this mean for Internet service and the retiree budget? When I list non-discretionary expenses, food and water are still going to be pretty high on the pyramid. My iPhone is a pretty poor substitute for Wi-Fi, but I'd hate to live without it. On my version of Maslow's pyramid, Internet service is high, but lower than food, water, shelter and the latest iPhone. Though an electric outage would be far worse, interruption of Internet service to our home is surprisingly disruptive.

I'm still thinking about where to rank beer.

The most enjoyable part of this experience? After I hung up on the TWC customer representative (politely), I walked down the hill to the mailbox and there it was – my free Google Fiber T-shirt.

The Fascinating (To Me, at Least) History of Sustainable Withdrawal Rates

I have always found the history of “sustainable withdrawal rates” (SWR) to be quite interesting (a fact that secures my qualifications as a geek, as if there might otherwise have been some doubt), so I enjoyed retirement researcher, Wade Pfau’s recent post, Safe Withdrawal Rates for Retirement and the Trinity Study.

As Wade's post explains, William Bengen published a seminal paper on the topic in 1994 (download PDF). The Trinity study, subsequently published in 1998 (download PDF), took a slightly different direction with important repercussions. The latter shifted focus from “the highest withdrawal rate possible in the worst-case scenario from history” to the proportion of thirty-year periods in which a portfolio would have (past perfect tense) survived.

As he also notes, both studies were based on historical market returns available in the mid to late nineties and basing a retirement plan on the assumption that future portfolio returns will equal or exceed those of the past is faulty logic. Given current capital markets, they are unlikely to, according to Pfau, Michael Finke and David Blanchett in The 4% Rule is Not Safe in a Low-Yield World.

There is another interesting piece of history regarding safe withdrawal rates that Pfau doesn’t include in his post. In the September 1995 issue of Worth magazine, Fidelity Magellan's fund manager, Peter Lynch, published an article entitled “Fear of Crashing” in which he suggested that a retiree should be able to invest her savings 100% in growth funds and safely spend 7% of the portfolio annually (damn, some days I miss the ’90s).

I apologize for not being able to provide a link to the Worth article. Apparently, 1995 was before the time that the Internet knew everything. Prehistoric, in today's world.

Scott Burns, then a financial columnist for the Dallas Morning News, published a challenge the following month, October 1995, entitled “Dangerous Advice from Peter Lynch.” Burns provided data showing that a retiree implementing Lynch’s advice would quickly have gone broke in many historical time periods.

(Timing is everything. Lynch wrote his column a year following Bengen’s paper. Burns apparently had read Bengen’s work; Lynch apparently had not. )

Lynch not only withdrew the “Fear of Crashing” statement, he hired Burns as a contributing editor for Worth, yesteryear's equivalent of hiring the guy who hacked you as your new security consultant, I suppose.

The story became even more interesting when, in 2010, Burns and economist Laurence Kotlikoff published “Spend 'Til the End”, in which the authors refer to the “rules of thumb”, like 80% replacement rates and 4% safe withdrawal rates that Burns had written about for so long in his columns, were better referred to as “rules of dumb.” (I recommend this book.)

SWR studies provide important insight into the portfolio survival process, but as Pfau points out, translating the results directly into a retirement plan is a risky proposition. I have concerns beyond Wade’s research showing that historical data is a poor basis for future expectations.

As I have previously pointed out on this blog, the model is based on the absurd policy that the retiree will continue spending the same amount annually even when it is clear that he is headed for ruin. As Pfau has noted, constant-dollar spending is a research strategy, not a retirement planning strategy. If your retirement plan is to spend a constant-dollar amount annually, you need a new plan.

Nonetheless, SWR studies can be enlightening and I find their history far more interesting than that of most retirement research – admittedly a low hurdle.

The Chain of Longevity Risk

I've spent the last several weeks working on some interesting portfolio survival research with my son and daughter, so my posts have been a bit few and far between. My apologies. Cary and I realized one day this summer, over a local craft beer after a round of sporting clays, that retirement portfolio survival and the medical research he does are largely the same research problem. I hope to have something here on my blog about our findings in a few weeks. In the meantime, here are some thoughts about portfolio survival in general.

Longevity risk is the risk that a retiree will outlive his or her retirement savings. It develops in four stages as we make decisions about funding retirement.

Let’s consider those risks by imagining a retiree who splits his retirement savings portfolio in half on the day he retires. The first "legacy" portfolio is intended for his heirs and the second “funding” portfolio is intended to fund his retirement expenses.

To simplify the example, let’s assume he invests both identically in the same 40%-equity index fund on the same day. The only difference between the funding portfolio and the legacy portfolio is that he will spend annually from the funding portfolio and then re-balance it to 40% equities. The legacy portfolio will remain untouched to be left to his estate.

A retiree can pretty much avoid longevity risk altogether by purchasing life annuities or TIPS bonds. There are plenty of good reasons to invest at least some of our savings in stocks and bonds, though, and that decision leads to the first risk, known as market risk. Market risk refers to the volatility of stock prices over time. Once we invest in risky assets like stocks, outliving our savings becomes a possibility.

We can mitigate market risk by reducing our equity exposure or we can completely eliminate it, by purchasing life annuities or TIPS bonds. Our imaginary retiree has decided to mitigate market risk in both portfolios by investing only 40% in equities, but he has not avoided market risk altogether.

If this retiree never spends from or saves to either portfolio, those portfolios will have equal values at the end of retirement. We don't know what that value will be, however, because both are exposed to unpredictable market risk. We only know that they will be exposed to identical market risk and that their "terminal value", or value at the end of life, will be the same.

When a retiree begins to spend from her funding portfolio, the outcomes of those two portfolios go their separate ways. No matter how little our retiree spends each year, so long as there is net spending, there is no future in which the terminal value of the legacy portfolio will not be larger than the terminal value of the funding portfolio at the end of retirement for two reasons.

The first cause is obvious – her funding portfolio will be smaller  because she is spending some of it – but the second cause, path-dependent risk, can make her legacy portfolio's terminal value larger or smaller. The funding portfolio will always, however, have less value than her legacy portfolio, again because she is spending some wealth and never saving, but path-dependent risk can leave the funding portfolio fatter or thinner than it would have been with no path-dependent risk.

Path dependence refers to the fact that, once we begin spending from a volatile portfolio, the order of market returns can change the portfolio’s value. A buy-and-hold portfolio has no path dependence (“Path dependence” means the outcome depends on the path we take to get there, which in this discussion refers to the order of annual portfolio returns.)

Let me provide a quick example to explain path dependence. Assume that over the next five years, the stock market will provide the following returns in the following order: 5%, -7%, 9%, 3% and 4%. If we invest $1,000 in this market at the beginning and neither buy nor sell additional shares, we will end up with $1,140 five years later, no matter which order those returns occur.

If we spend $30 at the beginning of each of the five years, however, the order of returns does matter. There are 120 different ways (5 factorial) those five returns can be ordered and each will provide a different outcome. The outcomes will range from $966 to $988, but always less than $1,140. Once we spend from or save to a volatile portfolio, the outcome is path-dependent.

Note that in none of these 120 permutations is our account balance depleted. Path dependence isn't the same as risk of ruin and if we are only spending 3% annually ($30), it is very unlikely that we will exhaust our savings.

Some refer to path dependence as “sequence of returns risk” but the term isn’t always used in that way, so I prefer to avoid it whenever possible. If returns are experienced with the highest gains early in retirement and the lowest gains toward the end, this path dependence helps our portfolios over time and if returns are experienced with the worst returns early in retirement, path dependence hurts our portfolio.

The best possible outcome is achieved when our market returns are ordered from best to worst. The worst possible outcome is the reverse. With 30 years of annual market returns over a long retirement, the odds of experiencing the best or worst outcome are literally astronomical (1 in 30 factorial, each – there are fewer than 30 factorial stars in the visible universe).

The source of path-dependent risk is selling in the spending phase of retirement finance and buying in the accumulation phase. We have no idea what price we will receive for the securities we will sell (or buy) in the future and that price risk is path-dependent. TIPS bond ladders held to maturity and life annuities have no path dependence risk because we know their future values relatively accurately.

(As an aside, savings portfolios during the accumulation phase also have path-dependence risk because we don’t know the future price at which we will buy equities. A lot less attention is paid to path-dependence in the saving phase because it doesn't lead to portfolio ruin. It does, however, greatly impact wealth accumulation.)

So far, our retiree’s legacy and funding portfolios are both exposed to market risk, and the funding portfolio is exposed to additional risk (path-dependent risk) once she starts spending from it. Note that this risk is introduced by the retiree’s decision to sell shares. Path dependent risk is not market risk, cannot be diversified away like market risk, and therefore we can’t be compensated for it. In general, more risk means a greater expected return, but the market doesn’t compensate us for taking path-dependence risk.

Our retiree will make another decision that affects path-dependence risk, how much to spend annually. The more she spends each year, the more she exposes her portfolio to that selling-price risk each year and the more path dependence risk and risk of ruin she accepts. Simply said, a 4% “sustainable withdrawal rate” is riskier than a 3% rate.

The term “sequence of returns risk” is also sometimes used to refer to the probability that a retiree will outlive his savings, which I refer to as "risk of ruin." Path dependence doesn’t cause a retiree’s portfolio to fail, at least it is not the proximate cause. Refusing to reduce spending when our portfolio declines in value causes portfolios to fail is the proximate cause of portfolio failure. This is not a market risk or path-dependence risk, but a poor decision on the part of the retiree. If your portfolio declines significantly in value and you don't start spending less, you risk ruin.

Most spending strategies, like ARVA, constant-percentage spending and "RMD" rarely or never deplete a portfolio because they reduce spending as a portfolio declines in value, lowering the risk of ruin. Constant-dollar spending is the exception.

I wrote a post some time ago entitled, "When You Have Less Money, You Probably Ought to Spend Less", showing that portfolio failure occurs under the (absurd) assumption that a retiree will continue to spend the same amount from his portfolio every year, even when it becomes obvious that the portfolio will soon be depleted. This is an interesting technique to use in research, but it is not a realistic retirement spending strategy. We sometimes refer to this as “constant dollar spending.”

That post also shows that retirees who spend a reasonable constant percentage of remaining portfolio balance each year will not deplete their savings. Their portfolio will eventually recover and spending can increase.

The  “RMD” spending strategy avoids ruin, as well, by dividing the remaining portfolio balance by your remaining life expectancy to calculate a safe withdrawal amount, similar to the manner in which the IRS calculates required minimum distributions for IRA's. Waring and Siegel's ARVA strategy (download PDF) does something similar. Both strategies reduce spending when a portfolio is faltering. In fact, constant-dollar spending is the only widely acknowledged spending strategy that results in portfolio ruin under reasonable spending assumptions.

The third layer of risk in the chain of longevity risk is that of portfolio ruin. It is introduced when a retiree decides to keep spending the same amount after significant portfolio losses. Rational, knowledgeable retirees will reduce spending when their portfolio wealth dwindles dangerously low, but they expose themselves to the risk of a permanent reduction of spending if they wait too long to adjust. (This is a key reason I recommend dynamic spending and annual adjustments. Small, annual adjustments are easier to tolerate and help avoid larger, permanent adjustments by limiting damage.)

To summarize, our decisions can lead us down a chain of retirement wealth risk. It begins when we decide to invest some of our savings in equities. We increase risk by allocating more of our portfolio to equities and decrease it by allocating less.

The next step is our decision to spend from our savings portfolio. Spending more raises the risk and spending less lowers it.

The final step in the chain of risk depends on the decisions we make when our portfolio dwindles in value.  Path-dependence can lead to portfolio ruin, but it probably won't if we lower spending when our portfolio is stressed.

Each step we take, we add more risk. Except for the final, "overspending" step, these can all be reasonable risks to assume. Understanding them can help retirees understand how much of each risk they should accept.

Have You Already Been Hacked?

I recently wrote a post entitled, “Assume Your Social Security Number is Already Out There”, which was inspired by an article I read suggesting that the personal information of about a quarter of Americans has already been hacked. My experience in the computer networking industry makes me think that number is likely quite conservative.

I have been notified four times in the past year that my personal information might have been compromised. When large companies like Target are hacked, they often offer their customers a year of free credit monitoring service and I currently have two such subscriptions going simultaneously.

There is only so much these services can do, however. Neither noticed when someone filed a tax return in my name, for instance.

Long before business school and my interest in retirement finance, I was a systems analyst with a degree in computer science. My specialty was data communications networks. Truth be known, computers are my first love and much of my financial research is done at my computer with code I write in Mathematica or R.

I had an email account 35 years ago. (As geeks go, I’m ancient.)

Today, I read an article in the New York Times Personal Tech section under the headline, “How Many Times Has Your Personal Information Been Exposed to Hackers?”. The authors began with this statement:

“Half of American adults had their personal information exposed to hackers last year alone.”

That sounds more like it, but since most companies don’t know they’ve been hacked until they find their data for sale somewhere on the Internet, it might be an optimistic guess. Many companies will never know they were hacked.

The quiz at the NYT article will give you an idea of your vulnerability, but look at the names. Who hasn’t subscribed to AOL, or used a charge card at Target or K-Mart, applied for a government job, joined E-bay or Twitter, or downloaded Adobe something-or-other?

The article reinforces my own feeling that nothing is currently safe on the Internet: “Security experts say there is no way to keep hackers out of systems with traditional defenses like firewalls and antivirus software.” The skills and tools available to hackers today have a huge advantage over the tools available to protect us. Passwords don’t work. Firewalls and anti-virus software are speed bumps.

I’m not suggesting you avoid these tools. It’s a little like making sure yours isn’t the easiest house on the block to break into. But if a burglar wants your house badly enough, he can probably find a weakness.

I have long suggested two-step authentication wherever it is available. A list of websites that support two-step authentication can be found at TwoFactorAuth.org. For many of these websites, a hacker would need your password and your phone. I use two-step authentication at Fidelity, Vanguard and Charles Schwab and on several other sites, including FaceBook.

(Some two-step authentication processes use a special key fob device to provide an ever-changing PIN (Charles Schwab, for instance) and others use an authenticator app on your smart phone (several companies use Google Authenticator). But many use text messaging to send a one-time password to your phone. Be aware that hackers may be able to access your phone at say, VerizonWireless.com, and forward these text messages to themselves. If your carrier's website is not also protected by two-step authentication, this leaves a hole for hackers to get through. A fob or an authenticator app are safer.)

Password managers like LastPass can help you create and “remember” complicated passwords. (They say the best password is the one you can’t remember.)

If you don’t have virus protection, don’t let the cost hold you back. I like Avast and it’s free, but there are plenty to choose from.

Another important step that I think makes a lot of sense, especially for retirees, is a credit freeze. I wrote about those in Assume Your Social Security Number is Already Out There. They can be a bit of a pain if you open credit accounts frequently, but most retirees don’t. Even if you do, it’s less painful than finding out someone has opened a credit account in your name and run up a huge bill. You won’t be responsible for much of that bill, if any, but cleaning up the mess will be formidable.

Personally, I’m not sold on credit monitoring services, though I do use them when the companies I trust with my personal information get hacked and offer those services free. They can’t hurt, but they monitor your credit report, not your accounts.

I use alarms on all my financial accounts that send a text message to my phone if there is an overseas charge on a card, an ATM withdrawal, or a charge above some maximum amount.

To summarize, here are a few things you can do to protect yourself:

• Consider a credit freeze at all three credit agencies
• Use two-step authentication whenever it is available
• Use your free annual credit report from one of the three agencies every four months to review your credit
• Use a password manager to help create and use strong passwords online
• Use a firewall and a virus checker at home. Excellent versions of both can be downloaded free.
• Set up text message alarms to notify you of unusual activity on your bank or credit card accounts

These won't fully protect you, but as my grandfather used to say, they're better than a poke in the eye with a sharp stick. It's more efficient for a hacker to steal your personal information in  bulk from Home Depot than to attack your home computer, but the latter still happens.

As I said in the previous post, I think it’s safest to assume that identity thieves already have your personal information, even if they haven’t gotten around to using it, yet. They probably do. The credit freeze may keep them from opening a new account in your name.

In general, the bad guys currently have all the artillery. If you don’t believe that, take the quiz at the Times article. It will open your eyes.

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My post on Social Security benefits and early retirement generated several comments. (Posts on Social Security always do.) If you're looking for a basic booklet that explains your benefits in a very readable way, I recommend The Social Security Claiming Guide from Boston College Center for Retirement Research. There is a small charge for hard-copies, but downloadable versions are free.

Early Retirement and Social Security Benefits

In my first post on this topic, The Risk of Retiring (or Being Retired) Early, I noted that retiring early means a longer and more expensive retirement. In my second installment, Retiring Early: Lost Savings, I reviewed the risk of saving less. And in the third, Early Retirement: Spending Sooner, I considered the combined consequences of simultaneously stopping savings and starting spending. Another major financial risk of retiring early is not optimizing Social Security benefits.

I recommend that most retirees delay Social Security benefit claims as long as possible, but there are some people I just cannot convince. They're afraid that fiscal conservatives who have tried to dismantle the program since its inception in the 1930's will soon have more success than they have had in the past 80 years, or that they will not live long enough after retiring to "break even." But, I suspect a lot of it is addressed by a recent Forbes piece entitled, Most Americans Can't Pass This Basic Social Security Quiz, and they just don't understand how Social Security works.

The basic problem we try to solve by delaying Social Security benefits is the mitigation of longevity risk (growing very old and outliving all our savings) and delaying benefits is the single most cost-effective way to achieve that.

Here's the problem we hope to mitigate by waiting. John can retire at age 70 and receive benefits of $36,000 a year, he can retire at full retirement age of 66 and collect $27,600 a year, or he can retire at age 62 and receive $21,000 a year.  John's wife, Martha, will be entitled to spousal benefits of $13,800 a year, assuming she claims at her full retirement age. Her spousal benefit, like his retirement benefit, is reduced if she claims early, but her spousal benefit, unlike her survivors benefit, isn't dependent on when John claims.

If John claims at 70 and dies first, which is more often than not the case, Martha's spousal benefit will be replaced by a survivors benefit equal to John's retirement benefit. If John claims at age 70, Martha's survivors benefit will equal (his) $36,000 a year but if he claims at 62, her survivors benefit will only be $21,000 a year for the rest of her life.

If John claims at 62 and dies at 71 but Martha lives to 96, Martha is stuck with a $21,000 benefit for two and a half decades when she might have enjoyed $36,000 a year.  (Whether your Martha begrudges the extra $375,000 after you're gone is between you and your spouse.) It really all boils down to whether you view Social Security retirement benefits as insurance against a very poor financial outcome or you view it as a game you are trying to win against the Federal government. But, be forewarned that the government doesn't care who wins and that you generally "win" when you claim early by not living long.

Here's the problem the "claim early" crowd hopes to mitigate. John, or John and Martha, plan to delay claiming, but both die in their late 60's and never receive a penny of their benefits. From a purely financial perspective, this isn't as severe an outcome as living to 100 with inadequate funds for the last decade or so. While we would all probably hope to live longer, a short retirement means we are far less likely to outlive our wealth.

Some of those arguments made by the "claim early" crowd are valid. Maybe you and your spouse won't live a long time, who knows? Maybe benefits will be reduced in the future. But living long enough to regret claiming early is a far more common event than reductions in Social Security benefits have been. Don't protect yourself from sharks and ignore heart disease.

Nearly all academics in the field and economists, some Nobel laureates, recommend delaying benefits as long as possible. If they can't convince you, I certainly can't. If you do, however, agree that delaying claims for Social Security benefits is a good idea, then it becomes a consideration for early retirement.

Retiring early often means that you will need to live completely off retirement savings until Social Security benefits kick in, unless you are lucky enough to have a pension. That may put pressure on your retirement plan, unless you are quite wealthy, to claim benefits sooner than you otherwise would and to forgo the most effective longevity insurance available.

Next time, I'll talk about my own decision to retire early in Early Retirement: Would I Do It Again?

Before I do, let me say that I really appreciate your questions and comments and I hope you won't feel constrained to the topic of the post you are reading. Feel free to ask any retirement finance question anytime. If I don't know the answer, I'll find it. Sometimes your questions spawn an entirely new post. If you have a question, there is a good chance that several others have the same one. I prefer that you log in any leave your name, but do so anonymously if it makes you more comfortable.

I hope you're enjoying your summer as much as I am mine!

Early Retirement: Would I Do It Again?

After my first post on this topic, The Risk of Retiring (or Being Retired) Early, several readers wrote comments about the rewards of retiring early, despite the financial risk. You don't have to sell me. I retired quite early and I am having the time of my life. But, none of these posts were meant to suggest whether you should retire early or not. My intent is simply to make you aware of the financial risks you ought to consider before you make that decision.

And then there is the darker side of this issue. First, the majority of American workers will not be able to accumulate enough savings to retire comfortably at 70, let alone years earlier. And as surveys I mentioned in that first post show, more recent retirees are reporting that they weren't able to retire when they planned than those who report they were. Unfortunately, that number is growing. Retirement isn't always a choice. It usually isn't.

The major factors that can make early retirement financially riskier are:

• a longer (and consequently more expensive) retirement, 
• fewer years to save, 
• lost returns on those forgone savings, 
• lost returns on savings that we spend at an earlier age,
• difficulty un-retiring the longer you are out of the workforce,
• a lower sustainable withdrawal rate (or life annuity payout) due to the longer expected lifetime in retirement, and
• the potential pressure to claim Social Security benefits sooner.

There are several others, of course. Health insurance cost should probably still be considered risky, though the Affordable Care Act has removed some of the risk of obtaining insurance until Medicare kicks in at 65. It is still costly. ACA was intended to make insurance more widely obtainable, not to make it cheaper. Consider this in your decision, particularly if you're used to company-provided health insurance.

There is also the loss of the safety net of returning to work. Wages typically peak around age 55 and decline afterward, anyway, but the longer you leave the workforce, the harder it is to return with anywhere near your previous income.

The converse of those risks provide a list of things you can do to make retirement financially less risky by delaying it:

• a shorter (and consequently less expensive) retirement, 
• more years to save when you're typically able to save more, 
• investment returns on those additional savings, 
• more years for our portfolio to grow without spending,
• a higher sustainable withdrawal rate (or life annuity payout) due to the shorter expected lifetime in retirement, and
• less pressure to claim Social Security benefits sooner.

In fact, this series of posts is not only about the financial risks of retiring earlier, but about the benefits of retiring later.

I suspect than many workers contemplating early retirement underestimate the risks I have pointed out in these past few posts. (I did.) Just a few years either side of a planned retirement age can make a difference; several years make a big difference.

You may be wondering how I feel about retiring early a decade after I made that decision. I'll share a bit of the experience.

I retired in 2005, just before the market crash (housing and stock) in early retirement that we financial analysts say you should fear more than just about anything except perhaps living to 110. Fortunately, my finances were positioned well enough to absorb it. My finances are in better shape now than the day I retired.

I struggled with health insurance before ACA because I had a pre-existing condition. I was able to find health insurance, but the cost was tremendous, much higher than I had planned, and in ten years my high-deductible insurance never paid a claim.

Would I do things differently? I retired early primarily for non-financial reasons. Given my same circumstances as 2005, I would make the same decision. But as much as I had studied retirement before deciding to retire early, I didn't fully understand the financial risk I was taking. After a decade, and knowing what I do now, I might have considered working a while longer to reduce some of that risk – but probably not.

I'm pretty sure that retiring early is far, far riskier than most people assume. Then again, I'm the happiest person I know. My day is packed and virtually everything on my calendar is something I really, really want to do.

On the other hand, the second happiest person I know loves his job so much that he barely slows down for weekends. He may never retire.

The decision isn't purely financial, but I would advise you not to ignore that part of it.

Early Retirement: Spending Sooner

In my first post on this topic, The Risk of Retiring (or Being Retired) Early, I provided some thoughts about the risk of retiring early and perhaps extending what might already have been a long and expensive retirement. In my second installment, Retiring Early: Lost Savings, I reviewed the risk of retiring early and consequently saving less. As I mentioned in that second post, limiting savings at the end of retirement has a significant impact, but when we stop saving early, we typically also start spending from savings. The cost of early spending is greater than the cost of forgone savings and the two combined are substantial.

(As always, click on a chart or table to see a larger version. Hover your mouse over any yellow text.)

Here's the chart from that second post showing the cost of forgone savings without the simultaneous cost of early spending, in other words, imagine a retiree who could stop saving, retire, and avoid spending savings until age 70. (Note a minor change to the chart from my last post: this one graphs balances at the beginning of each year whereas the last post assumed the worker retires at the end of the year.)

Chart 1

As you can see, were this imaginary retiree able to retire at age 55 and not touch retirement savings until age 70, her portfolio value at age 70 would be about $265,000 less than it would be if she had kept saving until age 70. She would save $156,000 less over those 15 years and lose $109,000 in interest on those forgone savings.

Typically, however, when a worker retires and stops saving for retirement, he also begins spending from savings. Chart 2 below shows the resulting portfolio balances when a retiree simultaneously stops savings and starts spending at a given retirement age. It also shows the amount of spending supported assuming a constant-dollar annual withdrawal of the portfolio balance at the retirement age.

The amount of the sustainable withdrawal percentage is calculated using Milevsky's formula for sustainable spending (download PDF) using the life expectancy from the "male" columns of the following table. Note that females have slightly lower SWR's because they have longer life expectancies. My first post on this topic noted that the longer you postpone retirement, the greater your expected savings will be and the larger the percentage you can safely spend annually.

Table 1.

For example, if our sample retiree stops saving at age 65 (the inflection point in the purple line on Chart 2), he would have accumulated $1,181,178 by age 65 and Milevsky tells us we can assume he could spend 4% of that amount, or $47,247 annually beginning at age 65. If he saves until age 70, he accumulates $1,712,935 and Milevsky tells us he can spend 4.6% of that amount annually because he has a shorter life expectancy.

These probably seem like hugely different outcomes, and they are, so let me walk through one example of retiring at age 65 (purple curve on Chart 2 above) versus waiting until age 70 (teal curve on Chart 2 above) in Table 2 below.

Table 2.

Retiring at 70 allows the retiree to contribute $56,000 more to savings in this example. Five more years of 7% annual returns with no withdrawals provides over $530,000 more in portfolio savings. Together these amounts create a portfolio at retirement five years later that is $531,756 larger. Because the 70-year old has a 4-year shorter remaining life expectancy, he can spend 4.6% of this portfolio, according to Milevsky, which is 15% more than the 4% he could spend at age 65. The increase in spending from 4% of $1.18M to 4.6% of 1.71M is more than $30,000 a year.

A lot of this difference comes from the huge growth in the portfolio the last few years of retirement resulting from compound earnings. These portfolios grow exponentially and each year that you delay spending affects your savings balance more than it did the year before. (This is why most financial planners urge you to be very cautious with your investments the last decade of your working career.)

A substantial amount of the sustainable spending difference also comes from the increased SWR – the retiree gets to spend a larger percentage of a larger portfolio. In this example, the additional spending increases $21,269 a year from a larger portfolio at retirement and another $10,278 from an increased SWR.

This scenario is an example and there is no guarantee that your portfolio will grow at all in the final five years of your career, let alone that it will grow as much as 7% annually. The intent is only to show how changes in retirement age affect retirement spending. How much it affects spending depends on market returns and life expectancy, things we can't predict.

The earlier you retire, the less money you can spend after you retire. A significant portion of the reduction of retirement spending can be attributed to the fact that you stopped saving earlier, and a larger portion of additional cost is attributable to spending savings earlier. Toss in the lower sustainable spending amount at younger ages because we have to plan for a longer retirement and the body blows add up quickly.

So far, those body blows from retiring early include:

• a longer (and consequently more expensive) retirement, 
• fewer years to save, 
• lost returns on those forgone savings, 
• lost returns on savings that we spend at an earlier age, and 
• a lower sustainable withdrawal rate (or life annuity payout) due to the longer expected lifetime in retirement.

Of course, you can turn that frown upside down by looking at the flip side of those bullets as advantages to delaying retirement: a shorter, less expensive retirement, more years to save, etc.

There is still at least one major financial risk to consider when deciding to retire early, or evaluating the impact of forced early retirement, and that is the impact on Social Security benefits. I'll cover that next time in Early Retirement and Social Security Benefits.


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Note: The assumptions for these calculations are the same as in the initial post, The Risk of Retiring (or Being Retired) Early. I assume the worker will earn the "typical" annual incomes shown in the charts in that post and will save 10% of earnings every year. I assume he or she will earn a consistent 7% annual return on all savings (an optimistic assumption in current capital markets). All calculations are in nominal dollars except for expected market returns used for the Milevsky formula, for which I assume a 5.6% real annual return with 11% standard deviation.