Three Degrees of Bad

The terms retirement writers use to describe retirement plan failure can be confusing. There are three progressive levels of failure: a loss of "market-funded" standard of living, a loss of standard of living below the household's "floor", and bankruptcy.

A fourth kind of failure, depletion of one's investment portfolio, can contribute to any of these three levels of failure or none of them depending on the extent to which the plan relies on investments to support the standard of living.

Investopedia defines standard of living as "the level of wealth, comfort, material goods and necessities available to a certain socioeconomic class or a certain geographic area."

Merriam-Webster defines standard of living as "a minimum of necessities, comforts, or luxuries held essential to maintaining a person or group in customary or proper status or circumstances."

Retirement writers and researchers often use the term "standard of living" in a more specific way that refers to the cost of purchasing these "comforts, material goods and necessities." For example, we might say that a household has adequate retirement assets to fund a $50,000 annual standard of living when what we mean is that the household can enjoy whatever standard of living $50,000 a year can purchase. We turn a dictionary definition into a dollar amount.

Losing Standard of Living

The term "floor" describes the amount of relatively safe income available to a retired household. The floor is generated from assets with no market exposure. It is often used in the context of "floor-and-upside" retirement funding strategies as I described in Unraveling Retirement Strategies: Floor-and-Upside.

Floor-and-upside strategies use financial products with no market risk, like fixed annuities, TIPs bond ladders, and Social Security benefits, to provide a floor, or minimum, of reliable income before investing any remaining assets in the stock market to provide the "upside" opportunity. The theory is that the retiree will be able to maintain some minimum standard of living (the "floor") even in the event of disastrous investment results in the upside portfolio.

Since nearly all Americans are eligible for Social Security benefits, virtually all of us have some amount of floor but the level of that floor can vary greatly. Wealthy households will be able to build a floor that completely protects their standard of living regardless of investment results, while other households may have a floor consisting of only Social Security benefits that provides very little safety. The higher your floor, the less market losses will harm you standard of living. A floor is insurance and the more wealth you have, the more insurance you can afford.

For example, assume that $50,000 a year is a retiree's desired standard of living but she believes that in the worst case scenario she could get by spending $40,000 annually. Spending less than this $40,000 a year would imply a significant change in her lifestyle.

With a floor-and-upside strategy, she might try to build a $40,000 floor with Social Security benefits and fixed annuities and invest any remaining assets in the stock market. She hopes to generate $50,000 or even more annual income at the risk of having only $40,000. Whether she generates more or less than the additional $10,000 annually depends on her investment results – it's "market-funded."

At the first level of retirement plan failure, our retiree would suffer a loss of standard of living providing less than her desired $50,000 of annual income but not falling below the floor level of $40,000.

Losing Standard of Living Below the Floor

At the second level of failure, the retiree suffers a greater loss of standard of living that drops income below $40,000 a year and requires a significant lifestyle change, but isn't a large enough deterioration of her finances to trigger bankruptcy.

If $40,000 of income is provided by "safe" floor assets, then how can a retiree's standard of living fall below $40,000? There are two ways.  First, no asset is perfectly safe, though TIPs bonds are pretty close. Social Security benefits might be reduced in the future. A pension plan might fail. In this context, "safe" means not exposed to market risk. A floor isn't totally safe from all risks but it is relatively much safer than an investment portfolio.

Second, standard of living can also be disrupted by unexpected expenses. A floor guarantees income; it does not guarantee that income will exceed expenses.

One challenge with this model is that the same standard of living has different price tags in different places. $50,000 purchases a higher standard of living in Manhattan, Kansas than in Manhattan, New York. Another challenge is that defining a floor amount is much easier in theory than in practice as you will see if you try making a list of living expenses you could live without.

Bankruptcy - The Real Ruin

A household whose wealth continues to decline below the floor level may end up in bankruptcy when liabilities significantly and permanently exceed assets. About 0.5% of retirement-aged Americans file for bankruptcy at some point[1], usually early in retirement. (The bankruptcy filing rate declines with age after early retirement.)

The term "ruin" better applies to bankruptcy than to portfolio depletion, which may or may not lead to bankruptcy.

Even in bankruptcy, a well-planned retirement can protect significant retirement assets. Social Security benefits are protected from creditors[2]. According to NOLO Press[3], "ERISA-qualified retirement accounts are generally protected from judgment creditors, as are employee welfare benefits (like medical insurance, HSAs, and employer disability benefits)". Non-ERISA plans are typically not protected.

Your state may provide additional protections in bankruptcy. A few states, for example, such as Florida, New York, and Texas, protect any annuity owned by a resident of the state from creditors. Check the bankruptcy laws for your state of residence.[7] Federal law also affords bankruptcy exemptions.[8] According to NOLO, "state law determines whether you can use federal exemptions or whether you must use your state property exemption list."

Portfolio Depletion

Perhaps the most common term to identify retirement plan failure is "ruin", as in "probability of ruin." In finance, this term is used in a number of ways that leave its definition somewhat imprecise:

"Risk of ruin is a concept in gambling, insurance, and finance relating to the likelihood of losing all one's investment capital or extinguishing one's bankroll below the minimum for further play." —Wikipedia.

"The complete loss of one's money and other assets." —Oxford Dictionary.

Definitions range from the total loss of all assets to the practically-total loss of investment capital only. In retirement finance, however, "ruin" almost always refers to the depletion of one's retirement savings investment portfolio.

While many retirees focus on the probability of totally depleting their investment portfolio prematurely, retirement's so-called "probability of ruin", a decline in portfolio value large enough to lower their standard of living without actually depleting their investment portfolio is far more likely and less catastrophic.

The magnitude of this risk depends on how much of the household's standard of living is funded by an investment portfolio compared to how much is funded by financial assets with no market risk. Higher "floor" lines, blue in the chart above, mean less risk to standard of living.

When sustainable withdrawal rate advocates say there's a 95% chance that you won't deplete your savings portfolio, they aren't promising a 95% probability that you won't lose standard of living. And when they say there's a 5% probability of ruin, they're referring to depleting your portfolio, which might or might not ruin your retirement.

A household that funds its standard of living entirely with Social Security benefits and fixed annuities can accept a greater probability of portfolio depletion — which is to say they can spend more, invest more aggressively, or both — than a household that depends on an investment portfolio to fund part of its standard of living.

Research by Wade Pfau[4] shows that purchasing fixed annuities can actually lead to larger final estates for this reason. "Though SPIAs [single-premium immediate annuities] do not offer liquidity, they provide mortality credits and generate bond-like income without any maturity date, and they support a higher stock allocation for remaining financial assets. Altogether, this allows a client to better meet both retirement financial objectives [spending and a legacy]".

In fact, there is a valid argument that depleting an investment portfolio before the end of retirement and relying on fixed annuities and Social Security benefits thereafter can be the most efficient way to fund retirement in some scenarios.

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Three degrees of bad: Level of retirement plan failure.

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To quote more research by Pfau, "Certain circumstances, which we will explore, may allow retirees to accept a higher probability of “failure,” and spend more aggressively from their investment portfolio. Depleting the investment portfolio is not always catastrophic."[5]

Depleting the portfolio can be part of an efficient retirement plan, no big deal for household's with other sources of income, or catastrophic for a household that greatly depends on income from the portfolio.

How does this relate to the list of risks I posted in Retirement is Risky Business – Here's a List?[6]

Portfolio Depletion Risk is a combination of risks already on that list. A retiree's portfolio can be depleted by withdrawing too much from her portfolio periodically (excess withdrawal risk, overspending risk), by experiencing an unfortunate sequence of market returns early in retirement (sequence of returns risk), or by experiencing unexpected spending shocks (unexpected financial responsibility risk, health expense risk, and others), so I think this one is already well covered.

Although my previous list didn't identify bankruptcy risk separately, it did identify other risks that often lead to bankruptcy. Less than half a percent of elder Americans claim bankruptcy but the consequences are usually grave.

The magnitude of bankruptcy risk often depends on how well the retiree has protected assets from creditors. Since it demands a different kind of mitigation (asset protection), bankruptcy really should be identified as a separate risk. I'm going to add bankruptcy risk to the list and define it as the probability that a retired household will need to claim bankruptcy and its magnitude as the total value of all assets not protected from creditors.

Retirees with an investment portfolio may be exposed to the risk of losing market-funded standard of living. I will also add it to the list and define it as the risk of losing standard of living due to investment losses, presuming that standard of living does not fall below the household's floor of safe income. The amount of standard of living at risk is the amount expected to be generated by the investment portfolio. The probability of the risk can be estimated with Monte Carlo simulation.

There are three degrees of retirement plan failure that should not be confused. The first is a decline in market-funded standard of living. Not the best outcome, but still better than having your standard of living decline below what you might consider unacceptable. Mitigate this risk with a higher floor.

The second is a decline in standard of living below what the retiree considers to be the minimum acceptable floor. This will likely result from expense shocks. Mitigate these risks with insurance when possible (health insurance, umbrella liability insurance, and long-term care insurance, for example), by setting aside reserve funds, or both.

The third level is bankruptcy, which represents the most severe failure of the retiree's finances. Asset protection is an important component of a good retirement plan. It is also worth carefully considering those risks that most often lead to bankruptcy, the first five on the list[6].

An unplanned, premature depletion of the household's investment portfolio can lead to poor outcomes but that event is not a single level of failure. Depending on the extent to which the retiree depends on that portfolio to support his standard of living, portfolio ruin can expose the household to one of the three levels of retirement plan failure or it might be acceptable.

A good retirement plan will address each of these potential poor outcomes (risks) separately as they have different levels of severity and are mitigated in different ways. You can identify these levels of risk in your retirement plan by:

• Calculating the amount of your standard of living that will be market-funded (subject to market risk).
• Calculating the amount of floor income that will be generated (from safe bonds, Social Security benefits, pension plans, fixed annuities, etc.)
• Calculating the total of assets protected from creditors. Review your state's bankruptcy protections. If your state permits use of federal exemptions, review those, as well.

Sketching a chart like the one above from this information may provide some interesting insights into your plan's levels of risk.

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REFERENCES

[1] The (Interconnected) Reasons Elder Americans File Consumer Bankruptcy: Journal of Aging & Social Policy: Vol 22, No 2, Deborah Thorne, Ph.D. (Downloads PDF).


[2] Can I Keep Social Security Benefits in Chapter 7 Bankruptcy?, NOLO.com.


[3] Can Judgment Creditors Go After My Retirement Accounts?, NOLO.com.


[4] An Efficient Frontier for Retirement Income by Wade D. Pfau, Wade Pfau, Ph.D.


[5] Taking Portfolio Spending into the Real World For Retirees, Wade Pfau, Ph.D.


[6] Retirement is Risky Business – Here's a List? (download spreadsheet).


[7] Bankruptcy Exemptions by State, Nolo.com.


[8] The Federal Bankruptcy Exemptions, Nolo.com.

Katrina, Fukushima and Retirement Risk: When Risks Create Risk

What is a retiree's greatest risk of financial ruin? Long-term care costs? Longevity risk? Market risk? Inflation?

The answer is none of these individual risks but a combination of interrelated or "dependent" risks.

The empirical argument to support this is research published by Dr. Deborah Thorne entitled, "The (Interconnected) Reasons Elder Americans File Consumer Bankruptcy"[1] that I reviewed in Why Retirees Go Broke. Dr. Thorne concludes:

"The data also suggest that the majority of elder bankruptcies result from multiple interrelated crises, rather than a single unfortunate event."

Note that I am talking about financial ruin or bankruptcy here and not the loss of a retiree's standard of living. I generally consider two classes of retirement plan failure: loss of standard of living and the more-severe bankruptcy or "ruin." Retirees rightfully worry about inflation, market losses, and spending too much from their retirement savings portfolio and a single "unfortunate event" may be all that is needed to suffer a loss of one's standard of living.

But, ruin appears to result most often from multiple dependent risks according to Dr. Thorne's research, such as an illness that results in job loss and large medical bills that, in turn, generate unserviceable credit card debt that ultimately forces the household into bankruptcy. Dependent risk losses can fall like dominoes.

In my last post, Retirement is Risky Business, I listed 26 potential financial risks of retirement. I'll probably add a few in the near future, so let's call it thirty-ish.

Not all of the risks on that list will apply to every household. For example, if you don't have a spouse then you obviously don't have a risk of your spouse dying. So, let's say that you are exposed to only twenty of the risks on the list.

If you calculate your exposure to each of those twenty risks and total them the sum will provide an underestimate of your overall risk and perhaps even a false sense of security.

Not only are risks difficult to quantify but they are even difficult to identify and they are often inter-dependent (not independent). Here are three major reasons it is misleading to merely check off the list of risks:

• Unknown unknowns,
• Hidden risk exposures, and
• Dependent risks.

Financial risks are uncertainties by definition but there are some uncertainties that we aren't even yet aware of — unknown unknowns.

Not long ago we weren't aware that identity theft would one day be an issue for retirees or that credit default swaps could imperil our personal finances. There are undoubtedly risks in our retirement future that we don't yet foresee.

An example of hidden risk that will be closer to home for most retirees can be found in broadly held mutual funds. A retiree who holds a half dozen large cap funds may feel well diversified. She will likely find, however, that most of the funds own Microsoft, Alphabet and other broadly-held company stocks[3] and that her exposure to the risk of these individual stocks is greater than expected. (Morningstar.com has a feature called X-Ray that will help you find these overlapping stocks but another solution is to hold fewer mutual funds.)

In other words, some risks may not be on your list simply because you overlook them.

The far more complicated and potentially much greater risk that will not be addressed by checking off a list of individual risks is what the risk management field refers to as "dependent risks."

“Dealing with Dependent Risk”, published by Claudia Klüppelberg and Robert Stelzer[4] in 2012, defines dependent risk and demonstrates its complexity. The paper begins with this paragraph:

“In most real life situations we are not only confronted with one single source of risk or one single risk, but with several sources of risk or combinations of risks. An important question is whether individual risks influence each other or not. This may concern the time of their occurrence and/or their severity. In other words, we need to understand how to model and describe the dependence structure of risks. Clearly, if risks influence each other in such a way that they tend to occur together and increase the severity of the overall risk, then the situation may be much more dangerous than otherwise.”

Here’s an analogy. Maybe you recall the classic Microsoft game Minesweeper[5]. Imagine a similar game except that it's played on a large field with different kinds of mines scattered around to represent individual retirement risks. Let's call it Risksweeper. Each mine has a different probability of exploding, representing risk probability, and each has a different potential “blast radius” range representing risk magnitude.

Classic Microsoft Minesweeper game winner and loser.

The goal of Minesweeper is to figure out where the mines are and to avoid "stepping on" one and ending the game. Notice that when you step on one mine (the red one on the right) they all explode. In the Risksweeper game, stepping on a single mine can end the game or only leave the player weakened but stepping on a mine that causes other mines to explode is likely to mean "game over."

The Risksweeper mine that I'll call “Medical Expense Risk” can make a small bang with a small blast radius (a $5,000 doctor bill). If we get the small bang, it is unlikely to set off other nearby mines and result in financial ruin.

On the other hand, the Medical Expense Risk mine can sometimes make a big bang (a $250,000 doctor bill) with a blast radius large enough to set off other mines. If the second mine is also a big one, like job loss, for instance, its blast radius may set off still other mines. If the third mine is large enough, the field starts to look like one of those mouse-trap-and-ping-pong-ball demonstrations of a nuclear chain reaction[6] or like Dr. Thorne’s description of interconnected losses leading to elder bankruptcy.

The biggest risk on the playing board is not medical expense risk, consumer debt risk or longevity risk; it's a chain reaction of multiple dependent risks.

In the following diagram, the solid circle represents the radius of a "typical" blast (a $5,000 doctor bill, for example) and the dotted line surrounding it represents the radius of an "extreme" blast from the same risk (a $250,000 doctor bill).

Risk management literature refers to the amount of connectedness, or dependency, between two risks as probabilistic distance. The less wealth, or “safety margin”, a household has the closer together the mines are situated on the field. Less probabilistic distance between the mines means that smaller bangs are more likely to set off a chain reaction that can lead to ruin.

Very wealthy retirees have very sparse “minefields” and have to be pretty unlucky for an explosion to be “extreme” enough to set off a chain reaction. A $5,000 medical expense might be easily paid by a wealthy retiree but represent an "extreme" loss to a marginally-funded household.

As you imagine this Risksweeper game (or view the mouse traps) it should become obvious that figuring out how closely all of the various risks are linked and the probability that explosions of various sizes will cause other explosions is incredibly complicated when you need to consider twenty or thirty dependent risks and even a few levels of inter-dependency. (This is, after all, a small scale version of the problem nuclear scientists had to solve at Los Alamos in the 1940's except they were trying to cause a chain reaction.)

You should also see that the retiree’s risk is not fully represented by the individual mines alone but includes the risk that one large bang can set off another and possibly even start a chain reaction of cascading financial losses leading to ruin.

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Katrina, Fukushima and Retirement Risk: When Risks Create Risk.

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A simple list of retirement risks does not take this connectedness into consideration, although I did include “Interconnected Loss Risk” in that list. (I'm going to refer to it as "Dependent Risk" going forward.)

Dependent risk analysis is a staple of many fields from nuclear power plant design to insurance to aerospace engineering but it appears to be rarely referenced in retirement literature. A Google search of "dependent risk and retirement" turned up a single reference including both terms and it's from the field of political science research[7] referring to retiring from an election. Dr. Thorne's analysis of elder bankruptcy data tells us that retirees should also be should be concerned about it.

Modeling these dependent risks can be done using a statistical construct referred to as a “copula” [8], but as Klüppelberg and Stelzer note, “copulae provide a way to characterize the dependence structure completely, but are rather complex objects.” The complexity seems to make them unrealistic for typical retirement planning processes, not so much because the math is complicated (it is) but because we don't have a good understanding of the probability distributions of the risks to model.

It seems likely, however, that if one did undertake a detailed analysis of the dependence risk structure of retirement using a copula the results would be the same as Dr. Thorne discovered with empirical bankruptcy evidence – the biggest risk is a sequence of dependent risks.

The scenario above describes a series of three dependent risks, healthcare expense risk, job loss risk and credit risk. A retiree might, however, succumb to the interdependence of even more individual risks.

Let's go back to the assumption that a retiree is exposed to 20 risks and that we only wish to consider failure due to a single pair of those risks. We would need to think about combinations of 20 risks taken two at a time, or 190 scenarios.

Twenty risks taken three at a time generate 1,140 scenarios. I won't bother with the household exposed to more than 20 risks or those scenarios of 4 or 5 combinations of dependent risks except to note that 30 risks taken 2, 3, 4 or 5 at a time would require an unmanageable analysis of 174,406 scenarios. Copulae are a probabilistic approach to solving the problem at this scale.

Importantly, Klüppelberg and Stelzer also note that “For risk assessment it is mainly the dependence structure of extreme events that matters. Thus, measures for dependence in extreme observations provide useful dependence measures for combined risks.”  The impact of dependent risks are largely felt under extreme conditions and are far less an issue under normal economic conditions. By definition, "normal conditions" means relatively small bangs that are unlikely to start a chain reaction.

Clearly, there are far more potential risk scenarios than we can reasonably expect to consider for a retirement plan. We might, however, be able to identify and consider the most impactful scenarios. We might do that by identifying the most common causes of bankruptcy or “ruin”, the ultimate retirement plan failure, and then considering only extreme losses resulting from those risks. This only identifies the worst cases, of course, but that might be the only manageable analysis.

As I described in Why Retirees Go Broke, elder bankruptcies are most often the result of one, two, three, four or five of the following risks:

• Credit card interest and fees,
• Illness and injury,
• Income problems,
• Aggressive debt collection, and
• Housing problems.

Aggressive debt collection is probably beyond our ability to manage, so let’s drop it from the list. Although neither market loss nor inflation is commonly cited as a cause of bankruptcy, they are common fears of retirees so I will add them to the list for the sake of a good night's sleep. This modified list of greatest concerns (biggest bangs) is then:

• Credit card interest and fees,
• Illness and injury,
• Income problems,
• Housing problems,
• Market losses, and
• Inflation.

Combined, these six scenarios considered one, two and three connections deep generate 41 scenarios. Still a lot, but perhaps manageable. Adding Klüppelberg and Stelzer's warning about extreme conditions, analyzing this smaller subset of risks only under such conditions might provide a good if incomplete start.

This also raises the issue of how we can best deploy our retirement assets to mitigate retirement risk. It appears that our goal should be to first avoid the worst case, a chain reaction leading to ruin. A chain reaction will likely have far worse outcomes than any individual risk.

This implies that we might want to use our risk-management assets first to "shield the biggest potential blasts" rather than spread these resources broadly to minimize all risks. Perhaps long-term care insurance and securing housing deserve priority consideration over market or inflation risk, for example, since the former are commonly-cited reasons for bankruptcy and the latter are not.

Because with dependent risk "it is mainly the dependence structure of extreme events that matters",  analyzing retirement risks independently may be adequate under normal conditions. But, we are probably underestimating our vulnerability under extreme conditions (think the 2007-2009 simultaneous crash of the mortgage and stock markets).

On the other hand, global financial meltdowns occur far more frequently than we might expect. Business Insider[9] claims there have been 57 stock market crashes, defined as a 20% or greater decline in one or more of the four major stock market indices, since 1950 and Wikipedia[10] provides a long, depressing list of global financial crises throughout history, leaving one to wonder how typical "normal conditions" actually are in this context.

Speaking of chain reactions and dependent risks, the Fukushima Daiichi nuclear disaster[11] resulted from a chain of dependent risks, which one might expect to have been thoroughly studied by the experts that designed a nuclear power plant.

The plant began to automatically shut down, as designed, when it detected an earthquake on March 11, 2001. About an hour later the plant was inundated by a tsunami, also anticipated in safety plans, although this one was 15-meters high. The tsunami topped a seawall and then flooded generators that powered the plant's cooling pumps causing the nuclear "accident." But, over one thousand people living near the plant died as the result of a fourth dependent risk – the evacuation plan.

What are the odds of experiencing an earthquake and a flood within the same hour? Probably quite low unless the earthquake causes the flood. This is the essence of dependent risks.

The string of dependent risk losses that resulted from Hurricane Katrina in 2005 disaster was similar[12]. New Orleans survived the hurricane but the resultant flooding of the Mississippi River from torrential rains upstream caused levees to fail, flooding the city. The flood from the breaches shut down most of the 149 pumps designed to pump flood water out of the city. Ultimately, many more people were killed or devastated by a failed evacuation. Like Fukushima and elder bankruptcy, the risk to New Orleans residents was much greater than the individual risks of a hurricane, failed levees or disabled pumps in isolation.

A reverse mortgage is a retirement example that also creates dependent risk. Borrowers are generally protected from foreclosure except in specific cases (inability to pay property taxes or maintain the property, for example) so long as they live in the home. It appears that actual foreclosures are, in fact, quite rare. In theory, a borrower needs only to continue to live in the home to avoid losing it but as a colleague of mine used to say, "just notice how easily that rolls off the tongue."

Imagine that a household experiences extreme medical expenses or the loss of a spouse after much of the home's equity has been spent and the survivor can no longer afford to live in the home or community or no longer wishes to. Leaving the home would render the mortgage due and payable with practically the same outcome as a foreclosure. The household would lose the home as a result of illness or death of a spouse triggering loss of standard of living exposing the risk associated with the reverse mortgage.

If the borrower set up the mortgage with tenure payments he or she would also lose those – yet another dependent risk – and be unlikely to have assets to replace that expected future income. Considering reverse mortgage risk, medical expense risk and loss of spouse risk separately without evaluating the dependent risks they create would not uncover this vulnerability.

(This is not an argument to avoid reverse mortgages, by the way – all financial strategies have risks and rewards. It is an argument to understand the risks as well as the rewards.)

Some general conclusions can be drawn:

• Retirement risk is more than the sum of its parts, potentially much more. Mitigating individual risks independently ignores dependent risks which may be much greater.
• The retirement field doesn't appear to have widely considered dependent risk nor do retirement plans.
• A thorough statistical analysis of dependent risk is typically well beyond the reach of a financial planner or do-it-yourselfer.
• Dependent risk grows under extreme economic conditions.
• Analyzing the inter-dependence of the few risks generally responsible for financial ruin and only under assumptions of extreme conditions may be manageable and helpful.
• The greater a retired household's safety margin (i.e., its wealth) the less likely a loss will be "extreme" enough to trigger dependent risk losses.
• Households with marginal retirement resources are more susceptible not only to independent risks but also to dependent risks.
• Dependent risk may result in the worst-case outcomes so consideration should be given to prioritizing them when allocating risk-management resources.

Bottom line, your retirement plan likely has a great deal more risk under extreme conditions than you know and it probably goes without saying that more wealth means less risk. These plans are acceptable if everything remains normal but if we could count on everything remaining normal we probably wouldn't need to plan much in the first place.

Evaluating retirement risks individually and in isolation, a common practice, is somewhat akin to analyzing the risk of driving your car by reviewing its safety features and ignoring the fact that there will be other drivers on the road.

Please note that I have made a few changes to the table of risks, including the downloadable version, in my previous post, Retirement is Risky Business.

Optional homework for this week's post is to play a game of Minesweeper[5] and to watch a short video of ping pong balls tripping mouse traps[6].



REFERENCES

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[1] The (Interconnected) Reasons Elder Americans File Consumer Bankruptcy, Dr. Deborah Thorne (download PDF).



[2] The Big Short, Michael Lewis.



[3] Top 10 Companies Held By Mutual Funds



[4] Dealing with Dependent Risk, Claudia Klüppelberg and Robert Stelzer, 2012. Download PDF



[5] Minesweeper game online.



[6] Mouse Trap Reactor video.



[7] Systematically Dependent Competing Risks and Strategic Retirement, dependent risk in election decisions.



[8] In probability theory and statistics, a copula is a multivariate probability distribution for which the marginal probability distribution of each variable is uniform. Copulas are used to describe the dependence between random variables. In the present context, random variables represent risk.



[9] Here's every stock market crash in the past 60 years, Business Insider, June 8, 2016.



[10] Financial Crises throughout history, Wikipedia.



[11] Fukushima Daiichi Accident, World Nuclear Association.



[12] Hurricane Katrina, History.com.

Retirement is Risky Business – Here's a List

After we develop a set of major personal retirement goals for our mission statement as I described in A Mission Statement for Retirement and then review them with an advisor to identify any glaring omissions, there are a large number of financial risks that every plan should contemplate. Many of these won't come to mind when we consider a list of major retirement goals for our mission statement, but one major goal of the mission could be to mitigate as many applicable common retirement risks as we can identify.

A list of common financial risks in retirement can provide a good starting point, though this list is not exhaustive.

Let's start with a list of retirement risks the American College developed for the Retirement Income Certified Professional^® (RICP^®) certification because it is the most extensive I've found. A little too extensive for my taste, actually. I'm going to combine risks 3 and 11 because they're both essentially sequence of returns risk. (See the table at the end of the post for definitions.)

I have also omitted Risk 17 from my list. Timing risk is the risk that you will choose a time to retire just before the next few decades suffer economically. While that is clearly a risk everyone takes, it isn't one over which we have any control making it relatively useless for planning purposes.

Eighteen Retirement Risks from RICP^®

• RISK 1: LONGEVITY RISK
• RISK 2: INFLATION RISK
• RISK 3: EXCESS WITHDRAWAL RISK
• RISK 4: HEALTH EXPENSE RISK
• RISK 5: LONG-TERM CARE RISK
• RISK 6: FRAILTY RISK
• RISK 7: FINANCIAL ELDER ABUSE RISK
• RISK 8: MARKET RISK
• RISK 9: INTEREST RATE RISK
• RISK 10: LIQUIDITY RISK
• RISK 11: SEQUENCE OF RETURNS RISK
• RISK 12: FORCED RETIREMENT RISK
• RISK 13: REEMPLOYMENT RISK
• RISK 14: EMPLOYER INSOLVENCY RISK
• RISK 15: LOSS OF SPOUSE RISK
• RISK 16: UNEXPECTED FINANCIAL RESPONSIBILITY
• RISK 17: TIMING RISK
• RISK 18: PUBLIC POLICY RISK

Adam Cufr, an RICP, created a list of 27 risks that largely builds on the RICP list. Some of these seem redundant to me. Nonetheless, there are some that clearly should have been added to the RICP list in my opinion, including:

• Asset allocation risk, though I could also argue this is market risk,
• Legacy risk, and
• High debt service risk, important because it is a major cause of elder bankruptcy.

I'll split Legacy Risk into Legacy funding risk, the possibility that a retiree's desired bequests will not be adequately funded because the household depleted its wealth and Estate Planning risk, the possibility that the retiree's estate will not be distributed as he or she had intended.

For a third source, I like to include a list of cited reasons for elder bankruptcy from research by Deborah Thorne, Ph.D. (I wrote about this in Why Retirees Go Broke.) These include:

• Credit Card Interest and Fees, or High debt service risk, as Cufr refers to it.
• Illness and Injury, also called Health care expense risk,
• Income Problems, such as losing a part-time job in retirement (Reemployment risk in the RICP list),
• Aggressive Debt Collection, whereby retirees are unable to negotiate a settlement and feel bankruptcy is the best option. I'll roll this under High Debt Service risk, and
• Housing problems, such as the mortgage payments increased, the respondent wanted to refinance the mortgage to lower the payments but could not, or a lender threatened to foreclose.

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Retirement is risky business – here's a list.

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Housing problems is one category I believe is not already on the RICP list and should be, but I cite the Thorne study for two other reasons.

First, if a risk is one of the five major causes cited for bankruptcy then it should be given extra attention in a retirement plan.

Second, the main point of the Thorne study is that bankruptcy is most often the result of a series of interconnected financial problems that cascade into ruin. In other words, it is less likely that a household's ruin will result from a single risk on this list than to multiple risks. These losses might occur simultaneously and be unrelated, but it is more likely that one will cause another, which may cause even more. Most survey respondents reported more than one cause for their bankruptcy. A few cited all five common reasons.

Source: Thorne, Generations of Struggle.

I'll add Overspending risk to my list. Overspending risk is different than Excess withdrawal risk, which refers to withdrawing from a savings portfolio faster than the portfolio can recover with market gains. A household can overspend its way into crisis without even owning an investment portfolio. It is also different than High Debt Service risk or Credit Card Interest risk in that overspending is a risk whether or not it is financed spending.

I'll also add Interconnect-ed loss risk to my list to call attention to the possibility that individual risks are not necessarily independent of one another.

From a planning perspective, this means that we can't simply consider the possibility that the household will succumb to each risk on the list, but we must consider the possibility of simultaneous losses or even multiple, simultaneous losses that begin with a single loss.

The simultaneous collapse of the housing market and the stock market in 2007-2009 provides a recent example. For some households, foreclosure and market losses might also have led to unemployment and income loss for workers in these fields. The struggling household, in turn, might have increased credit card debt as the last remaining financial option creating a row of dominoes that tumbled into ruin.

Every retirement plan should consider all of the applicable risks on this list and their potential correlations.

The following table is my consolidation and "pruning" of the three lists discussed above. Links to the lists I curated are provided in the reference section below. Some of the explanations were taken from the RICP list (my edits are underlined.)

You can download a Word document containing this list and edit it as you like. Use it as a starting point and add risks that I missed. Risks that are unique to your household might warrant inclusion in the mission statement.

Major Cause of Elder Bank-ruptcy		Risk	Explanation
✔	1	Health Expense Risk	For those who had employer health care coverage, retirement may mean paying more for medical insurance (Medicare Parts B and D and Medicare Supplement policies). Even with insurance, some expenses will be paid out of pocket. Also, chronic or acute illnesses may mean more significant and unexpected out-of-pocket expenses.
✔	2	Income Loss Risk	Many retirees plan on working in retirement. Income loss risk is the inability to supplement retirement income with employment due to tight job markets, poor health, and/or caregiving responsibilities.
✔	3	High Debt Service Risk	The risk of bankruptcy resulting from an inability to service debt, especially consumer debt. May result from spending beyond budget.
✔	4	Housing Problem Risk	Risks to housing including mortgage payments increase, inability to refinance the mortgage to lower the payments, unpayable increase in property taxes or a lender threatening to foreclose. Includes reverse mortgage risk.
✔	5	Dependent Risk	The risk that a loss due to one risk might cause losses due to other risks. (Formerly "Interconnected Loss Risk".
✔	6	Long-Term Care Risk	Chronic diseases, orthopedic problems, and Alzheimer's can restrict a person from performing the activities of daily living, which will require financial resources for custodial and medical care. Includes Lack of Available Facilities or Caregivers risk, Change in Housing Needs risk and Uninsurable Medical Conditions risk.
	7	Longevity Risk	No one can predict how long he will live. This complicates planning since a retiree has to secure an adequate stream of income for an unpredictable length of time.
	8	Inflation Risk	When working, inflation is often offset by an increased salary. In retirement, inflation reduces the purchasing power of income as goods and services increase in price, impeding the client's ability to maintain the desired standard of living.
	9	Excess Withdrawal Risk	When taking withdrawals from a portfolio during retirement to fund income needs, there is a risk that the rate of withdrawals will deplete the portfolio before the end of retirement.
	10	Frailty Risk	Frailty risk is the risk that as a result of deteriorating mental or physical health, a retiree may not be able to execute sound judgment in managing her financial affairs and/or may become unable to care for her home.
	11	Financial Elder Abuse Risk	The possibility that a family member or caretaker might steal assets.
	12	Financial Advice Risk	The possibility that an advisor might recommend unwise strategies or investments or embezzle assets.
	13	Fraud Risk	The risk of losing one's assets as the result of fraud or identity theft.
	14	Market Risk	The risk of financial loss resulting from movements in market prices.
	15	Interest Rate Risk	Technically, this is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market.
	16	Liquidity Risk	The risk that the retiree's assets cannot be converted to cash quickly and inexpensively enough to meet short-term expenses or debt.
	17	Sequence Of Returns Risk	Investment returns are variable and unpredictable. The order of returns has an impact on the how long a portfolio will last if the portfolio is in the distribution stage and if a fixed amount is being withdrawn from the portfolio. Negative returns in the first few years of retirement can significantly add to the possibility of portfolio ruin.
	18	Forced Retirement Risk	There is always the possibility that work will end prematurely because of poor health, disability, job loss, or to care for a spouse or family member. This event can quickly derail a retirement plan.
	19	Employer Insolvency Risk	Employer-provided retirement benefits are an important part of retirement security for many. If the employer has financial problems, employees may lose their jobs and in some cases their benefits.
	20	Change of Marital Status Risk	The loss, divorce or separation of/with a spouse is a major personal loss, but without planning can also result in a decline in economic security.
	21	Unexpected Financial Responsibility Risk	Many retirees have additional unanticipated expenses during the course of retirement, in many cases due to family relationships and obligations.
	22	Overspending Risk	The risk that a household will spend beyond its means and prematurely deplete savings or an investment portfolio.
	23	Public Policy Risk	An unanticipated change in government policy with regard to tax law and government programs such as Medicare and/or Social Security can have a negative impact on retirement security.
	24	Legacy Funding Risk	The risk that planned bequests are not funded.
	25	Estate Planning Risk	The risk that one's estate will not be distributed as he or she had desired.
	26	Asset Allocation Risk	The risk that one's asset allocation does not achieve expected results or is inadequately diversified.

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REFERENCES

Retirement Risk Solutions, Dave Littell, RICP® Program Director, American College.



27 Retirement Risks: Which Is (Arguably) Most Damaging?, Adam Cufr, Fourth Dimension Financial Group, LLC.



The (Interconnected) Reasons Elder Americans File Consumer Bankruptcy, Deborah Thorne Ph.D.



Generations of Struggle. Deborah Thorne (Ohio University), Elizabeth Warren (Harvard Law School), Teresa A. Sullivan (University of Michigan).



Common Risks That Can Ruin Your Retirement, Ken Hawkins.



Society of Actuaries list of retirement risks. (Download PDF.)

Delaying Social Security Claims (or Not)

Should all retirees delay claiming Social Security benefits?

That's the question I was asked on Dan Farnsworth's Boomer Income Ideas website this past week. Since this a common question and Social Security retirement benefit claiming is so complicated, I'll share my thoughts on the topic with you, as well. (Dan's interview is scheduled for release in July and I'll post a link when it is available.)

First, a very quick review of how delaying Social Security benefits works. Workers can claim retirement benefits as early as age 62 but for every year they delay claiming they increase their benefits by about 8%. There is no additional benefit to claiming after age 70. Survivors benefits may also be affected by the age at which retirement benefits were claimed by the deceased spouse, so if hubby claims at an early age his widow may pay the price.

Households may receive a larger lifetime benefit by delaying claiming if one or both spouses live a very long time, say, into their nineties. If neither does, claiming earlier can provide a larger lifetime benefit. If the retiree lives to somewhere in the neighborhood of median life expectancy the claiming age doesn't make a huge difference but that isn't something we can plan on.

The easy answer to Dan's question is no, not everyone should delay claiming, easy because there are precious few meaningful retirement finance strategies that every retiree should implement. Off the top of my head I can think of a few retirement scenarios in which retirees might not want to delay claiming, though there are no doubt more:

• Retirees who have over-saved
• Retirees who need the income right away
• Lower-earning spouses
• Retirees in poor health
• Retirees convinced that Social Security is going away

I sometimes have readers contact me for planning help who have saved $10 million or more for retirement. (I often wonder exactly what retirement finance problem these readers would have me solve.) It really doesn't matter a bit when they claim Social Security benefits, or even if they claim.

The risk for people who have "over-saved" is that some people aren't as over-saved as they believe. I've had readers ask if they can retire at age 50 with a million dollars. (They can't.) Households that have saved two or three million dollars aren't totally free of longevity risk and should they deplete their savings they may eventually regret having claimed benefits early. In general, though, retirees who saved a ton of money don't need to worry much about delaying Social Security benefits. The benefits won't make much difference either way.

At the other extreme, a large majority of Americans will have very little in the way of retirement savings. About half will have almost no savings. These retirees may need the income as soon as they retire and will not be able to postpone claiming.

Source: MotleyFool.com

The exception to this scenario is households with little or no savings who can delay claiming Social Security benefits by working longer. In addition to increasing Social Security benefits, working longer provides a number of benefits for the under-saver. Every additional year worked reduces the length – and thereby the cost – of retirement. It provides an opportunity to increase retirement savings. It may provide another year of company-paid health insurance.

Couples analyzing their Social Security benefits face an even more complex task. I used MaximizeMySocialSecurity.com to analyze my household's options and it found 13,651 claiming scenarios. Often, both spouses claiming at the maximum age does not generate maximum lifetime benefits if one or both live a long life.

It is often most beneficial for the lower-earning spouse not to delay claiming past full retirement age (FRA, about 66 years for those claiming benefits today) and for the higher-earning spouse to delay claiming to age 70. It is typically beneficial for the lower-earning spouse to wait until FRA, however, and not to claim at age 62.

(For the record, I plan to claim at age 70 and my wife claimed at FRA.)

Retirees who have good reason to believe they will not live beyond median life expectancy for a healthy person of their age and gender might consider claiming benefits earlier. Like retirees on the borderline of "over-saved", however, guessing how long you will live is risky.

Mortality tables tell us how long a large group of randomly selected people like us is likely to live but they don't tell us, for example, how long Dirk will live. All American males my age might on average live another 20 years, but I may die tomorrow or in 35 years. Best to plan on the long side.

My son tells me that students in med school are taught that doctors are notoriously bad at predicting when patients will die unless death is imminent. In 2001, the FDA approved a drug called Gleevec that resulted in "converting a fatal cancer into a manageable chronic condition." If you expect a short retirement but experience a long one, you may well regret having claimed Social Security benefits early.

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Delaying Social Security benefits is like saving some acorns for a long winter.

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Lastly, if you're someone who fears that your Social Security benefits will one day be taken away and that fear causes you significant distress, I think you should claim early. As I wrote in What Makes Us Happy, the ultimate goal of a retirement plan is to make you feel safe and secure. If the fear of losing your benefits before you claim them outweighs your fear of lower income in your nineties, claim early.

These are a few examples of retirees who might not want to delay claiming Social Security retirement benefits. I don't believe the list is exhaustive, only that it shows that delaying claiming isn't always the right choice for everyone, but again, hardly any retirement strategy is.

All things considered, I still believe that most retirees should delay claiming Social Security benefits for as long as they are comfortable doing so. Delaying claiming is simply transferring some income from early in retirement until late in retirement for the benefit of those of us who do enjoy a very long life. It is the cheapest longevity insurance you can buy.

Delaying claiming your benefits isn't unlike a squirrel eating some acorns in the fall and hiding some for a long winter. You have to strike a balance between how much you eat today and how much you will have to eat if the winter is exceptionally long.

Unless you've saved $10 million dollars, of course, in which case you can eat whatever you want whenever you feel like it.

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REFERENCES

Boomer Income Ideas



Full Retirement Age, www.socialsecurity.gov



Gleevec and CML.



Social Security Made Simple, Mike Piper.

What Makes Us Happy

I recently watched a brief video interview with Michael Finke entitled, "Risk Tolerance in Retirement Planning." It's a great return on a two-minute investment of your time.

Finke is the Chief Academic Officer at The American College of Financial Services and one of the retirement researchers I most respect.

Although his interview primarily addresses risk tolerance, the line that caught my ear was this one, addressed to retirement planners:

"Your goal is to make [clients] as happy as they can be in retirement and it may make them happier to have less anxiety about their investment portfolio."

The issue this addresses for me is how we, as planners, researchers or bloggers, view our goals. I think it also applies to how do-it-yourselfers view their own goals in developing a retirement plan. As Finke so succinctly states it, the goal is a happy retiree.

Those of us on the plan-development side sometimes think our job is to create the retirement plan that we think is best for the client. "Best" may mean to us the plan that survives the most simulations, the plan that eliminates worst-case scenarios, or the plan that uses retirement resources most efficiently, for example. Those are all pretty good standards, but they don't measure happiness.

Claiming Social Security benefits, buying fixed annuities, setting a portfolio spending rate and investing retirement savings are common retirement decisions that can play economic theory against client happiness.

Retirees who delay claiming Social Security benefits will receive greater lifetime benefit payments if they live a long time but lesser benefits if they don't survive long after claiming. Retirees who claim early will receive greater lifetime benefits if they don't live a long life but lower benefits if they grow quite old. In other words, to delay the claiming of these benefits is effectively to purchase longevity insurance and at an attractive price.

Most economists (and I) generally recommend delaying but most retirees don't for many reasons. The primary reason is probably that most retirees need the income right away and can't afford to delay. But, some think their Social Security benefits will be taken away so they should grab them while they can (I don't). Some are convinced in the absence of any supporting evidence that they simply won't live a long time. Still others who aren't as dependent on the income believe they should claim benefits early and invest them in the stock market. A wealthy retiree or one with a substantial pension might not need more longevity insurance. It is possible that delaying Social Security claims might not make these clients happier than claiming at an early age would.

If I recommend to a client that she delay claiming her Social Security benefits and she lies awake at night worried that the Social Security program will be shut down before she receives any benefits then I have not created a happy client. Though I will do my best to explain the advantages of delaying, if delaying is going to make her unhappy then claiming early is the "best" strategy if we agree with Finke.

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If a large equity allocation or an annuity will keep you awake at night, don't let me talk you into one.

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Similarly, I have spoken with clients and readers who can't imagine handing over their life savings to an insurance company to purchase a fixed annuity. Readers have also told me that they would never consider investing their very dear retirement savings. Purchasing a fixed annuity might be a no-brainer for an economist or financial planner but if it doesn't make the client happy it isn't the right strategy.

If a large equity allocation or owning a fixed annuity will keep you awake at night, don't let me talk you into one.

Finke's video isn't only about happy clients, of course. It's primarily about risk tolerance. It's a brief video that I could summarize here, but I'll ask you to watch it, instead, because I'm reminded of a conversation I had with a retirement planner/author some time back. I told him that I had loaned my copy of his recent book to a friend.

"That's wonderful!" he replied. "But, next time how about being a sport and buying her a copy?"

Finke's video can be seen at Risk Tolerance in Retirement Planning.

Sun Tzu or a Rubik's Cube?

The ancient Chinese military strategist, Sun Tzu, wrote, "Know your enemy" around 500 years before the birth of Christ. A better translation is something along the lines of "Know your enemy and know yourself and you need not fear a hundred battles."

I readily confess that I have not read The Art of War, or at least don't remember reading it, though I have read many things written about it. I stumbled across such a reading this week.

I would paraphrase the "general" idea (pun intended) behind "know your enemy" as recommending that the more you know about your opponent in a strategic game with uncertain outcomes[1] the better your chances of success. Retirement finance is such a game. Knowing a lot about your enemy doesn't guarantee success in warfare or in retirement finance.

The "enemy" I have in mind is the loss of one's standard of living in retirement. It helps to understand this enemy but understanding it doesn't guarantee you won't succumb to it.

This brings me to the Rubik's Cube I noticed in the back of my closet this week. I could only remember how to solve one face but I recalled that there are well-defined algorithms for solving the entire cube and I googled one[2]. Follow these directions and you will solve the Rubik's Cube every time.

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Retirement finance is harder to solve than a Rubik's Cube.

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There is no equivalent set of algorithms to solve the retirement spending problem with certainty. Sure, we can fund retirement solely with Social Security benefits and fixed annuities but that only guarantees the income side of the equation. The expense side will always be uncertain and our goal in retirement isn't really to secure income but to secure non-negative cash flow.

Warfare and a Rubik's Cube are both complex problems to solve but unlike warfare, the Rubik's Cube problem has no opponent – neither man nor nature – to introduce uncertainty.

The problem is that many of us hope to approach the retirement planning problem as a Rubik's Cube instead of a battle, a stochastic game against nature, or a visit to a roulette wheel[3]. Buy an annuity, time-segment your portfolio, invest in index funds, minimize your taxes. Surely there is some list of directions on the Web like those for solving a Rubik's Cube that more or less guarantees a successful retirement, right?

Unfortunately, there is not. Retirement finance is intrinsically fraught with risk. We can know our enemy well but the main thing we know about that enemy is its uncertainty. We can do all the right things and fail. We can do all the wrong things and succeed.

My favorite example of doing the wrong things and succeeding is my friend Gerry's blackjack hand. I once watched Gerry split a pair of fives in a blatantly rookie move, turning a pretty good hand of ten into two bad hands of fives . . . and win both hands.

Sometimes the force is with you.

If you retired in 1982, according to a column written by Wade Pfau[4], and lived 30 years you would have had a hard time depleting your savings with a reasonable sustainable withdrawal rates strategy. Pfau figures a 9.8% annual withdrawal rate would have avoided portfolio depletion. The same retirement beginning in 1966 would have survived only 4% withdrawals. Those who retired in 1982 could split a pair of fives and probably still win.

My favorite example of super-intelligent people creating lovely, complex algorithms that failed miserably is the story of Long-Term Capital Management. This hedge fund, the subject of the book When Genius Failed by Roger Lowenstein, was initially highly successful under the leadership of a former Wall Street bond manager and two future Nobel laureates. Eventually, however, LTCM failed, bankrupted its founders and brought the global financial system to its knees.

(I highly recommend Roger Lowenstein's book, but Business Insider published a synopsis at the link below.)

As an aside, I often quote the William Bernstein dictum, "When you win the game, stop playing." Occasionally, someone will write me to say that's a bad idea (Note: Bernstein doesn't have a lot of bad ideas).

Buffett: …It’s…an interesting story…The whole story is really fascinating because if you take John Merriwether, and Eric Rosenfeld, Larry Hilibrand, Greg Hawkins, Victor Haghani, the two Nobel Prize winners, Merton and Scholes, if you take the 16 of them, they probably have as high an average IQ as any 16 people working together in one business in the country…an incredible amount of intellect in that room. Now you combine that with the fact that those 16 had had extensive experience in the field they were operating in…In aggregate, the 16 had probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor that most of them had virtually all of their very substantial net worths in the business. So they had their own money up. Hundreds and hundreds of millions of dollars of their own money up. Super high intellect, working in a field they knew. And essentially they went broke. And that to me is fascinating…

…But to make money they didn’t have and didn’t need, they risked what they did have and did need, and that’s foolish. That is just plain foolish."[5]

Sounds like Warren Buffett and William Bernstein agree on this point.

My point is this. Retirement finance is a probabilities game. There is no set of rules that guarantees a successful outcome like the set of rules for solving a Rubik's Cube, even though both are complex problems. Retirement finance is more of a Sun Tzu thing.

Had Sun Tzu been a retirement planner of the probabilist school, he might have said, "Know your enemy and know yourself and you need not fear about 95 out of a hundred battles."

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REFERENCES

[1] A Tiny Bit of Game Theory, The Retirement Cafe´.



[2] How to Solve a Rubik's Cube.



[3] Retirement Roulette, The Retirement Cafe´.



[4] What If Retirees Don’t Want To Run Out Of Money In 30 Years? by Wade Pfau.



[5] WARREN BUFFETT ON LTCM, BLIND SPOTS, LEVERAGE, AND UNNECESSARY RISK,



[6] The Epic Story Of How A 'Genius' Hedge Fund Almost Caused A Global Financial Meltdown, Business Insider.

Retirement Planning Explained Backwards

Some time ago, I began looking for research identifying what a good retirement plan document should address and a process for developing one but was surprised to find very little written on the subject.

The best resource I found was from the Retirement Income Industry Association (RIIA)[1]. RIIA's philosophy is that planning begins with a Household Balance Sheet® that identifies all of the resources available to the retiring household.

That's fine as far as it goes, but I like to begin planning a step earlier. From my perspective, the RIAA approach jumps into figuring out how to get there before figuring out where we want to go. I suspect RIIA would say this is implied, but I think it should be written and agreed with the client from the start.

I'd rather identify the highest-level goals in a mission statement[2] and then implement the RIAA or an equivalent process as step two rather than try to accomplish three different things in one step. I refer to this second step as finding the intersection of what's desirable and what's possible[3] but that is essentially what the RIIA process does.

I believe that retirement planning should be top-down like the strategic planning process used by many businesses[5] but I suspect that the entire process is easier to understand when explained from the bottom up.

Let's use this process to plan a vacation. First, we decide on a mission. Do we hope to spend our days relaxing, learning about another culture, visiting old friends, communing with nature? Say we choose "learning about another culture."

Next, we decide on our objectives: where we want to go, how long we'll stay, and how much money we have available to spend – and this is key – to learn about another culture. In other words, our objectives stem from our mission.

Lastly, we choose the specific tactics to meet the objectives that achieve our mission. Will we fly United (insert joke here) or Spirit (insert joke here). Will we stay at a Marriott, a Holiday Inn Express or a campground? What will we pack? Those decisions depend on our objectives and our objectives depend on our mission.

This may seem obvious and intuitive but it isn't uncommon to hear someone say that they have decided to fund retirement with annuities, a stock portfolio, or even an increasing stock allocation when they have documented neither their mission nor their objectives. That's a little like deciding to fly American Airlines and then deciding where you want to go and then deciding why you want to go there.

So, let's start at the end of retirement planning. We'll start with the bottom layer, Step 3. in the diagram above. Every year we need to place a series of bets, though often these will only be a tweak of existing bets. I identified several of these bets in Retirement Roulette[4]. They include a bet on a retirement date, a bet on an amount to spend this year, a bet on stocks, a bet on bonds, a bet on cash, and so on.

I further noted in Retirement Decisions with Expiration Dates[6] that not all of these bets will always be available. We might be able to place a bet on long-term care insurance this year, for example, but a future disqualifying decline in our health could take that bet off the table. If we claimed Social Security benefits last year we can't claim them again this year.

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Retirement plans explained backwards.

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We can't effectively plan year-at-a-time without the context of long-term retirement objectives. That context comes from our strategic retirement plan. We can't identify the next leg of our journey without knowing our next milestone, so we need to identify those strategic objectives in the step before making our annual bets.

A strategic plan is based on The Intersection of What's Desired and What's Possible[3]. It identifies the strategic goals or "milestones" we believe we need to meet in order to achieve our mission, so we need to identify that mission in the step before identifying our strategic objectives.

We should begin retirement planning by crafting A Mission Statement for Retirement[2] that is effectively our idea of what would constitute a successful retirement. Again, this may sound intuitive and obvious, but most retirees to whom I recommend this process find it challenging to articulate their mission in a paragraph or two. Many want to say, "My mission is to retire and not run out of money." That's probably true but not terribly helpful.

While these three components of a strategic retirement plan constitute a "living document", they will change with different frequencies. An annual operating plan will be changed most frequently, although the changes will range from substantial to minor tweaks.

Strategic plans should be changed infrequently as the result of major unexpected changes in our life that affect our finances (divorce, death of a family member, bankruptcy, major illness, etc.)

A mission statement might change on rare occasion but is intended to be an enduring statement of retirement goals and personal values and hopefully is written as such.

I have explained the steps of developing a retirement plan in reverse order because I believe it is easier to understand the entire process that way, but I suggest that retirement planning should be a top-down process. In simplest terms, it goes something like this:

1. Write down the major things you hope to accomplish in retirement. Accomplishing these major goals constitutes what you would consider to be a "successful" retirement[5]. I want to maintain our standard of living. I want to live in Peru. I want to leave the family home to my children.
2. Identify the strategic objectives that would achieve your mission. If an important part of your mission statement is to never outlive a certain standard of living, for example, annuities, Social Security benefits and/or bond ladders might be your chosen strategies.
3. Review your mission statement and strategic plan every year and modify them if necessary when there have been major life changes.
4. Identify the steps you need to take in the coming year to progress toward the strategic objectives you just reviewed and perhaps modified. Decide if this the best year to buy an annuity or claim Social Security benefits, for example. As I said in Retirement Roulette, place your bets.

What if you have already retired and didn't do any of this stuff? 

Get started. It's never too late to plan.

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REFERENCES

[1] Retirement Income Industry Association (RIIA).



[2] A Mission Statement for Retirement, The Retirement Cafe.



[3] The Intersection of What's Desired and What's Possible, The Retirement Cafe.



[4] Retirement Roulette, The Retirement Cafe.



[5] A Model of Retirement Planning, Part 1, The Retirement Cafe.



[6] Retirement Decisions with Expiration Dates, The Retirement Cafe.