Friday, July 2, 2010

The Three Horsemen of Retirement Apocalypse

We have stated many times in past articles that the brain uses facts as factors, but makes decisions on emotion. This article will present some extraordinarily important facts for people approaching, or already in retirement. Unfortunately, the facts alone are unlikely to motivate readers to change their behaviour; for most of us, it generally takes substantial emotional trauma to compel us to change. For example, smokers may continue to smoke until someone close to them is diagnosed with lung cancer. Interestingly, it has been established that even doctors are vulnerable to this type of cognitive dissonance. To whit, the likelihood that a physician is a smoker relates directly to how much their individual specialty relates to the lungs. Respiratory and cardiovascular specialists are least likely to smoke, while psychiatrists and podiatrists are most likely.

In the same way, most investors will not come to grip with the new realities of retirement until it is too late. The investment industry spends billions every year to maintain the illusion of certainty about long-term market returns, and most investors buy into this because it supports their emotional need to feel like they are in control. As humans, we do not handle ambiguity very well, so most of us avoid it where possible, even when it means potentially sacrificing our future. It is not the policy of Butler|Philbrick & Associates, however, to tell our clients what they want to hear. There are thousands of Advisors across Canada who will be happy to accommodate you in this. Instead, we are committed to telling our clients the truth, so that we can make smart decisions today that provide the greatest likelihood of future happiness.

The 3 Threats to Retirement Success

In light of our continuing effort to promote a more scientific approach to managing wealth, this post will focus on the three biggest threats to retirement success. These threats are (drum-roll please):
  • The threat of inflation eroding purchasing power
  • The threat of living longer (or less long), than you expect
  • The threat of poor or negative investment returns, especially early on in retirement

Most investors are aware of these threats, but most Advisors do not effectively address the tug of war that exists between them. For example, most investors would avoid the stock market roller coaster in favour of safe bonds and cash, if they felt this solution would deliver retirement success. Unfortunately, retirees have to deal with the fact that safe assets like bonds do not effectively protect them against inflation. At the same time, stocks carry a significant risk of losses, especially over short time periods like ten years. Chart 1. shows that stocks have delivered between -6% and +20% over 10-year periods during the past 140 years. So what is one to do?

Chart 1. Annualized 10-Year Stock Market Returns, 1870 - 2010
Source: Butler|Philbrick & Associates, Shiller (2010)

Risk #1: Inflation

Inflation occurs when the price of goods and services increases slowly over time. The mechanism by which inflation occurs is actually subject to some debate, but this is less important to retirees. What is important is how inflation can impose significant restrictions on lifestyle over time. 

Inflation can be a difficult thing to wrap one's mind around, so examples are helpful. Postage costs are one good example: in 1950, a 1st class Canadian stamp cost 4 cents. Today, it costs 57 cents + GST to send a letter in Canada. This represents 4.53% per year in inflation over that time period. If we apply the same rate of inflation to a $1.00 bottle of Coke today, that same can would have cost 7 cents in 1950.

The chart below shows how the purchasing power of income declines over time due to inflation. Put another way, the chart shows how a fixed retirement income can purchase fewer and fewer more expensive goods and services. Note that $100,000 will only buy $70,000 worth of goods and services after just 10 years; purchasing power is cut in half after 19 years.

Chart 2. Purchasing power of $100,000 erodes over time due to inflation
Source: Butler|Philbrick & Associates

Most Advisors incorporate some sort of inflation forecast into portfolio return expectations when creating financial plans. This is better than completely ignoring the effects of inflation, but it ignores that fact that inflation also impacts the returns to other asset classes, like bonds and stocks. For example, bonds do especially poorly during periods of high inflation, so a high allocation to bonds 
would have very negative consequences should inflation accelerate higher. Conversely, stocks do very poorly in periods of negative inflation, or deflation, such as during the Great Depression when stocks dropped almost 90%.

Our methodology does not use a specific inflation forecast. Instead, we use monthly portfolio return numbers based on actual market returns that go back to 1870, and are already adjusted for inflation. This is an important difference, as this method explicitly incorporates the relationship between inflation and portfolio returns, rather than assuming that it doesn't exist. Traditional models assume that inflation rolls merrily along at 3% per year, even during the Great Depression. This assumption has serious implications for investors that are drawing retirement income.

Risk #2: Longevity

Longevity risk really refers to two related risks:

  1. The risk that you save too little, or spend too much, because you end up living longer than you expect. In this case, you run out of money before you pass.
  2. The risk that you save too much, or spend too little, because you end up living less long than you expect. In this case, you make needless sacrifices to lifestyle.

Traditional financial plans use a specific point estimate for lifespan; they usually assume death on a person's 86th or 91st birthday. This is tragically misguided however, as you can see from the table below. Table 1. shows the likelihood that a man, woman, and at least one person in a couple, will live to various ages, assuming that the person/couple has already reached age 65.

Table 1. Probability of Survival at Age 65
Source: The Society of Actuaries RP-2000 with full projection

You will note that the table indicates that 75 out of every 100 couples will see one person in the couple reach at least age 85; 50 out of every 100 couples will see one person live to age 90 or beyond
! With this knowledge, it seems foolhardy in the extreme to rely on a plan in which between 50 and 75 couples out of every 100 will run out of money.

If you are uncomfortable with a 50% to 75% chance of retirement failure, imagine instead being able to tailor your plan to minimize your chance of retirement ruin, while maximizing your lifestyle. Butler|Phlibrick & Associates applies a different approach that accounts for the wide range of possible lifespans, and their respective probabilities. Our approach enables clients to tailor their plan to accomplish their individual level of comfort and confidence. As an example, some of our clients are comfortable with a higher chance that they will run out of retirement funds before they pass. These clients may be able to accept as much as a 30% chance that they will have to dramatically cut back on their lifestyle in their later years, in order to maximize current spending. On the other hand, more conservative clients require near certainty that their retirement funds will see them through with comfort to the end.

Of paramount importance, our approach allows us to update clients on exactly how their spending and portfolio performance during each year has impacted their chances of retirement success d
uring annual review meetings. If markets have not cooperated, or if there was unanticipated spending during the year, we will discover that spending needs to be cut back, or portfolio risk needs to be adjusted, in order to move the plan back into an appropriate comfort zone. If on the other hand performance has been stronger than expected, clients may discover they have a surplus of cash. These fortunate clients have the option of maintaining their current standard of living, but enjoying a higher confidence in a successful retirement, or withdrawing a higher income to boost lifestyle expenditures. Image 1. below shows how retirement plans should be tracked over time to ensure clients remain in 'The Zone' to maximize their chances of balanced retirement success.

Image 1: Keeping clients in 'The Zone' during annual reviews

Risk #3: Poor or Negative Market Performance

You may have noticed that the first two risks are long-term risks. In the face of long-term risks like inflation, investors tend to behave like the proverbial frog in a pot of water that boils slowly. If you place a frog in boiling water, he will leap out quickly, grumpy but unharmed. However, if you place a frog in cool water and then boil it slowly, the frog will slowly die from the heat. In the same way, investors are unlikely to notice the effects of inflation over a period of a few years. Instead, they will wake up one morning many years from now to discover that their money only goes half as far as it used to. Perhaps they can no longer afford their membership at the golf course. Perhaps they are astounded at how much food costs, or how much of their monthly income is consumed filling the tank of their car with gas. Longevity risk manifests in the same way; slowly, and then all at once.

In contrast, market risk is often front and center in people's attention. They are bombarded with stock market prices every evening on the news, and every day in the papers. They receive a monthly statement and obsess over whether the value of their portfolio is higher or lower than in the previous month. Investors celebrate their peaks and grind their teeth at the troughs, mostly cursing the annoying roller-coaster ride of stock markets.

Strangely though most investors, and indeed Investment Advisors, fail to account for the volatility of stocks and bonds when they build retirement plans. Traditional plans are constructed with the inconceivable assumption that markets go up consistently every year. For example, many Advisors assume an 8% rate of return, and that investors will receive this 8% return every year, without fail. We have yet to meet an investor who has experienced the same return on their portfolio every single year. 

Rather, contemporary investors are used to seeing a wide range of returns, especially over the past ten years. Since June 2000, stock markets have lost over 25% of their value after accounting for inflation. This is catastrophic for people in or near retirement. Readers may be interested in reviewing some of our previous posts (click here for an explanation of our Gestalt Architecture), where we demonstrate how we strive to avoid these major long-term losses while still providing substantial exposure to growth assets.

Dr. Moshe Milevsky is a professor at York University School of Business, and sits on the boards of many Canadian and international life insurance companies. He may know more about retirement risks than any other person on the planet. In the following video, Dr. Milevsky discusses the importance of considering market risk, or what he calls 'Sequence of Returns Risk' when formulating retirement plans.

Video 1: Moshe Milevsky Discusses Sequence of Returns Risk


In his presentations, Dr. Milevsky often performs a thought provoking exercise that illustrates how important it is to address 'Sequence of Returns' risk in retirement plans:

Sequence of Returns Example:
  • Couple age 65 with $1,000,000 in retirement wealth
  • Couple withdraws $7,500 per month in income from the portfolio
  • Annual expected investment return of 7% after inflation

He then introduces the idea of a rotating sequence of returns, where investors receive 7%, -13%, and 27% returns in years 1 through 3, and then the series repeats for years 4 through 6, 7 through 9, etc. He then changes the order of returns to see how this impacts the age at which the couple will run out of funds. This is illustrated in the Retirement Merry-Go-Round below.

Image 2:The Retirement Merry-Go-Round
Source: The IFID Centre

There are 4 unique ways that an investor can experience the returns from the Merry-Go-Round. In the table below, we show how these 4 sequences of returns affect when the couple described above runs out of money (Ruin Age), and how the actual results differ from what would be expected from a traditional retirement plan (the +7%, +7%, +7% example below).

Table 2. Ruin Age Under Different Sequence of Return Assumptions
Source: The IFID Centre

It is important to understand that the couple receives a 7% average return under each of the scenarios in the table above. However, despite the fact that average returns are constant, the order of those returns can impact the age at which the clients run out of funds by as much as 14 years! Poor returns early on would cause the couple to run out of funds in their 81st year, while strong early returns would see them safely through to age 95. The sequence of returns in the example may seem extreme, but in fact the example assumes a volatility of 20%, which is comparable to the historical volatility of stock markets.

You may be wondering whether it is better to have higher returns, or a more predictable sequence of returns. The following example (Table 3.) shows that it is much more important to avoid poor returns early on in your retirement than it is to increase overall average returns. The investor on the right, which receives 8% average returns, but has poor early returns (-12% in the first year), runs out of funds before her 85th birthday. In contrast, the investor on the left earns 7% average returns, but her funds last through age 95 because of strong early returns (+27% in her first year).

Table 3: Is It Better to Receive Higher AVERAGE Returns, or Better EARLY Returns?
Source: The IFID Centre

Two things should be clear by now:

  1. It is extremely risky to rely on a financial plan that does not account for 'Sequence of Returns' risk 
  2. It is extremely important to avoid large investment losses, especially early on in retirement 

Fortunately, Dr. Milevsky has provided a framework that allows us to model the risk of poor or negative market returns. His model also enables us to account for the range of potential lifespans and inflation expectations. His framework differs from traditional financial plans in the following ways:

For illustrative purposes, we provide an example of our proprietary model, which is based on Dr. Milevsky's research papers, found here and here. Note the table of inputs in the upper right of the image. The 'Expected Real Return' input is the return we expect on the portfolio, after accounting for inflation. The 'Expected Portfolio Volatility' input allows the model to account for 'Sequence of Returns' risk, while the 'Median Remaining Lifespan' input is related to longevity risk.

Image 3: Sample Sustainable Income Model with Confidence Interval
Source: Butler|Philbrick & Associates

So what happens when we plug some numbers into our model, using assumptions based on actual market returns, and including very conservative fees? The chart below shows the safe withdrawal rate from an all-stock retirement portfolio assuming 4.6% annual average returns (see posts here and here for why we chose this return), and assuming 0.5% in management fees (about what you would pay for a diversified basket of ETFs if you were to manage the portfolio on your own).

Chart 3: Safe Rate of Withdrawal for A Diversified Global Stock Portfolio
Source: Butler|Philbrick & Associates

The chart above demonstrates that, if one were to create a pure diversified global stock portfolio through ETFs, and manage it on one's own, current assumptions would provide for a safe income of 3.1% of current portfolio value. This means that, for every $1million in portfolio value, an investor can take $31,000 per year from the portfolio, adjusted each year for inflation. This is interesting, but unrealistic as most investors would, quite rightly, feel that a pure stock portfolio is too risky in retirement. So what happens if we invest in a balanced portfolio, with 50% stocks and 50% bonds (See Chart 4.)?

Chart 4. Safe Rate of Withdrawal for A Balanced Portfolio
Source: Butler|Philbrick & Associates

Interestingly, the model arrives at the same 3.1% safe withdrawal rate for a balanced portfolio, despite significantly lower expected returns of just 2.18%. This is because we have reduced our 'Sequence of Returns Risk' input by almost 50% by introducing a 50% bond allocation, because bonds are generally much less volatile than stocks. This underlines the importance of accounting for sequence of returns risk, or the risk of poor returns early in retirement.


We hope this article has helped to drive home the importance of explicitly accounting for all three of the major threats to a successful retirement. To reiterate, a realistic and useful financial plan must account for the following three risks:

  1. The risk that inflation erodes purchasing power from the portfolio over time 
  2. Longevity, or the risk of living longer, or less long, than we expect 
  3. 'Sequence of Returns Risk', or the risk of poor or negative returns early on in retirement

Most financial plans today do not account for the wide range of possible outcomes in either of the above variables. Please visit our web site to see how our Gestalt Architecture can deliver higher confidence, flexibility, and a substantially better lifestyle in retirement.