A couple of years ago, I wrote an article about your retirement cistern. People occasionally bring that article up as having had an influence on their thinking, so I thought I would return to the subject.
A picture is worth a thousand words. I recently hired an illustrator to create an image of the retirement cistern as I see it. Here is the picture:
Essentially, all strategies for financing retirement -- even those as philosophically different as maximizing capital vs. maximizing income rights -- use the same "plumbing." Your assets are in the cistern. For retirement, there are two goals:
- The cistern must fund your retirement adequately.
- The cistern must never go empty. In fact, it must never get even close enough to empty that you worry about it or lose sleep over the possibility.
There is continual change in your cistern. It is dynamic, which is why I prefer this image to the more static "nest egg." The cistern's contents expand and contract throughout your life, both before you retire (your accumulation years) and after you retire (when you are living off of the cistern).
Let's examine the cistern system. The numbers correspond to the numbers on the diagram.
I mentally flow every asset into my cistern, even cash (such as Social Security) that really is not saved at all but simply goes to spending money.
What else is in your cistern besides cash flows? All your assets: Your savings; 401(k); house; real estate; stocks; dividends; "dividend rights"; salaries; royalties; Social Security; pension payments; annuities; bonds; interest; "interest rights"; inheritances; the contents of your wallet; etc.
The reason that I visualize cash flows such as Social Security payments as flowing through the cistern, even if they remain as cash and flow right out again as spending money, is that this puts all assets on an equal footing for analysis. The value of income rights can be directly compared to the value of capital, for example.
Say someone maximizes income during their accumulation years by loading up on dividend-paying stocks, then lives off the income in retirement. We can picture the dividend distributions as flowing into the cistern through pipe #1, but they flow right back out through pipe #3. Such a person might say that she is not making "withdrawals" if they just take the dividends directly, but she really is, because if not taken immediately as cash, the money would stay in the cistern. The same reasoning applies to pension or Social Security income. You may take it directly, but it is helpful to view it as flowing into and out of the cistern. It provides a better picture of the dynamics of retirement funding.
2. Cistern Contents
The "pie chart" at the top of the water level in the cistern represents your various assets. It's similar in intent to the familiar MPT pie charts used to represent asset allocation. You can visualize each slice any way you want, depending on how you think about asset classes. You might be tempted to segregate out assets that would not normally be considered "investments," such as your car or furniture. But let's face it, some people get into situations where, to fund retirement, they sell things that they never would have thought of selling when they were younger, like family jewelry or old Heisman Trophies. It happens. That's why I put everything in there.
One asset deserves to be called out for special attention: Cash. In my humble opinion, every asset can be placed into two broad categories: Cash and Not Cash. Anything that is not cash has a market value of some kind. You might think of your cistern as a snapshot on any given day of your net worth. Some of it is cash. Everything else is "marked to market." The importance of this will become clearer later.
Obviously, the outflows pipe represents cash and other assets leaving the cistern.
You have considerable control over outflows. In your accumulation years, you can select a savings level. This decision (or series of decisions made over decades) is where many people end up in bad shape for retirement. What's in their cistern is the end result of years of decisions about what to spend and what to save. We read about the average retiree being woefully short of assets for retirement. While obviously some people have an easier time accumulating assets during their accumulation years than others, most people have some control over their lifestyle and spending. Decisions made in their 20s can have profound effects on their ability to fund retirement in their 60s.
Outflows are also at least somewhat controllable after retirement. Someone who spends his Social Security check upon arrival must acknowledge that if he did not spend all of it, he could leave the balance in his cistern for a future day.
Whether before or during retirement, outflows represent spending. Throughout life, everyone must spend on the necessities of living. "Necessities" are often subjective. Some people consider their iPhone and its data plan to be necessary to their life; others do not. I like to get a mocha from Starbucks each morning; it's almost a necessity for me. Others would laugh at that as an extravagance. Reasonable minds can differ.
Some people raid their cisterns prior to retirement to cope with emergencies, or to make large purchases. Taking out a home equity loan to buy a boat, for example, changes the level of your cistern in at least two ways: The cash you receive for the loan decreases the net market value of your home. The payment obligations that you assume are a net negative to your cistern level. But the value of the boat enters your cistern, where its value is determined by the market for boats.
Investing is spending. You pay money to a seller for, say, some stock. You have converted cash to a non-cash asset. The complete picture is a round-trip, as it was with the boat: An outflow of cash to the seller is exchanged for the stock. The stock comes back in through pipe #1 and resides in your cistern as a capital asset. Its capital value is now determined by the stock market. It also bears dividend rights that have a value, which raises the level in your cistern.
Running everything through the cistern helps clarify the debate between income-maximizing strategies and capital-maximizing strategies for funding retirement. In both approaches, the individuals are betting that their chosen strategy will provide sufficiently for retirement and that their cistern will never run dry. So the cistern analogy is strategy-neutral and allows for more reasoned comparisons of strategies.
4. Mr. Market
Anything that is not cash has a value that is determined by a market. Mr. Market controls those values. You have no control over them.
As you can see, Mr. Market has his hands ready to twist thermostatic controls that can either heat up (expand) or cool down (contract) the values of your assets. I have only shown a single Mr. Market here. But as noted in my first interview with him, he and his extended family control all markets:
My family controls everything. Interest rates, the bond market, the stock market, everything. We love to watch you humans react to what we do.
So the level in your cistern constantly goes up and down as a result of the heat and cold applied by Mr. Market to the assets that you own. So that applies to:
- Stocks, ETFs, mutual funds, and the like
- Your house
- Personal possessions -- that boat, your car, furniture, jewelry, collectibles, junk that you want to sell on Craigslist
- Investment real estate or a small business you may own
So the level in your cistern rises if the cumulative net market value of your various assets rises, but it goes down if the net market value of the assets declines.
Asset declines are a major risk to retirement. During the 2007-2008 financial crisis, some people were forced to delay long-planned retirements, because the levels in their cisterns went down so far that the sufficiency of their assets to fund retirement -- which had seemingly been enough -- suddenly collapsed by 30% or 40%.
Everybody's cistern has a leak: Inflation. That is a continuing outflow, sometimes rapid, sometimes slow, that insidiously reduces the value of the contents of your cistern. You don't have much control over inflation.
Some investors tend to forget about inflation. It's not as if we receive a bill for it every month. But it is always there, leaking out the contents of your cistern and placing more pressure on the remaining contents to fund your retirement.