Retirees on a preset spending schedule do not go to the ATM one day to find, to their shock, that they just outlived their assets any more than drivers continue blindly into the desert at the same speed until they run out of gas. People adapt to changing circumstances.
And yet financial advisors today are using, and unconsciously abusing, fashionable "retirement ruin" simulation software that miscommunicates the viability of their clients' retirement plans - either falsely reassuring them or needlessly scaring them.
So argues a genuinely seminal essay titled "It's Time to Retire Ruin," to appear in the March/April issue of the CFA Institute's Financial Analysts Journal but which the elite investment analysts association has made available online.
Written by Moshe Milevsky, perhaps the foremost authority on the intersection of wealth management and retirement income issues, the paper boldly challenges the reigning paradigm in professional retirement advice and proposes a new advice model that clients are capable of understanding.
The groundbreaking contribution - written with a wit and clarity usually foreign to academic journals, it should be added - starts with the notion that today's trendy financial advice on "shortfall probability" obscures a lack of consensus on acceptable levels of risk in retirement income planning.
Does A Less Risky Portfolio Really Enhance A Retiree's Finances?
Advisors use financial planning software that generates scary statistics about retirement ruin. Does choosing an option that reduces the probability of failure by 1% really enhance a client's personal finances or might it unduly reduce his financial welfare?
"Remember that the opposite of failure is success. A 10% shortfall is a 90% probability of achieving your goals," writes Milevsky, a professor of finance at York University's Schulich School of Business, who goes on to cite "compelling theoretical arguments… suggesting it's optimal to exhaust your investment portfolio and live off pension income by some advanced age."
If this theory is correct, he adds, "ruin should not be feared."
Is An Aggressive Allocation Worth The Extra Risk?
Beyond the issue of selecting a 10% rather than 9% shortfall probability, Milevsky wants wealth managers to know that one can have, say, three very different portfolios - all with the same spending rate and shortfall probability though with differing risk/return probabilities.
It is, therefore, incumbent on financial advisors to understand that "all 10% shortfall probabilities are equal, but some are more equal than others," Milevsky writes, paraphrasing George Orwell.
In other words, advisors must know that a higher stock allocation can go far toward reducing the probability of retirement ruin - at least from the standpoint of the advisors rather unemotional software program - while also potentially imperiling the clients and their heirs.
Thus, advisors would do well to bear in mind both the legacy clients want to leave their children and its flip side - the probability the clients' children will have to bail them out - when choosing among conservative, balanced and aggressive investment options of equal shortfall potential.
Are Statistical Programs As Reliable As They Seem?
Another difficulty inherent in the simulation programs advisors use is that the data is woefully inadequate. As Milevsky wryly observes, "…a 65-year-old retiree can look forward to 500 months of retirement. And yet at best, we have 2,000 months of reliable data on asset class returns."
And besides a limited past from which to draw, what assumptions does the advisor's software make about the future?
"Your black box is subliminally forecasting how interest rates, stock prices, inflation and mortality will evolve over the next 50 years and how they will co-vary with each other," Milevsky warns.
This problem is not merely theoretical. As Milevsky, a veteran insurance industry consultant, goes on to say: "I have observed some ridiculous parameters hardwired into retirement simulation engines based on the mythical long run -- for example, cash that earns 3%, bonds that are expected to return 6% when yields to maturity are 4% or my favorite sin: the agnostic absence of correlation assumptions between stocks and bonds."
That is to say, the simulation spits out authoritative-looking portfolio optimizations and pretty pie charts, thus instilling a confidence that is illusory and dangerous.
Stacking The Deck In Favor Of Insurance Products
Also dangerously illusory is the aura of complete reliability that hovers around insurance products. Annuities touting "100% guaranteed income for the rest of your life as long as you live" position these products as risk-free.
"But as every insurance product marketing brochure -- whether for a simple life annuity or a complicated variable annuity (VA) with a living benefit --reminds us (albeit in 7-point font), all guarantees are subject to the claims-paying ability of the underlying insurance entity." Milevsky acerbically adds that investors need to read the "2,000-page prospectus" to find out what factors might limit how the company pays claims.
What's more, insurance companies themselves "face a ruin probability" and "income is rarely 100% guaranteed in real after-inflation terms -- which are the only dollars I can consume," he adds.
Despite these limiting factors, wealth managers often stack up the insurance product's 100% guarantee versus an "85% or 77% or 51% value of a systematic withdrawal plan (SWiP)" as though they were apple-to-apple comparisons.
"Ruin probabilities are being used to give insurance products an unfair advantage," Milevsky laments.
An Intuitive Way To Define And Calculate A Retirement Portfolio's Longevity
With imperfect products, inadequate simulation tools and antiquated conceptual models, advisors are bound to ill-advise their clients. Here then is where Milevsky offers his most valuable, and original, insights. The retirement quant builds on Fibonacci's famous equation - determining how long money can last in the face of constant withdrawals and interest payments - in an effort to help wealth managers help their clients intuitively grasp the longevity of their portfolios. (Advisors are advised to refer to the original article for the equation - and nuances in the author's arguments.)
Milevsky's premise is that advisors must keep things simple, so he proposes equating the longevity of the portfolio with the client's life expectancy, a number that any retiree can get a hold of simply by asking his or her physician.
Next, his equation incorporates just three variables that are all easy to grasp. The first is the number of dollars (rather than a percentage, which is less real to most people) that the client expects to withdraw annually. Second, and also simple, is the total value of the client's nest egg.
The third variable is the portfolio's annual growth rate. This is the key to focusing the conversation with the client because it determines how much volatility the client will experience and how long the portfolio will last:
"The doctor gave you 20 years of longevity…and your portfolio has only 14 years of longevity…There is a mismatch. Tell your client to do something about it," Milevsky writes. In other words, Milevsky's new paradigm helps wealth managers help clients decide - in a manner they can easily grasp - how much they should save, what they can spend and when they should retire.
More sophisticated clients may desire more complex modeling based on the addition of dynamic inputs such as changing health conditions, spending needs and sequence-of-returns issues. Nevertheless, Milevsky argues, a simpler static view of the portfolio must precede any stochastic view if the advisor is to succeed at educating clients on the key factors influencing their money's longevity.