I've been auditing a Yale course on global financial crises with Tim Geithner and Yale prof. Andrew Metrick.
The critical issue for retirees is the impact of a financial crisis on the savings they need to support their retirement, particularly if they have a significant amount of their savings invested in the market exposed to market risk.
Just as high finance is household finance writ large, with income and expense, source of funds, and a balance sheet, a global financial crisis is also not unlike a household financial crisis -- just with many more players involved. If we use the household as an example, perhaps it becomes easier to understand how a global crisis develops.
It starts often enough with exuberance -- feeling good about a new job, a big raise or bonus, maybe winning the lottery. It looks like pretty smooth sailing, so exuberance leads to relaxed spending. Relaxed spending leads to more spending and then to leveraging, borrowing to buy more now which you intend to pay back later.
I'm reminded of a story a friend who worked for Nationwide once told me. When an agent joined the team, his boss would encourage him to go out and buy a new car, a fancy one -- back in those days, a big Caddy. The idea was that the big car payments would keep him motivated.
At some point you find yourself in over your head, and when something goes a bit awry, you get caught short. Then some big unexpected things start piling on, and you spiral down and down.
This is how it works for nations and global markets as well, except maybe for the big Caddy -- though there's plenty of money sloshing around in the global markets to keep speculators focused, and governments buy plenty of chrome-plated junk with taxpayer money.
So markets go through a period of exuberance where investors bid (spend) up the value of assets. They leverage their investments to increase gains. Then something goes awry, and some are caught short and some selling happens. A few more shocks and the downturn (correction) begins to turn into a panic, as more and more sell as values fall. There's a rush to the exits. Last one standing will have trouble finding a buyer at anything better than a fire-sale price, at a deep loss.
This cycle happens over and over again, with differing exuberances as the "bubble" moves around -- housing, tech stocks, currency, gold, emerging markets. But when the music stops playing, everyone runs for the exits -- all the exits, as financial contagion drags down everything. If you study even a little market history, you know this has been happening over and over again for hundreds of years.
Why does this keep happening? Exuberance creates its own validation, the sense that this time is different, and that any risk is somewhere else for someone else to endure, but not me. A long period of steady, tranquil growth heightens both the complacency and the risk that the uphill trend will overheat into an irrational mania.
And there's the added impact of moral hazard, like advisors who push products they are well paid to sell to investors who would be better off putting their money more safely elsewhere. The mania can drive some fraud into the mix as well, like toxic mortgage-backed securities. Meanwhile, the massive expenditures on branding in the mass media -- television, internet, print -- create a relentless marketing drumbeat that investing with our smart advisors is the best thing you can do with your money.
Even if we are not invested in the markets, we are participants in the global financial system the markets support. When the markets collapse, the system reels and even those on the sidelines suffer job loss, dried-up credit, low interest rates for savers, losses for investors, recession, deflation, hyper-inflation and even financial depression.
Those approaching retirement are even more vulnerable. They can ill afford to be caught short and overextended in the bubble du jour that's beginning to pop.
Consider a soon-to-be-retiree with $1 million in savings who is 50% invested in stocks. The Milevsky funded-ness formula tells us that at today's low risk-free real return rates (1.31% after inflation), this soon-to-be-retiree can take about $42,000 a year from savings, and her savings will last about 28.5 years, which is the near edge of a prudent retirement time horizon. So if the retiree has $25,000 in Social Security benefits, she has about $67,000 in reasonably safe and reliable annual income for all her living expenses, including taxes.
Then England votes itself off the European Union island, oil stops moving through the Strait of Hormuz for some reason or another, and Japan jacks up its debt to 400% of its GDP. Or maybe an earthquake decimates Silicon Valley.
Whatever it is, something happens. And her stocks drop 50% just as she begins taking annual withdrawals from savings. So her million dollars is now $750,000 and Milevsky tells us she can now only take $31,000 a year from savings if it is to last 28.5 years, and that by withdrawing from the reduced portfolio, it will be that much harder for it to grow back to its previous balance.
Instead of $67,000 in annual income, she now has $56,000 a year to live on, a 16.4% pay cut, possibly forever.
In other words, a major market drop can result in a permanent impairment of income for someone who has a high market exposure and not much cushion -- someone much like today's typical affluent retiree with a million in savings.
Financial crisis is not the only or even the worst risk retirees face, but it is the central risk for a retiree with significant investments in the stock market. And unlike life shocks and major unexpected expenses which can dramatically drain down savings and even lead to bankruptcy, stock market risk is something that you can control.
We can control market risk by finding the risk capacity on your household balance sheet. That's the cushion or the amount of your savings above the Floor needed from savings to cover the present value of your lifetime expenses. We call this risk capacity your Upside. If we limit your exposure to market risk to your Upside risk capacity, we can protect your Floor, the amount of your savings needed to support your lifestyle throughout retirement.
We can't prevent financial crises and the risk of loss in the markets. But we can prudently limit how much market risk you take as a retiree based on the strength of your household balance sheet -- using your balance sheet math (not investment theories or arbitrary formulas to set your Upside allocation) with a solid Floor as the foundation supporting your lifestyle throughout a hopefully long and productive retirement.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.