In my last post, A Model of Retirement Planning, Part 1, I suggested that "The challenge of retirement income planning is to best position our available resources to maintain our desired standard of living throughout an unpredictable length of retirement with somewhat-predictable future income but largely unpredictable future expenses."
Let me break that down. "Best positioning our available resources" means placing our best bets because retirement is unpredictable, and we can't know in advance which strategy will outperform the others. "Maintaining our desired standard of living throughout retirement" is typically the retiree's first goal, but it may not be the only one.
I began building a high-level view of retirement finance and the main point of that post was that the three most critical factors of retirement finance are lifespan, income, and spending and all three are largely unpredictable.
Once we lay out an estimate of the cost of the standard of living we desire in retirement (the expenses), estimate the amount of income we might be able to generate from all available wealth resources, and choose a life expectancy for planning purposes, there will be a large range of potential retirement strategies still at our disposal. Different households with virtually the same expected income, expenses, and lifetimes may plan very differently because their risk tolerances differ. We need to add risk tolerance to the model.
The primary risk of retirement is that of losing our standard of living. (Notice I didn't say the primary risk is depleting our savings. It's possible to deplete our savings - or even to not have savings - and still maintain our standard of living. The latter is more important.)
Risk tolerance refers to how much risk we can tolerate emotionally and psychologically. Nearly everyone is risk-averse, meaning that, when exposed to uncertainty, we attempt to reduce that uncertainty. But, some of us are more risk-averse than others, and some are more risk-tolerant, so we tend to choose whatever strategy "lets us sleep at night."
Given identical expectations of future expenses and income, two households might choose very different retirement strategies because one household is significantly more worried about the prospects of losing their standard of living than the other. Generally, the higher standard of living one chooses, the greater the risk of outliving savings.
Because income can be a range and not a single amount and expenses are a range and not a single amount, there is a budget range within which we can plan. Say we expect annual expenses to range from $30,000 to $35,000 and income to range from $40,000 to $42,000. We can take some risk and plan on $42,000 of income and $30,000 of expenses, be conservative and plan on $40,000 of income and $35,000 of expenses, or choose something in between.
The amount a household will spend in retirement depends somewhat on how much risk they are willing to accept that they will run short of money late in life. Consequently, risk tolerance is a key factor in the basic retirement finance model.
A household that finds that it doesn't have enough expected income to pay for the expected cost of their desired standard of living has three levers to pull in any combination. The household can reduce expenses, increase income, or take more risk of a lower standard of living late in life.
First, we can lower our expenses, reducing discretionary expenses like travel for example, or accept a lower standard of living. We might relocate to someplace where our desired standard of living is less expensive. We can also lower expenses in retirement by working longer and thereby shortening the length of our retirement.
Second, we can increase income by delaying retirement and working and saving longer (the most effective strategy). We may also be able to increase income through part-time employment. We can increase income by delaying the claiming of our Social Security benefits. We may even increase it by changing our funding strategy. A life annuity, for instance, might generate more lifetime consumption than investing in stocks and bonds.
Third, we can spend more early in retirement if we are willing to accept more risk of a lower standard of living at the end of retirement. One way to do this is to bet a lot on the stock market. If the market performs very well during our retirement, we will have more money to spend. Unfortunately, if the market performs only moderately well or poorly, we will have less to spend later in retirement. Many people seem willing to make that bet.
We can also take risk with our life expectancy. Some people bet that they won't live a long life and they increase spending accordingly. That seems like a risky bet for a healthy person, the downside being a low standard of living in old age, but people tell me frequently that they "won't live past 80." I have no idea how they know that. Once again, this allows us to increase spending in early retirement at the risk of a lower standard of living late in retirement.
Regardless, if you are willing to take more risk of a lower standard of living in late retirement, of not reaching late retirement, or of not encountering many large, unexpected expenses, you can increase your spending in early retirement. Spending won't depend solely on your income and expenses, it will also depend on your risk tolerance.
Imagine two married households with identical financial resources on the eve of retirement, but with vastly different risk tolerances.
The risk-tolerant household can assume that they won't live much past median life expectancy, that they won't need long-term care or have other large unexpected living expenses and that the market will return 8% after inflation throughout their retirement, so they invest most of their savings in a stock and bond portfolio and spend 4% of it each year.
The more risk-averse household will assume the husband will live to age 90 and the wife to 100. They will work as long as they are able and delay claiming Social Security benefits. They will purchase long-term care insurance and use their savings to purchase a life annuity so they maximize consumption and avoid market risk entirely. They will relocate to an area with a lower cost of living. They will spend less early in retirement and hold some back for a possibly long retirement.
Risk tolerance is critical to retirement planning, but can vary over time with risk capacity and risk perception.
The risk-tolerant household will feel comfortable spending significantly more in early retirement than the more risk-averse household, which is to say that they will choose a higher standard of living with a greater risk of dying broke. If the more risk-tolerant household is too conservative, they will have a lower standard of living than they would have otherwise had. If the more risk-tolerant household loses the bet, they will have a higher standard of living in early retirement than in late retirement.
One last important point about risk tolerance should be considered. We might imagine that risk tolerance is constant for a given retiree, but that isn't always the case. Like most other key factors of retirement planning, risk tolerance can be unpredictable. It can change situationally or with age.
William Bernstein has written often about investors who feel quite risk tolerant during a bull market only to find during a market crash that they fear losses much more than they expected. He recently wrote that investors who take measure of their risk tolerance during good times should probably halve it. It is difficult to predict how you will feel in a gut-wrenching crash like 2007 until you have lived through one or two.
Research differs on the correlation between age and risk tolerance. This 1997 study (download PDF) concluded that "Risk tolerance increases with age when other variables are controlled", while a 2010 study reports that "Risk tolerance generally decreased as people age." In both cases, risk tolerance changed significantly with age, but the direction of the change differed.
Interestingly, the study that showed older people become more risk tolerant concluded during the Tech boom and the study reporting that risk tolerance generally declines with age concluded just after the Great Recession, consistent with Bernstein's observation.
Regardless, the important point for a retirement model is that risk tolerance is critical to planning but it can vary over time as our risk capacity and perception of risk change. Like most critical factors of retirement finance, it isn't something we can establish at the beginning of retirement and assume will remain unchanged. And, because we frequently can't predict our future risk capacity with any certainty, nor our future perception of risk, our risk tolerance over time can be somewhat unpredictable.
To plan for retirement, we need to estimate future expenses, estimate future income, establish a life expectancy for planning purposes and understand how much risk we are willing to take with those estimates. We add the risk of losing our standard of living to the basic retirement model as follows.
"The challenge of retirement income planning is to best position our available resources to maintain our desired standard of living throughout an unpredictable length of retirement with somewhat-predictable future income but largely unpredictable future expenses. Retirees can choose to spend more or less, within the range of available resources, depending on their risk tolerance. Retirees with high risk tolerance can increase spending in early retirement and consequently increase the risk of a lower standard of living in late retirement while more risk-averse retirees can decrease spending in early retirement and consequently reduce the risk of a lower standard of living in late retirement."
Once we have an estimate of expected retirement income and expenses, choose a "comfortable" level of the risk of losing our standard of living late in life, and choose a life expectancy parameter for planning, we have gone a long way toward bounding a set of retirement finance strategies appropriate for our household. Choices of details like asset allocations, withdrawal rates, construction of a safe floor portfolio, and annuity considerations will flow from these basic decisions.
Retirement planning should be a top-down process, rather than choosing from a menu of strategies.
The previous paragraph has significant implications for retirement planning. It suggests that planning should be a top-down process driven by the choices identified initially within the high-level model, rather than a process of choosing from among a menu of all possible strategies. By identifying the key factors first, we immediately eliminate many inappropriate or irrelevant strategies from consideration.
There is at least one more important top-level characteristic of retirement finances our high-level model must incorporate - retirement's "chained state" nature. Retirement planning isn't a one-time decision. It's a series of moves in a sequential financial game. (A little more game theory.)
I'll get to that next time.