Tuesday, June 26, 2012

Book Review: Moshe Milevsky's The 7 Most Important Equations for Your Retirement


With The 7 Most Important Equations for Your Retirement, Moshe Milevsky has written in the style of my favorite genre of book about my favorite research topic. It's fertile ground for me to like the book.

About the genre, I like reading about the history of people and ideas who've shaped our modern world. You can see this approach in books such as Robert Heilbroner's The World Philosophers, Peter Bernstein's Capital Ideas, Justin Fox's The Myth of the Rational Market, Niall Ferguson's The Ascent of Money, countless books by Bill Bryson including, in particular, A Short History of Nearly Everything, as well as television series such as James Burke's Connections. I really have a soft spot for these sorts of works.

Though it would be nice to see what Bill Bryson could have done with the same source material, and comparing the biographical sketches about Irving Fisher presented by Justin Fox and Moshe Milevsky shows the some of the missing potential for really helping us to feel a connection to life and times of the thinker, I do think that Moshe Milevsky pulled off a really difficult feat. That is, he wrote in an entertaining manner about these historical figures in a respectable way. This is an extra special feat for Milevsky, because he is really showing his versatility by branching off to a new style of writing. Even if it hadn't worked, he can always fall back on being the world's leading researcher and authority on retirement income strategies.

The book works very well, building up the intuition behind key results, and culminating in a chapter which essentially provides the intuition for one of Milevsky's important research papers, "A Sustainable Spending Rate without Simulation," from a 2005 issue of Financial Analysts Journal. We learn about present value analysis and calculating sustainable spending with a fixed return from Leonardo Fibonacci, and then about adding in the randomness and uncertainty about our remaining lifespan, but how that randomness follows a predictable pattern observed by Benjamin Gompertz. Andrei Kolmogorov further teaches us about what to do in the case that market returns are also volatile and random. We learn how to calculate the value of a lifetime of annuity payments with the work by Edmond Halley, and how to calculate the current cash value of a life insurance policy with the work of Solomon Huebner (who also brought us the idea that life insurance should be used to protect the value of our human capital). Paul Samuelson teaches us how to determine our stock allocation, and then answer depends on our holdings of human and financial capital, our expectations about future market returns and volatility, and how we feel at a gut level about fluctuating market returns.

Milevsky also has a chapter on the proper spending rate based on the work of Irving Fisher, which is of special interest to me as this is where I am personally doing research these days. Just a note, Milevsky must have ran out of sugar for his Cheerios (and I don't mean the honey nut kind) the morning he wrote this chapter, as he is none too kind to the Journal of Financial Planning, referring to it first as a "trade magazine" (page 81) and then as a "rather obscure journal" (page 82). I don't think that's fair. Certainly, the JFP has aspects of a trade magazine, but it's "Contributions" section at the end does provide proper peer-reviewed research articles. The journal may not have much reputation with academics, but it provides an outlet for quality works and is a widely read and influential publication. Milevsky published several articles there as well, including an influential 2003 article with Peng Chen on allocating between annuities and mutual funds. This section also has typos, as unless Milevsky is back from the future, Bill Bengen didn't write his article more than 20 years ago (it was 1994), and at the end of 30 years you'd be left with zero in the worst case scenario, not on average.

Back to the story, though. I've said before that Milevsky is The Simpsons of retirement income research, as any idea you can think of has already been investigated by Milevsky. With Fisher, he describes his idea of longevity risk aversion, which provides a good explanation for why the 4% rule is not a good baseline retirement income strategy. Working with Michael Finke and Duncan Williams, I like to call this same idea "spending flexibility." We wrote an article about that in... naturally... the Journal of Financial Planning. I also wrote a blog post "Is it Optimal for Retirees to Plan for Reduced Spending with Age" which provides a discussion of these issues and includes this figure:


To make a long story short, you have to be extremely inflexible with your spending or extremely averse to outliving your wealth to prefer a strategy of constant spending over retirement. Generally, constant spending will force you to make too much cutbacks on spending in early retirement to allow for the same spending much later on when the probability of survival is quite low. As Milevsky adds, if you are really so inflexible then you should probably use an immediate annuity. That eliminates your longevity risk.

Milevsky's book provides fresh insights about these and a host of other issues, and I think it makes for good summertime reading for those interested in retirement income. It is a pretty short book. Maybe I'm finally learning how to read faster or something, because I got through the book in a couple of hours despite thinking that I did pay pretty close attention to what I was reading.