Retirement Risks
This week I've made two posts about different ways to think about risks in retirement. The first post ("Retirement Risks: It all starts with Longevity") is at Forbes and treats longevity risk as the overarching risk facing retirees, since the longer retirement lasts, the more exposed retirees are to other risks. The other main categories I described there are related to macro/market risks, inflation risk, and personal spending.
The second post ("Breaking down retirement risks") is at RetireMentors. In this post I distinguish risks with regard to whether they are risks to the asset (wealth) or liability (spending needs) side of the household balance sheet, and whether they are macroeconomic (impacting everyone simultaneously) or individual specific.
A very helpful big picture view of retirement risks. I think we sometimes tend to overly focus on market returns vs spending (e.g. sustainable withdrawal rates). Another example of public policy risk not specifically mentioned is the looming crisis in public pensions. Millions of retirees are going to be affected by uncertain, but probably painful, changes coming in the next decade. Warren Buffet alluded to this a few weeks ago, Here's one link to his comments.
ReplyDeletehttp://www.businessinsider.com/warren-buffett-warns-of-public-pension-crisis-2014-3
That's a good point about public pensions and the uncertainty creates for a part of the balance sheet that is generally treated as a safe and secure asset.
DeleteAll of the listed risks are important and must be considered. It does no good for an individual to generalize any or all risks; instead the individual must evaluate and weigh all possible material risks in the context of the individual's specific financial, life-style, and psychological picture. No formula approach (of which there are many) can do the job for the individual. No material risk can be ignored; the individual must attach probabilities to each risk and evaluate base case and worst case scenarios and the resulting spending parameters. An investment/spending plan must then be established in the context of these spending parameters. The financial, etc. picture and spending parameters must be updated on a regular basis, and changes made to the plan as necessary. Nothing short of this will do IMO.
ReplyDeleteI'd love to see something that ties consideration of these risks to decisions about a retirement financial plan. Not sure exactly what, other than discussion, examples, or studies of some kind. Seems like an area ripe for research. I like John Craig's probabilistic approach above, which I've crudely tried to incorporate in our plan (Expected risk = estimated NPV of event impact x estimated event probability). It's helped us prioritize possible risk mitigation strategies.
ReplyDeleteGrinder, what I do is model the amount available for me to spend each year until death at age 100. The model computes a base case inflation-adjusted annual available spend using after-tax fundamental returns. With this model it is then easy to input reasonable worst case scenarios (Bernstein's deep risk -- inflation, market). Within these parameters it is easy to insert other risks in whatever year deemed appropriate. I find that comparing such actual and computed annual available spends in my specific situation greatly simplifies my spending and investment decision making.
DeleteDon't look for research to be of much help in assessing risk probabilities for you. Good judgment is required to determine what risks are relevant and material in your specific case.
The model described above is described in an article here: http://johndcraigaas.blogspot.com/
DeleteWade's discussion of risk maps very closely with the RIIA's risk exposures in retirement, which drive the Retirement Policy Statement allocation to upside/floor/longevity/reserves as a way to allocate capital to the risk exposure of a specific household--all part of the Retirement Management Analyst (RMA) planning process. -- mlonier@gmail.com
ReplyDeleteJust to follow up, Michael Lonier's comments were completely unrelated to a separate discussion I had yesterday with RIIA about this diagram. Michael was trying to provide more information to Grinder12 about how to learn more with tying these risks into a retirement plan.
DeleteThe third spoke of RIIA's Retirement-Management and Retirement-Income Advisory Process is "Retirement Risk Mapping."
You can, indeed, read more about this topic in the The Retirement Management Analyst (RMA) Designation: Curriculum Book for RMA Candidates.
Hi Wade--
ReplyDeleteSomewhere in your model, it would be good to include behavioral risks (e.g., emotional buying or selling of investments, excessive reliance on market timing, buying or being sold inappropriate investments, refusal to adjust spending/investments even when the data indicate it’s warranted, etc.) and cognitive risks (e.g., being too conservative or speculative, not paying attention to fees, being off-base about how much one really spends, having a distorted perception of one’s own risk tolerance or actual rates of return, not doing one's homework re: investments, etc.). Parameter estimation and modeling errors also belong in risk mapping (e.g., mis-estimating living costs in retirement or their relationship to the CPI, mis-estimating the long-term CPI or the relationship between the CPI and medical inflation, mis-estimating how discretionary spending will change later in retirement, mis-estimating how public policy like tax rates and Medicare might change, etc.).
If you want to be really expansive, you might think in terms of a risk + opportunity model. The basis for this could involve not only asking "what could go wrong?" in terms of retirement investments and spending, but "what could go right?" In the latter category, the possibilities are endless (e.g., SS benefits could be adjusted according to a more generous CPI-E, market returns could be great for many years, new drugs could be invented that square the mortality curve somewhat, family members might become wealthy and readily offer financial support rather than become a financial drain, and so on....). Kepner-Tregoe offers a simple technology for assessing potential problems/risks as well as opportunities, evaluating their likelihood, brainstorming and narrowing down preventive/promoting factors, and making informed decisions accordingly. In practice, that approach could help individuals turn your taxonomy into an action-oriented guide for retirement planning.