The business of predicting the future
There is a lot of good information out there on retirement planning, especially by Society of Actuaries.
Retirement planning is not unlike making a wager in options in that they both try to glean at the future and construct a hedging strategy toward a desired outcome prior to placing the bet.
Suze Orman was right when she said 5 million dollars or more was needed to retire early.
What is probably implied here is that by retiring early, there is much larger window of time for things to go wrong and this is the brute force approach to absorb all the possible risks and to maybe make it out on the other side.
There are five most talked about risk variables in options - delta, gamma, theta, vega, rho. (SKIT-V) (Even then, rho is usually not considered unless it's LEAPs - which brings the list down to four)
These are the retirement risk variables as published by SOA:
Society of Actuaries Retirement Risks List
- The risk of outliving retirement resources
- Loss of purchasing power.
- Lower interest rates make retirement less affordable.
- Loss of invested retirement savings.
- An annuity provider or pension plan goes out of business.
- Loss of supplemental job income.
- Loss of social program benefits or tax increases.
Unexpected Health Care Costs
- A major cause of bankruptcy.
Lack of Access to Caregivers
- Unavailability or unaffordability.
Loss of Independence
- Accident, illness or chronic disease.
Change in Housing Needs
- Housing that doesn't accommodate physical decline.
Death of Spouse
- Can be a major financial setback.
Other Change in Marital Status
- Divorce can be a major financial setback.
Family Member Needs
- Family members outside the retired household need support.
Bad Advice, Fraud, Theft
- Can result from declining mental acuity.
This by RICP:
RISK 1: LONGEVITY RISK *
RISK 2: INFLATION RISK *
RISK 3: EXCESS WITHDRAWAL RISK *
RISK 4: HEALTH EXPENSE RISK *
RISK 5: LONG-TERM CARE RISK
RISK 6: FRAILTY RISK *
RISK 7: FINANCIAL ELDER ABUSE RISK *
RISK 8: MARKET RISK *
RISK 9: INTEREST RATE RISK *
RISK 10: LIQUIDITY RISK *
RISK 11: SEQUENCE OF RETURNS RISK *
RISK 12: FORCED RETIREMENT RISK *
RISK 13: REEMPLOYMENT RISK *
RISK 14: EMPLOYER INSOLVENCY RISK *
RISK 15: LOSS OF SPOUSE RISK *
RISK 16: UNEXPECTED FINANCIAL RESPONSIBILITY *
RISK 17: TIMING RISK *
RISK 18: PUBLIC POLICY RISK *
Combining the two:
Interest rate *
Market / Sequence of returns / *
Liquidity / Excess withdrawal *
Business continuity / employer insolvency *
Unexpected financial responsibility / employment *
Public policy *
Health care *
Forced Retirement / Reemployment *
Lack of Access to caregivers / Independence / Frailty / Longterm care *
Change in housing needs / Death of spouse / Family member needs *
Bad Advice, Fraud, Theft / Financial Elder Abuse *
And the combined risks can be divided into five major groups:
Liquidity / Excess withdrawal / Market / Sequence of returns
business continuity / employer insolvency
3. Unexpected financial responsibility
Family member needs
Lack of access to caregivers
Bad advice, fraud, theft / Financial elder abuse
5. Public Policy
Social Security / Medicare
What are the ways to deal with these risks? Looking at the items one by one:
To reduce longevity risk, the obvious solution is to continue working and retire later. By continuing to save, this will also reduce liquidity and excess withdrawal risks. (3 for 1)
Liquidity / Excess withdrawal / Market / Sequence of returns
These are the risks associated with running out of money during retirement. Based on the research so far, I am planning to adopt the income floor approach.
There is a saying about investing in companies. There are two kinds of companies that one should invest in - ones that are fortunate and able and ones that are fortunate because they are able. I will be adopting the income floor approach, because I am the latter kind.
This approach advocates eliminating unpredictability of income in retirement by setting up an income source that provides a steady fixed monthly income which is not affected by the market in any way.
This income source can be a pension or an annuity. This is the floor upon which people can reliably stand on during retirement, covering the cost of basic necessities and living expenses.
The rule of 72 says 3% inflation will cause prices of everything to double in 24 years. (72/3=24). Therefore, the type of income source in the income floor matters greatly.
The income floor should be comprised of inflation hedged income source as much as possible. Then semi-inflation hedged income source. Then with simply fixed income source without inflation hedge.
So this meant for me:
Social Security is the most precious of the income sources***. It is a low cost, fully inflation hedged annuity with low risk of insolvency. Based on open social security analysis (https://opensocialsecurity.com/
) I will delay taking social security.
The calculation of SS benefits is very simple. Take 35 years of wages earned, with each year's wage multiplied by its own inflation index factor, then averaged for a monthly payout. The first $926 of the monthly payout is adjusted to 90%. Amount between $926-$5583 is adjusted to 32%. The remainder is then adjusted to 15%. The sum of the three is the SS monthly benefit at age 66 1/6. This is adjusted to 72.5% when taken early at 62. (https://www.ssa.gov/pubs/EN-05-10070.pdf
The index factors and adjustment thresholds change year to year. I have noticed that the benefit amount at age 62 has been going down and the benefit amount at age 66 1/6 has been going up from prior years. (!)
Unfortunately, too many people have been reading off of bathroom stalls, because they believe that social security trust fund will "run out" after 2034. The fact is there is no social security trust fund now - it exists only as an IOU for government accounting purposes. The social security payments aren't as dire as the climbing interest payments of our national debt.
Pension, in my case, is going to be the largest income source for the income floor. It is only semi-inflation hedged. Inflation is only hedged up to 2% per year. In addition, there is a capped 75% purchasing power protection in an event of a runaway inflation. In an event of a catastrophic runaway inflation, the PPP cap will be reached and protection will be reduced or eliminated, depending on the severity of inflation.
I am of the opinion that few additional working years is probably worth the increase in monthly pension benefit to cover the costs of basic necessities during retirement.
I also examined the scenario of duplicating the pension using the market returns:
Pension vs. Lump Sum
A rather significant portion of the net worth will be invested in taking the pension route. Though I had hoped less so, the reality is that pension isn't free.
Using the "How long will the money last" calculator viewtopic.php?f=9&t=3599&start=200#p187207
a calculation was made to determine the interest rate that would generate a perpetual monthly income equivalent to the monthly pension, with the pension lump sum.
The results are as follows, marking the earliest retirement window as "Year 0"
Year 0:..... 15.6%
Year 0 + 1: 17.2%
Year 0 + 2: 18.6%
Year 0 + 3: 20.2%
Year 0 + 4: 21.3%
Year 0 + 5: 22.1%
Thus in taking the lump sum route, depending on when it is taken, the pension lump sum must generate at least 15.6% to 22.1% every year to match the pension equivalent.
Reducing the number of years that money lasts from perpetual to say, 30, 40 or even 50 years made very little difference in the required rate of return - less than half of a percent.
So the rate of return required to make money last 30, 40 or 50 years is pretty much the same as the rate of return required to make money last forever.
To generate the same cashflow, at a more reasonable rate of return between 8-10%, the following portions of the net worth will have to be put to risk in the market and stay illiquid vs. the pension.
Year 0:..... 56% (lump sum) vs. 40% (pension)
Year 0 + 1: 66% vs. 40%
Year 0 + 2: 69% vs. 40%
Year 0 + 3: 78% vs. 40%
Year 0 + 4: ...
Year 0 + 5: ...
The break-even point without considering the time value of money between lump sum vs pension is as follows:
Year 0:..... 11.9 vs. 7.4
Year 0 + 1: 12.3 vs. 6.8
Year 0 + 2: 12.3 vs. 6.4
Year 0 + 3: 12.2 vs. 6.0
Year 0 + 4: ... vs. 5.7
Year 0 + 5: ... vs. 5.5
Less capital is at risk and faster break-even is possible with the pension route. Also pension delivers a stable 15.6%-22.1% return year after year. With the market, standard of living will fluctuate between the good and the lean years.
The real problem, is the inflation. The purchasing power that is enough to cover all of the basic necessities today will be barely enough to cover just the food expenses decades from now.
The obvious problem with inflation risk is that social security is far way and the pension does not provide full inflation protection. So what is one to do?
One possibility is to hedge by purchasing an immediate inflation protected annuity from "too big to fail" companies such as fidelity or vanguard.
The issue here is that a relatively large sum will be permanently committed and it incurs a higher business continuity (insolvency) risk as compared to pension or social security.
To be continued.
*** IMO, it is a grave mistake to forego social security for retirement. To be eligible for social security retirement benefits, minimum 10 years (40 quarters) of gainful employment is needed. In 2019, at least $1,320 in a quarter must have been earned for it to count as a credit.