29 Sep A TALE OF DOOM AND GLOOM: “ONE SIZE DOES NOT FIT ALL”
I recently ran into Kyle who I’ve known since high school and was one of my very first clients. He is a deep thinker, a quick study and has always been a bit irreverent so I wasn’t surprised that the first words out of his mouth were “Hey Carlos, how’s it going in the world of doom and gloom?”
He was poking fun at me, and my profession. What he meant was that the majority of financial advice, regardless of your age, makes people feel depressed and inadequate about their future. The reason is due to the one size fits all approach taken by many of my peers and popular press. Let me explain. Many advisors think in a disciplined manner but unfortunately, they often don’t allow for flexibility. Flexibility comes with wisdom and in many cases, it is glaringly lacking. For many advisors, flexibility or wisdom wasn’t in their book, a beer and a weekend curriculum. They don’t ask the right questions and espouse beliefs that often produce unintended consequences.
What are these beliefs and what should someone getting started do. Furthermore, what would I do differently today if I could go back to my 20’s or 30’s knowing then what I know now? First, let’s look at the established principles or beliefs advisors follow. Their principals are fourfold and are generally sound but there is a flaw if followed blindly. The first principle is, you must save. The second is, you must invest wisely. The third is, once you retire you must ensure you don’t outlive your assets. The fourth is, you must stay ahead of inflation. I am sure you’re familiar with these principles and they sound reasonable. Unfortunately, there is a missing ingredient and I will get to that a little later in this tale. However, before you can appreciate what you will learn, I need you to skip forward in time and picture ourselves as an 80 plus year old man or woman. The next paragraph will explain a bit better and has a purpose. Retirement, like any other endeavor or game has rules. If you don’t know the rules of the game, or said differently, the end goal, then how can you make intelligent decisions today? So let’s look at what happens at the end of the game.
A few days later, I was having lunch with Dr. Fred and he asked me to tell him about a good retirement investment. It was an odd question because he had never previously asked me about retirement. I told him my approach is to manage portfolios the same in retirement as before retirement and to set aside some and sometimes no money into conservative investments as a function of the client’s situation. There is no magical retirement investment bullet in my opinion. He then said he had read about various types of annuities and asked what I thought of them. I gave him my opinion and explained the appeal of these insurance contracts is never the rate of return since historically they are unattractive relative to most balanced, diversified stock and bond approaches. I explained that what makes their rate of return low and thus annuities attractive to many is the guaranteed income for life, which is a necessary tradeoff since annuities are excellent at eliminating the serial risk associated with starting a retirement distribution plan at the wrong time.
His next response I found curious and unique but I understood it to be the viewpoint of a physician who often sees people at their worst. You may too and you may or may not share his opinion. He said, “So what you are saying is that if I buy an annuity I get less for longer? Who the heck wants that? If I haven’t spent all or most of my money by the time I am 85 I probably haven’t lived life to the fullest. Carlos, have you ever seen how an 85 year old lives?”
After thinking about how my family and friends that are over 80-85 actually live I saw his point of view and I am sure many of you will as well if you look inside your own family or community. So how does this apply to you today? The answer is you must examine your situation but it isn’t enough. You must understand something the vast majority of advisors don’t understand. I call it the lifestyle factor.
So let’s come up with an example and see if we can better explain what Kyle and Dr. Fred are talking about and relate it to you. First, we need to reduce the 4 principles to two very uninspired and inflexible rules. The first is, thou shall save 15% of every paycheck and invest it wisely. The second is, thou shall distribute no more than 4% of your retirement capital annually to ensure you keep up with inflation and don’t outlive your assets. There is no new ground covered here. Read any popular material on retirement planning and how to manage money in retirement and you will come across these concepts. The assumption behind rule 1 is that if you save 15% out of every paycheck and invest it wisely you will be in a good financial position for retirement. I have no problem with that rule. You will have a lot of money. However, even if you follow this rule it doesn’t mean you will have enough to retire based on some other well known retirement income rules of thumb. Namely, many advisors and the popular press believe you should retire on 80% of your pre-retirement income and keep up with inflation. I don’t agree, Dr. Fred certainly doesn’t agree and neither do most of the people I know.
So let’s do some math and try to tie this all together and understand the lifestyle factor. The following table depicts the standard assumptions and discipline. It shows 18 year old Johnny entering the workforce right out of high school making $25,000 per year, saving 15% of every paycheck until age 65 while never getting a salary increase. Upon retirement the then 65 year old takes out the recommended 4% of capital and in order for the retirement plan to succeed it must be greater than 80%. Guess what? It works in this case. But is this case the norm? Of course it isn’t. It is anything but the norm. But we’ll get to that a little later.
The first row of the table below shows that even with a rate of return as low as 4% Johnny has saved $508,516 by age 65. He needs $20,000 per year which is 80% of pre-retirement income and at a 4% distribution rate the portfolio can generate $20,341 which is 102% of what he needs. Since 102%, what I call the lifestyle factor, is greater than the threshold requirement of 80% you have a successful outcome.
|Rate of Return over 47 years||Money saved at retirement||Salary at retirement||Income required at 80% of salary at retirement||Income at 4% distribution rate||Lifestyle Factor|
We can also see that the greater the rate of return the more successful the plan becomes. If the return on the portfolio is 7% during the 47 years of saving and investing then it can produce $51,112 a year, which is a 256% lifestyle factor for Johnny in his retirement. Here’s the problem. Johnny doesn’t exist in the real world. I defy you to find one single person like Johnny in real life.
Johnny doesn’t exist in real life, which means you still have no idea what to do. Fortunately, my friend Kyle knows life, people and math better than most financial advisors. I should know, because I taught him and soon you will know. The table above isn’t even close to reality for most people and does not tell the story about how most real lives are led. Beware of tabloid financial advice and rules of thumb that aren’t focused on your situation. Good advice incorporates flexibility and wisdom.
How are real lives led? In real life, many people experience real wage growth. With real wage growth they need to save more than 15% out of every paycheck in order to meet the magic 80% lifestyle factorassuming the 4% distribution rate. The following table shows only the lifestyle factor the same person as above would have under various wage growth factors and rate of return factors. Wage growth appears on the left and rate of return appears above. The results are alarming and explain why Kyle jokingly calls financial advisors the Doom and Gloom profession. More importantly, it is why once you understand this basic math you will see why so many become victims to this way of thinking and why so many people reach ages 40-60 and think they don’t have enough money for retirement. Let me give you a hint. It is in the best interest of the financial industry to make you think you don’t save enough or invest as well as you should.
Lifestyle Factor Under Various Annual Wage Increases and Rates of Return
Let’s analyze this table. We can see the same results for an annual wage increase of 0% as we saw in the previous table for Johnny. We can also see there are many cases where the financial plan fails despite the individual saving 15% out of every paycheck. For instance, if Johnny saved 15% out of every paycheck for 47 years and experienced a 7% annual rate of return for each of those 47 years if his wage increased 6% annually his portfolio can only produce 46% of his final salary upon retirement. This is ridiculous. Johnny did everything right for 47 years and was successful in his career and based on the popular press he can’t retire! Give me a break! This is what I know now that I didn’t know then.
Let’s make sure we understand how ridiculous this is, what is going on and do the math for the 7% annual rate of return with a 6% annual salary increase scenario above. In this case Johnny started out making $25,000 at age 18 and ended up making $386,648 in his final year before retirement. This means Johnny should require 80% of his pre-retirement income which means he needs $291,810 in retirement. At the 7% rate of return Johnny would have experienced over his life he would have savings of $3,330,031 at age 65. Assuming the popular 4% distribution rate, this means the portfolio can only distribute $133,201 which is 46% of the $291,810 the rule of thumb dictates. Excuse me but something is wrong! You can’t tell me that someone with $3,330.031 in savings doesn’t have enough money to retire because they have to spend $291,810 and only take out 4% per year.
Now you understand the math that Kyle was talking about and why so many people think they don’t have enough money for retirement. Their belief is based on a mathematical fallacy for many people and certainly for clients of cookie cutter financial models and advisors. Ask your advisor if saving 15% of every paycheck for 47 years and investing it at 7% is enough to retire and they will 9 out of 10 times say yes. If they do, you now know more than they do.
The table shows the following;
1) Despite the great habit of saving 15% every year,
2) Despite an annualized 7% rate of return that would be the envy of most investors,
3) Despite Johnny’s success at generating higher and higher wages
4) The less likely he is to have enough money for retirement because
5) His lifestyle has increased at a rate that is greater than what his portfolio can provide.
6) Furthermore, I started this example in the best of circumstances. I started Johnny out as an 18 year old. In truth, very few people enter the work force this early and for every year you delay, the equation becomes more impossible.
Very few people understand the lifestyle factor concept. Unfortunately, most advisors don’t either and why we hear and read such doom and gloom advice and why most of the “research” in this area is simply either not based in reality or self-serving. Fortunately, the 46% number isn’t real. So what is real? Actual behavior is real. People behave in some combination of the following;
1) Most people reach a point well before their retirement where they are comfortable with their lifestyle. I call this financial homeostasis and it is a state where regardless of how much more money you earn, it isn’t used for enhanced lifestyle or consumption. After this stage is reached people that have never saved begin to save and those that have, save even more. This means they don’t increase their lifestyle proportionally throughout their lives as their real wage increases.
2) Once retired, most people often have no problem distributing more than 4% of their portfolio because they don’t worry as much about outliving their assets as financial advisors. They would rather spend now than later given the certainty of a diminished capacity like Dr. Fred suggests. The standard assumption calls for the annual distribution to increase every year someone is alive to keep up with a hypothetical 3% per year annual inflation. To show the absurdity of this assumption let’s go back to the case where Johnny retires with over $3.3 million and needed $291,810 per year. Guess how much money the standard assumption assumes Johnny needs at age 85? If you answered $527,041 for the year you would be correct. How silly. I know very few 85 year old millionaires that need almost twice the money at age 85 as at 65.
3) Most people don’t worry as much about outliving their assets because they recognize that while their health care costs will increase as they age they also recognize their discretionary expenditures will diminish. Every one of my clients expressly states they need some money as they approach their very late years in life but nowhere near as much as most models would have you believe.
4) The 80% figure is simply too high. It was originally derived from a simple concept. If you are retired and no longer saving 15%, or paying Social Security taxes you are immediately at approximately 80%. However, most people have no mortgage, car payments or educational expenses by the time they retire. Their needs are much smaller. 80% is on the high side.
5) If they haven’t saved enough they either keep working until they have saved more, or reduce their lifestyle until what they have is enough. It isn’t very complicated.
6) Lastly, sometimes you just outlive your assets and you have to rely on the charity of family, friends and other people’s taxes.
Let me leave you with one last encounter. A client and friend of the family I have known for over 40 years recently told me the following; “Carlos, my wife and I have been retired now for 8 years and live very comfortably from our Social Security benefit and small pension. We don’t want for anything. Our two children have young families and they could use the $2.4 million we’ve accumulated more than we can. In fact the money we have isn’t worth much to us since we don’t use it. It is just a number with a bunch of zeros we look at. It has no value or meaning. It would be worth a lot more to our children now when they need it most than if we were to give it to them in a lump sum one day when we pass away and they won’t need it as much. Can we transfer some or all of it to them?”
I hope this tale has given you some food for thought. What I know for certain today is that before you make a decision on how to play the game in your 20’s and 30’s you have to understand the rules of the game when you are older. The more you understand how money grows and markets operate, the better you will be at gauging your savings rate and risk appetite. In my opinion, there is a fine line between over-saving and under-consumption or under-living as well as a fine line between under-saving and over-consumption or over-living.
The obvious lesson of this tale is that if you save 15% of your income while increasing your standard of living in proportion to your wage increase, you will accumulate a lot of money but it probably won’t be enough to retire if you subscribe to popular wisdom. Therefore, popular wisdom is wrong and self-serving. You must be mindful. The second lesson is one size does not fit all. Popular wisdom is dangerous, inflexible and wrong more often than right. You should question popular wisdom. Which leads to the conclusion this tale offers.
However much you save for retirement it won’t seem like enough and no matter how much it is, it is probably more than you will need.