By Henry K. (Bud) Hebeler

12/8/04

I used to get upset when financial analysts and theorists treated risk of investment as though the future would be little or no different from the past. Now, at age 71, I look at such journal papers and their highly touted "safe" spending levels with amusement, because they still haven’t got the big picture at all. There’s not even the usual apology that, "There is no guarantee that past results may not represent future performance." They have become so enamored with the (mis)application of Monte Carlo analysis, that they often quote predictions down to the tenth of one percent.

I’d enjoy just writing about the falsehoods embedded in return risk papers which usually use faulty security statistics, make insufficient provision for the exorbitant management costs of many mutual funds and financial advisors, leave out the statistics of the companies and mutual funds that have failed, assume no withdrawals during the periods analyzed and ignore how humans actually react when investments increase or decrease beyond their expectations. But that would give too much attention to security risk that, when all is said and done, can be reduced significantly by holding widely diversified portfolios.

Actually, retirees face many other risks, and, as they age, the uncertainty of returns in the stock market are relatively less important by comparison. That’s due to several things. First, most retirees gradually gravitate toward fixed income securities. Often, and unfortunately, that’s precipitated by a severe drop in the stocks they own, so they are selling stocks when the prices are low. But, more importantly, it’s because the aged spend more of their principal than they do of their returns. At least that would be true if retirees followed the traditional and commonly applied financial equation that says the amount they can afford to spend from investments is a function of return, inflation, years yet to live, and current principal. When "years yet to live" get small, that and the remaining principal remaining dictates the theoretically feasible level of withdrawals.

In real life, elderly retirees do worry about the risk of return, but this usually concerns the interest they can get from their fixed income investments, not returns from widely diversified and continually rebalanced mix of securities such as REITs, large and small company value stocks, small company growth stocks, emerging foreign company stocks, some foreign bonds, a little bit of treasuries, etc., even though in many cases that might have been a good portfolio for them They well understand that longer-term CDs or bonds have higher returns, but they also realize that long-term investments may not match their life expectancy nor their possible cash needs in the intermediate future.

So that brings us to the largest uncertainty for retirees: That’s some unknown potentially catastrophic future event. Some things can wipe out the entire savings of a retiree. I’ve seen this happen when adult children come to their retired parents seeking money and gradually consume all the parents have left. Perhaps a daughter with several young children just got divorced and needs assistance. Sometimes it happens early in retirement when the retiree’s own parents have run out of money and seek support. It takes ice water in one’s veins to turn down a hungry or homeless relative. Many retirees have nest eggs so small, that they should not plan on using any of their principal for normal living expenses. If a plan doesn’t include at least some reserve for unknown contingencies, it’s not a realistic plan. The reserve determines the amount you may be willing to use to cope with and yet survive unknown events.

The next largest uncertainty for retirees is how long they will live. Most financial plans assume both spouses will die on the same day. Often they assume not only a single life-expectancy (which is less than joint life-expectancy), but also that the life-expectancy will not be exceeded. By definition, 50% of the population lives longer than life-expectancy statistics, and life-expectancy continues to increase every year. Surely, retirees don’t want a plan that’s based on the assumption that they will be in the half of the population that dies before the life-expectancy statistic.

For some situations, retirees might get a satisfactory plan by assuming both spouses die on the same day if they add enough years to their (joint) life-expectancies. However, in many cases, it’s more important to assume that the major earner dies early. Then what matters is whether the surviving spouse can afford to live on what remains. This is particularly important when the major earner decides to take Social Security at age 62; and/or has a pension survivor benefit that is 50% or lower; and/or has little life insurance. That’s one of the reasons that it’s important to get the lower earning spouse to participate in such decisions by asking what would happen if the other spouse dies relatively young.

For many people, the next biggest uncertainty concerns health care costs. Those who are still working and enjoying medical insurance from their employer have little understanding of the uninsured costs of retirees. Medicare has some big holes as does even state financed Medicaid for the indigent. Hearing, sight, and dental care are among the things retirees first discover are not covered in their budgets. The ultimate shock is often the cost of long-term-care insurance. Unfortunately, medical costs suffer from the compounding of two simultaneous things: (1) Increasing costs of almost any kind of medical service, and (2) increasing need for health care as people age. A retirement plan that has no provision for the potential "double compounding" is not worth very much.

Then there is the risk of inflation. In recent years, people have come to think that inflation is not much of a problem. WRONG! During the first ten years of my retirement, my fixed pension and fixed returns from my municipal bonds lost 30% of their purchasing power. When my father retired, he lost over 80% of his purchasing power before he died. Inflation compounds just like investments. The oft quoted 3% historical inflation includes many years of the great depression. More recent long-term history is well over 4%. And remember, that high inflation may be the only feasible strategy left for the government to reduce its record national and international debts. This strategy might even be welcomed by holders of huge credit card debt IF they still have many years of employment left. But inflation is absolutely deadly for a retiree. Of course there are those exceptional people who have a cost-of-living-adjusted (COLA) pension like our congressmen, who have a great influence on actions that affect inflation.

That brings us to the subject of the risk of income tax increases. It’s pretty hard to believe that tax rates will not go up. The aging of our population is sufficient reason to be cautious. As the number of elderly increase much faster than the number of workers, the demands on both Social Security and Medicare will be well beyond the reach of current tax levels. Add the increasing trend toward costly social policies compounded by an ever increasing size of government administration and otherwise reduced working population, and you have a virtually unstoppable juggernaut. Add the increasing dependence on imported goods, exported technology, US financed education of high-tech foreign students making foreigners even more competitive, expectations by foreign countries of our continued generosity, a never ending battle with terrorists, and you can hardly come up with any answer other than oppressive taxation in the decades ahead.

So, back in my comfortable chair, I am reading a theoretical report that retirees can safely withdraw X% of their investments in the first year of retirement and increase that amount by inflation every year. Not only does this ignore all of the realities I’ve mentioned above, it assumes that the reader would be stupid enough to follow this advice and never make a new plan again. Ah well. Without an unduly optimistic view of the future, the financial community would not be able to live so well at our expense. Since they take well over $100 billion in fees and charges every year from our investments, they have something to protect.

Having said all that, I respect the many people in the finance community who serve us well when they help us select low cost and appropriate securities for the risk that we retirees should consider. I just want those risk considerations to go beyond the historical statistics of securities to much broader considerations such as surprise events that can destroy our nest eggs, our deteriorating health, dying earlier or later than the average person, and both inflation and taxes exceeding expectations. We all need to make new plans periodically to cope with these additional risks.

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