Putting It In; Taking It Out-
Part II: Context is Everything
I’ve cut so much hair, I’ve lost my concept
Warren Beatty in Shampoo
Yada, yada, yada.
Enough already, Mr. Enough!
What is the best method for withdrawal (decumulation – takin’ out) for income that I won’t outlive???”
‘Tough cookies!’ as we would say at West End Drive while playing boxball in the street in Overbrook Park, Philly with the likes of Marvin ‘Dog Food’ Dash, Alan ‘Wonderwoman’ Winderman, and Rickie ‘Rosenbag’ Rosenberg. You’ll just have to get through Part II first as: things not worth doing are not worth doing well or as Mae West would say, ‘things worth doing are worth doing slowly’ if Part III will be of any value.
Context is everything.
“The Answer” isn’t an answer as there are only tradeoffs. The appropriate tradeoff is framing the correct question, specifications and criteria.
There are two overarching contextual questions to determine:
1. The Goal/Objective Parameters (from a deterministic and as well as stochastic perspective ((Monte Carlo probability simulation)
2. The Boundaries (specifications and criteria)
The Goal Objective Parameters
(the following assumes the objective is interrelated with other personal financial objectives – not in being dealt with in isolation- otherwise you solve /tradeoff one problem and create two others)
Typically a deterministic (1) personal financial objective should address the following elements:
1. Amount (Expected Outcome)
2. Start Date (2)
3. Duration (Time Horizon)
4. After Tax Rate of Return (remember it is not what you make, it is what you keep)
5. Inflation Rate
6. Funding Required per the aforementioned (before offsetting accumulated resources)
7. Annual Payment Required to Fund Risk Adjusted (3)
A faulty premise in retirement funding and distribution is that the amount required even after meeting the required rate of return – risk adjusted – and increased for inflation (or decreased for inflation) will be the same required amounts throughout all of retirement.
Typically, not always, there are three phases to retirement (not including the slow down transition period prior to retirement):
1. Go go
2. Slow go
3. No go
Each of these ‘sub’ retirement objectives typically requires different funding amounts as well as distinctive assumed inflation rates (especially considering increased non covered medical expenses – as ‘everyone wants to go to heaven,’ as comedian Timmie Rogers would state, ‘but nobody wants to die’ ((even if Medicare won’t cover the expense))). Thus, there is really at least three ‘retirement objectives’ regardless of deterministic or stochastic approaches to ‘what the number is’ and how much can be withdrawn.
There are other criteria, factors and specifications (rational and emotional) to consider including but not limited to:
1. Risk Capacity (as opposed to risk tolerance)
2. Withdrawal sequence taxable accounts versus tax deferred accounts (pension, profit sharing, IRAs, 401ks etc) and, for example, the sequences’ impact on the Obamacare 2.3% surcharge threshold
3. Inheritance desires for your lucky sperm and ovarian club progeny
4. Volatility buffers
I’d love to play center for the Denver Nuggets. But at 5’5” tall, regardless of skill set, but I don’t have the required height capacity.
Planners throw around ‘risk tolerance’ like it was Oprah telling the audience everyone gets a new car today. The risk tolerance measures are typically global and qualitative NOT IN CONTEXT OF THE OBJECTIVE. Therefore, I find them worthless. If all one requires is a 5% after tax rate of return – even if the S&P is up 20% who cares – you manage the goal with the least risk – rather than managing the asset as the vast vast majority of so called personal financial planners (commission, fee and commission, and yes even fee only especially the a little bit pregnant percentage of assets under management supposedly fee only planners as well as personal financial planning pornography journalists) assert.
Risk capacity is 1) at what point a decline impairs the objective versus the percentage decline (capacity) in the resources in hand the objective can absorb.
Period – end of sentence (and not an Obama ‘period’)
Withdrawal Sequence Taxable & Non Taxable Accounts
While technically your ‘tax deferred’ withdrawals are not subject to the Obamacare surtax, the withdrawals ADD to the base for calculation and imposition of the Obama Doesn’t Care surtax.
All things being equal, however, the longer withdrawals can be delayed from the tax deferred account up to the required age of 70 ½ for required minimum distribution (RMD) the better. (That said, a discussion of Roth IRA’s in this regard is outside the scope of this discussion)
Stipulating my opinion for a hand up not a hand out per the negative principle upon which America was founded (against hereditary privilege ()aka The Lucky Sperm Club)), too many work free retirements have been deferred, delayed etc due to the personal financial ebola of higher education costs incurred for offspring who have subsequently boomeranged back with resentment rather than gratitude to top it off.
The above stated, here is the question, ‘will you jeopardize the retirement objective (income preservation) through requiring riskier higher rates of return and delaying retirement and its duration for wealth preservation (inheritance for your lucky sperm club?).
If so, the legacy funding should be figured into your overall financial plan and its consequences on the retirement objectives (go go, slow go, and no go).
Volatility kills investment. We confuse volatility with risk (the risk of not making the goal – outliving the money) but still volatility is risky killing objectives because of fear of the moment – managing assets instead of managing goals.
You know the story of Joseph and 7 good years and 7 leans years per the dream of the fatted cows and the emaciated cows.
(Note per the dream after the 7 prosperous years represented by the fatted cows, the emaciated cows ate the fatted cows and gained no weight. This was the first instance of the Adkins Diet).
In any event, under Joseph’s viceroy tenure, Egypt not only withstood the 7 lean years but Pharaoh (not the Egyptians per se) prospered by having prepared during the fatted years.
Joseph had created a buffer from the volatility by storing during the fatted years.
In several studies of mutual funds, there has been a curious finding: the mutual fund’s rate of return is much higher than it’s average shareholder’s because of fear during downturns and resulting turnover (volatility).
To buffer the natural human tendency to retrench during volatility, a 2 year or more buffer of cash and cash equivalents is suggested.
Yes, this will lower the overall rate of return though often not as much as one would think if as a result of the buffer one increases their deductibles on home, auto, blanket insurance as well as increasing the waiting period in their long term care insurance lowering premiums per year.
An alternative for those over 62 who can’t afford this large a buffer given their retirement goals – a standby reverse annuity line of credit – can buffer and help one withstand the inevitable volatility swings that can destroy investment.
The above said – there is a major flaw in deterministic (average rate of return) personal financial planning – The Flaw of Averages
(Oy vay iz mir (oh, woe is me)!!! You had me slough through all above to state this???
Yes, because as useful the probabilistic method (Monte Carlo simulation) is, it too has problems ((not the least of which is keeping, sometimes unnecessarily assets from distribution, which, increases the basis for assets under management fees for ‘personal financial planners)) )
The Flaw of Averages in Deterministic Planning
Given all the boundaries, criteria, and assumptions above, the major problem with the ‘deterministic’ approach – is ‘The Flaw of Averages.’ Per author Sam Savage’s book by the same title, The Flaw of Averages he describes the fallacies that arise when single numbers (usually deterministic averages) are used to represent uncertain outcomes.
The Platte River averages say 4’ in depth. Being 5’5” (compact, not vertically challenged) on a good day, I should be able to slough across it.
I’ll drown because at some points the Platte is 4” high and at other points 20’ deep.
So using an average after tax rate of return, the average desired amount needed for the objective per year, average inflation rate etc – exposes one to what is called ‘sequence (of returns) risk.’
For example per Savage’s book
Let’s say you had $200,000 to invest in 1973 and expected it to last 20 years throwing off $32,000 (given a 14% rate of return – the average of the S&P Index from 1952-2001 - in the deferred IRA). Well the market was off over 38% in 1973 and the account would have tanked in 8 years. However per Savage, starting in 1974, the account would have made all 20 years distributions would some left over, versus starting in 1976, the fund would have tanked in 10 years thru 1974 and your little nest egg might last 7 years at that.
Thus there is a sequence risk to average rates of return.
Monte Carlo Simulation per Objective
The deterministic model does not address sequence risk, stochastic (Monte Carlo simulation) methods do. The result should be after going through thousands of iterations, the probability of meeting the goal and or at 80% thru 95% what it would take additionally to make the goals.
I prefer a baseline Monte Carlo step – what if I change nothing and precede as is – what is the probability of failure stipulating bad data in bad data out. Critical and typically overlooked – is running different longevity scenarios.
More often than not, the results of Monte Carlo analysis are so bad – clients go ‘here, I thought I was doing great’ or worse, ‘what the ((well you….))’….
That is why both the deterministic and the monte carlo simulation should be run with the three retirement phase portfolios (go go, no go and slow go) as well as differing longevity assumptions – to see the probability of failure which sets up the discussion for next Part III – Methods of Distribution for Income Preservation.
· Context Is Everything
· Manage Goals Not Assets
· & Mae West
(1) Deterministic Model – a mathematic model in which outcomes are precisely determined through known relationships without any room for random variation. In comparison, stochastic models (i.e. Monte Carlo simulation) uses ranges of values for variables iin the form of probability distributions. In personal financial planning, the deterministic model, for example would yield, the average payment necessary to fund a goal, the average distribution available during the duration, etc. The Monte Carlo method would yield given the criteria inputted – the probability of reaching the goal.
(2).- One study indicates that retirement date explains 53% of the fluctuation in withdrawal rate.
(3).- Some use ‘beta,’ return on beta, downside risk measurements, standard deviation etc as the proxy for risk. Risk, not a game by Parker Brothers, when all is said and done, is making or not making the objective.