The Family Office Chronicle April 2024
Americans are living and working longer. It seems likely that breakthroughs in medical and health technology will continue to expand the human lifespan even further. While that seems like a very positive forecast, it will put a strain on retirement security, as nest eggs will have to last for many, many years.

Demography is Destiny

You may have read that life expectancy in the United States, after more than a century of expansion, has contracted over the past few years. The Centers for Disease Control reports that life expectancy hit 79 in 2019 but fell to 77 in 2020 and 76.4 in 2021. The CDC says this trend is not an anomaly and that overdose deaths, which have grown five-fold over the past 20 years, are a significant contributor to the decline.

If you’re reading this, there’s a very small statistical probability that an overdose will be your accidental cause of death. And, if you’re careful about diet and exercise, take comfort from the fact that a 76-year-old male living in the U.S. today has a life expectancy of 87.3, while a female is expected to live until 89. If you’re healthy and careful, you have a shot at 100, which used to be extremely rare.

Ray Kurzweil is an American computer scientist, inventor, and investor with the fascinating title of “futurist.” He has written books on health technology, artificial intelligence, transhumanism, and a fascinating topic called “technological singularity.” An example of singularity is something called “longevity escape velocity,” the moment when life expectancy rises by more than one year every year. Yes, that means immortality. Kurzweil, who is 76 himself, takes over 80 pills per day in an effort to hang on for that singularity event. He says it will happen in the next 10 years.

America is an aging country. According to the Urban Institute, the number of Americans who are 65 and older will reach 80 million in 2040, and the number of people 85 and over will quadruple between 2000 and 2040. Living longer is not free, of course, and the Bureau of Labor Statistics has reported that the number of workers over 75 will double in the next ten years to nearly 4 million.

Workers over 75 are the fastest-growing cohort of workers, and those between 65 and 74 are the second fastest-growing group. Working late in life is correlated with education, but clearly, many work out of necessity, not by choice. Social Security payments represent the only source of income for 40.2% of the 50 million American SSI recipients. Living solely with Social Security income is no picnic: the average monthly retirement benefit payment from Social Security is $1,907.

Five Major Threats to Retirement Security

Immortality, in the dream of Kurzweil, is an expensive proposition. Let’s say you only live to 200. If you work from 22 to 65, you would need to earn enough to support yourself for 135 years. But here’s some positive news: it turns out that if you can manage it for 30 years, you’re probably good for another 105, and maybe even forever. The trick is to build up a self-sustaining nest egg that can survive a number of very real threats to your financial security.

Retirement planning often fails for one or more of five reasons. Commonly used investment planning methodologies solve some of these five problems but not others. And keep this in mind: all five of these conditions may exist at the same time.

Timing. Investing for retirement at the wrong time in the stock market cycle can devastate your plan. As an example, if you are withdrawing a fixed amount of money from each of your investments on an annual basis, and your portfolio declines by 30% in a bear market, you may deplete your principal at a potentially unsustainable rate and damage your plan’s viability.

If you are spending $40,000 per year from your $1M nest egg, you’re taking 4% per year. But if the market drops 30%, your portfolio falls to $700,000, and $40,000 just became a 5.7% withdrawal rate. Few, if any, financial planners would recommend a withdrawal rate that high for the simple reason that a net 5.7% portfolio growth rate, after costs, taxes, and inflation, is an aggressive target. If your costs are low at 1.5%, taxes take another 2%, and inflation 2% more, you’d need a gross return of 11.2% per year.

Inflation. Inflation is the silent killer of financial plans. Many investors plan for retirement without considering inflation. First, consider purchasing power. We’ve had a long period of low inflation, but that’s unusual: Since World War II, there have been six periods in which inflation—as measured by CPI—was 5% or higher.

You are probably keenly aware of inflation’s effects, but an example might be enlightening. Let’s say you bought something in 2014 for $100. If that same thing rose in price along with the CPI, it will cost you $132.72 in 2024. Bad, but likely survivable. But let’s look at the really long term: that same thing cost you only $7.22 in 1924.

In the 1970s, inflation averaged 7.8% per year and was 13.5% in 1980. Cash and bonds are not likely to keep up with that kind of inflation, meaning that exposure to stocks or high-return asset classes is a virtual necessity to keep up.

Longevity. A trip to Target or Walmart, or just a walk down Main Street, will likely demonstrate that longevity has grown significantly in our lifetimes. Over the long haul, longevity has gone crazy. At the onset of the Industrial Revolution, global life expectancy was just 27 years.

Whatever may happen, a responsible plan will assume that one partner in a marriage is going to live a long time. Fifty years ago, the greatest concern was dying young; for many today, the greater worry is outliving their money. It’s no wonder so many Americans are delaying retirement until well beyond 65.

Risk Drift. Risk drift is one of those fancy terms economists use to describe a fundamental human condition: we get less risk-loving as we age. There are many reasons for this, but the phenomenon is real. Economists have studied the topic of loss aversion for decades and have found physiological evidence that older folks are naturally more risk-averse.

This is all well and good, of course, but it has implications for portfolio management. An allocation of 80% or more to stocks may look good to a 40-year-old, but may create real stress in an 80-year-old. However, an 80-year-old may reasonably expect to live 15 or more years, which is historically long enough to withstand market volatility. As we’ve shown, the friction of costs, taxes, and inflation virtually require exposure to stocks to sustain their purchasing power.

The Human Element. We are all the downstream result of millennia of human evolution, and deep in our primitive psyche is the fight-or-flight response. Humans who lacked this essential stress response disappeared over time, either under the fangs of a saber-toothed tiger or through poor resource management.

This built-in risk response makes humans genetically unsuited for investing. When markets tumble, we get a strong urge to sell, and then risk aversion keeps us from buying back in until we are certain everything is safe again. This is the buy low/sell high trap, the classic outcome of market timing.

This is one example of the need for a trusted advisor. Warren Buffett, arguably the world’s greatest investor, advised, “Be fearful when others are greedy and greedy when others are fearful.” Maintaining the patience and discipline to ride out natural market volatility is the single most important behavior for investors.

The threats are real, and most of us have experienced at least a couple of them in our investing lifetimes. Financial planners have been working for decades on ways and means of dealing with these threats, but a perfect solution remains elusive. The most common approaches, systematic withdrawals and bucket planning, are fundamentally flawed because they are not dynamic; they aren’t meant to respond to changing conditions in real-time.

Old-School Retirement Plans Have Fundamental Flaws

Systematic withdrawals are an alternative to owning dividend and interest-paying securities to provide income. Systematic withdrawal planning is based on two key inputs: the investor’s risk tolerance and the investor’s annual spending requirements. Those two things will determine the annual withdrawal rate.

The “4% rule” is a common benchmark in systematic withdrawals—if the percentage of a portfolio required per year is less than 4% of the corpus, then the investments should be able to support the desired income. If the investor is very conservative or has a large nest egg, then rather than 4%, 3% might be used as a guide. As that number goes down, the likelihood of plan success rises.

But, the systematic withdrawal methodology can fail the investor if the stock market declines shortly after the plan is initiated because investors might have to sell stocks when they are cheap, thus quickly depleting the portfolio; that’s the timing risk. In addition, investors are often unable to stick to the plan during down markets—the human element risk.

Systematic planning could work well for a lucky robot or a wealthy human but does not solve for at least two of the five largest retirement risks.

Bucket planning also starts by determining how much money the investor needs to withdraw every year and then essentially punts the timing and human element threats down the road, perhaps to be confronted late in the plan’s life.

Bucket planning is a simple concept. Hold several years of spending in cash-like assets, hold several more years in medium-risk assets, like bonds, and keep the remainder in stocks. The investor spends the cash first, then the bonds, and finally the stocks. By having, say, ten years of spending out of cash and bonds, the theory goes, the investor feels less of an urge to dump stocks in a bear market and enjoys 10 years of growth.

Bucket planning calls for simply spending down the money in each bucket one after the other and doing so in reverse order of riskiness. It is essentially a lazy, set-it-and-forget-it method, which is the major weakness of this approach.

Bucket planning may fail as a lifetime income program because it’s not intended to adjust which investments to use for spending during normal versus down markets. In other words, it is not reality-optimized. For example, let’s say the first year of an investor’s retirement is like 2023 was, with the S&P 500 up over 25%. That would be a good year to withdraw from the stock account—to sell high, and leave the cash undisturbed. That would effectively add another year to the plan’s safety, and since we don’t have singularity quite yet, it would reflect the plan’s main job: income for life.
Ime Optimized Planning™ — Worth the Extra Effort

Both bucket planning and systematic withdrawals address some of the retirement income puzzle, but only the recently developed Time Optimized Planning (TOP) approach solves all of the five principal reasons that retirement plans fail. Let’s review:

Time Optimized Planning is designed to avoid the age-old problem of selling low. Rather than simply spending down assets in reverse order of their riskiness, meaning spending cash equivalents, then bonds, and finally stocks, TOP seeks to provide income from assets that have performed best in each period. If the market is up in a given year, income is derived from stocks. If the market is down or still recovering, less volatile investments are used.

TOP is to be rerun every year, and when the market is fully recovered and growing, money is moved back into less volatile securities to reposition the portfolio for the next decline. It requires ongoing oversight but seems a small price to pay for a more certain outcome.
We believe the extra work required by TOP is more than justified by its potential financial and psychological benefits to retirees.

Systematic withdrawals may avoid retirement timing risks if they are taken as sell rebalances: less or none will be withdrawn from stocks and more from cash and bonds during down markets, and similarly, more will be taken from the risky assets during up market moves. This is something bucket planning does not do and is not intended to do, which is a big reason why we feel bucket planning is the least attractive method.

TOP is engineered specifically to buttress the investor against retirement timing risk—the risk that the stock market will experience a significant drop early in the income years.

Bucket planning, however, may be useful in dealing with the human element by focusing the client on the need for lifetime income and by deferring the time until risky assets are needed.

Because TOP can be reoptimized every year, taking into account changing situations, life events, and market events, longevity risks are reduced. This is not the case with systematic withdrawals; in fact, longevity risk may be the most serious flaw with systematic withdrawals.

Investors taking a fixed amount of money every year may simply spend all of the money before they die; clients taking a set percentage may see the number of dollars they receive shrink to the point where costs are not covered. Both are failures of the planning process and, in our view, of the planner.

There is a question about how well bucket planning deals with longevity risks because it lacks the flexibility to take profits to provide income during up markets, relentlessly spending down principal protected assets until they are depleted, and leaving the retiree in the uncertain position of invading principal during down markets, and doing so when the client is entering the final phase of their income needs. You can see the potential for a double whammy: a serious decline in account value when there is too little time for a recovery, and it’s easy, if pretty awful, to imagine the impact on the emotions of the retirees.

Finally, accounting for risk drift is a major feature of TOP, which is designed specifically to respond to the realities of human aging. TOP is intended to reduce risk in income-generating investments to near zero in the last several years of the client’s life. This also has the powerful benefit of negating the client’s fight-or-flight instincts during bad market events. Neither bucket planning nor systematic withdrawals solve that problem and may often exacerbate it.

There is another safety net built into TOP. Many investors don’t want to spend all their money on themselves, preferring to leave a legacy to loved ones or charity. TOP segregates this money into a separate account. The implication of this is some additional safety cushion for the investor. This end-of-plan goal money is typically invested in principal at-risk investments because it is intended for a much longer-lived individual and, therefore, should have a longer-term, more risk-loving orientation. Although the client doesn’t intend to spend this money, it can provide additional peace of mind that they do have the wherewithal in the event it should be needed.

If you are concerned about your security in retirement or concerned that your existing financial plan may not account for the various threats that may exist, we can provide you with a customized Incomize™ retirement income report.

Set-it-and-forget-it approaches may appeal to clients who don’t like to think about the future and what it may bring, but Incomize can offer something more and better: true peace of mind.