Tuesday, February 14, 2012

The Safety-first, Goals-based Approach to Financial Planning


My new monthly column is now available at Advisor Perspectives. It is, “The Safety-first, Goals-based Approach to Financial Planning.” This column is partly a review of the new book by Zvi Bodie and Rachelle Taqqu called, Less and Prosper: Your Guide to Safer Investing. It is also partly a general discussion about the safety-first, goals-based investment portfolio approach. This column is connected to the discussion in my recent blog entry, “Safe Withdrawal Rates: Have I been barking up the wrong tree?” The intro to my new column is:
Little of what is taught in traditional investment textbooks is of value in personal financial planning. Risk is not standard deviation; it is the probability and consequences of not meeting one’s goals.  That real-world perspective animates a new book by Zvi Bodie and Rachelle Taqqu that implores advisors and their clients to lock in the funding of their essential expenses before worrying about their discretionary goals.

A few other issues…

While I haven’t had a chance to review all of the other Advisor Perspectives articles yet, one thing I do see that is worth a look is page 2 of the Letters to the Editor. There, Joe Tomlinson explores whether it might be a worthwhile to begin Social Security earlier rather than later, and to then invest the proceeds yourself. 
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Kay Conheady, CFP, has created a new website called CAPE Research Catalog. CAPE is another term for what I usually call PE10 here, though CAPE is broader to include cousins like PE5 as well. Be sure to check her research timeline which has a rather extensive collection of research related to the cyclically-adjusted price earnings ratio. She is working to make it comprehensive, and it does look quite complete and detailed to me.
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Finally, regarding my previous post, “Are Annuities (SPIAs) Okay When Interest Rates are Low?” Nords began a discussion of it at the Early Retirement Forum. There, Midpack provided a good critique. For some of his points, it is just a matter that the analysis is still incomplete and not comprehensive. But one really good point in particular is that my graph showing how the annuity payout rate increases with age is not a particularly useful way of looking at the information. Retirees may have in mind a set amount of spending they wish to obtain from their annuity, and so what they care about is how much it will cost to obtain this annuitized income stream as they age. The following figure shows the cost of purchasing $1 of real income for each year that one lives as a function of age:

To understand this, consider a 65-year old male. The cost of obtaining a real annuity of $1 is $18.48.  For a 70-year old male, the cost has fallen by $3.35 to $15.13. That’s an 18% drop. But that is assuming interest rates remain constant at 1%. If interest rates change during those 5 years, so would the 70-year old numbers.  That might be a wash though, as interest rate decreases would make the annuity more expensive but also boost the returns on your bond holdings. You would also need to consider whether your unannuitized wealth would hold its value or not over those 5-years as you spend it down and experience the unpredictable market returns. After all, you did miss $5 worth of real income from the annuity by waiting, and that presumably needs to come from your portfolio instead. These combined factors would tell you, mathematically and probabilistically speaking, whether it is worthwhile to wait.
What this makes clear to me is that I don’t have any answer about this issue yet. There are now 3 or 4 projects where I need to be using simulations for bond yields rather than simulations for the total returns on a constant-maturity bond fund. I do hope to look at this some more in the not too distant future. Also, this might be something that Moshe Milevsky has already investigated, and so I do need to read his research articles too.
Any reading suggestions or other comments are appreciated. Midpack has earned a spot in the acknowledgments section of any research article I might eventually write about this :)

7 comments:

  1. One small correction - Midpack is a "he".

    From the "About Me" section of the E-R.org website:

    About Midpack

    Gender
    Male

    ReplyDelete
  2. Thanks, it's corrected.

    That avatar threw me off.

    ReplyDelete
  3. Good article, Wade. I've also been thinking more about the SPIA "buy now or wait" discussion. The argument for waiting is not just that rates are going to rise, but that rates are going to rise faster than the rate forecast already embedded in the yield curve (and in the payout rates for SPIAs). So I realize that my current hesitancy about SPIAs means I'm personally forecasting a bigger rate rise than the consensus. I can certainly understand why others may have a different opinion.

    Milevsky has written about the "mortality-adjusted" return that increases with age and how one chooses the age to annuitize based on when the "mortality-adjusted" return exceeds the return on normal investments. However, if stocks are part of the normal investment mix, it's not an apples-to-apples comparison on a risk basis.

    Another argument for waiting that I've heard relates to the risk of adverse health changes. What seems like a sensible decision to buy an annuity today may suddenly change, so that's a reason to wait. However, I don't think that's a valid economic argument for waiting because such contingencies are already factored into SPIA rates.

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  4. Regarding your final section on the declining cost of annuitizing. Most everyone is entranced by the slope of the line, without factoring in (what you mentioned in passing) the opportunity cost of receiving very high payouts in the interim (of any delay). IMO most people would UNDERestimate the cost of delay.

    The ways to address this are discussed at http://www.retailinvestor.org/annuity.html#delay and there is a spreadsheet for calculating your own tradeoff. http://www.retailinvestor.org/DefAnnuity.xls

    ReplyDelete
  5. Joe and Retail Investor,

    Thank you both for the excellent comments. Sorry for the delay, I've really been falling behind schedule. But I'm trying to catch up. It looks like your page on annuities is full of useful info and I'm definitely going to read that.

    ReplyDelete
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