LISTEN: Retirement: Work longer. Spend more. Save less. Have fun. (Really?) (mp3audio) (14:38 min)
Math never lies, but sometimes its practical applications don’t add up in real-life circumstances. And when you take a purely mathematical approach to retirement planning, these practical limitations can be a problem.
About 30 years ago, the advent of personal computing made it possible for anyone with a spreadsheet program to develop a Retirement Calculator. Suddenly, retirement planning became as simple as a mathematical formula. “Just plug in a few variables (personally tailored to your expectations), and voila! – you have ‘your number.’” Or two numbers actually; the lump sum you’ll need to retire, and the regular contributions that will be required to reach your lump sum target. It was almost too easy…
And it didn’t work. Early retirement calculation programs were too simple. They couldn’t account for fluctuations in annual returns or irregular increases or decreases to income, inflation, etc. But since math never lies, the problem must be with the inputs – garbage in, garbage out, right? So the math-driven strategy was to use more sophisticated models, ones that took into account historical trends, probabilities and worst-case scenarios. Instead of a one-page print-out with two numbers, the new retirement calculators could produce 20 pages of alternative numbers, all theoretically realistic. Every possibility was considered, unless a “black swan” showed up.
Black swans are what statisticians call those once-in-a-lifetime occurrences. Like a black swan, these unusual events could possibly occur, but almost no one has ever seen them. For example, who could ever imagine a housing bubble featuring massive defaults and fore-closures, with prices dropping 20 to 30% in two years? Or stock market investments that would show negative returns over 10-year periods? Or persistently high unemployment levels that would disrupt the ability to plan or save for the future? And who could imagine all of those things happening in the past five years? These events just weren’t part of most people’s retirement calculations.
Which is why a December 6, 2010 Wall Street Journal Investing Report begins with these less-than-cheery comments:
Imagine this scenario: You’re only five or 10 years from when you hope to retire – but your portfolio looks like it needs another lifetime to bulk up…Most people, of course, don’t need to imagine it. It’s their reality – the result of watching their investments get clobbered in the two bear markets of the past decade. And many others will face this sad state of affairs in the years ahead.
What are appropriate responses to retirement in light of these current economic realities? First, the article recommends that you “take a deep breath and remind yourself that you’re far from alone. Misery does love company.” Then “you need to get serious about trimming your spending to save more money, or resign yourself to working more years.” Oh, and one more thing:
“When your nest egg is small and time is short, you can make things worse for yourself by being either too conservative or too aggressive.”
Wow.
Breathe deep, cut spending, work longer – and don’t mess it up. (There’s a slogan that’s sure to motivate.)
But with a math-driven retirement program, there isn’t much else to do. When you finally recognize that so many variables (rates of return, taxes, inflation, etc.) are beyond your control, the only numbers that you can change are the size of the deposits and how long you plan to make them. Intended to be a predictive aid, most mathematical retirement calculators actually do a better job of explaining your past mistakes. “Oops! It looks like you should have saved more. And that investment was too risky, while this one was too conservative – if only you had made this decision instead!”
For some, the bottom line from a mathematical retirement calculator is even more depressing. According to the numbers, retirement is now impossible. There is not enough money to save and not enough time to save it. And since those are the only variables you can affect, math can’t help you. At a certain point, math says your financial future is beyond recovery.
Just on principle, there ought to be a better approach.
Change the Math – or Change the Path?
Some people in the financial services industry are beginning to acknowledge the limitations of math-driven retirement planning and are searching for alternative models. Like any concept that exists outside the box of what we see as conventional, the first exposure is likely to regard these ideas as unrealistic, provocative, even subversive to the known order of life. But even the most outrageous concepts often contain a kernel of truth that may lead to real-world solutions. One “out-there” retirement concept that seems to be gaining traction:
Adding a fourth leg to the retirement stool
The old retirement model that originated in the 1950s was often illustrated as a three-legged stool, because retirement was going to be funded by assets and/or income from Social Security, a company pension and personal savings. But given the financial uncertainty facing some or all of these legs today, a host of financial commentators are adding a fourth leg: continued earnings from employment. Yes, retirement now means continuing to work. This work is perhaps not as long or as hard, or for as much money – but is still steady employment. Continued employment can not only provide current income and essential insurance benefits, but it can also increase savings and shorten the period of “full” (i.e., non-working) retirement.
In this retirement model, the fourth leg is pretty important. So while you may want to adjust your investment portfolio or change your accumulation objectives, there are other “planning” issues to consider. In a November 8, 2010 article published on the Financial Planning Association website (www.fpanet.org), Jeanie Schwarz, a Virginia CFP® gives some “fourth-leg” advice:
Take classes to enhance your existing job skills or to learn new skills. Keep in touch with your professional network to improve your chance of finding a new job if your current circumstances change. Focus on maintaining a healthy lifestyle to reduce the risk that illness or injury will cause you to leave the workplace before you are ready.
It’s a bit different when a financial professional sounds more a career guidance counselor isn’t it? That’s because this is almost a no-math approach to retirement planning. The basic idea is to make sure you keep working, stay healthy, and save what you can. Full retirement, whatever it looks like, will be what happens when you stop working.
Keep working, save less, enjoy today. Christine Fahlund, a senior financial planner and vice president from a global investment management firm (i.e., a mutual fund company), expands the fourth-leg idea with something almost counter-intuitive to the paradigms established by the mathematical retirement models. In a video interview accompanying the above-referenced WSJ article, Ms. Fahlund tells reporter Karen Damoto that since many Americans can’t meet the saving and accumulation requirements of a retirement calculator, it might be time to “stop knuckling under and start having fun.”
Where the almost universal hue and cry from the financial service industry is that Americans aren’t saving enough, Ms. Fahlund offers a strikingly different perspective. “Have fun while you’re working,” she says. Furthermore, if you are approaching 60 and haven’t accumulated enough to retire, she suggests that you may even want to stop contributions to a qualified retirement plan. In a February 2010 interview with Morningstar, she explained her logic:
“Well, what we found, as I said before, was the contributions really aren’t helping you that much at that point in time. And so our suggestion is delay the date but not the gratification. So instead of contributing each year while you are still working, start taking those trips. Start spending those contributions instead. So that way, it is more of a gradual transition. You are already starting your retirement while you are continuing to work. And the results will really pay off in the long run.”
Hold on. Instead of contributing to your 401(k), you might want to take a vacation? Is this a Twilight Zone episode?
Not at all. Ms. Fahlund recognizes one of the major motivations for saving in the present is to enjoy the money some time in the future. But if an enjoyable future can’t be achieved by saving because you are starting too late or don’t have enough, saving becomes a negative strategy; it won’t work and it’s no fun.
Is this approach realistic?
These comments represent a fairly significant departure from conventional retirement thinking. First, the new definition of retirement includes working longer. Second, “retirement” and “working” are not separate phases of your financial life; they overlap. Third, the enjoyment phase of retirement – travel, relaxation, indulging in personal projects, etc. – is scheduled to begin earlier. It’s an interesting trade-off. But can it work? And if so, how would it affect your financial decisions?
The idea of people working as long as they can is nothing new. It has been the default option for most of history; even today, true retirement (i.e., no working income) is quite rare on a global basis. In some ways, planning to keep working is a better hedge against economic volatility and financial uncertainty than a math-driven plan that hopes the numbers work out, because you can add another variable (generating new income) under your control.
Furthermore, none of these outside-the-box commentators are suggesting that continuing to work means you should stop saving. But this idea does suggest that some financial decisions should be different. In a scenario where the ability to generate ongoing income is a critical retirement resource, life, health and disability insurance benefits have greater importance. People using a fourth-leg retirement approach need the income insurance.
In many math-driven retirement models, the approach to life insurance is to buy coverage in one’s 30s and 40s to replace family income in the event of a premature death. Thinking the need for income replacement will be met by accumulated funds in retirement, many of those same people anticipate dropping the life insurance in their 60s. They may purchase a 20-year term insurance policy with low premiums, knowing that continuing the coverage beyond 20 years will be cost-prohibitive.
But in a retirement scenario where working longer is the key ingredient, life insurance become a crucial piece of long-term financial protection. The financial relevance of replacing income may extend to age 60, or 70 – or until the end of life. Instead of needing life insurance for 20 or 30 years of prime earnings, life insurance may be required for 50 years – or longer. This requires a different approach to life insurance, with different plans and premiums.
As Ms. Fahlund mentions, there may be less incentive to use a qualified plan as a primary saving vehicle in a fourth-leg approach because one of the principal assumptions is that saving will be consumed, perhaps before retirement, and often in irregular amounts. These criteria may prompt you to consider other options for saving, perhaps with different risk levels and/or different tax treatment.
In consideration of all the uncontrolled variables in mathematical retirement scenarios, it is possible that a retirement strategy which emphasizes continuing to work, yet also allows for greater immediate enjoyment of the fruits of one’s labor is not only realistic, but perhaps both desirable and practical – provided you adjust your financial allocations accordingly. As Ms. Fahlund says “you stay in the workforce longer, but you’re having a lot of fun while you’re doing it.”
