A Study in Retirement

"Retired is being twice tired, I've thought.  First tired of working, then tired of not." - Richard Armour

"Retirement can be a great joy if you can work out how to spend time without spending money." - Author Unknown

We all want to be able to retire.  The problem is that there are so many forms of retirement that it means a totally different thing to different people.  To some the idea of retiring is akin to dying while to others retirement is the holy grail and should be grasped as soon as possible.  One thing that we can all agree on though is regardless of whether you actually retire in the true sense of the word or not, we all want to have the financial strength so that the freedom to be able to retire is available to us.  So the big question is how to get that financial strength and once you have it how do you protect it?

Well a lot of this is answered in my book How to Thrive in the Obama Economy (available on Amazon) and I do not plan to repeat it here but there are many schools of thought about how to protect your retirement and I will focus today on four strategies popular with the financial planners of the world. 

The first is the Floor Leverage Rule.  This strategy invests the vast majority of your investment portfolio into low risk investments and the remainder, roughly 15%, into very high risk investments such as a 3x fund.  A 3x fund leverages the investment to such a degree that the returns and losses are magnified three times the underlying portfolio.  So for example if you invested in a 3x S&P500 fund your returns would be three times greater than the current market returns.  So in effect you would be up over 50% year to date on 15% of your portfolio.  The key now comes through rebalancing as you would now allocate a large portion of the gains to the low risk portfolio bringing the whole position back into the 85:15 ratio again.

The second strategy is the 4% Rule Strategy.  Using this strategy retirees set up an amount of the portfolio that they will use to fund their retirement per year.  In an effort to keep spending sustainable throughout retirement the draw can be increased each year by an amount equal to or great than inflation.  This of course brings in a myriad of issues such as what is the actual rate of inflation (refer to an earlier blog for an analysis of this) and what happens later in life when the portfolio is a lot smaller but you have the large medical bills associated with the elderly.  In order to address this some advisers suggest drawing less in the beginning and more in the end.

The third strategy is based on behavioral finance and takes mental accounting to task in that it sets up the portfolio in buckets.  Each bucket is drawn on at certain times in the retirement spectrum so for example you can start by drawing on the low risk bucket first as this allows your higher risk bucket of stocks time to mature and iron out the fluctuations.  The question here is that as you get older your risk tolerance changes so you are constantly tinkering with your buckets and this can create havoc with your overall returns.

The fourth strategy is a utility strategy which takes the utility function of an additional retirement dollar and allocates a risk strategy based on this.  In this strategy the basic economic principle that each additional dollar losses its utility is used.  The theory goes that as you earn more money each dollar earned has less utility so that by the time you are earning $1 million a year, earning one more dollar is essentially meaningless.  In this example the last dollar can be put to use in a very high risk investment as the impact of loss of this dollar is essentially nil while if it turns into another million it has a big impact.

The problem as you can tell in all of these strategies is that they are mostly based on allocations of stocks and bonds.  As my book suggests this is too short sighted as the risks associated with limiting yourself to these two broad investment allocations results in a very high opportunity cost and opens you to large volatility.  In addition using derivatives such as the 3x strategy will result in high slippage costs.  These are the costs associated with running the fund and not tracking the index closely.  In my experience the 3x funds have very high slippage and do not produce even close to the results that are expected meaning that you do not make as much as you expect when the markets run and lose more when they dive.  Mental accounting is rife with problems as I do not know one person who uses this investment that is sufficiently disciplined to stick to the buckets.  This type of person is constantly tinkering with the buckets either out of greed or fear and ends up under performing the market.

What is needed in my opinion is a strategy that combines the utility strategy with a broader array of investments such as hedge funds, commodities, real estate and other exotic style investments.  Limiting yourself to the standard investment strategy will end up with the result that most of the population obtain and that is a sub par 2% annual compound rate of return.  I am not joking the statistics show that this is the return that most retirees obtain.  Looking at it that way either you should invest in Fixed Rate Deposits and earn 4% or at worst read my book but once again make sure that you take responsibility for your investment portfolio as the onus is now firmly placed on your shoulders since defined benefit plans became defunct and given the current manipulation of the markets 2% may end up looking very good!