Take a look
at two of the articles and discussion topics on APV -- "Retiring in a
Low-Return Environment" and "How to Link Retirement Strategies to
Sustainable-Spending Rates". Both
are a testimony to the never-ending quest for the best scientific approach to
optimal retirement planning. Both
articles are intelligent and logical and dutifully report the results of
volumes of research and analysis. I
commend Messrs Blanchett, Finke, and Pfau (BFP) on their diligence and fine
work. Of course they are only three of
many who have contributed to the vast volume of research on retirement
planning.
OK, now that
the niceties are out of the way, let me turn to my thought experiment. Let's begin by scrapping all existing models
and formulas that are used for retirement planning. No MCS, SWR, glidepaths, guardrails, etc. Instead we are going to ask BFP and perhaps
others, say, Bill Bernstein, Swedroe, (and maybe even Edesess and Taleb, if
they promise to behave themselves :-) ) to put their heads together and see if
they can agree on two things -- expected returns and reasonable worst case
scenarios.
By expected
returns I simply mean the stock and bond expected returns going forward,
ignoring sequence of returns, outliers, etc.
BFP et al (team) will no doubt consider current stock market valuations,
current interest rates, global market conditions, etc. and come up with what
they believe are fundamental expected returns going forward. I suspect that it would be relatively easy to
come up with agreed expected returns within a narrow range. I further expect that the team would also
find it relatively easy to agree such base case expected returns at any time in
the future, adjusting their estimates to the then existing market conditions.
Agreeing
reasonable worst case scenarios will be a tougher challenge for the team, but I
suspect that again agreement can be reached within a fairly narrow range. Both market and inflation scenarios should be
considered. Presumably reasonable worst
case market scenarios will go beyond the general periodic sequence of returns
fluctuations. Some of these can be quite
severe, e.g.2008, but relatively rapid reversals take them out of worst
case. The question would be: what is a
worst case scenario that you believe would be reasonable for a retiree to
prepare for. Peoples' imaginations could
go to imploding into black holes, but when considering reasonable worst
cases, I suspect that something much less drastic would arise. I suggest starting the search with an
immediate permanent equity decline of 60%; not too unlike Japan. Then each member of the team could submit his
views on whether a reasonable worst case should be more or less severe. I suspect that a narrow range of reasonable
worst case scenarios could be reached. A
similar exercise would be necessary to arrive at a reasonable worst case
inflation scenario and any other type of worst case that might be considered .
OK, now we
have agreed expected returns and reasonable worst case scenarios, now
what? Unlike MCS, we have no idea of the
probabilities of the worst case scenario occurring. Obviously many other events between base case
expected returns and worst case might arise, and we have not identified their
nature or likelihood of occurrence. What
good are two points when there is an infinite number of points in between? Time for the thought experiment.
My
hypothesis is that the two points -- base case and worst case -- are the only
forecasting tools that are needed for retirement planning. The endless MCS studies, etc. can be scrapped
and replaced with these two items. If
this hypothesis is correct, then it is obvious that retirement planning
technicalities will be substantially reduced and simplified. The base case is our 50% point, and we know
our actual could be more or less, likely centered on that point. We know that our worst case is possible, but
very unlikely to happen. We know that
other less worse events between base and worst may happen, which may become
more likely as we move from worst to base, e.g., a 30% permanent equity decline
is more likely than 60% and a dip of short duration is more likely than a
permanent decline. Starting with the
worst case, it is easy to evaluate possible less worse cases and obtain a
complete picture of what the future possibilities may be.
"But we
have lost MCS that derived all those in between probabilities." Really?
Those probabilities were simply unreliable and therefore unhelpful. But MCS told me that I had an 85% probability
of success in meeting my goals. Yeah,
but what if the worst case of a 60% permanent (or even 20 year) equity decline
happened tomorrow? "But my MCS and
guardrails told me the amount I can spend." Unfortunately, that will not work out for you
given the long-term decline.
I am not
suggesting that retirement planning should be geared to cover the worst case,
which is extremely unlikely to happen.
What I am suggesting is that once we have both base and worst, then it
is possible to evaluate spending and investing by considering any of the
outcomes that fall between those two, which the advisor considers most
pertinent and relevant to the client. For
example, the advisor could show the client how an event like 2008, which is
definitely possible, would impact spending and investments. The extensive computer modeling of MCS, etc.
is replaced with planning for various contingencies that are most relevant to
the client's situation. Most
importantly, the client understands what a worst case is, and how other less
worse case scenarios would play out in his specific situation. Judgment replaces formulas. Needless to say, the base and worst case are
continually reviewed and revised as necessary, together with the rest of the
retirement planning.
