Saturday, February 7, 2015

A Little Thought Experiment



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.

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