My supervisor suggested me this book saying it would serve as the core for my literature review
Moshe A. Milevsky, “Are you a stock or a bond? Create your own pension plan for a secure financial future”
After reading the book, I have found out that personal financial planning is the very field that I want to do research about because this is going to be an essential subject for country like Vietnam when the golden population ages. This would be helpful for each and everybody to plan for their retirement future.
General summary (Chapter 1 and 11)
In today’s volatile economic environment and financial markets, investors are constantly reevaluating their attitude to financial risk on virtually a daily basis. However, your approach to financial risk should not be based on a psychological mindset based on your temper du jour, but instead on the composition of your entire personal balance sheet. The ...broadly defined...investment account is no longer a retirement income supplement or... a part-time hobby... but the means by which you will be able to finance the and support the last 20 or 30 years of your life.
...we have a long way to go before individuals truly consider the risk and return characteristics of their human capital and invest their financial capital in a way that balances their comprehensive risk.
The purpose of the book is to help manage and grow your nest egg so that it can eventually be converted and allocated into a pension. The ultimate goal is retirement income planning by using the unique nature and composition of your human capital.
As the trends in aging..., the topic of pension and retirement income will only grow in importance. ...
Also, the situation is that major corporations are moving away from providing pension income for life (Defined benefit pension plan which is calculated by the product of the accrual rate, the number of years you have been part of the pension plan and the final salary) to shifting the responsibility to the employees (defined contribution plan which includes self-directed accounts such as 401(a), 401(k), and 403(b) with only the regular periodic contributions are known and determined in advance). Many of the companies freezing or converting their defined benefit (DB) pensions and replacing them with defined contribution (DC) plans are doing so partly as a result of the demand from employees (who need retirement savings with mobility and flexibility), partly because it help take the unquantifiable longevity risk off their corporate balance sheet and transferred it to the employees’ personal balance sheets.
DC plans contain no formulas or income guarantee. They are salary-deferred, tax-sheltered savings plans. Your final retirement nest egg will depend on how much you (and/or the company) contribute to the plan, how your investments perform on the way to retirement.
Retirees face a number of unique financial risks that are not (as) relevant earlier on in life: (1) Longevity risk: the uncertainty of their life horizon and its costs (2) Unique inflation risk (3) A particular type of financial market risk (sequence of returns).
Strategy to deal with the risks:
Step 1: Get a retirement needs analysis, i.e. estimate what you will need in retirement by adding up the estimated annual cost of all the things you simply can’t live without
Step 2: Determine your income gap by adding up the sources of all of your retirement income benefits or guaranteed pension benefits (adjusted for inflation) and then subtracting that benefits from the retirement needs. If your income gap is a mere 15% of your projected income needs, then you do not need to get any insurance or other forms of guarantees and protection. Also, the larger the...ratio between the market value of your financial assets and your income gap... the better your situation. In fact, the income risk management depends on the 2 ratios: Income gap over income needs and financial wealth over income gap. If the first ratio is high and the second is low at the same time then at some point during your retirement, you will be forced to reduce your standard of living (unless you delay retirement for a few years).
Other factors should also be taken into account such as: (1) retiring at a younger age (2) trying to protect a spouse, i.e. planning for two people.
Human capital and personal balance sheet
- The traditional accounting measures of personal financial net worth and equity, which is computed as the value of assets minus the value of liability.
- The single most precious asset on a young person’s financial balance sheet is the present value of all the salary, wages, and income he will earn in his working life (Human capital). The greater your income prospects, the greater your human capital. The discounted value of this income can be in the millions of dollars and thus the balance sheet should include human capital along with tangible assets to truly reflect the value of a person.
- In many cases, the financial investments might have declined in value, but your human capital might have increased by much more, and vice versa. Spending on education should be viewed as an investment as opposed to consumption or expenditure.
- Your human capital’s riskiness should be incorporated into all your investment decisions. Depending on how risky your job is, it can be considered as a stock or a bond.
- As a person ages, he converts human capital into financial capital. Individuals who expect to receive little or no income from a defined benefit pension plan must be even more careful to manage that conversion in order to secure a smooth income stream over their entire life cycle.
- The typical 40-year-old has almost $50 of debt per $100 of assets. Overall, the tyical family unit has $30 of debt per $100 of assets. The median amount of money in retirement accounts is a mere $35,000, and 50% of American families do not have any retirement account. It means that many Americans will have to drastically reduce their standard of living at retirement or retire much later than they expected.
Life insurance as a hedge for human capital
- Life insurance policies and almost all financial instruments that we purchase for risk management purposes, should not be viewed as investments, but as hedging instruments. Still, the goal for most of these hedges is to lose or waste the money because it meant only to financially protect your loved ones, not to compensate them for the associated psychological pain.
- When a person is young, she should long mortality risk (buy life insurance)to secure a financial payoff for her dependents. But when she gets older, she should go short and hedge the risk of a long life (buy a pension annuity), i.e. the risk management focus should shift to the risk of outliving your wealth.
Diversification over space and time
- Diversification is very important at all stages in life. Thus you should have exposure to bonds, (domestic) stocks, international stocks and alternative asset classes altogether.
- Human capital... has characteristics of a stock or bond. The riskier your human capital , the more it resembles a stock, the less stocks you should have in your investment portfolio and financial capital. You can afford to take more diversified investment risk...when you are saving for retirement... because you have an investment in human capital, which may behave more like a bond than a stock. You also have the option to delay retirement, which gives you a buffer against market risk and volatility.
- Over long time horizons, the probabilities favor investing in stocks, i.e. as the time horizon increases, the probability of shortfall(regret) in stock investment decreases rapidly (decays exponentially).
The importance of debt
- Debt is a financial strategy which makes perfect sense for investment purposes as long as the interest you are paying... is less (on average) than the return you are earning on the borrowed funds.
- When you borrow money to invest, you are increasing the chances of financial shocks. Make sure you can withstand these shocks and have the funds to cover the interest payments during turbulent times, i.e. the leverage ratio and the borrowing (margin account) interest rate should be paid close attention.
- If your human capital is more bond-like (e.g. secure job with a predictable income stream, you might be overexposed to bonds and hence you might be able overexposed to bonds and hence might be able to afford to borrow money to invest, even if you don’t need the loan. You should short bonds and neutralize some of your holdings to invest in stocks to make sure your total balance sheet is diversified.
Personal inflation and retirement cost of living
- True inflation is personal and not an atmospheric phenomenon, i.e. personal cost of living and the population inflation rate should be distinguished.
- As you age the inflation rate is likely higher because the elderly spend their money on goods and services that tend to appreciate at a higher rate over time.
Sequence of investment returns
- When you accumulate wealth, and invest for the long run, the exact sequence of investment returns does not matter (with buy-and-hold strategy – no cash flow goes in or out). But when withdrawing money, the sequence of investment returns counts as you can earn a positive average return but still end up exhausting your portfolio early in retirement. Thus, in retirement, the fundamental axiom of modern portfolio theory and current investment management that investments can be ranked solely on the basis of their mean return and variance no longer applies.
- Underestimating life expectancy or getting unlucky in the first few years of retirement...are roughly on the same order magnitude of a impact on income sustainability.
The failure of bucket to retirement income
- Bucket approach is used to avoid the damaging impact of a poor consequence of investments returns: one places few years’ worth of retirement spending needs money into safe investments, and then plans on not touching the remaining funds in the event of a bear market. Then, if markets decline, a retiree should simply be counseled to only take income from his bond allocation, then “wait for the stock allocation to recover” and thus avoid selling at a loss.
- However, Milevsky showed that if you are unlucky enough to earn a poor sequence of initial returns, so-called bucketing of your retirement income is not a guaranteed bailout. He used an example comparing 2 people using different strategies starting off with the same amount of wealth: one used bucket, the other used a balanced 70/30 portfolio. Although the bucket has higher probability of winning, it is not a guaranteed way to avoid a poor consequence of returns. In all the scenarios for which the market lost money in the first 2 or 3 years, the balanced 70/30 portfolio performs better. Thus, bucket approach does not protect investors from a prolonged bear market.
- Adopting the so-called buckets approach to retirement income planning will lead to an increased implicit exposure to equities leading to unpredictable fluctuation over time. Moreover, if indeed you experience a poor initial sequence of investment returns so that you have been forced to liquidate all your cash investments, you might find yourself with a 100% equity exposure well into retirement and possibly deep into a bear market. This is in contrast to the nonbucketer who is maintaining the same exact asset mix and hence the same financial risk profile over time. Bucket approach thus does not allow you to hedge your financial capital against the sequence of returns risk.
- Getting average in the long run might not be enough as averages can be very deceiving in retirement. That’s one more reason why pensions and other products that are means to create a pension-like income stream are such an important component of a healthy retirement income portfolio.
Longevity risk
- Life expectancy numbers are not meaningful as they apply at birth, not at retirement, and do not account for possible reductions in future mortality. They are based on today’s death and survival rates. Also, those numbers are on average. Healthier, wealthier, and more educated individuals tend to have lower mortality rates and better longevity.
- When you reach your retirement years, in good health and wealth, there is a high probability you will reach the advanced 90s. There is a nontrivial chance you will reach triple digits, and the odds are better for females.
- Our inability to precisely know how long we are going to live and spend in retirement falls under the label of “longevity risk. If there is a downward shock and your mortality rate declines, and you live longer, you face the risk that your nest egg will not suffice or provide enough income to last for the rest of your life.
Using Monte Carlo in asset allocation
- Retirees should have a substantial exposure to equity-based investments, at the very least to beat their personal inflation rate.
- The essential step is to conduct a need analysis to determine whether your nest egg fill the income gap.
- You’d better deal with long-term planning by budgeting and stating your needs in real, after-inflation terms, specified on an after-tax basis. At the same time, you must also project your investment returns in real, after-inflation, after tax terms.
- Compute when the money will run out and then look at the probability of being alive at that time. The higher the number, the more likely it is that your standard of living is simply not sustainable.
- The idea is to plan ahead and to realize the consequences of your actions in their most drastic, worst-case scenarios.
- Use the “Dual Uncertainty model”: two sources of uncertainty must be dealt with: future investment returns and mortality rates. Use the Monte Carlo simulation to calculate the probability of outliving with money. Then sift through the cases to locate the asset allocation that minimizes the probability of outliving wealth.
- An alternative is to use a mathematical formula relating 3 retirement risk factors – inflation, investment/sequence of returns, and longevity risks – into a summary risk measure called the probability of sustainability. The inputs include (1) the median remaining lifespan obtained from a longevity or mortality table (2) the planned inflation-adjusted retirement spending rate denoted in percentage term of your retirement nest egg (3) the anticipated inflation-adjusted risk and (4) return from investment portfolio
The effect of asset allocation on sustainability
- The odds of earning a specific return depend on asset allocation: how you divide capital between stocks, bonds, and other investments.
- The numbers level off at a 60% allocation to equity, i.e. any additional allocation doesn’t do much to improve the probability of sustainability. This is because higher equity allocations will increase the portfolio growth rate in the long run but also increase the risk of a bad run of luck in the short run.
Annuities are personal pensions
- Annuities are risk management instrument and are the foundation of defined benefit pension plans as well as the U.S. Social Security system.
- Variable annuity can be thought of as a mutual fund with a selection of different investment options, together with a number of implicit and explicit guarantees. Some of these guarantees are quite valuable. The new generation of guaranteed living income benefits (GLiBs) provide fair value to the consumer and can be appropriate for funding one’s retirement.
- An annuity is best viewed as a process as opposed to just a product. The goal of this process is to grow the account by receiving dividends, capital gains, and interest. Three exit strategies:
ü Surrender (lapse) the policy by withdrawing the entire sum of money.
ü Die, which result in a guaranteed minimum death benefit to a beneficiary
ü Opt to receive slow and periodic income payments, which can be guaranteed for life or a fixed period of time until the money runs out.
- The previous version of variable annuity only offered a basic guaranteed return-of-premium death benefit. That a promise of getting your money back when you die was pointless and at the very least can be replicated using cheaper forms of life insurance. The new version of variable annuity focuses on the pay-out stage of the annuity life cycle and the concept of annuitization.
- When an annuity policyholder ends the pay-in phase by electing to receive a guaranteed income benefit, he is said to annuitize the account or to purchase an immediate or pay-out annuity. In exchange for the lump sum, the company promises to slowly return this money until the day of the retiree’s death. The retirees cannot securitize, cash in, or monetize the income stream.
- Advantages of annuitization:
ü An immediate annuity provides lifetime income that cannot be outlived – an invaluable hedging tool against longevity risk.
ü Provide a mechanism for pooling, sharing, and hedging longevity risk over a large population, which leads to a higher yield for annuitants
ü Provide stable and predictable income that is not subject to vagaries of the stock market
ü Although annuity yields have been steadily declining over the last few decades as a result of both lower long-term interest rates and increasing longevity, immediate annuities always yield more than bonds because annuity is an integrated blend of three distinct cash flows: (1) a type of interest coupon on your money (2) aportion of the premium and (3) some of other people’s money – mortality credits (the tontine)
- Disadvantages of annuity:
ü Complete irreversibility of the decision after the policy has been funded and the product is acquired: one cannot redeem, cahs in or sell in the secondary market.(although some annuities are designed to provide partial-liquidity refunds and death benefits)
ü Concern of inflation
ü Credit risk: the risk that the insurance company is unable to meet its payment obligations.
- New living benefit riders being attached to variable annuities:
ü Income benefit(GMIB): Provides the ability to convert the best or most favorable policy value into lifetime income at a guaranteed rate by annuitizing
ü Withdrawal benefit (GMWB fL): Allows for a systematic withdrawal plan that guarantees a minimal income for a fixed period of time or for life
ü Accumulation benefit (GMAB): Guarantees to return at least your entire original investment back, if not more, at some predetermined horizon or age.
ü Longevity benefit (ALDA): Provides lifetime income that starts at advanced ages in exchange for a small insurance premium that you pay upfront or over time.
- Some products and strategies use the word annuity but are very different from the above-mentioned annuity.
Product allocation is the new asset allocation
- At retirement one should strive to create a diversified portfolio of products that protect against various retirement risks and make sure to allocate a portion of the money to some sort of annuity instrument, whether fixed or variable, immediate or deferred to get some mortality credits.
- In the retirement income phase, product allocation is the much more important than asset allocation. Product allocation means the decision of how much of your retirement income should come from conventional financial instruments, such as mutual funds or exchange traded funds, and how much should be generated by pension-like products, such as life annuities, variable annuities, and other guaranteed insurance products.
- Risks that appear only in the retirement phase: (1) Longevity risk (2) Inflation risk (3)Sequence of returns risk
- Three principal financial and insurance categories that should be considered for a comprehensive product allocation strategy:
ü The systematic withdrawal plan (SWiP): a strategy in which money is systematically withdrawn from a fund allocated among various investments to generate a retirement income. This process continues until the account value hits zero, or until the end of the retiree’s life cycle
ü The latest generation of variable annuities offers the option to elect a number of riders or features with embedded guarantees that address retirement risks – the guaranteed living benefits (GLiBs)
ü Life-time pay-out income annuities (LPIAs) also known as single premium immediate annuities (SPIAs) or fixed immediate annuities (FIAs): provide longevity insurance
- The three products are economically equal: each offers a valuable benefit that is “paid for” via trade-off in another risk management or goal achievement attribute
Retirement product evaluation
| | Risk management attribute | Goal achievement attribute | Fees and expenses | ||||
| | Inflation | Sequence of returns | Longevity | Liquidity | Behavioral “self-discipline” (help avoid investor’s mistakes) | Estate | |
| LPIAs | 1 | 2 | 5 | 0 | 4 | 0 | 0 |
| SWiP | 4 | 0 | 0 | 5 | 1 | 5 | -2 |
| GLiBs | 2 | 5 | 3 | 1 | 3 | 3 | -4 |
Optimal product allocation for retirement income (PrARI) methodology:
- Input variables: Retirement age, estimated retirement wealth, desired spending rate, existing pension and social security income, etc. + Capital market projections and assumptions
- Output:
ü Retirement sustainability quotient (RSQ): the probability that the spending strategy will be sustainable and will not result in a spending shortfall.
ü Expected discounted bequest (EDB): the present value of the amount expected to be left to the estate.
- Retirement priorities will be assessed to select optimal retirement product along the frontier. A guiding concept should be the economic trade-off that is implicit within any selected product allocation: security for oneself versus security for one’s heirs.
- Investors consider guaranteed living benefits as an equity put option and thus have greater confidence to take on equity market risk.
- In most cases retirees will not be able to finance a sustainable retirement income with only one or two traditional product classes. All three product categories – income annuities, mutual funds, and variable annuities with embedded guarantees mixed and matched in various combinations are required to maximize one’s retirement sustainability quotient.
Interesting points about Milevsky’s writing style:
- Give hypothetic examples with imaginary people
- Start each chapter with a myth and then give antithesis to that myth.
Questions:
- Do you really follow Milevsky’s strategy, i.e. do you borrow to invest in stocks?
- Does bucket approach mean holding money and equity only?
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