There is an ongoing discussion in personal finance about the differences between safety-first and probability-based approaches to managing money, especially money for retirement.
You are (probably) familiar with the probability-based approach from hearing some of these well-known rules of the thumb:
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- You can withdraw 4% a year and (probably) not run out of money.
- You (probably) need about 80% of your working income to live on when you stop working.
- If you save 7x your annual salary, you will (probably) have enough to live on.
- You will (probably) make money in the market in the long-run.
There are few certainties in our universe. The sun will probably rise tomorrow. Though it is far less probable, you will probably live to see it, at least we hope so. One certainty is a day will come when you won’t. We don’t worry too much about these things, and the probability-based approach to managing money is commonly viewed in much the same way. For a variety of reasons, it is the default, mainstream view, supported by most of the big money firms. They’re ready with formulas for stocks, bonds, and cash that will (probably) work for you.
The other side of the discussion starts with the idea that the sun coming up is one thing, but running out of money before the sun sets is personal, and high on the list of events we don’t want to have happen after working for 30 or 40 years. ‘High’ as in top of the list, or very close to it. We get one chance to do this right, and the consequence of screwing it up is not acceptable to most of us. No one wants to see their retirement income cut in half by Wall St. shenanigans or a down market. For many of us, that it probably won’t happen isn’t good enough.
That is the essence of the safety-first approach. How does it work?
Safety-first starts with your income, expenses, balance sheet, and your household risk exposures, not with stocks/bonds/cash, which means safety-first is based on your financial situation and goals, not on probable market performance.
We add up all of your expected income and expenses in retirement and discount it to present value to see how well you are covered by your savings. We do the math on your household risk exposures—some of you have special situations with dependents, health issues, employment, and other interests that magnify or diminish the broader risks we all face from inflation, regulatory change, economic volatility, longevity, and household shocks.
The math results in a coverage ratio—at the heart of your balance sheet—that shows whether you should save more or less, spend less or more, and how best to manage your household risks with the resources you have. Safety-first is about managing all the risks you face over a possible 30 years of retirement, not just risk in the stock market.
From your coverage ratio we derive your household allocation to upside/floor/longevity/reserves. This allocates your savings to the four fundamental methods of risk management—diversification (upside), hedging (floor), insurance (longevity), and retention (reserves).
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- The floor is crucial to successfully managing retirement. Your floor is the current amount of savings you need to cover your future expenses throughout retirement. We make the floor increasingly secure as you approach retirement, and ultimately turn it into a risk-free ladder of TIPS bonds sized to cover your expected expenses while hedging inflation. Your floor has your lifestyle covered.
- The longevity allocation is the amount of savings we’re going to use to insure your expenses late in life with some amount of guaranteed income to cover you if you live longer than average. The amount will depend on the strength of your balance sheet and your health risk exposures. Together with Social Security, an allocation to guaranteed income insures that you won’t outlive an income sized to your expenses late in life. Determining a Social Security claiming strategy that fits your household is also part of the longevity allocation.
- Reserves is the amount of your savings we keep in cash to cover you from things that are difficult or expensive to insure against—life shocks, regulatory change (higher Medicare premiums), long-term care, and other unexpected changes in income and expenses.
- Upside is what’s left over. Upside is the only amount of your savings that you can safely expose to market risk in the stock market. We invest upside in a low-cost global market portfolio of passively managed index funds designed to reliably deliver market returns year-in, year-out.
If your upside account drops in a downturn, you can afford to wait it out. A drop in your upside account does not impact your income floor—the money you need to support your lifestyle. This is quite a bit different from the focus on growth and performance common during the accumulation/working years. It also works pretty well—so much so that more and more people are using this approach during their accumulation/working years instead of hit-or-miss performance-based strategies.
For many of you, after you’ve covered your floor, the upside may not be a big chunk of your savings. Now you know a key reason safety-first is not more widely espoused by financial professionals—it doesn’t leave much on the table for hungry Wall Street banks. They’re doing everything they can to keep you in the mutual fund world where you built your savings inside 401(k)s and IRAs. You won’t hear much about upside/floor/longevity/reserves from your big firm rep. You may never hear one recommend a TIPS ladder to create risk-free inflation protected income throughout your retirement.
So after we’ve done the math, you might have a safety-first retirement allocation of 10/70/10/10 upside/floor/longevity/reserves, compared to the typical Wall Street recommendation of 60/40/0 stocks/bonds/cash.
For the safety-first, the “70” means the bulk of household resources are dedicated to risk-free inflation protected income that will fund all expected retirement expenses. For the probability-based, the “60” means more than half of the household savings is exposed to market risk. Yes, there is possible reward for bearing that risk, but there is also the probability that over a 30 year retirement period, that more than half the household savings could experience one or more significant drops, dramatically impacting the household standard of living.
Can you afford to take that risk?
Doing the safety-first math is the one sure way, based on your household balance sheet, to answer that question.
–Michael Lonier, RMA℠
Visit www.rmap-planner.com to check out my safety-first planning software!