Tuesday, January 19, 2016

Unplanned Expenses in Retirement

It’s Going To Happen!
Whether an unexpected medical emergency(1), kids move back home, or Uncle Buck needs a loan…..it’s going to happen. That unanticipated expense that your otherwise robust retirement plan didn’t explicitly plan for.

Dirk Cotton of the Retirement Cafe blog coined the academic term sequence risk of consumption for unexpected retirement expenses. You may already be familiar with the more well known sequence risk when taking distributions from your retirement portfolio, sequence risk of returns. Sequence risk is random and problematic for retirees, and that uncertainty applies to both expenses and savings.

Sequence Risk of Returns Review 
Let’s first review sequence risk of returns using my Hypothetical Portfolio Growth Paths visual below to review the issue. Given the randomness of portfolio growth (i.e. variation of portfolio returns in any given year), many retirement planning models forecast asset growth over time using an annual return average. But the variation in actual annual returns from that average in any given year can be huge in either direction.

So whether your portfolio returns approximate the positive orange return line (Path 4) or trend closer to negative green return line (Path 5), this will make a huge difference in your ability to fund ongoing retirement if your asset mix is heavily dependent on volatile assets and you are currently taking distributions. I’m defining volatile assets here as stocks, bonds, and alternatives where the asset prices fluctuate daily.

For an in-depth discussion with live examples of  sequence of return risk please review this video; to access visual growth paths app above please click here.

Visualize The Risk 
Even if your favorite retirement planning calculator tells you that your plan will be successful 95% of the time, are you really safe? The screenshot below is an example of Koch Capital’s Household Balance Sheet (HHBS) planning tool that we use with our retirement planning clientele. The HHBS dashboard summary provides a 30,000 foot view of a hypothetical household’s retirement funding status as reported in the current funded ratio value. You can think of the funded ratio as answering the question – Am I on track for retirement? If the household balance sheet and funded ratio concepts are new to you, please see this video for additional information.

Source: Koch Capital

Please note that even though the Flintstone household is slightly over funded (i.e. funded ratio > 1) against its anticipated future living expenses, this hypothetical retirement plan is NOT securely funded.  As Mr. Cotton points out in his white paper, randomness happens on both sides of the balance sheet, negatively impacting both savings and expenses, and sometimes at the most inopportune time…...well into retirement.

Heavy dependence on volatile assets to fund retirement living expenses is risky business, especially over a 30-plus year retirement given asset price fluctuations and the timing of withdrawals from those asset pools. I’m defining volatile assets here as IRAs, 401ks, Trust investments in the Current Financial Assets category and real estate and private businesses in the Current Real Assets category. Drawing down a portfolio during a significant market correction can put your long-term funding of future retirement living expenses in jeopardy.

Sequence Risk of Consumption Reality 
Likewise, unexpected Essential Living Expense, Medical Expense or even Tax Expense costs in retirement can jeopardize your future retirement spending plans too. There are  two remedies to deal with sequence risk on both sides of the household balance sheet ledger.

First, convert some of your volatile assets into safer income assets like Social Security (possibly by delaying benefits), TIPS, annuities and date-certain government bond ladders. Think of this as your secure income floor targeting, at a minimum, your essential living expenses.
Next, if possible maintain an asset surplus given no retirement model is perfect nor perfectly accurate. Striving for a funded ratio over 1.2 provides an emergency reserve surplus to counterbalance modeling errors and sequence risk. You can think of this surplus as your household’s well-earned owner’s equity cushion against whatever life throws at you in retirement.

Source: Koch Capital

The Value of Flexibility in Dynamic Modeling
The final point to consider is your retirement plan’s ability to adapt to potential downside costs from unexpected sequence risk events on either side of the household balance sheet. Can your retirement plan survive the worst case possibility of a sequence of return risk event and a sequence of consumption risk event occurring at or near the same time?

In my opinion, all retirement planning models need to adapt better to not only changes in savings but also changes in client spending behavior. It’s one thing to incorporate real-time account balances into your model, but quite another to anticipate and adapt to asset valuation expectations due to changes in inflation, market valuations, currency, withdrawal timing and longevity. Even more important are the behavioral aspects of the spending side where an unexpected but emotionally charged spending decision will trump a distant spending goal every time. Detailed cash flow budgeting is great start and helps savers to better understand the trade-offs between spending now and saving for later. But your retirement plan needs to adapt too to fully explore the alternative paths to keep the saver on track for a secure, lifelong retirement.

Liquidity within asset categories later in retirement helps too, so please don’t get too carried away with promise of big returns on illiquid assets that will do you no good if you can’t cash out when you need the funds most. Finally, don’t forget to review and adapt your retirement plan, and please do it regularly.

Thank you for your continued interest......Jim   

Footnote: (1) Click here for Billy Crystal’s definition of an unexpected "medical procedure".

About Jim Koch
Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to individuals, families, trusts, business entities and other advisers so they are better able to achieve their goals. Jim sees himself as an “implementer” of financial innovation, using state-of-the-art technology to provide practical investment management and retirement planning solutions for clients.

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1 comment:

  1. Francois Gadenne of the Retirement Income Industry Association (RIIA) rightly pointed out to me that there had been worked on the Sequence Risk of Consumption (SROC) prior and/or in conjunction with Mr. Cotton's work. Pleases see Mr. Gadenne's comment below. Thank you Francois.......Jim Koch

    "Note that Sequence of Consumption Risk is a concept that was developed by RIIA and PwC with its results first published in the 2015 Spring issue of theRMJ: 'Leveraging Behavioral Simulation to Enhance the 4% Rule.' and shortly there after in the attached RMA Update Bulletin."