By Benjamin Messinger
My favorite economics professor started our first class by asking: “What is the purpose of a business?” A classmate called out, “To make a profit.” Our professor replied, “Wrong! The purpose of a business is to MAXIMIZE profit! Making a profit leads to golfing in Ritzville. Maximizing profit leads to scuba diving in the Caribbean.”
If you operated your business with no expertise beyond adherence to “rules of thumb” which scenario do you think is most likely: Ritzville or the Caribbean?
Consider your household as a business. Can you expect to maximize your personal financial performance by simply following rules of thumb?
I realize many of this publication’s readers are entrepreneurs and as such, you are born do-it-yourselfers. Trust me. I get it. I’m afflicted with the same condition. Whether you DIY your own wealth-building roadmap or access the services of a professional, I hope I can influence you to abandon reliance on rules of thumb in favor of a more optimized approach. You only get one shot at this. I’d like to see you make the most of it.
We are drawn to rules of thumb because they seemingly solve complex problems simply. In reality, some problems just aren’t simple to solve. Let’s take a look at some common retirement planning rules of thumb and see where they can steer us astray.
We’ve all heard this one, right? Always save 10 percent and magically you’ll amass the perfect amount of capital to fund your retirement. Unfortunately, life is not linear. Young adults are typically less wealthy and carry some debt. We raise families, develop our career or business, and hit our highest earning years after many of the hardest financial burdens have already been overcome.
Is it optimal to save at the same rate through every phase of your working years? I would argue that it is not. Saving at a steady 10 percent produces regulated savings that grows with your income. There is logic to this, but not a complete solution. Ignored are many important details such as the dynamics of expenses, income and lifestyle that change over the course of your working years.
Saving at 10 percent in the early years may be a poor choice if there are high-interest debts to pay off and 10 percent may be far less than optimal in those pre-retirement empty-nest years when your saving capacity may be much higher.
Rather than “set it and forget it,” personal savings should be determined strategically as part of your cash-flow plan, just as it should be for your business.
This rule is no more likely to provide you a perfect experience than one-size-fits-all clothing. Should a younger investor’s portfolio hold more equities (stocks) than an older investor’s? Usually, but not always. Is a 55 percent bond allocation ideal for every 55-year-old under all conditions? Definitely not!
Regardless of age, the primary factors influencing selection of stock-bond ratio include timing and magnitude of cash-flows, time horizon, market conditions, inflation, interest rates and dividend yield. Two of those factors are influenced by age, but there is no universal age-based formula for the best portfolio mix.
The problem is a universal age-based recommendation is exactly what you’ll get from your robot overlords (online tools) and from humans who know just enough to be dangerous.
This is a rule that works better in a test-tube than outside the lab. Several academic studies have used back-testing against historical market performance to determine that a hypothetical balanced portfolio with a 4 percent initial distribution rate is not likely to run out of money for at least 30 years. These observations are very useful in understanding some fundamental limits of portfolio yield. The observation is frequently misinterpreted to imply that 4 percent is the best distribution rate under all conditions and time-horizons. This does not take into account significant variations in income required of the portfolio at different times. For example, an individual retiring at age 62 may wish to delay Social Security or pension benefits to a later age in order to maximize them. This may require an initial portfolio distribution rate higher than 4 percent, but results in a much lower rate later. Also, using 4 percent as a rule of thumb ignores time-horizon. A 60-year-old with a 7 percent distribution rate is probably going to run out of money at some point. An 85-year-old probably will not.
Time-horizon is a critical consideration, and the 4 percent rule is not effective as a one-size-fits-all.
This rule of thumb is true if you started investing in 1926. Unfortunately, you’d be dead by now. As they say, your mileage may vary. Someone who retired 15 years ago with a stock portfolio invested in the S&P500 composite index (including dividends) would have experienced an average return of 7.1 percent (period ending March 31, 2017). That’s just shy of 30 percent below the supposed 10 percent rule. I doubt most DIY retirement plans have the margin to absorb a 30-percent return miscalculation. An investor wishing to more accurately forecast equity returns would do well to study the relationship of various valuation metrics to long-term returns. The research of John Y. Campbell and Robert J. Shiller are good places to start.
An emergency fund is a form of insurance. It is better to be over-insured than under-insured, but that does not make it efficient. Consider two households. Household No. 1 consists of a single wage earner and 4 dependents. They have a mortgage, student loans and a car payment. Household No. 2 consists of a retired couple. They have no mortgage or other debts. Pensions and Social Security benefits cover 90 percent of their income needs. It should be clear that household No. 1 has a much greater cash-flow risk. If the wage earner suffers illness, injury, or some other disruption in their ability to bring home a paycheck, the size of their emergency fund becomes very critical. Household No. 2 should certainly maintain a liquid emergency fund, but it should be clear that their liquidity needs are significantly different.
I hope that by now it is becoming clear that every aspect of retirement planning, or financial planning in general should be approached strategically with the objective of personalizing to maximize effectiveness based on your needs and circumstances.
I suspect many of you devote significant effort to specific goals for your company’s cash-flow statement, balance sheet and profit-and-loss report. Those goals are tailored specifically to the unique aspects of your business. Are you applying that same level of attention to your personal finances and retirement planning, or are you leaving fate to rules of thumb? I hope you’ll take the better path and maybe someday send me a postcard from the Caribbean.
Benjamin Messinger is an adviser with HFG Trust in Kennewick.
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