The following is a special guest post by Michael Zwecher, Ph.D. He is the author of the highly worthwhile book, Retirement Portfolios: Theory, Construction and Management
(Wiley Finance). This book explains the process for seemlessly shifting
from the accumulation to the retirement phases and constructing a
retirement portfolio that first provides an income floor and then seeks
upside potential. In a lot of ways, the following essay provides a
succinct summary of his book. This essay is something I plan to cite in
my own writings, so I am glad to help bring it to public attention.
Michael is also a co-author with Francois Gadenne of the curriculum book
for the Retirement Management Analyst (SM) designation.
They Each Get Only One Whack at the Cat
by Michael Zwecher
I’ve only heard this expression used in the
Midwest, Wisconsin to be precise, but I love it for its shock value and for the
simple way that it conveys a truth: Each client gets only one chance at
retirement, and they want to preserve a lifestyle. Statements about portfolios that contain
phrases like ‘on average’ or ‘expected returns’ or ‘expectations’ or any such
terms should trigger a wary posture if they omit hard stops on losses. If I
were going to be able to play a game repeatedly I’d be happy to know that the
odds were on my side and if I lost a round I could come back. But if I only get
one turn, one whack at the cat, then I want to make sure that losing doesn’t
break me, no matter how favorable the odds. To put it another way, even a
single round of Russian roulette is not for me, no matter what the payoff.
Most of modern portfolio theory contents
itself with discussions of risk and return.
But clients don’t usually build portfolios just for show. Most have
their portfolios as a means for preserving their lifestyle in later life.
Preserving that lifestyle means preventing outcomes that reduce the portfolio below
the lifestyle-preserving level.
In the realm of Practice, retirement
portfolio strategies usually fall into one of two basic types, 1) those that
work probabilistically, either based on historical returns or based on
projections of future returns under some probability distribution, and 2) those
that work with probability one, by construction. It’s important to recognize
that just because something works in the typical case or has always worked in
the past, it will do your client no good if they are in the unlucky tail of the
distribution. With risky prospects, the word risk is there for a reason.
It’s easy to take this one step too far and
think that this means that one must be prepared for a doomsday scenario, but
it’s not that dire. Treasury strips, insurance annuities, municipal fund yields
are all things that may not be riskless in the absolute sense, but relatively
speaking, the risks are low; for an American holding Treasury strips the risks
are vanishingly small.
For retirement when we say build a floor
and expose the client to upside, we mean that for each period of retirement,
the client should be able to count on a known minimum level of income, coupled
with the potential that spending power will likely be above that level, but not
below. For someone familiar with the graphical representation of a
call-option’s payoff, it means that at each period you’re creating a call-like
profile for the client.
Without the floor, clients are exposed to
more two-sided risk. One can dampen the volatility of 2-sided risk with a
greater reliance on, say, bond funds, but that tends to lower the probability of
missing by a wide margin. Put another way, the odds of drowning don’t much
change, what changes is how far underwater the client is when they run out of
oxygen/money.
At the Retirement Income Industry
Association, RIIA, there is a cottage industry in exploring all of the myriad
ways of creating portfolios that have both floors and exposure to upside. The
important thing to remember is that for retirement it’s not just about risk and
return, it’s about risk, return and maintaining a minimum lifestyle. You have
many clients, but each of your clients gets only one whack at the cat.
