Reducing Uncertainty

The great thing about owning our home free and clear by the time we retire is that it takes a lot of risk out of retirement. In fact, it's extremely profitable way to live. Instead of having to generate income (which is taxed) to pay rent, we get to, in effect, pay ourselves rent and we don't have to generate any income to do it! It's like getting a discount on our living expenses equal to our tax rate. It also means that as housing expenses change due to inflation, the economy, whatever, we are protected. That's a very comforting thought.

Still, owning a house isn't a completely free ride. Maintenance is still an issue as are property taxes. As anyone living in California during the 1970s can tell you it is quite possible for housing prices to explode and property taxes to go with them. This is what eventually contributed to the introduction of Proposition 13, which made it a lot safer to own a house but did a real number on California's finances [CAP]. Many states, afraid of the repercussions of Prop 13, have therefore put in place protections for the elderly against property tax increases.

So while there is no such thing as a free lunch owning our own home by the time we retire seems a pretty good idea.

Store of Value?

But the real question is – should we treat our home as an investment? Should we count on the value it will build up and expect to tap that value for income during our retirement? Treating a house like an investment seems to me to be the equivalent of buying a single stock and saying we're invested. Strictly speaking it's true but we've exposed ourselves to a lot of risk by not diversifying properly. Lots of things can happen to a particular house. For example, here is a sample of things that have happened in our upper middle class neighborhood in the last few years:

• What apparently was a meth lab was run from a house down the block

• Convicted sex offenders have moved into the area

• The city is trying to re-develop a near by military base into a traffic choking sports complex with flood lights that will be on until late in the night

Any one of these things could have done a number on our individual home's value.

Besides, how exactly should we estimate the likely value of our house three decades from now? And then how are we to estimate the value of our house during retirement, not to mention estimating things like interest rates which have a strong affect on how much equity we have in the house and how easily we can extract that equity? We don't know what state we'll be living in three decades from now much less what house.

It's also fair to wonder if housing prices are necessarily predestined to go up over extended periods of time. [BBP], for example, argues that housing prices move in tandem with the portion of the population that is employed. But we know that in the future a smaller and smaller portion of the American population will be working (see the last column of Table V.A2. in [SDP]). Which is why [BBP] argues that housing prices, in the long term, are going to fall in America. Now it's only fair to point out that [BBP] makes a whole boat load of assumptions which may not turn out to be true and it ignores a lot of factors to simplify the analysis but I think the argument is interesting enough, when combined with the diversification and location issues, to make me hesitant to treat our house as an investment.

Cashing In

Once upon a time the only way we could realize the equity in our house would be to leave it, either by renting it out or selling it. These days there is a third option, a reverse mortgage. See [FRM] and [HCR] for good, but brief, descriptions of the key features of reverse mortgages.

If we plan on extracting the equity from our house by selling or renting it we have to leave the house (or have tenants, yuck). That actually seems a reasonable enough plan to me as the house we want to own now is designed for a family and when we retire it will just be the two of us. But watching my own parents make these decisions I've seen how hard it is to leave a home you've made your own over a period of decades. My parents aren't moving from their family sized home and I hope to have the same option to stay where we are for Marina and I.

If we use a reverse mortgage we can stay right where we are but at the risk of never being able to move. For example, let's say we have taken out a reverse mortgage. All the money we are lent earns interest which is due back to the lender. But the interest is secured against the equity of the house. The good news is that if the amount we owe exceeds the value of the house the lender looses, a reverse mortgage only allows the lender to get the equity in the house and that's it. But interest is due on all money lent out under a reverse mortgage and that interest is charged against the equity in the house. The end result is that a reverse mortgage can very quickly eat up all the equity in the house. So if we decide we want to move, for whatever reason, we can easily find ourselves with no equity left in the house and so no funds with which to move. In a very real sense we end up prisoners in our own home.

If we end up needing money we will be very glad that we have the option to rent or sell or to get a reverse mortgage. All of these options have their place and the world is, I believe, better off with these choices available. But these choices come at a real cost and so we hope to try and avoid that cost by planning our retirement so that we don't have to depend on the equity in our home.

Appendix – House Price Appreciation in the Seattle Area

I wanted to get a better understanding of housing prices in the Seattle area so I did some simple analysis using the following data sets (full details on these data sets is available below):

• East Side Average – This data set measures the average prices for houses in the East Side of King County which includes Bellevue/Redmond/Issaquah.

• King County Average – Average sales price of houses in King County, Washington.

• King County Median – This measures the median price for houses sold in King County.

• Seattle/Bellevue/Everett – This measures the average prices of conforming loans (e.g. Fannie Mae/Freddie Mac loans) in northern King County (including Seattle and the East Side) and South Snohomish county.

The only period of time that all three data sets overlap is 1996-2000 and two of the data sets overlap for 1996-2004, I have included below a summary of their behavior:

Table 1: Geometric Average Yearly Return (Standard Deviation) in Inflation Adjusted Dollars

The difference in growth rates between the East Side and King County as a whole illustrate the old real estate rule – location, location, location. A house in the right place increases in value a lot faster than a house in the 'wrong' one. But the comparison of the King County Average and the King County Median illustrates another rule, the rich get richer faster than the poor do.

The comparison of the King County Median and the Seattle/Bellevue/Everett average is interesting because the King County Median price from 1996-2004 was always just under the conforming loan limit. So one can think of the King County Median as showing the most expensive conforming loans while the Seattle/Bellevue/Everett average shows the entire range of conforming loans. But, again, although the geographical areas aren't quite identical, I suspect it's still reasonable to conclude that the rich get richer faster.

It was also interesting to note that all of the data series contained periods of time with negative real returns. In other words, the old saw that housing only goes up just isn't true. In Seattle housing regularly loses value, it's just that over longer periods of time they tend to go up.

I have included a spreadsheet which contains all the data, analysis and a graph of inflation adjusted housing prices from the various data sets. Note, however, that this spreadsheet is in Open Office 2.0 format. To view it please download Open Office 2.0, it's open source and so available for free. Please note that this spreadsheet does include a macro and so if you get a dialog asking if you want to enable macros when you load the spreadsheet you will need to say yes in order to see the analysis results.

Adjusting For Inflation

In the original version of this article I adjusted by inflation by taking the CPI-U and removing the shelter component. The theory being that by including the shelter component I was double counting housing inflation since I was also measuring house prices. But I later realized that this didn't make any sense. The point in adjusting the housing prices for inflation is to get a feeling for what the value of a house was given the value of a dollar at a specific point in time. To measure the subjective value of a dollar (and inflation measurements are nothing if not subjective) I was best off using the full inflation index since that best measures the general 'worth' of a dollar.

What would be mildly interesting is to do the calculations again but only use the shelter component (specifically rent substitutions) as a way of stripping out of the data series the inflation component of housing. I would then be left with 'constant' "house dollars". By "house dollars" I mean dollar values that reflect how much "house" I can buy. But these dollars would be more than a little deceiving because they would only apply to buying a house. If I used the "house" dollars for anything else then their 'actual' value would be different. Yes, I know, confusing.

In any case I decided in the end to use the CPI-W index because, to be blunt, it includes the 'better off' 32% of city dwellers and thus is closer to the inflation rate Marina and I experience. I also choose non seasonally adjusted data mostly because I use annual averages not monthly averages so the seasonal adjustment (which adjusts monthly results for seasonal effects) wasn't useful. Besides only the national inflation average is calculated using seasonally adjusted data and I wanted to use the Seattle-Tacoma-Bremerton CPI-W data series which is not seasonally adjusted. One slightly odd thing is that the monthly data series (CWURA423SA0) does not provide coverage for all months but that's o.k. because it gives the annual data which is what I actually wanted. But even odder the monthly series is missing all data for years 1987-1996. But the semi-annual data series (CWUSA423SA0) does contain the annual data for that period. Just to add to the fun the monthly series goes back to 1914 but the semi-annual series only goes back to 1984. But when I compared similar years the annual data was identical. Go figure.

Sources of Data I Used

King County Annual Growth Report (KCAGR) 2001 – The KCAGR, until 2001, provided average prices of houses in the East Side and King County from the Central Puget Sound Real Estate Research Report [CPS]. The listing is available in section IV, sub-section "Sub County Areas" of [KGR]. KCAGR reports after 2001 compromised their data sets by pulling data from multiple different sources and then gluing them together which means I can't rely on their consistency of methodology, which is why I haven't used KCAGR data subsequent to that contained in the 2001 report (which itself only listed information through 2000).

Office of Federal Housing Enterprise Oversight's (OFHEO) Housing Price Index [HPI] – The OFHEO is a government agency responsible, amongst other things, for determining if Fannie Mae and Freddie Mac are sufficiently capitalized. To help it do that the OFHEO generates the Housing Price Index (HPI) which is an index that measures the cost of housing in various areas. The problem with the HPI is that it is calculated based exclusively on conforming loans, that is, loans issued and/or serviced by Fannie Mae and Freddie Mac. In 2006, for example, the maximum principal amount of a single family conforming loan is $417,000 [FMC]. The HPI is broken up by various metropolitan areas, the one I used covers Seattle-Bellevue-Everett. The index data is generated on a quarterly basis so to calculate the yearly price changes I averaged the results over the four quarters and then calculated (average year 2 – average year 1)/(average year 1) where year 2 is the year I want to know the growth rate in house prices for and year 1 is the previous year.

Washington Center for Real Estate Research (WCRER) [WCR]- WCRER is run by Washington State University and collects and publishes housing data about counties in Washington State including median prices for King County.

Alternate Data Sources I Didn't Use

U.S. Department of Housing and Urban Development & U.S. Department of Commerce American Housing Survey [AHS] – This is the survey equivalent of a colonoscopy, no secret remains hidden. They do have a report covering both Seattle and Everett (ala the HPI) but unfortunately they organize their data in a less than useful way. They break house prices down into price segments, the final one of which is "all housing costing over $300,000" which is too low to be interested in areas like Seattle. They do include median prices but the WCRER data set is better for me since it focuses exclusively on King County. The WCRER data set also covers a slightly longer period of time, running from 1995 where the AHS dataset only seems to go back to 1997.

U.S. Department of Labor, Bureau of Labor Statics (BLS), Consumer Price Index (CPI) – [CRR] explains the gory details but the upshot is that when the consumer price index, the usual measure of inflation, is calculated a "shelter" component is included in the calculation to measure changes in housing costs. Once upon a time this index was calculated by sampling both rents and actual house prices. But in the early 80s the BLS changed the methodology to measure rent and "rent equivalent". A "rent equivalent" is how much the owner of a home would get if they rented the home out. From an economics point of view this approach makes a ton of sense because the true 'value' of a home should be more or less equal to the income stream it can generate, e.g. rents. But when you live in odd times, odd rules apply. For example, in the East Side one can trivially rent a house that would sell for $1.2 million for only $2,500/month. So, in so far as the CPI is concerned, that house is worth $2,500 in rent equivalent even though buying the house would cost many times that per month assuming 20% down and a 30 year fixed rate mortgage, not to mention property taxes and maintenance. So the bottom line is that the CPI is not a good measure of housing price behavior because it isn't actually measuring house prices. An interesting consequence of this is that the CPI will completely miss the inflationary aspects of a housing bubble which I suspect means that the current CPI is a lousy measure of inflation.

References

[AHS] American Housing Survey (AHS), U.S. Census Bureau & The Department of Housing and Urban Development. http://www.census.gov/hhes/www/housing/ahs/ahs.html.

[BBP] Martin, Robert F. "The Baby Boom: Predictability in House Prices and Interest Rates", Division of International Finance, Board of Governors of the Federal Reserve System, 11/2005. http://www.federalreserve.gov/pubs/ifdp/2005/847/ifdp847.pdf.

[CAP] Moore, Stephen, "Proposition 13 Then, Now and Forever", Cato Institute, 7/30/1998. http://www.cato.org/dailys/7-30-98.html.

[CPS] "Central Puget Sound Real Estate Research Report", The Central Puget Sound Real Estate Research Committee. http://www.realestatereport.org/report.htm.

[CRR] "Consumer Price Indexes for Rent and Rental Equivalence", U.S. Department of labor, Bureau of Labor Statics, 3/29/2002. http://www.bls.gov/cpi/cpifact6.htm.

[FMC] "Fannie Mae Announces 2006 Conforming Loan Limit of $417,000", Fannie Mae, 11/29/2005. http://www.fanniemae.com/newsreleases/2005/3649.jhtml?p=Media&s=News+Releases.

[FRM] "Facts for Consumers – Reverse Mortgages: Get the Facts Before Cashing In On Your Home's Equity", Federal Trade Commission, 6/2005. http://www.ftc.gov/bcp/conline/pubs/homes/rms.htm.

[HCR] "Top Ten Things to Know if You're Interested in a Reverse Mortgage", U.S. Department of Housing and Urban Development, 6/28/2004. http://www.hud.gov/offices/hsg/sfh/hecm/rmtopten.cfm.

[HPI] Housing Price Index (HPI), Office of Federal Housing Enterprise Oversight. http://www.ofheo.gov/HPI.asp.

[KGR] "2001 King County Annual Growth Report", King County Washington, 2001. http://www.metrokc.gov/budget/agr/agr01/.

[SDP] "V. Assumptions and Methods Underlying Actuarial Estimates", 2002 OASDI Trustees Report, Social Security Administration, 3/26/2002. http://www.ssa.gov/OACT/TR/TR02/V_demographic.html.

[WCR] Washington Center for Real Estate Research, Washington State University. http://www.cbe.wsu.edu/~wcrer/.

Social Security (With A Side of Medicare)

There have been oceans of ink spilled on the threat we are facing due to out of control growth in Social Security, Medicare and Medicaid bills. "The Coming Generational Storm" [COM], although a bit on the histrionic side, is amongst the best summaries I've seen of the problem.

The key to the whole mess is that people are dying too late. For example, when Social Security was introduced in the 1935 the age of retirement was 65. 65 was a good number to pick because, for example, from 1939-41 the average life expectancy was 63.62 (see Table 11 of [NVS]). In other words, the average person would never live long enough to collect Social Security. In 2002 however the average life expectancy had risen to 77.3 (same table), but, well, the age of retirement for people born in 2002 is 67. Oops.

I'll refer the reader to [COM] for the gory details but just to give a flavor in [COM] Table 2.3 shows what has to change if we are to maintain Social Security and Medicare benefits into the future assuming we start trying to fix the system in 2008. The choices are to: Increase federal income taxes by 74%, Increase payroll taxes by 103%, Cut federal purchases by 115% (and yes, that is impossible) and finally cut Social Security and Medicare spending by 47%. It is possible however to mix and match the different choices but I think the numbers tell the story. Whatever is going to happen in the future, it won't include a Social Security or Medicare plan that looks anything like what we have now.

There are a few brave folks who argue that maybe things aren't quite as bad as they seem, e.g. [BSS], but such arguments appear to be based on the government raiding the Treasury bonds held in the Social Security trust fund. But the point missed about the 'trust fund' is that it is an accounting fiction.

In reality what the government does is take real money today in the form of Social Security contributions and spend it on current government needs and then put an IOU, in the form of "special" Treasury bonds, into the trust fund. What makes these bonds "special" is that they can't be bought or sold on the open market and they can be redeemed at any time for their full face value (e.g. value at maturity). This makes them, in theory, as good as cash. But in reality these bonds are an accounting fiction, they are money the government owes itself. There are no 'assets' behind these bonds. So when the government wants to 'use' one of these 'special' Treasury bonds it can only do so by raising immediate revenue, e.g. spending tax money.

But what I think is often missed in the discussion of Social Security is that, in fact, Social Security can be considered in good shape compared to Medicare and Medicaid. The unfunded liabilities running around in those two programs dwarf the liabilities of Social Security and there isn't even a fictional lock box to "protect us" from them. Again, see [COM] for the gory details.

Social Security and Minimum Retirement

The minimum retirement scenario is predicated on a sustained down turn in the stock and bond markets that obliterates our portfolio and requires us to live on our minimum retirement funding of TIPS bonds. In other words, it's a nearly worse case scenario.¹

My assumption however is that if the stock and bond markets should fall so far that the minimum retirement plan kicks in then the U.S. government is not going to be in any shape to pay out any significant benefits. In fact, we'll be lucky if the government doesn't try to get out of paying what it owes on the TIPS bonds. Even in the nearly worse case scenario I suspect the government will pay something in the form of Social Security and other benefits but how much isn't something I care to try and estimate.

So for purposes of minimum retirement planning I intend to ignore Social Security benefits. I also intend to assume that Medicare/Medicaid benefits will be severely curtailed. If they are removed all together then I sincerely doubt we have the financial ability to save enough money in a minimal retirement program to replace them, at least not with our existing brain dead medical payment system. In other words, there's certain bets (e.g. that Medicare/Medicaid will be available in some form) that we just can't afford not to make.

Still, there are at least two situations in which I can see us re-thinking our decision to ignore Social Security for minimum retirement: 1) The current programs are changed in a way that indicates they are likely to survive over the long term (and this most certainly does not mean private accounts [PSS]) or 2) Our current financial situation worsens and we have to revise our savings strategy. Much like Medicare/Medicaid, I fully appreciate that writing off Social Security is a conceit that we may eventually not be able to afford.

Social Security and Comfortable Retirement

While I have high hopes for the long term future of the U.S. economy the Social Security math isn't going to change and as time passes the burden of paying out Social Security will almost certainly grow to the point where the program is changed.

The first change will be to increase the age of retirement. That, in fact, has already started. The actual age at which Social Security pays out benefits changes based on when one was born. Someone born in 1937 or early gets full benefits at 65, someone born in 1960 or later gets full benefits at 67. [ARH] I suspect the age will keep on slipping.

The second change will be to means test benefits. In other words, the more money we have from non-Social Security sources the more money we will lose in Social Security benefits. This has, in fact, already started. For example, Social Security benefits are theoretically exempt from income tax, unless you have too much income. For example, in 2006 if 50% of Social Security benefits plus all other income (including tax-exempt interest) adds up to $44,000 or more than 85% of Social Security benefits are liable for Income Tax. See [SSE] for the details of Social Security taxation.

My suspicion is that as the funding situation gets worse we will see Social Security benefits further restricted until, at some point, if one's income is high enough, one will receive no benefits at all. Yes, I fully appreciate the political uproar this will cause but it's astonishing what a country can do when it's facing financial ruin.

Since I know the current Social Security program is unsustainable and since I have no idea what actually will happen and given my suspicion that anyone with a decent income during retirement (and I bloody well intend that to be us) won't see a penny, the conclusion I've drawn is that I can't include Social Security as part of our comfortable retirement.

Pensions

One doesn't see pensions very much any more and for Marina and I that's a good thing. Pensions are a very dangerous asset. They are predicated on the company issuing the pension sticking around long enough to honor that pension. Since the average expected corporate lifetime is 40 or 50 years [ELP] and as we are a good 30+ years from retirement and expect to spend more than 30 years in retirement any company we get a pension from is likely not to survive the whole run.

Besides, both Marina and I change jobs all the time. These days it seems that staying at a company more than 5 or 10 years is considered odd. I've only been working ten years and I already have had 4 full time employers. Since pension plans typically require one to work for the company for a long time in order to get full benefits our ability to choose our employer would be severely restricted if we depended on pension. Besides, even companies that survive often have problems meeting their promises. United Airlines, for example, abandoned its pensions to the PBGC (see below) in 2005 [UGA], IBM closed its pension plan in 2006 [IFP], etc.

It is true that the Pension Benefit Guaranty Corporation (PBGC) insures pensions in America but it does not insure them to their full value (for example, in 2006 they insure up to $47,659 in yearly benefits for people who retire at age 65 [MPB]) and there are more than a few questions about how well provisioned the PBGC is to meet its obligations [EDR]. Besides, unlike insurance on bank accounts, the U.S. government does not stand behind the PBGC's obligations². Nevertheless the PBGC's guarantee looks to me like too little, too late.

Marina actually did have a pension at one point from a state hospital she worked for but it was a tiny thing and even when fully vested wouldn't be all that interesting. So theoretical issues aside, pensions just aren't relevant for us.

Fixed Annuities

Annuities come in a dizzying array of flavors, some of which I'll touch upon in Step 5, but for now I'll just look at fixed annuities. A fixed annuity is basically a combination of a contract and an insurance policy. The contract specifies that in return for providing a certain amount of money today the annuity issuer will return a specific sum of money every year or so for life or for a fixed period of time. The insurance policy states that should the annuity company go bankrupt then the purchaser of the annuity will get back the principal.

The insurance policy is added on in order to 'protect' investors against their annuity company going bankrupt but in reality, given inflation, protection of principal just isn't all that interesting. (all puns intended)

The way annuities are actually run is that the annuity company takes the money it is paid for annuity contracts and invests it in the market. Since the annuity company has to get the same return as anyone else in the open market this would lead one to believe that an annuity company can't offer a return higher than the market return (at least not without going bankrupt).

But annuities, at least in theory, do have an extra source of income. If someone dies before spending all the money their annuity earned then the annuity company gets to keep that money. This point can sometimes get a bit confusing. For example, one can get annuities that will pay back the difference between the initial principal and any paid benefits but as I pointed out above that's not necessarily terribly interesting. Other annuities will pay out for a fixed number of years, even after the original beneficiary dies. But the real point of this game is that the money that was put into the annuity has been collecting interest/dividends/whatever for years and so long as people die early enough the annuity company comes out ahead. It is this extra money that the annuity company can use to offer higher benefits, assuming the annuity company got its actuarial tables right.

But most annuity companies are fully aware of the fact that they can't really pay even a market return so the return they offer on their fixed annuities tend to be low. For example, the two most reputable annuity companies I know of are Vanguard and TIAA-CREF. Vanguard's fixed annuity-single 5 on 1/7/2005 was quoting a return of 4.35% guaranteed for 5 years (then the annuity rolls over into a new contract). TIAA-CREF's Lifetime Fixed V, a similar contract, was offering 4.20%. To put this into perspective a 5 Year treasury bond quoted on the same date was offering 4.32%.

For me, the moral of this story, is that a fixed annuity is a lousy way to build up money for retirement.

Conclusion

So the bottom line is that while there are some defined benefit assets available to us it looks to me at least that their value is highly unreliable and quite likely to never materialize so I don't consider them a legitimate part of our retirement assets.

References

[ARH] "Retirement benefits and reductions by year of birth", Social Security Online. http://www.ssa.gov/retire2/agereduction.htm.

[BSS] Francis, David R., "A brighter outlook for Social Security", Christian Science Monitor, 3/8/2004. http://www.csmonitor.com/2004/0308/p17s01-coop.html.

[COM] Kotlikoff, Laurence J., Burns, Scott. 2005. "The Coming Generation Storm – What You Need to Know about America's Economic Future." Boston: MIT Press.

[EDR] "American pensions: Deeper into the red – America's guarantor of corporate pensions is in trouble", The Economist, 2/5/2004. http://www.economist.com/displaystory.cfm?story_id=2413316. (Note: Subscription required)

[ELP] "How to live long and prosper", The Economist, 5/8/1997. http://www.economist.com/displaystory.cfm?story_id=149064. (Note: Subscription required)

[IFP] Crenshaw, Albert B., "IBM to join trend of freezing pensions in favor of 401(k)s", The Washington Post, 1/6/2006. http://seattletimes.nwsource.com/html/businesstechnology/2002723350_ibmpensions06.html.

[MPB] "PBGC Announces Maximum Insurance Benefit for 2006", PBGC Website, 12/12/2005. http://www.pbgc.gov/media/news-archive/2005/pr06-09.html.

[NVS] Arias, Elizabeth, "National Vital Statistics Reports, Volume 53, Number 6 – United States Life Tables, 2002", Centers for Disease Control, 11/10/2004. http://www.cdc.gov/nchs/data/nvsr/nvsr53/nvsr53_06.pdf.

[PSS] "Privatizing Social Security – The Short Route To A Managed Economy", Stuff Yaron Finds Interesting Blog, 1/30/2005. http://www.goland.org/socialsecurityandmanagedeconomy.

[SSE] "Social Security and Equivalent Railroad Retirement Benefits", Internal Revenue Service Publication 915, 2004. http://www.irs.gov/publications/p915/index.html. [Ed Note: Although this was published for filling out 2004 tax returns both the IRS Social Security website and the Social Security Administration's website, as of 1/6/2006, point to this publication as providing the correct instructions for calculating the tax exposure of Social Security benefits.]

[UGA] "United gets approval to shift pension plans", Associated Press, 5/11/2005. http://msnbc.msn.com/id/7804770/.

Rolling', rollin', rollin'

• 1964 – Eugene F. Fama's Ph.D. dissertation introduces the concepts that would lead to the Efficient Markets Hypothesis

• 1975 – Individual Retirement Accounts (IRAs) introduced

• 1976 – Vanguard offers the first Index fund to the general public

• 1978 – Internal Revenue Code section 401(k) is introduced, although 401(k) plans as we know them wouldn't come into existence into the early 1980s

• 1990 – The Toronto Stock Exchange introduced the first Exchange Traded Fund

• 1997 – The United States Government offers its first Treasury Inflation Protected Security (based, I believe, on the Canadian Real Return Bond)

• 2006 – The Roth 401(K) is introduced

The previous is just a random sampling of events that have a non-trivial affect on my retirement planning. The point being that every once in a while things do change, often in non-trivial ways and will require me to make significant changes in how I execute on my retirement plan. Thankfully really big changes in asset types, asset locations and financial theory are pretty rare so it's not like I'll be making serious changes every year or two. But the moral I take from this story is mostly that while it's important to get my retirement planning right I shouldn't over obsess on it since inevitably I will need to change our plan.

Caveat Emptor

I actually think that it makes a lot of sense to use a financial planner. I've interviewed a few financial planners over the years and even hired one once and although the experiences left me cold I'm willing to chalk up the results to bad luck rather than financial planners being a bad idea. But there is still a fundamental problem with using a financial planner – how do I know if the plan the planner came up with is the right one for Marina and I?

I would compare this situation to visiting a doctor. (I'll leave Marina out of this example since she's a pharmacist.) When my doctor gives me a diagnosis and a proposed course of action I am able to ask questions and understand the answers. This makes me a good health care consumer.

But in order to be a good health care consumer I do need a basic background in human health. I received this background from my classes in High School on Biology, Chemistry, Physiology and Health. In College I took a quarter of Chemistry and during both High School and College I was an avid reader of Scientific American which did an outstanding job of explaining many basic processes of the human body. I have also read a number of books on human health and keep up on health news. The effort didn't make me a doctor but it did give me enough knowledge to ask hard questions and fully understand the answers.

Which brings me back to financial planners. If I'm going to get maximum value out of a planner then I have to be educated enough to know what questions to ask and to be able to understand the answers. However, other than a dimly remembered project on the stock market in Junior High, I have no formal personal finance or even general economics education what so ever.

A Bargain at 1/2 the Price

The price I have paid for my financial education is a high one but I'm convinced that it didn't need to have been. All that I've learned could easily have been put into a 1 year High School course on personal finance or maybe a two quarter College level course. Certainly, given the importance of finance in our lives, such courses would be time well spent. But unfortunately such courses weren't available to me and the books I've read on personal finance and retirement planning were mostly bad. I did find a few gems and I listed them in recommended reading but even they are far from complete.

What kept me going through this process, other than my innate interest in the subject, was the goal of finishing our retirement plan. So the irony is that now, when I'm finally ready to benefit from a financial planner is the time when I don't need one as much. I wouldn't be surprised if I don't eventually end up hiring a financial planner to review our plan but until then let's see how well the good folks on the Internet do the job.

The Undiscovered Country

I never expected to know, say, the exact geometric average stock returns for the next few decades. What I had hoped to learn was the likely distribution of stock returns, e.g. an understanding of what are the most probable outcomes. With such a distribution I could create a retirement plan geared toward those most probable outcomes.

But near as I can tell, nobody has a clue as to what the distributions actually are. To define a distribution one has to understand the list of possible outcomes and be able to calculate how likely each is. Alas, no one knows how to do that for future asset behavior. So instead lots of folks spend their time trying to read the past.

The more sophisticated attempts to use the past to predict the future usually start with an economist who creates a model of how they believe the market works. They then feed in some set of 'starting state' information into this model and then the model makes predictions of future behavior. The model is tested by seeing if it can successfully predict behavior in past markets.

The fact that a model fits historical return data may or may not be a useful piece of information. For one thing I have no doubt that in many cases the models are tortured until they output the expected results. Even when models are tested against data sets that weren't used in their original creation the declaration of a 'match' is often astonishingly generous. Besides, is the future really going to be the same as the past? Can we be sure that factors that may have been critical in forming past market behaviors will continue to be as relevant in the future?

But even if someone does manage to come up with a model that accurately foretells the probable distribution of returns for some non-trivial period of time into the feature, how do I pick that particular model from its enumerable competitors? How do I test that it is telling me the truth? After all, the number of 'outcomes' in my case, say 30 years to retirement, are tiny. Just about any distribution will likely cover them, but that doesn't mean that the distribution was right or useful. So even if someone did have the 'answer', there's no way for me to know it which means that for me, the answer is as good as non-existent.

This Won't Hurt a Bit

So I have convinced myself that trying to come up with the 'right' distribution of stock returns or stock/bond correlations or any of the other numerous but critical inputs I need in order to put together a reasonable retirement strategy is a waste of time. But I still need estimates for these values otherwise I can't calculate how much money to save or where to save it.

So, lacking any other option, I have guessed. Sure, I have read a bunch of academic articles and looked at various estimates but in the end I recognized that all I am doing is guessing. So, for example, when I use the simulator I'll describe in a future article I recognize that the recommendations it makes for how much money we should save for retirement are nothing more than guesses on top of suppositions with a side of conjecture. I also recognize that because all of the inputs to the simulator are really just guesses it doesn't make sense to spend too much time agonizing about exactly what input to use for the simulator. It's not that one guess is as good as another but rather that at some point trying to improve a guess is just wasted effort.

For someone brought up in a world that believes science conquers all this is all terribly distressing. But, oh well, as one of my favorite philosophers once said "…always look on the bright side of life…"

References

[SWN] Bernstein, William J. "S.W.I.N.E.", Efficient Frontier, Summer 2002, http://www.efficientfrontier.com/ef/702/swine.htm.

Dedications

To Marina, for providing no help what so ever. While most authors speak at length of the suffering and perseverance of their families during the authoring process my wife made it clear from day one that our marriage came before everything, writing and such be damned. Frankly, I feel sorry for those other authors. Some things should not be borne and family does come first.

To BG, so you'll have the freedom to soar.

Acknowledgments

If anyone one person can be said to be the intellectual inspiration for "Planning to Retire" it has to be William J. Bernstein. To be clear, I've never met Mr. Bernstein or even exchanged an e-mail with him. But after several years of feeling extremely frustrated about what to do about retirement planning in general and investing in particular I read his first book "The Intelligent Asset Allocator" in 2000. It gave me hope that I could master the skills necessary to plan intelligently for retirement. His newsletter, Efficient Frontier was also an inspiration, showing what an intelligent person could do if they were willing to get a bit of education.

But it was Mr. Bernstein's "The Four Pillars of Investing : Lessons for Building a Winning Portfolio" that changed everything. In fact "Planning to Retire" began life as an attempt to turn Mr. Bernstein's instructions in Four Pillars into a set of concrete steps I could follow to execute on my own investing plan.

While Mr. Bernstein provided the big picture ideas it was Professor Peter Ponzo (a.k.a. Gummy) who helped me understand the math that makes finance work. Thankfully most of the math needed to deal with finance isn't much more sophisticated than algebra but it was Gummy's tutorials on his website Gummy Stuff that convinced me that I could do the necessary math. While I have exchanged a few e-mails with Gummy (he was kind enough to answer a few questions for me), like Mr. Bernstein, he can in no way be held responsible for the contents of these articles.

The Absolute Basics

Get A Financial Life: Personal Finance in Your Twenties and Thirties – Beth Kobliner – Fireside – 6/6/2000 – This is the single best book I've read on basic finance. Ms. Kobliner covers issues like insurance, loans, bank accounts, etc. The advice this book has given me has literally saved me thousands of dollars in insurance and other costs.

The Four Pillars of Investing : Lessons for Building a Winning Portfolio – William J. Bernstein – McGraw-Hill – 4/26/2002 – If I could only own one book on investing this would be it. Mr. Bernstein's clear prose, concise explanations and general wit makes the fundamental principles of investing easy to digest. I assume that anyone reading the "Planning To Retire" series has either read this book or has equivalent knowledge.

Good Back Ups

A Random Walk Down Wall Street – Burton G. Malkiel – W. W. Norton & Company – numerous editions – If I could have two books on investing this would be the second one. Mr. Malkiel strips Wall Street down to its fundamentals and explains how investing really works. Bernstein's book was explicitly written to be "finance for poets", Malkiel's is intended to be "finance for people who are interested in finance" so he goes into a lot more detail than Bernstein. I love this book so much I actually own and have read the sixth, seventh and eighth editions.

The Index Fund Solution : A Step-By-Step Investor's Guide – Richard E. Evans and Burton G. Malkiel – Simon & Schuster – 3/21/2000 – Both of the previous two books argue that index funds are the way to go when investing in equities and most bonds. That was enough to convince me but reading this book was actually a really nice adjunct as it focuses exclusively on the issue on index funds and explains in gory (but very easy to understand) detail why they are the right choice over individual stocks or managed funds.

Worry-Free Investing : A Safe Approach to Achieving Your Lifetime Financial Goals – Zvi Bodie & Michael Clowes – Financial Times Prentice Hall – 5/13/2003 – Unfortunately I didn't really enjoy the prose of this book. I found it's tone ranged from condescending to didactic. But it is an easy read and it's ideas directly led to the 'minimum retirement' portion of our retirement strategy.

For Those Who Enjoy Finance

Reminiscences of a Stock Operation – Edwin Lefevre – Wiley – 5/11/1994 – This book was first published in 1923 and is the semi-fictionalized story of Jesse Livermore a master "stock operator", that is, someone who made their money manipulating the stock market. Amongst other things Mr. Livermore is apparently accused of having caused the 1929 stock market crash that signaled the start of the Great Depression. This book taught me a lot about how finance works in the real world. Don't let its age fool you, as the latest scandal ridden headlines should illustrate, plus ca change, plus c'est la meme chose.

Disclaimer

I am not an economist or a financial planner and I don't play either one on television. That's why I don't give out financial advice. The purpose of these articles is strictly to share my wife and my's experiences in planning our own retirement so that others can see how a real life couple handled these issues and maybe get some inspiration, even if only to say 'wow, I'd never do that!' If, however, you run across something in these articles that looks like financial advice I'd appreciate it if you could use the comment feature at the bottom of the article's page to let me know so I can fix the offending text.

In fact, I hope lots of folks will use the comment features in order to provide feedback, requests for clarification, alternate views, etc.

Who We Are

Marina and I are in our early 30s and our first child is due early next year. I work in the software industry and Marina is a Pharmacist. We are both compulsive savers and have both been saving in 401(k)s, 403(b)s, IRAs, taxable savings, etc. since we started working. We expect to retire several decades from now.

A Financial Autobiography?

"Financial Autobiography" was the best phrase I could come up with to explain what I'm trying to do with these articles. These articles are a testimony, not a textbook. I am stating what we did, not what anyone else should do.

Outline

I have broken our retirement planning process into a series of steps that I outline below. Each step will itself be made up of a series of articles that I will post on my website.

Introductory Material

• Introduction – You're reading it!

• Recommending Reading – Two books that I found very useful in matters financial

• Dedications & Acknowledgments

• How I Learned To Stop Worrying and Love Finance – How we deal with uncertainty in our financial planning

• Two Words: "Financial Planner" – Why I didn't just use a Financial Planner

• The Times They Are A Changing – Quick thought on innovations in finance

Step 1 – Calculating How Much Money Is Currently Available For Retirement

In this section I walk through a variety of things that Marina and I are saving for, e.g. cars, houses, emergency funds, etc. I quantify how much we need for those goals and subtract that from our available assets, the remainder is what we have available for retirement. I also look into the issue of social security and short term money management. There is a spreadsheet that goes with this section. A lot of the material in this topic was inspired by [GFL].

• Defined Benefit Assets – What we intend to do with Social Security, Pensions and Fixed Annuities

• How Much Is That Housey In The Window? – The role of housing in our retirement plans

Step 2 – Planning a Minimum Retirement

I spend most of my time planning for a bright future filled with successful stock markets and happy societies. But anyone who has studied financial history knows, it's smart to have a plan B. Our plan B is taken from [ZMW] and we call it our 'minimum retirement'. The minimum retirement fund consists of super safe inflation adjusted investments like Treasury Inflation Protected Securities (TIPS). In this section I'll go through the gory details of figuring out exactly how much we think we will need to meet our 'minimum retirement' goals, figuring out where we think we should put the money (mutual funds? individual bonds?) and how much money we think we will need to save each year to achieve our goals. This section will include the fairly trivial algebra we use to calculate how much we need to spend each year on our minimum retirement.

Step 3 – Planning a Comfortable Retirement

Figuring out how much money we need to have a comfortable (as opposed to minimum) retirement turns out to be tricky. In this section I'll look at issues like our expected final income, average retirement spending amounts, expected growth in income, etc. All of which we use to figure out what our retirement goals actually are. I'll also look at how we intend to save for retirement (hint: we intend to save a fixed percentage of our income every year from now until retirement), how we intend to pull money out at retirement as well as our expectations for long term stock and bond returns. [TRS] and [GTS] were the main inspirations for withdrawal rates. [FPI] was the main inspiration for the stock and bond return estimates.

Step 4 – Picking Asset Classes and Their Relationships

What are asset classes? What are asset types? Is a TIPS a bond or a separate asset class? Do REITS provide much real estate exposure? Should we use a globally balanced stock portfolio? Are mortgage backed securities a good idea? What about whole bond market funds? What should our stock/bond balance be? This section explores how we struggled with these questions and what answers we came up with for ourselves. [BEF], [FPI] and [RWD] are the main inspirations for the content in this section with a lot of back up from academia.

Step 5 – Picking Prospective Investments

Theory is interesting but retirement is built on specifics. This section will turn the theories of the previous section into a list of assets (e.g. specific mutual funds, bonds, stocks, etc.) and our best guess at the best asset locations (e.g. IRAs, taxable accounts, annuities, etc.) to place them in.

Step 6 – Asset Location

The previous section provides a shopping list of possible asset/asset location combinations (e.g. an EMEA index in a 401(K)) but the total number of reasonable combinations is large and so some winnowing is called for. This section provides a bunch of algebra that shows how we model an asset's expected behavior when placed in a particular asset location. Using this data I then specify a set of heuristics we use to prioritize how we spend our retirement money.

Step 7 – Calculating The Constant Savings Percentage (CSP)

This is where all the previous sections come together to figure out exactly what percentage of our salaries we think we should save each year in order to meet our retirement goals. This section builds up the math to create a simulator that spits out the 'answer' This section will also discuss why the simulator shouldn't be treated very seriously. If all goes well I will release a Java implementation of the simulator.

Step 8 – Portfolio Averaging

Portfolio averaging is a name I came up with to describe how I try to keep our portfolio in balance, which is that as new money comes in (or as we get dividends/interest) I allocate the new money in a way designed to keep the portfolio as close to balance as possible. This section provides the math and Java code for a program that takes the current state of a portfolio along with available cash and calculates how best to allocate that cash to meet portfolio balancing goals without rebalancing.

Future Topics

I don't have much in the way of notes yet on issues such as re-balancing (if portfolio averaging fails) as well as more advanced portfolio management strategies such as tax harvesting. I intended to get to these areas eventually.

Conclusion

In the conclusion I'll mostly talk about changes I see coming down the road that I suspect will require changing the strategies outlined here. As I mentioned in the introduction, change is inevitable.

Appendix 1 – Dealing with Inflation

Although I do most of the math in these articles in real terms (i.e. in inflation adjusted dollars) from time to time I need to deal with inflation. This section walks through my possibly flawed understanding of the math of how to calculate the rate of inflation, how to adjust returns for inflation and especially how to adjust interest or capital returns for inflation.

Appendix 2 – Background on Playing with Stock Indexes

Stock indexes make up a huge portion of our retirement portfolio so I have more than a little interest in them. In this section I talk about the different kind of stock indexes available, how they are calculated, etc. I then identify indexes that are available on-line that I use frequently.

References For This Article

[BEF] Bernstein, William J., Sharin, Susan F., "Efficient Frontier – An Online Journal of Practical Asset Allocation", http://www.efficientfrontier.com/ef/index.shtml.

[FPI] Bernstein, William J., "The Four Pillars of Investing: Lessons for Building a Winning Portfolio", McGraw-Hill, 4/26/2002.

[GFL] Kobliner, Beth, "Get A Financial Life: Personal Finance In Your Twenties And Thirties", Fireside, 6/6/2000.

[GTS] Greaney, John P., "The Retire Early study on safe withdrawal rates.", June 1, 2000. http://www.retireearlyhomepage.com/restud1.html.

[RWD] Malkiel, Burton G., "A Random Walk Down Wall Street, Completely Revised and Updated Edition", W. W. Norton & Company, 12/4/2003.

[TRS] Cooley, Philip L., Hubbard, Carl M. Walz, Daniel T., "Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable", AAII Journal, February 1998. http://bobsfiles.home.att.net/trinity.htm.

[ZMW] Bodie, Zvi, Clowes, Michael J., "Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals", Prentice Hall/Financial Times, 2003.