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On today's episode, we're continuing our conversation from last week where we
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asked, "What does retirement failure look like and how can we avoid it?"
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Let's identify all the risks we might face or ways we might fail and only then
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decide the positive actions we should take to mitigate those risks. Welcome to personal finance for long-term
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investors, where we believe Benjamin Franklin's advice that an investment in
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knowledge pays the best interest both in finances and in your life. Every episode
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teaches you personal finance and long-term investing in simple terms. Now, here's your host, Jesse Kramer.
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Welcome to Personal Finance for Long-Term Investors, episode 141. I'm Jesse Kramer. I'm a financial planner
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and I work with retirees and busy professionals preparing for retirement across the USA. You can learn more at
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planwithjesse.com. This week's review of the week is from Ethan Gilbert, who left kind words and a
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fivestar rating on Apple Podcasts. So, Ethan, drop me an email to jessebinest.blog blog and I'll get you
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hooked up with a super soft podcast t-shirt. We'll mail it out to you. And now on with the show. If you haven't
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listened to last week's episode, that's episode 140. Please go listen to that
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one. That episode is really part one to today's part two. And in part one, I
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kind of introduced this entire exercise and also discussed the first seven key retirement risks and what we can do to
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combat those risks. Specifically, I spoke about longevity risk, inflation risk, partner or household risk, market
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risk, sequence of returns risk, withdrawal risk, and then health risk in general. Continuing onto today's
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episode, I'm going to dive into long-term care or other shock spending risk, cognitive decline risk, behavioral
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risk, assumptions risk, policy or legislation risk, identity and purpose risk, and then last, the deep risks. And
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enough preamble, let's just dive in. So, I'm going to start today talking about
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shock spending and long-term care risk. Shock spending as a general term describes where some sort of unforeseen
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circumstances means we are going to spend a really big amount of money all at once. And throughout most of our
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lives, these spending shocks might be something like medical expenses causing us to max out our $10,000 insurance
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deductible, for example, or a mini housing disaster causing us to max out our homeowners deductible. something
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happens to a spouse, a child, or some other relative causing you to spend a lot of money all at once. And these
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shocks are no fun. That said, a healthy emergency fund and proper insurance coverage kind of dampens the blow.
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Without that emergency fund, the or the insurance coverage, these kind of spending shocks can begin a a slippery
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slope into some of the really bad financial situations that we we hear horror stories about. But again, this is
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why emergency funds or proper insurance coverage are two of the pillars, two of the first steps of basic personal
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finance priorities. Now, in retirement, those same shocks could certainly apply.
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It's no fund replacing your roof if you weren't expecting it, whether you're
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working or retired. But there are three major types of spending shocks that tend
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to occur maybe more frequently for retirees than they occur for other people. They are one, health care costs
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in the gap years before Medicare. Number two, supporting an adult child. And number three, long-term care. Health
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care costs in the gap year before Medicare. Let's talk about that one first. Medicare starts at age 65. And
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retirees who retire earlier than age 65, they do have a few different ways they can fill in the health care gap until
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Medicare kicks in. Now, in episode 108 of this podcast, I spent a good 25 minutes tackling this very idea. And
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rather than spending 25 minutes here, again, I recommend you add that to your listening list. Again, that was episode
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108. So, now we'll move on to supporting an adult child. Now, unfortunately,
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there's very little you can do to prepare or derisk yourself from this occurring. It's one of those things
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that's both very unique to your circumstances and that nobody, such as an insurance company, is going to help
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you out with. The only thing I can say here is to offer some very similar oneliner that I think it applies to when
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it comes to helping your kids with college, for example, is that you can get a loan for college. You can't get a
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loan for your retirement. Now, if your adult child is in trouble, they might not be able to bail themselves out. But
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one thing I know for sure is that you cannot get a loan to bail yourself out if your retirement funds run dry. So
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that's why from a kind of cold financial point of view, we do want to be cautious
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about mortgaging our own retirement requirements to bail out an adult child in some way. Or perhaps a better way to
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put it is you really want to understand the cold financial math before you make what is obviously going to be a
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challenging emotional decision to help your child. And if you make that emotional decision without first digging
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into the cold finances, I do think you are doing your future self a bit of a disservice. But that brings me to the
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third one, long-term care. Now, long-term care is scary for a few reasons. Now, first, there's the human
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side of it. Long-term care is a depressing topic for many people because it represents some loss of control or
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autonomy, a loss of the familiar daily routines. It signifies for many people the end of home, right? They're moving
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out of home, probably for good. It requires some sort of forced dependence on other people for the basic needs of
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life, a loss of a sense of purpose, maybe it leads to loneliness and and social isolation, often some anxiety. So
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long-term care is just a hard topic to deal with even without considering one lick of finances. It's just hard to
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think of from a human perspective. But then of course there is the financial portion. Long-term care is ridiculously
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expensive. How expensive? Well, depending on your level of care, costs between $5,000 a month and $20,000 a
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month are very much normal. So that's between $60,000 a year and a4 million a
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year. But wait, there's more. Because depending on the source you look at, somewhere between 50 to 70% of
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65year-old adults will need some form of long-term care before they die. Women are more likely to need long-term care
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than men with an average day somewhere around three years for women and somewhere around two years for men. In
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other words, some retirees are going to need $0 of long-term expenses in their life, while other retirees could easily
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surpass half a million, $500,000 of long-term care expenses in their life. That's a crazy dispersion. When faced
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with such an expensive and risky coin flip in that way, one of the common ways to derisk yourself involves insurance.
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And sure enough, long-term care insurance is a real product meant for just these kind of situations. But
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long-term care insurance is very controversial. And I'm going to pull some paragraphs right now from a
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wonderful KKF article. I'll link it in the show notes. KKF is a healthcare think tank and I use various articles
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and tools and calculators of theirs all the time. I highly recommend if you've
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never been to the KKF website, I highly recommend if you're thinking about specifically health care and retirement
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and how they overlap. It's a good uh website to spend a few minutes on. And so anyway, now here goes a few
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paragraphs from an article from the KKF website. Take for example the story of the Gemtt family from Sacramento. For 35
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years, Angela Gemtt and her five brothers paid premiums on a long-term care insurance policy for their now
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91-year-old mother. But the policy doesn't cover home health aids whose assistance allows her, the mother, to
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stay in her Sacramento, California bungalow near her friends and neighbors who she loves. Her family pays $4,000 a
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month out of pocket for that. The private insurance market has proved wildly inadequate in providing financial
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security for most of the millions of older Americans who might need home health aids, assisted living, or other
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types of assistance with daily living. For decades, the industry, again, that's
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the insurance industry, severely underestimated how many policy holders would use their coverage, how long they
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would live, and how much their care would cost. Repeated government efforts to create a functioning market for
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long-term care insurance or to provide public alternatives have never taken hold. Today, most insurers have stopped
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selling standalone long-term care policies. The ones that still exist are too expensive for most people, and
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they've become less affordable each year with insurers raising premiums higher
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and higher. Many policy holders face painful choices to pay more, to pair back benefits, or to drop coverage
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altogether. Okay, so now back to me, back to Jesse and my words. That is a pretty sobering uh set of paragraphs
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right there, set of words. And the takeaway is that long-term care insurance is not unfortunately a good
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way to derisk yourself from long-term care costs and the shock spending risk. So, how do we tackle it instead? I've
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got a couple ideas. They're not exactly easy, but I think it's the best we can
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do. First, I think we need to be honest with ourselves and admit that long-term care costs almost always come at the end
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of life, as far out into our financial futures as could possibly be. And if you forced me to put a $500,000 expense
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somewhere in my financial future, I would choose to put it way out at the end of life, at the end of my financial
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plan. For example, if you need to make a $500,000 payment in 30 years, and you assume a real rate of return, so that's
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an inflation adjusted rate of return of say 6% maybe, right? 9% on the investments minus 3% for inflation. If
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you assume a rate of return of of 6%, then you would need to allocate about $90,000 today in order for it to grow
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over 30 years to your needed half a million in 30 years. Now, don't get me wrong, $90,000 is still a lot of money,
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but it's not the same as half a million. And the point here is that time is your
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friend inside your financial plan. Though it might not be your friend, I suppose, when it comes to to health
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itself, but time is your friend inside of your financial plan. And it's one of
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the reasons why I'm a big proponent of cash flow modeling and asset liability
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matching. I want to understand the money I'll be spending in the future and ensure that I'm allocating the right
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amount of dollars today into the right asset class today to grow to what I need it to be in the future. And that brings
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me to my second point. Speaking of cash flow modeling, in my experience, long-term care isn't purely a new
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expense. Now, what do I mean by that? Well, what I mean is that the typical retiree might be spending, we can pick a
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number, might be spending $8,000 a month on their normal lifestyle. And then when
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they enter long-term care, that $8,000 a month is going to drop down a ton because so much of their normal
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lifestyle expenses will change. Whatever the circumstances are that merit them going into long-term care are
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circumstances that mean they're not going to be spending as much money on their normal lifestyle. So maybe their
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their normal expenses drop down from $8,000 a month to $3,000 a month. And yes, now we have to add in a new $10,000
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a month line item for long-term care. So there are $3,000 a month expenses plus$10,000 for long-term care. That
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brings the new total to $13,000 a month. But our previous lifestyle expenses were
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$8,000 a month. The new total is 13. So even though the long-term care costs $10,000 a month, technically, this
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person's expenses only change by $5,000 a month. Most of the time that kind of
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tit fortat inside of someone's cash flow ends up being the way reality plays out.
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Third, I'm going to ask you, what about Medicare and Medicaid? Now, at this point, this is a little funny, so I
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think I've maybe shared this before. I can keep straight Medicare and Medicaid.
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Now, at one point, I couldn't keep them straight. And I had to remember that
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Medicare rhymes with hair as in white hair because Medicare is for the elderly. And Medicaid has aid right in
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the name as in I don't have money and I need some aid. Medicaid is income needsbased. Medicare does not cover
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long-term care. Technically, there are some hospital recovery scenarios that someone might go through in retirement
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where roughly the first 100 days of their long-term care like services are actually covered by Medicare. But again,
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that's if you're recovering from a hospital stay for about 3 months. It's
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not the same as when someone potentially needs years of help with simple daily living activities. That's long-term
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care. But Medicaid can help you with long-term care. Though, depending on the state of your personal balance sheet,
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right, how much assets you have, you might qualify for Medicaid to help you get into and pay for long-term care.
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Some people, however, don't like this option because you might not get to go
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into the long-term care facility of your choice. It might feel like a bad facility. And then there's this thing
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Medicaid planning for long-term care. It's a very deep and complex topic, too
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deep for today's episode. You can let me know if you'd like a further uh deep
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dive episode into long-term care and Medicaid planning. But the point is that if long-term care is this giant risk,
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Medicaid planning can potentially be one of the ways to derisk yourselves of that. So again, if we are going to bring
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this baby home, how do we de-risk ourselves against shock spending risk and specifically long-term care costs?
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To me, the answer is is kind of simple. We include these costs in our financial plan today. Well, right now. meaning our
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current plan has to account for the possibility of that major expense many decades into our future. And I I think
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it's worth running an analysis where there's a 100% probability of these
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costs just to see how it looks. But if you do that, I also think it's equally
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important to run an analysis where those long-term costs aren't in there at all
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or maybe an analysis where one spouse requires some long-term care and the other one doesn't. These are such big
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numbers that to assume the worst case across the board is simply more conservative than than most of us will
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need to be. Okay, that was a lot. It was more than maybe I was expecting to talk
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about, but long-term care and just shock spending in general, it can be for some
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families, it can be such a big risk looming on the horizon. I think it's certainly worth planning for today. But
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that brings us to the next risk of today's episode, cognitive decline risk. And again, here I'm not going to talk
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about the health risks of cognitive decline. I'm also not going to talk about the health care costs or long-term
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care costs of cognitive decline because those are real. But what I really want to talk about is the financial side
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effects that begin to creep in if someone loses their mental acuity. Stuff like decision-making and the ability to
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process complex financial information, the ability to evaluate risks and to manage someone's assets properly. You
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hear stories about people who miss bill payments, messiness and disorganization in their financial life. And then you're
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right, inability to understand basic information. That's a real side effect from cognitive decline. You also hear a
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lot of stories about susceptibility to scams and exploitation. There's no doubt
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that cognitive decline increases someone's vulnerability to scams, to fraud, to theft. Billions are already
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lost every year by older adults who who fall victim to scams. I'm really worried
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about this one personally, especially with some of the things that AI can do. I guess it's hard for me to even explain
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some of the possibilities. I'm sure I don't even fully understand them myself,
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but they sound so science fictiony. But I can foresee a future where unless information is being transmitted face to
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face, it's going to be really difficult to determine if it's real or if it's
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fraud. Meaning, hearing someone's voice on the phone, even someone who you feel
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like you know really well, might not be enough to determine if it's actually
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them because technology is getting so good at mimicking people's voices. Similarly, and perhaps even more scary,
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seeing someone's moving face over video on FaceTime uh on a Zoom chat won't be
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enough to determine if it's actually them. And I know that sounds like sci-fi, but I really don't think it's
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that far around the corner. And who among us would be most susceptible to that type of scan? They hear a voice or
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they see a face and they think, "Oh, that's a person I know." It's probably
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the people who are the least familiar with the technology, meaning elderly people. And cognitive decline magnifies
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that risk even more. So that's scary stuff. Cognitive decline is also associated with irrational investment
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behavior. Right? Individuals are going to make drastic shifts in their investment approaches probably for all
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the wrong reasons simply because the knowledge that they maybe once possessed has started to escape them. Then there's
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also overconfidence in one's ability. People with declining cognitive function
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often remain overconfident or can grow overconfident in their own abilities, their own financial abilities despite
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their impairment. So where do we end up after all these things are combined? we end up with just straight up losses in
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wealth, irreversible financial errors, duplicate transactions, misransactions. It's a long list of possibilities. So,
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how do we combat this risk? How do we combat cognitive decline risk? Well, first there are are health related steps
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we can take. I'm not a doctor. I'm hesitant to go too deep into detail here. Now, depending on where you look
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in the health literature, though, there are exercise and cardiovascular interventions. There are diet related
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interventions. There are sleepreated interventions, too. So anyway, I would say talk to someone who knows more than
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me about health. But using health is one of the ways to de-risk yourself from from cognitive decline. But then what
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can we actually introduce into our financial plan to help mitigate the risk of cognitive decline? I think it's a
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simple answer. Backup systems and backup people. The worst outcomes here in the realm of cognitive decline come from
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when one person and that person alone has all the power, controls all the buttons, knows all the information for
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their financial life. And if that one person starts to slip, there's no backup
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system in place to bail them out. So what are some of these backup systems? One is establishing legal protections,
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creating a durable power of attorney document for finances, creating a a healthcare proxy for health while you
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are still competent to ensure that there are trusted individuals in place who can
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act on your behalf. The second one is to set up trusted contacts. And I say that
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in quotes because the the exact terminology can change from custodian to custodian. But a lot of custodians
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meaning Schwab, Fidelity, Vanguard, whoever, they have these idea, this idea of a trusted contact where you can
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notify that financial institution of a trusted contact person who could be alerted if unusual activity suggests
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maybe that you're the victim of some sort of financial abuse, financial fraud, or maybe you're starting to slip
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up to uh cognitive decline. The third idea I have is to simplify and automate your finances. you know, consolidate
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your bank accounts. Set up automated bill payments to avoid a missed payment. Set up a Social Security Advance
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designation if you don't have that for representative payes. Get organized. That's the fourth idea. Compile a
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secure, accessible list of assets, insurance policies, passwords, all the important documents, your estate
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documents. Really get organized and then let a second person understand what organization you've done, where it is if
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something happens to you. Kind of let them in on at least some of those secrets, for lack of a better term. The
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fifth idea is to establish a team of trusted adviserss. Now, I was talking to my wife literally today as I was writing
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out the script for this episode, and we had a little side conversation about who
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she should reach out to if I got hit by a bus. And it made me realize here we are at age 36, and I need to put down in
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writing for her some things that she doesn't know. and I owe it to her to let
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her know who wrote our estate documents, who our insurance agent is for life insurance, who our accountant is, who I
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would contact as a financial planner to help her if I got hit by that bus, which
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of our friends and family I would share questions with if I were in her shoes. So again, that's how you derisk yourself
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from cognitive decline risk. It's all about getting backup systems and backup
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people in place. Here's a quick ad and then we'll get back to the show. Did you
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know my written blog, The Best Interest, was nominated for 2022 Personal Finance
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Blog of the Year, and it's been highlighted in the Wall Street Journal, Yahoo Finance, and on CNBC. I love
00:18:15
writing, especially when that writing is to share financial education. And I usually write one or two articles per
00:18:21
week. You can read them all at bestinterest.blog. Again, the web address is bestinterest.blog.
00:18:29
Check it out. Now, let's move on to behavioral risk. This is a giant risk for investors of all stripes. And the
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risk here is that your own emotional, irrational, biased decision-making as opposed to kind of logical analysis will
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lead to financial missteps that jeopardize what would otherwise be a comfortable retirement. And I think for
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retirees in particular, this risk is is amplified by other fears. I won't spend
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a ton of time talking about the individual possible behaviors, but you might be familiar with them already.
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stuff like loss aversion, recency bias, herd mentality, overconfidence, the status quo bias. How these very human
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but also sometimes illogical tendencies can get us to do objectively bad stuff like timing the market or panic selling
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and the like. So, how do we combat behavioral risk? Well, the first thing I think of is to automate our cash flow,
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right? Set up automatic consistent withdrawals like a direct deposit from a retirement account into a checking
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account rather than making manual emotional decisions to withdraw money. A second thing you can do is to think of
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buckets. Now, you don't have to use a quote unquote bucket strategy to build
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your portfolio. You don't have to do that. But I think you should realize that there are various assets that you
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own. And these assets do have certain tendencies that place them into shorter term or longer term quote unquote
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buckets. And if your longerterm bucket is behaving with extra volatility, you can ignore it because that's the
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long-term bucket and you don't need to worry about it for years if not decades.
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So whether you want to use the bucket metaphor or something else, it's simply
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important to realize that the different assets you own inside of a diversified portfolio are usually there at least in
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some part because they have different timelines associated with them, different levels of volatility
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associated with them. And sometimes your certain assets are simply going to be more volatile than others. That's by
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design, right? That's by design. And so as long as you think about it that way,
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it can kind of help you realize that some of the uh concern that you feel about volatility is a again, what do
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they say? It's a feature. It's not a bug. Number three, create a written
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investment policy statement or IPS. It's a formal plan that outlines how to react
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during market volatility to prevent knee-jerk fear-driven sales. I think of it as kind of a a break glass in case of
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market panic. That's what you do when things are getting tough and you're
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getting worried. You can whip out the IPS that you wrote when you were of sound mind, that you wrote when
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everything was calm, and you can almost remind yourself of, "Oh, yeah, that's
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right. Here are the reasons why I I made the portfolio I made." And if you adhere
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to that plan rather than reacting to news headlines, you'll be better off for
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it. You can set your portfolio to automatically rebalance if you want to, or you can set that up inside your IPS,
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how often you rebalance, and that forces you to sell high and buy low rather than
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selling into fear. I think the fourth thing on my list is to to limit how much you monitor your accounts. If you check
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your portfolio balance too frequently, especially during market volatility, during panicky times, well, that can
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lead to panic selling or just bad investor behavior in general. And number five is to remove yourself as best you
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can. For most of us, we are our own worst enemies. And if you feel the urgent need to do something drastic,
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it's really helpful if some little Jiminy Cricut voice in the back of your mind convinces you just to pause. If you
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feel like you can't help yourself though, well, maybe you can't and you need to outsource it to someone who can.
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And we already discussed it here. You know, automate as much as you can. Automate, automate, automate. Remove
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yourself if you need to as much as you can. And whether, like I said, whether it's that Jiminy Cricut voice in the
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back of your head, whether it's a trusted friend or family member who can convince you to remove yourself, or
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whether it's leaning on a professional, trying to automate and remove yourself
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from the decisions is almost always a good thing as opposed to a bad thing. Now, the thing about behavior risk is
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that by the time you realize that it's hurt you or that it's hurting you, it
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might already be too late. Now, for example, you could have gotten your ducks in a row in in 2015, that's a year
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old pick here, and you've been in a really good spot. all your systems are smooth and then March of 2020 happens.
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You get scared, you do something that only afterward you realize was stupid and that's behavior risk. And the thing
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is, you might not have realized it during the panic of the spring of 2020 when COVID was hitting in March of 2020.
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But by the time things calm down and you realize it, it's too late. So anyway,
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that's why behavior risk, by the time you realize it that it's hurt you, it
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might be too late. You really want to get your anti-behavior risk systems set up early. it can do it can undo so much
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important work that you've already done. So set up those systems, automate what
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you can, remove yourself where you can to help you mitigate behavior risk. And next, let's pivot to assumptions risk.
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And I I want to break this one down into two small sub risks. The first one involves the assumptions you're making
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about your future self. And the second one involves the assumptions you're making about the future world. and and
00:23:01
specifically here I mean the assumptions about market returns and inflation and tax policy the very assumptions that
00:23:06
create your retirement projections in the first place and the idea of knowing your future self it's a very kind of
00:23:12
deep academic psychology topic where again I am not an expert don't consider
00:23:16
myself an expert but when I read about it the big takeaways are that okay humans are generally inaccurate at
00:23:22
predicting their future emotional states we consistently overestimate both the intensity and the duration of our future
00:23:27
emotions and number two we tend to project current preference references, moods, and feelings onto our future
00:23:32
selves. For example, a person who is currently full of food, they had a big meal, they are actually worse at
00:23:38
predicting how hungry they will be while grocery shopping later on than someone who is currently hungry. We use our
00:23:44
current preferences and moods and feelings and project them onto our future self. Uh, number three, we tend
00:23:48
to focus too narrowly on single future events while ignoring daily routines and other mundane contexts that will
00:23:54
influence our emotional states. Number four, we fail to recognize that the human brain has an unconscious ability
00:24:00
to rationalize, cope, and adapt to negative events. And that makes those negative events feel less devastating in
00:24:06
the moment than we currently anticipate them to be. And then number five, we quickly return to a baseline level of
00:24:11
happiness after major positive or negative life events. Because we underestimate this adaptation that we
00:24:17
have, we incorrectly believe things that, you know, winning the lottery will bring us lasting happiness or that a
00:24:23
relationship breakup will bring lasting misery. You might be familiar with this one, listeners. It's called the hedonic
00:24:29
treadmill. And anyway, my point is that if you assume that retirement will fundamentally change who you are as a
00:24:35
person or fix the problems in your life, if you see retirement as a hammer whose
00:24:38
job it is to pound in the various nails that surround you, you might be at risk of some pretty poor assumptions. And the
00:24:45
solution here, I think, is is kind of to know yourself, right? So, how do you derisk yourself? I would recommend some
00:24:51
self-study. For example, two books that immediately come to mind are Stumbling on Happiness by Dan Daniel Gilbert and
00:24:57
then Thinking Fast and Slow by Danny Conaman. I'll link to those two books in
00:25:01
the show notes, but basically in order to not make bad assumptions about your future self, it's really helpful to to
00:25:07
know who you are and know how your brain works and and maybe educate yourself just on how human brains work in
00:25:12
general, especially when it comes to predicting who we will be in the future. So, that's the thought process there.
00:25:18
But now let's pivot to the assumptions you're making about the future world.
00:25:21
And specifically, again, I mean market returns and tax policy and inflation. The very assumptions that create your
00:25:27
retirement projections. This is a place where I constantly and consistently see mistakes from both DIYers and
00:25:34
professionals alike. And I see five major assumption categories that retirees need to consider. At least when
00:25:40
it comes to kind of the the long-term cash flow portfolio projection, the the Monte Carlo projection type thing. There
00:25:46
are five categories that we need to consider. They are social security, investment returns, expenses and other
00:25:52
cash flow, inflation, and tax rates. And the risk here is that you assume unrealistic numbers in those five major
00:25:58
categories. Because when you do that, these numbers, they don't just add, they
00:26:02
multiply. They compound inside your retirement plan. And any lack of realistic numbers is going to make your
00:26:08
final answers even further from the truth than they ought to be. Now, what do I mean specifically? Well, a very
00:26:14
conservative person might say the following five things. Again, very conservative. On social security, I'm
00:26:20
assuming it's not even going to be there at all. It won't even exist anymore. On
00:26:23
investment returns, I could say, well, historically, a 60/40 portfolio might return 9% a year. I'm going to assume, I
00:26:29
don't know, 6 or 7% a year. Let's just plant a flag and say 6.5% per year. on
00:26:33
expenses. I know that most people's nominal spending actually goes down in retirement or there's a lot of good
00:26:38
research about the retirement spending smile they call it because the graph kind of looks like a smile. But
00:26:43
actually, I want to be safe and I'm going to assume that my spending will go
00:26:46
up in retirement. Maybe I'm convinced I'm going to travel a lot. So, I'm going
00:26:49
to assume that my spending goes up by 25% a year. On inflation, historically, it's been 3%. I'm just going to assume
00:26:56
5%. I mean, after all, 22 2022 and 2023 had really high inflation. And then for taxes, I'm going to assume federal tax
00:27:03
rates are going up in the future. I mean, why not make that assumption? And so, I'm going to assume my personal tax
00:27:08
rates will increase, and I'm going to use a a 20% effective tax rate. Now, we
00:27:11
all know that conservative assumptions are are naturally going to lead to conclusions that ask you to work more
00:27:16
years, to save more money, to spend less money. That's just a natural consequence
00:27:20
of financial planning conservatism. But for this specific person with these five
00:27:24
very conservative assumptions, I can almost guarantee that these assumptions are costing them 10 to 15 years of
00:27:30
additional work. In other words, you know, if this person was simply realistic, they might be able to retire
00:27:35
at age 60. But their assumptions would ask them to work into their 70s. And I know this is true because I ran all the
00:27:41
numbers and you can check it out for yourself in one of the probably one of the more viral articles I've ever
00:27:45
written called the crushing cost of conservative retirement planning. And we will link to that in the show notes.
00:27:51
When it comes to assumption risk, retirees can also be too aggressive with their assumptions. And I think that's a
00:27:56
big risk, too. I think loss aversion, speaking of behavioral risk, the loss aversion in our brains suggests that
00:28:02
being too aggressive is the bigger and scarier risk. You know what? If I assume a 9% return on my portfolio, but then I
00:28:09
only get a 7% return and then I'm forced to reenter the workforce at age 80. That
00:28:13
is a little bit scary. So, what's the best practice here when it comes to assumptions risk? First and foremost,
00:28:19
you need to be aware that conservatism compounds. Well, and I guess being too aggressive, that compounds, too. These
00:28:24
assumptions, they all multiply together. They all compound. Now, what I mean is that if you had five inputs to a math
00:28:29
problem, and those inputs all multiply together and compound, and you choose to be 25% conservative with each of those
00:28:36
five inputs, then your final answer is actually going to be 200% too conservative. Why? Because 25* 25* 25,
00:28:44
if you do that five times, your final answer is 200%. Now, instead, if you do want to add some conservatism, which is
00:28:51
okay, simply to maybe create some bookends or at least just understand what a conservative outcome might look
00:28:56
like, you you want to do your multiplication the normal way and then only add on 25% at the very very end.
00:29:03
You want to use the most realistic numbers that you can throughout your math such that your final answer is, as
00:29:08
far as you know, totally realistic. And then you tack on your conservative margin, if you will, onto your final
00:29:14
number. So instead of being 200% too conservative, you maybe you're only 25%
00:29:18
too conservative. Now when this topic comes up, you might hear the term base rates and it's important. Per the
00:29:23
dictionary, base rates are the fundamental probability of an event occurring within a specific population,
00:29:28
often established through historical data or observation. Base rates are crucial because they provide an accurate
00:29:34
starting point for forecasting and decision-making. So 99% of the time, listeners, assumption risks occur
00:29:40
because somebody is tampering with the base rates. History says a 60/40 portfolio will provide a 9% annualized
00:29:45
return over the long run with an annual volatility of 10%. Great. That's your
00:29:49
base rate. Now, if you decide to reduce that rate of return to 8% and you decide
00:29:54
to increase the volatility to 15%, you are now tampering with the base rate. You're putting your thumb on the scale.
00:30:00
You're layering your brain's need for conservatism on top of objective reality. And that's a risky practice and
00:30:06
in general a bad practice, a sub-optimal practice. Now, one little side note, one
00:30:10
more point though, because someone might ask, well, what if I have a really good
00:30:13
reason to edit a base rate? And okay, maybe there can be some good reasons to edit your personal base rates as being
00:30:19
different from the historical precedent or the global base rate. For example, we
00:30:22
already discussed back on last week's episode, episode 140, that your personal
00:30:27
longevity, the age that you die at, might just be the most important number in your retirement plan. And your
00:30:32
lifespan, your personal lifespan will almost assuredly be different than the average lifespan. And I think it does
00:30:39
make sense for you to attempt to discern why you specifically might live longer or shorter than the average. I think
00:30:44
that's fair. Another one, we've discussed at length on prior podcast episodes why the 4% rule is probably not
00:30:50
the thing that you want to base your entire retirement future on, but at one point it was a pretty reasonable base
00:30:56
rate. So the point there being that base rates can change. How about another one?
00:31:00
What if analysis? So again, your base case for retirement, your base case should be based on the base rates. And
00:31:07
that's actually a line from my upcoming Dr. Seuss retirement book called Oh, the
00:31:11
Places You'll Nap. But of course, you you probably should then run some whatif
00:31:15
analyses. For example, on the Social Security front, we've discussed here that your uh the current path to Social
00:31:20
Security does actually have retirey benefits going down to something like 80% of what's been promised as of 2034
00:31:26
and 2035. Yes, that's kind of a political suicide for Congress, but you might want to ask yourself, what if
00:31:33
Congress doesn't step up to the plate and do something about this? So, okay,
00:31:36
if it's a what if analysis and you're adjusting the base rate to understand
00:31:40
that, I think that's fair. Anyway, assumptions, risk, assumptions, risk. A very good risk to be aware of and a very
00:31:46
good one to try to make sure that your numbers are as accurate as possible. Next, we have policy, legislation, and
00:31:52
tax risk. And yes, uh we just talked about social security. It's time to talk
00:31:56
about social security again because the biggest kind of sub risks that fall under the overhead umbrella of
00:32:02
legislation and policy and tax risk are social security tax rates themselves. Medicare, RMDs, inflation I actually
00:32:10
think belongs in here in a way and I'll explain that. And then for an honorable
00:32:14
honorable mention number six, maybe we can throw the estate tax in there too. So for some more specifics, social
00:32:18
security, we did just discuss that a little bit. The main risk here is that somehow our benefits decrease in a way
00:32:23
that we're currently not planning for. taxes. We are living in a historically
00:32:27
low tax regime. It's conceivable that we could live through increases to uh income taxes, capital gains taxes,
00:32:34
dividend tax treatment is really nice right now. We could see that retirement accounts are somehow treated differently
00:32:39
in the future or that state level taxation of retirement income changes. You know, in most states, maybe in all
00:32:45
states, I actually don't know this. I know here in New York State, social security income isn't taxed. What if
00:32:49
that changes anyway? So taxes could change for Medicare. I think about the 65 year old eligibility age. The
00:32:56
premiums themselves for part D and part B, B and D, boy and dog, they have premiums, coverage changes, out-ofpocket
00:33:02
costs. Again, the idea is that could legislation somehow change our access to Medicare and what it does for us. On the
00:33:09
RMD front, we've recently seen the RMD age change from 70 12 to 72 to 73 and
00:33:17
it's soon to be 75 years old. We've also seen a lot of changes when it comes to
00:33:20
inherited IAS over recent years. Number five, inflation policy is a very interesting one. It's a little nerdy,
00:33:27
but fiscal policy, so-called fiscal policy is set by Congress, whereas monetary policy is determined by the
00:33:33
Fed, Federal Reserve. And for the most part, inflation is related to and controlled by monetary policy. Whereas,
00:33:39
you know, Congress will certainly hear your frustration if they pass fiscal policy that negatively affects you. They
00:33:44
might not change anything, but at least you can access your local congressperson
00:33:48
to complain. The Fed is much less likely to care about your personal hardship if
00:33:53
they enact monetary policy that raises inflation and hurts your retirement plan. And then last, estate taxes. This
00:33:59
only affects a small portion of people right now, at least on the federal level. May probably more of you are
00:34:04
affected at your personal state level when it comes to estate taxes, but either way, these rules are certainly
00:34:09
subject to change, and that's really the risk here. Someone might be all set with
00:34:13
their estate taxes right now only to find that some change that occurs in 10 or 20 years might totally screw up their
00:34:18
retirement plans. So, what can you do about policy risk? I think most retirement plans are built on a set of
00:34:25
uncertain markets plus stable rules. We consider uncertain markets, but we think
00:34:30
of the rules as being stable. And going back to a couple minutes ago, I think that should be the base rate. I think
00:34:35
it's okay and even good to assume stable rules. And the reason there is that to
00:34:40
predict the instability in the rules I think is way too much of a crystal ball exercise than is merited. Right? I
00:34:46
cannot predict the future and we shouldn't be in the business of predicting the future. But I think we
00:34:50
can be realistic and admit that policies have changed before and probably will change again. We don't know if they'll
00:34:55
change in our favor or change against us. But I think it's okay to assume that
00:34:59
they'll change again. And I think it's okay if in our planning we ask those
00:35:02
whatif questions, right? The base rate reflects reality. The base plan reflects reality. But then we ask some what if
00:35:08
questions that might involve uncertain rules. You know, what if my social security benefit does decline by 20%.
00:35:14
What if my effective tax rate does go up by 5%. Those kind of things. And I think
00:35:18
those are fair questions. Certainly worth understanding the answers to, but again, it doesn't mean that those
00:35:23
answers belong in your base rate assumptions. Here's a quick ad and then we'll get back to the show. Serious
00:35:30
question. Why do podcasters constantly ask for ratings and reviews? Yes, they do help highlight our shows to new
00:35:37
listeners. They help strangers find us on Apple Podcast and Spotify. It's totally true and a good reason to ask
00:35:42
for ratings and reviews, but I have something more important, at least more important to me. I want to know if you
00:35:49
like this stuff. I want to know if you like my podcast episodes, my monologues, my guests, the information I share with
00:35:55
you and the stories I tell. I want to improve and make your listening more enjoyable in the process. So, yeah, I
00:36:01
would love to read your reviews. And sure, if you throw a rating in there, too, that's great. If you like what I'm
00:36:06
doing, please share it with me. It's such a great feeling to read your feedback. I'd love to read your review
00:36:13
or see a rating on Apple Podcasts or Spotify. Thank you. And now, let's get to our second to last risk today. We're
00:36:20
going to dive into identity and purpose risk. You know, there are entire books, entire websites, entire podcasts, just a
00:36:25
big body of work dedicated to this one topic. And you know the idea here is you don't want to retire from something, you
00:36:31
want to retire to something. You want to think about all the positive things you
00:36:34
get from work and ask yourself how you'll replace those things in retirement. You want to think about, you
00:36:39
know, the structure of your days and the social interactions and status that you
00:36:43
get at work and how you were made to feel useful in your life. Here's a fun one. Think about all those phrases that
00:36:49
currently maybe or or used to be when you were working. They're in the form of
00:36:52
I am a blank or I do blank or I help people with blank. And when you retire, all those phrases become past tense. I
00:36:58
used to be blank. Oh, back when I was working, I did blank. Oh, yeah. I used to help people with that back in the
00:37:04
day. Is it Marlon Brando in that movie On the Waterfront? >> You don't understand. I could have had
00:37:08
class. I could have been a contender. I could have been somebody instead of a bum, which is what I am.
00:37:18
Let's face it. The point here is that a lot of retirees struggle with their identity and the purpose that they
00:37:26
didn't realize they are missing until it's too late. It might have and usually
00:37:29
does come from work in some way, shape or form. And anyway, many retirees struggle with that. And I think the
00:37:34
takeaway or at least the solution is that it takes legitimate work to mitigate identity and purpose risk,
00:37:40
mental work, thought. It takes legitimate thought. Back on episode 106 of this podcast, I spent most of that
00:37:46
episode talking about just this topic. The episode is called The Big Disconnect: Pre-retirey Expectations
00:37:51
Versus Retirement Reality. I think there's the one stat from that episode that I come back to time and time again,
00:37:56
which is that the average pre-retiree ranks finances as their top concern, but the average postretire finances is
00:38:05
something like number six. And all of their top concerns as an actual retiree as a post-retire, almost all of their
00:38:11
top concerns have to do with identity and purpose. But back in that episode, I talked about three exercises you can do
00:38:17
to help on this front. They're called the perfect day exercise, the icky guy
00:38:21
map exercise, and then the rocking chair test. So, I I highly recommend you go check out that episode and and make sure
00:38:27
you've done all three exercises if retirement is kind of on your horizon. Purpose and identity risk is the driver
00:38:32
behind why retirement increases the probability of depression by about 40%. I mean, just think about that for a
00:38:39
moment. You know, most people probably assume retirement is like an extended vacation, right? free time, travel,
00:38:44
tennis, seeing the family, doing crosswords on a calm morning than a hot coffee in hand, loons calling to each
00:38:50
other in the distance on the lake. I mean, that is what people think about in retirement. And how could that image
00:38:55
elicit more depression than the 9to-ive grind? So clearly, I mean, what I'm saying is that many of our assumptions
00:39:01
about retirement must be misplaced, just not meshing with the actual realities of
00:39:07
retirement. And I think that purpose and identity risk are probably a really big
00:39:11
reason why. So anyway, that is an important thought process when it comes to purpose and identity risk. And that
00:39:16
brings us to the final risk of this two episode series which are called the deep
00:39:21
risks. Now many people put Bill Bernstein on their Mount Rushmore of investment communicators. He mostly does
00:39:27
writing, you know, along with the the Warren Buffetts and the John Bogles and the Jason Swags of the world.
00:39:32
Bernstein's most well-known books are are probably the four pillars of investing, the intelligent asset
00:39:36
allocator. He has a really short book, I think it's only 15 or 16 pages long,
00:39:41
called If You Can, and it's targeted toward, I believe, investment beginners.
00:39:45
He also has a couple interesting books that are more about economic history, a splendid exchange, and the birth of
00:39:50
plenty. But in 2013, he wrote a book only 56 pages long, and it's called Deep
00:39:55
Risk: How History Informs Portfolio Design. And Bernstein's main point in that book, Deep Risk, is that standard
00:40:02
investment strategy, the kind of stuff that we talk about here, to be candid, the kind of stuff that almost all
00:40:07
personal finance and investing content talks about, looks at relatively short-term volatility and thinks about
00:40:13
bare markets that last, you know, a few months, maybe a couple years, 3, four years, that kind of thing. But Bernstein
00:40:19
says that real world investors are subjected to sometimes long horizon perils that we ought to be much more
00:40:25
focused on. These perils can stem from both economic and military concerns and they can actually cause sometimes
00:40:31
multi-deade hiccups in our retirement plans which let's be honest multi-deade
00:40:36
might just be the full tenure of your retirement plan in the first place and these perils are what he would call deep
00:40:42
risks and Bernstein writes these risks have names inflation deflation confiscation and devastation and any
00:40:49
useful discussion of portfolio design incorporates their probabilities consequences and costs of mitigation.
00:40:55
Now, we already talked about inflation as one of our major 14 risks. That was last week on episode 140. So, I'll leave
00:41:02
inflation there. But let's talk about deflation, confiscation, and devastation
00:41:05
real quick. If we're going to discuss deflation, we probably should just look
00:41:08
at the Great Depression. Falling prices, collapsing demand, a financial system that's under stress. Whereas inflation
00:41:14
makes you want to invest all of your cash, right? Deflation is where cash is king. So, how do we combat deflation?
00:41:21
You probably want to hold some high quality bonds and cash. You want to maintain your liquidity. You want to
00:41:26
avoid excess leverage if you can. Then again, right, deflation has almost never happened. It's really only happened in
00:41:31
one consequential way here in the US. But that's part of Bernstein's point is
00:41:36
that these deep risks are very damaging when they occur. They can occur over a long timeline when they occur, but
00:41:42
they're also kind of rare. And that's part of the really hard part about deep
00:41:45
risk is like how do you handle something that if it occurs could really screw you
00:41:49
up, but it's just probably not going to occur. That's a hard problem. Anyway, we
00:41:53
we'll come back to this idea. I I told you it's a hard problem. Bernsteeen has
00:41:56
some thoughts on that that I'll share with you at the end. But first, let's
00:41:59
talk about confiscation as a topic and it tends to make people a little uncomfortable if we zoom out to a global
00:42:04
perspective. History is full of governments who change the rules or just large institutions who change the rules.
00:42:09
Sometimes it might just be higher taxes. Sometimes it might be asset seizures or
00:42:12
like nationalization. Confiscation is a risk that someone more powerful than you
00:42:16
changes the rules to your disadvantage. So, how do we combat this risk? Bernstein admits it's not easy and at
00:42:22
times not even worth doing. In other words, it might be one of those risks that we simply have to live with. But we
00:42:27
certainly want to diversify across jurisdictions if it's easy. We want to hold assets from different parts of the
00:42:32
world. And if you want to really get crazy, and it's certainly crazier than anything I have done or am doing, you
00:42:38
could even choose to custody your assets in different jurisdictions. I I guess that means, you know, have a brokerage
00:42:43
account in the US and in Switzerland and in Japan. I don't know. Like I said,
00:42:47
that's it's too much complexity for me. But technically it does reduce your
00:42:50
exposure to confiscation risk in a in one particular country. And that leaves us with the last one, devastation risk.
00:42:57
You know, war, revolution, societal collapse, situations where entire markets are wiped to zero or where your
00:43:03
your citizens property rights are simply erased. Those are probably situations where, frankly, financial planning
00:43:09
doesn't even really matter anymore. Now, if your home, your country, your society
00:43:13
collapses, yeah, I'm not sure there's much you can do. But it's possible that
00:43:16
in a globally diversified portfolio that some portion of your investment holdings
00:43:20
do go through some form of devastation. I think as an example, you could look at
00:43:24
the country of Venezuela over recent decades, the really 30,000 foot highlights or low lightss. The oil
00:43:30
industry in Venezuela grew and grew and grew until partially in the 1970s and then it kind of finished off in the
00:43:36
early 2000s led by Ugo Chavez. the oil companies in Venezuela had their assets seized by the government and were
00:43:42
basically forced out. That's nationalization. Maybe that's not a devastation risk, right? Maybe that's
00:43:47
certainly more of a confiscation risk. But then I guess you could say what's
00:43:50
going on in Venezuela today is much more similar to a devastation risk than anything else. And certainly the the oil
00:43:56
nationalization and what happened there was a bit of a preceding event to what's
00:44:00
occurring today in in modern Venezuela. It's not good. Now, assuming you listening that you're not Venezuelan,
00:44:05
these events probably don't impact you too much in your day-to-day. But as a a
00:44:09
globally diversified investor, yeah, you probably had some exposure to these energy companies when Venezuela kicked
00:44:15
them out. And you might have some exposure to some side effects of some of the devastation that's going on in
00:44:19
Venezuela. It's probably a small exposure that you have because Venezuela is a relatively small country, but that
00:44:24
risk is there. Now, the big insight when it comes from Bernstein's wisdom on the
00:44:29
deep risks is that no single asset protects you from all the risks, let alone from all the deep risks, right? We
00:44:36
talked about 14 different risks over these last two episodes. Stocks help with some risks, but stocks actually
00:44:42
expose you to other risks. Bonds help with deflation, but bonds get eaten alive by inflation. Global
00:44:48
diversification helps out, but not perfectly. Some risks are totally out of your hands. Some risks are deeply
00:44:54
personal, tied to our health or tied to our happiness. Some risks are tied to markets. Some are tied to the
00:44:59
government. Some are tied to the other people in our lives. Right? There's no
00:45:02
silver bullet when it comes to combating all these risks. But I hope that this exercise over the last two episodes has
00:45:08
helped you conceptualize these 14 unique risks that I think most retirees face or
00:45:13
could face and has given you some ideas about what you might address in your personal retirement plan. Maybe where
00:45:18
some of the holes are. Maybe as Charlie Munger would have said, "Show me where
00:45:22
I'm going to die to make sure I never go there." I've shown you a lot of the
00:45:25
risks that could face you in your retirement. Now, it's up to you to decide if you're exposed to that risk or
00:45:30
what you can do to quote unquote never go there. So, thank you as always for listening to Personal Finance for
00:45:35
Long-Term Investors. >> Thanks for tuning in to this episode of Personal Finance for Long-Term
00:45:40
Investors. If you have a question for Jesse to answer on a future episode, send him an email over at his blog, The
00:45:46
Best Interest. His email address is [email protected]. Again, that's jessevestinterest.blog.
00:45:55
Did you enjoy the show? Subscribe, rate, and review the podcast wherever you listen. This helps others find the show
00:46:01
and invest in knowledge themselves, and we really appreciate it. We'll catch you
00:46:06
on the next episode of Personal Finance for Long-Term Investors. Personal Finance for Long-Term Investors is a
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personal podcast meant for education and entertainment. It should not be taken as
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financial advice and it's not prescriptive of your financial situation.