Retirement Income Strategy Challenges – On Quitting Early, the Decumulation Problem and Living to 100
The game of chess has taught me a lot about how to make decisions. Most of my early lessons were given to me by my father, who was still able to beat me years past the point where I had become a better player. He used to tell me often that “resign is the weakest move.” For chess players, that is undoubtedly good advice, but when facing choices in other areas of our lives, particularly those that relate to money, chess is perhaps not the best model — largely because the position on a chessboard board is visible for all to see and the only unknown to ponder when choosing a plan is what move your opponent will make in response to the one you choose and how the future might unfold as a result. It is a complete information game, even though the future has almost (but not quite) infinite scenarios that would need to be evaluated in order to make the absolutely correct move.
Annie Duke, who used to be one of the best female poker players in the world, has written some great books on making decisions under uncertainty, including Thinking in Bets, How to Decide, and most recently, Quit. In all three she provides important insights drawn from her years at the card tables as well as her graduate work in cognitive psychology on how to make decisions when faced with not just an unknown future, but a present where you don’t have all the information.
The missing, ambiguous, and/or dubious information that has to be considered when making financial decisions is why I believe that people should consider Annie’s advice when making important choices with respect to their lives and their money.
Annie was featured on the April 2023 episode of my podcast talking about Quit – her new book that addresses one very important decision that is fraught with uncertainty as well as more than a little psychology. (Listen to the podcast at PeterNeuwirthRadio.com and click here to watch our video interview on PeterNeuwirth.tv.)
As an actuary focusing on retirement income strategies, I was naturally interested in Annie’s views on one the most important “quit decisions” that most of us eventually have to make – i.e. when to stop working and begin living on all the assets we may have accumulated along the way,
In talking about the decision to retire, Annie said that she thought that too many people view the decision to stop working as “last and final” when it really isn’t. She suggested that “status quo bias” keeps many people working past the time when they should be retiring.
When I pressed her on the financial aspects of knowing when you have accumulated enough to live on for the rest of your life, she suggested that that was a question of determining whether you have “enough runway” for a safe landing while you consider what to do next. She did, however, acknowledge that when approaching the end of a career that there is a “stickiness” associated with the shortening time horizon that might keep you working longer than you otherwise might.
She said that while this “time element” is important, the more important question for those who are tired of their jobs and are contemplating retirement to ask themselves, “for how much longer are you ok with being miserable at your job?” and then once you have answered that, she suggests setting a date and then holding yourself accountable to that timetable.
I think the above is great advice for thinking about when to retire, but whether Poker, Chess, or Actuarial Science is the right kind of thinking to use in developing and managing a retirement income strategy is, to my mind, an open question. This is because once you have made that first and most important quit decision, i.e. actually retired, the “decumulation problem” rears its ugly head, and that is a problem where even though “thinking in bets” might be helpful, there are clear, quantifiable risks where the actuarial perspective can also be extremely useful. Here too, though, Annie’s insights regarding our cognitive biases and systematic miscalculations are well worth keeping in mind.
Actuarial Science is designed to attack problems where time, risk, and money all play a part. As a general rule, actuarial science focuses on quantifiable risks and things that are easily measured, leaving it to others to guide individuals through the minefield of human nature that we have to traverse before making our choices. That is why Annie’s books are so worth reading. She enumerates and addresses the myriad of ways we end up making choices we later regret. Annie discussed many of those biases on our podcast but also noted that some of her approaches to making decisions under uncertainty need to be modified based on the timeline over which you are making decisions. As noted earlier, she indicated that plans could become more “sticky” when your timeline is short, and quitting becomes less and less of an option as you get closer to the end.
This time element is also important for those who have already quit working and have begun drawing down their assets in a manner designed to sustain themselves for the rest of their lives. In fact, many of us retire because our timeline is now shorter even if its actual endpoint remains, except in rare circumstances, highly uncertain.
The Nature of the Problem
Decumulation is a brutally difficult problem, and there are 4 distinct risks that retirees face during this phase of life that are either immaterial or non-existent during the years when they are working and saving for retirement. For a more detailed description of each risk, see https://www.advisorperspectives.com/articles/2023/01/03/the-four-unique-risks-in-decumulation
Each of the 4 risks has its own unique aspects, and while there are different techniques that can be used to manage each, the techniques available can be more or less effective depending on when they arise during retirement. For example, an unexpected “spike expense” is less dangerous to your financial health if it happens early in your retirement since then you will have longer to recover the assets lost and/or modify your future drawdown strategy to accommodate your “post spike” income/expense planning.
But the one risk that always manifests itself at the worst possible moment is longevity risk. Specifically, longevity risk only becomes manifest when you are older than you ever expected to be – exactly at the point where your financial resources may be running out. Therefore, if you don’t consider longevity at the outset of your retirement, even if you manage the other three risks effectively, you still may find yourself struggling to make ends meet at the very point in life when you have limited resources to draw on, potentially diminished capacity and few options for addressing the prospect of running out of money.
Longevity is hard to think about as a “risk”, because the benefits of living a long healthy life are, for most of us, overwhelmingly positive. No one really wants to think about the downsides of living to 100, or if we do, we simply discount it as either wildly unlikely or as something that is best ignored. After all it is a long way in the future, so why bother thinking about it now?
While I tend to agree with Annie’s view that the decision to retire is one that people often wait too long to make, not realizing that it is possible to “unretire”, I think most people who have no serious health issues should seriously consider the fact that their retirement may last much longer than their life expectancy might suggest.
The real problem with longevity risk is that it gets more acute (and harder to deal with) the longer you live and the healthier you stay. For example, a 65-year-old man in decent health might expect to live another 20 years until his mid 80’s. However, once that same man reaches 80 while still in good health, he is better than 50-50 to make it into his early 90s with a decent shot at making it to 100. And that is not the worst of it. If you are a woman, your odds are even better, and the risk that much more acute.
How to manage longevity risk
Because longevity risk gets more acute and difficult to manage as you get older, intuition suggests that it should be most cost-efficient to start thinking about the possibility you might reach age 100 long before you approach that age, and that is where my colleagues and I have begun to research possible risk mitigation approaches. Below are three possible techniques for addressing this risk directly.
- Purchase Longevity Insurance. At age 65, you can buy a 20-year deferred life annuity (where payments begin at age 85) to insure against the risk of outliving your assets. And because so many 65-year-olds will not stay healthy enough to collect much, if any of their benefit, the price can be very reasonable. But like any insurance, the price is set to make a profit, and so in that sense, it is a “bad” bet. I believe that expensive as longevity insurance might be, it should be considered in the same way most people buy fire insurance. It is a means of protecting yourself against a risk you can’t afford to bear and something that could potentially be devastating to your financial well-being.
- Become your own “insurance company” and self-insure the risk. When my colleague Barry Sacks and I first started discussing the dynamic nature of longevity risk, and I suggested buying longevity insurance from a Life Insurance company, Barry said, “why do you need an insurance company? Can’t retirees do it themselves?” In fact, Barry is right. What an insurance company does to provide that deferred annuity is to take in premiums (as a lump sum or installments) and invest the money in a laddered bond portfolio (i.e. a series of bonds of varying duration) that are held until maturity. As each bond matures, the proceeds are reinvested in the longest-duration bond available. Since insurance companies sell many annuities, they will then have the cash to make payments when the annuitant reaches age 85. As an individual, you can do that, too, though managing the cash flow on the back end is a little tricky. More generally, you can reduce your longevity risk by simply reducing your drawdown and investing what you save in a separate account that can be drawn on when your current assets begin to run out, though without a careful, disciplined approach, you may end up substituting additional investment risk for the assurance that you won’t outlive your assets.
- Become your own actuary and reevaluate your retirement income strategy every year. Ken Steiner is a retired actuary who has been thinking about the decumulation problem for more than a decade and identified many of the unique risks associated with drawing down assets to live on well before it became apparent to the rest of us. His view on how to develop a retirement income strategy is that we all need to become our own actuary, and just like the way we serve our pension clients, we should annually reevaluate our assets, liabilities, income, and expenses as well as the key assumptions, including how long you expect to live, that we use to project and manage both. From a theoretical standpoint, I think he is right, but many will find the task of actually implementing Ken’s idea to be arduous and complicated. That being said, Ken’s approach is described here and is well worth thinking about: howmuchcaniaffordtospendinretirement.blogspot.com.
With respect to retirement income planning, longevity risk has, at this point, no perfect or “cost-free” solution. There are, however, at least a few approaches retirees can consider that will make this risk less dangerous than it might be if it is ignored completely.
Fundamentally, from an actuarial perspective, Decumulation is a problem in asset/liability matching and risk management.
As can be seen above, there is still much work to be done.