Are We Taking the Wrong Retirement Risks?

Not a factory where I want to work.

“Retirement at sixty-five is ridiculous. When I was sixty-five I still had pimples.”
–George Burns

It’s pretty well known that we’d rather have pleasure now than pleasure later. A whole self-help industry popped up in the 1980s based on the notion of delaying gratification and the benefits of doing so rather than giving into our Monkey Brains and buying the 138” wide screen TV for our man caves now. It’s also the same reason that we’re willing to pay a monthly gym membership, but we don’t actually go – instead, we tell ourselves that we’ll go tomorrow and never wind up going.

In the same vein, we’re actually not that good at assessing our own tolerance for risk. Many times, we think that we are risk seeking, but only because we’re so willing to discount whatever our future selves will experience for whatever we can get today. It’s Wimpy from the Popeye cartoon, gladly eating a hamburger today and paying on Tuesday, regardless of the costs. Think of people who smoke. Smoking certainly causes negative health repercussions down the road, but because the lung cancer, emphysema, stinky clothing, etc. are in the future, smokers discount the negative outcomes for the hit of nicotine now, even though there can be no doubt in their minds that they’re playing with fire (both literally and figuratively in this case). Yet, how many emphysema or lung cancer sufferers think to themselves “Boy, am I glad I smoked all of those years! It was WORTH it!”

It is the combination of psychological foibles we exhibit which also causes us to invest suboptimally when we make retirement investing decisions. A recent study by Harry Markowitz (of the Modern Portfolio Theory fame), Sanjiv Das, Jonathan Scheid, and Meir Statman in the Journal of Financial and Quantitative Analysis shows just how the combination of future discounting and poor risk awareness add up to poor retirement portfolio planning.

If you talk about retirement planning, the concept actually covers several goals. It includes your basic living expense needs – what you’ll need to get in income to keep you off the streets and eating cat food when you have exhausted your human capital. It includes your lifestyle goals – the income you want to have in order to meet some of your other non-essential goals in retirement, such as cruises, travel, or that mid-life crisis convertible. Retirement planning also includes having assets set aside to cover for expense shocks, such as deteriorating health or boomerang kids needing your support. Finally, it includes your estate planning goals, such as inheritance for the kids and grandkids and charitable contributions.

Each of those goals has a separate risk profile. For the basic living expense goal, failure is nearly catastrophic. At some point, even if your mind is willing, you’re pretty much going to be physically unable to work as you advance in age. Not meeting your basic living expense needs at that point will put you in a horrible, nearly untenable situation. Therefore, your risk tolerance for meeting basic living costs (food, shelter, basic healthcare) is exceptionally low.

However, as you move up a hierarchy of goals, the similarities will mirror the Maslow hierarchy of wants. While you may be disappointed if you can’t give to charity when you pass on, it won’t cause you years of suffering like not having enough to cover food and shelter would. Your risk tolerance should be, rightly, higher. The same goes with some of your lifestyle goals. You might be willing to put money in riskier investments if that money was allocated to more or less vacations or to the grandkids’ education funds. Failure, while disappointing, would not be ruinous.

Yet, because we don’t consider the relative allocations of our portfolios for our retirement goals, we tend to lump everything together and wind up with a riskier portfolio than necessary. Financial planners often tell you to put money aside in IRAs, 401(k)s, 403(b)s, 457s, etc., and go with asset allocations such as 110 – your age for the stock/bond split, and send you on your merry way. It’s an incomplete approach because it doesn’t probe deeply enough into what matters to you.

How can we align our investing strategy with our retirement strategy?

  • Prioritize our retirement goals. Think of everything you want to accomplish in retirement, and then rank order them from high in priority to low in priority. Hint: food, shelter, basic healthcare, and clothing should rank highest.
  • Determine how much we need/would like to have for each goal. The higher order goals will probably be more income oriented, e.g, it will take $X per year to meet basic living expenses, and then $Y per year for lifestyle goals. The lower order goals will probably be considered more in terms of assets, e.g., you’d like to leave $Z to your favorite charity.
  • Create separate portfolios for each goal. This was the main conclusion of the aforementioned mental accounting article – each portfolio can have its own set of investment and risk objectives which suits the goals we are trying to attain within that portfolio.
  • Consider annuitization for the higher priority goals. The high priority goals are the ones where we will need income and have very limited tolerance for failure. If pension income or Social Security does not cover those goals, it’s worth evaluating an annuity to meet those goals. Don’t get slammed by fees and commissions, though!

Mental accounting and our psychological biases affect every part of our financial lives, and retirement planning is no exception. Rather than aggregating our retirement portfolio, we should consider segregating it out to match the goals that we have in retirement. That way, we won’t take excessive risk in investing to try to buy the nice convertible and wind up without enough to put food on the table or even have a table.

Have you divvied up your portfolio this way? What do you think? Tell us about it in the comments below!

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Jason Hull was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business. He held a CFP certification from 2015 - 2021. You can read more about him in the About Page. If you live in Johnson County, Texas or the surrounding areas, he and his wife are cash buyers of Johnson County, Texas houses.

4 thoughts on “Are We Taking the Wrong Retirement Risks?

  1. I suggest doing the same kind of segregating for your living expenses now, for the same reason: mental accounting error-prone. Error-ridden, even. Separating out your necessary expenses from your discretionary ones, your fixed from your variable, and your regular from your irregular sounds more complex in theory, but in practice the ability to see at an instant how much money is in what category without having to do any mental categorizing is so much simpler.

    (Long way of saying: I concur.)

  2. Very nice synopsis. It’s not very often I read a retirement planning article that actually addresses something more important than calculating how much money we’ll have – such as our health and happiness. It’s these types of goals that I too feel are much higher in priority than the other ones. Focusing on things like your marriage, your relationship with your children, your health, etc are all excellent things that if not properly cultivated will lead us to a very empty retirement.

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