Investment Risk and JG Mullaney
Living standard risk and the decision when to retire.
In a prior post, I introduced how to solve the “when to retire” decision crafted for the attributes of the hamburger-loving cardiologist JG Mullaney and his wife Beth who live in Dallas. The Mullaney’s want to retire at age 60, travel the world, but do not know the economic cost of achieving that goal. Both 35, they have targeted another 25 years of work in a lifetime that is expected to span until age 90. They need post-retirement resources which will dictate a specific spending and saving pattern today to achieve their goal. But, the “when to retire” question, like any other financial decision, entails a decision made under the uncertainty about future income, changes in laws that affect household wealth, and investment performance. In this follow-up, the focus is on investment risk and return.
The economics-based approach began with the Mullaney’s question about how much to save to retire at 60, while recognizing they will reduce their nearer term living standard to reach that goal. Then, iteratively, how much additional benefit would accrue to their current standard of living if they retired at age 62 or age 65? Working longer accrues more economic benefits. However, they defer their dream of traveling the world. Working more years beyond age 60 is five fewer years of fun and the Mullaney’s can assess that cost to their well-being. Only when the best representation of the trade-offs is put in front of the Mullaney’s are they best-informed. If they have an investment advisor or wealth manager, alternatives are developed and the Mullaney’s use their utility, taste, and risk tolerance to make their choice.
Investments Matter to Living Standard
In this note, I intersect Personal Finance Economics with the wheelhouse of a private wealth manager and bring together the optimization of the Mullaney’s living standard with the prospects for their investments. A key point is that investment risk and return are not singular in their importance to the Mullaney’s financial plan and choice when to retire choice. Their living standard depends, among other items, on the work-related earnings of JG and Beth, the taxes they pay currently, and prospectively, real asset values, social security benefits, and the returns they receive when saving money.
The Mullaney’s may find the annual percentage yield (APY) of their local bank’s savings account offerings are less than 1% today, while an investment in the stock of a dividend-paying company is likely greater. But, of course, the risk that the value of the stock will decrease or increase in the future will reveal an actual return different from the return expected while it is being held. An obvious point: a stock investment has more risk than a bank savings account. What is the effect of stock risk on living standard risk? Higher returns on investment produce the happy outcome of lowering the future need for more savings, and that “savings of savings” translates to a higher living standard and more discretionary spending. If the Mullaney’s save from age 35 to 60 and earn 25% year-in and year-out on their savings, rather than 2%, then a sunny future is in store. But, it may not be that way. Stocks are volatile. If the Mullaney’s invest their savings in a safer investment what is the effect on their budget if they retire at age 60?
The Mullaney’s Investment Risk and Living Standard Risk
Investment risk creates living standard risk, but the range of future living standards needs to be cast within the development of a full financial plan. The effect of future changes in investment performance can be measured and juxtaposed against all the household’s resources. Indexed social security retirement benefits, the value of a home, the ability to work and earn an income, the choice to switch geographic location, whether to own or rent a home, etc., matter to the Mullaney’s living standard and possess risk attributes different from financial securities. How does the full financial plan for the Mullaney’s change when investment risk is introduced? The answer begins with determining how the Mullaney’s sustainable lifetime living standard adjusts for future changes in investment performance.
To illustrate, new financial plans for the Mullaney’s are developed for the “Retire at 60” and “Retire at 65” choices where the Mullaney’s brokerage account and 401(k)s are evaluated across two broad investment types.
A “safer” investment scenario where all the Mullaney’s financial assets including 401(k)s are invested in a portfolio composed of 80% in the Total U.S. Bond Index and 20% in the Total U.S. Stock Index
A “riskier” investment scenario where the investment proportions are switched: 80% in the Total U.S. Stock Index, and 20% in the Total U.S. Bond index
Details are in the financial plans posted here. A standard technique called “Monte Carlo simulation” is used to help understand future investment performance of these securities.
Panel A and Panel B display discretionary spending bands for the age 60 and 65 retirement decisions, respectively. Regardless of Panel, tracing the bands from age 35 to age 90 represent the range of plausible trajectories of optimal discretionary spending differ by the impact of investment risk. Blue bands show how discretionary spending varies for the higher risk (riskier) strategy, and the green bands show how discretionary spending varies for the lower risk (safer) strategy. The lower, lighter blue line is the 5th percentile of all spending trajectories when investing in a higher risk stock portfolio and the dark blue line is the 95th percentile of all trajectories for that same portfolio.1 In other words, the gap in optimal spending totals from the 5th to the 95th percentile of the blue lines capture the vast majority of all the potential outcomes for the Mullaney’s optimal spending path given the risk-return characteristics of the riskier portfolio. The same percentile gap interpretation is true for the green lines, except they are derived under the safer investment strategy, and as a result, are more narrowly differentiated over time.
How the Mullaney’s Use this Information
JG and Beth have a higher current living standard if they elect to retire at 65, rather than 60. Retiring at age 65 yields an optimal amount of spending in the current year of $164k which is greater than the $126k if the Mullaney’s retire at age 60. An expected outcome because of more years working, higher levels of post-retirement 401(k) benefits, and higher social security retirement benefits.
From this initial point, optimal spending, e.g., the optimal living standard fluctuates based on investments. Indeed, in some ways, the trajectories of the lines on the age 60 chart are similar to the age 65 chart, reflective of the same underlying investment portfolios used in the simulations.
To clarify the Mullaney’s choice, the table below lists a subset of the years represented in the charts for both the “age to retire” decision and the “how to invest” decision. Suppose, JG and Beth focus on their optimal spending prospects at age 75. If the Mullaney’s retire at 60 and want to choose the safer portfolio, their spending range at age 75 varies between $185k and $275k. Retiring at age 65 with the same investment portfolio uplifts the range to between $217k and $319k. The riskier investment choice widens the optimal spending range considerably. Retiring at age 60 and electing the riskier portfolio could lead to a lower outcome, but note the 50th percentile results. This is the point at which 50% of the simulated trajectories had total lifetime discretionary spending above the threshold as below. The 50th percentile result if investing in the risky portfolio is $281k, but with far greater upside than the safer investment. A safer investment has a 50th percentile value of $244k and the 95th percentile is only $275k. This latter choice may be most suitable for JG and Beth. It is their taste for risk that matters and if they are more risk-averse may be their preferred choice. A little less risk-averse may lead them to invest in the riskier asset choice.
One last way for JG and Beth to look at the investment choice question is to isolate on a near-worst case scenario. That is, what is the downside risk to their optimal amount of discretionary spending? How low might discretionary spending go when subject to investment risk? The chart below shows the 5th percentile of optimal discretionary spending outcomes, e.g., 95% of all other optimal discretionary spending trajectories lie above these lines. In other words, it helps the Mullaney’s assess their optimal spending floor.
Evident is that about $128k is the starting spending floor for both alternatives then they vary by age when one strategy is higher than the other. The low point for the risky strategy for this simulation is at age 63 with an optimal spending amount of $104k. Never does lower risk strategy reach that point.
How Advisors Can Help
The results for the Mullaney’s show how investment risk and their taste for risk are important to the retirement decision. Advisors are good at helping their financial planning clients assess risk tolerance.
That assessment can be put into an economics-based context to help the decision-making. Given the Mullaney’s results, if they have very little tolerance for investment risk, then they should choose the safer investment option. But, if they can tolerate some risk, they should go with the riskier investment option. The risk analysis section of their plan offers the details.
In the simulation, there are 500 trajectories built. Trajectories are ranked based on their cumulative lifetime living standard.