I believe effective life cycle estate and financial planning is anchored in the Quadrant of Facts, Forecasts, Life Stages, and Unexpected Events. Over the past several weeks, ten posts covered a lot of territory about Facts and Forecasts.
This is a pivot point at which we begin exploring planning issues in the first of several Life Stages: Early Adulthood. when one is post-college but still single.
Early Adulthood has several Facts, but the biggest one is Time: you have a lot of it, because your life expectancy is long. Over time, small variances in human capital formation (the driver of future earning power) or savings rate in Early Adulthood compound into very large differences in your Total Income Statement and Total Balance Sheet. Another Fact of Early Adulthood tends to be a relatively low income.
Early Adulthood is invariably a time of Forecasts: Where is the best city to live? Will this person make a good spouse? What career will make you happy? Will your career succeed? Like any Forecasts, these may turn out to be wrong. In Early Adulthood, it’s particularly important to build resiliency into your planning in the event your Forecasts miss the mark.
Career development is one of the two key projects of Early Adulthood (the other is family formation). Three key elements of career development include skills acquisition (making sure you’re good at doing something), career exploration (finding something to do that you like), and networking (coaxing serendipity to work in your favor). Over the years, I’ve identified what I think are three “best in breed” resources for each of these elements.
For those reading this post who are not Early Adults, these books would make great gifts for Early Adults you know (although yes, you will run the risk of being the “Plastics” Guy from The Graduate at presentation time….)
Our previous post explored a model of the cost of the promise you make to yourself to fund your retirement, but that model omitted a very important real-world risk: volatile equity markets.
Most recently, the 2008 stock market crash changed many retirement plans for the worse. A 2009 study by the Urban Institute, “What the 2008 Stock Market Crash Means for Retirement Security,” provided a quantitative forecast of the crash’s effects. When the study was published in 2009, it included three scenarios for the stock market: no recovery, a partial recovery, and a full recovery.
With the benefit of six years’ hindsight, we see (happily) that the full recovery scenario they modeled is the one most closely describing the retirement effects of the 2008 crash.
The Urban Institute study quantifies some important (and perhaps obvious) insights:
Higher earners are more exposed to stock market volatility, because they save more, and more of their savings tend to be allocated to equities.
Pause and reflect on what a pension is: income for life after you retire, intended to replace part of all of your employment income.
For retirees in the “Greatest Generation,” pensions were common. For a host of reasons (presented well by Jacob Hacker in his 2006 book The Great Risk Shift) structural changes in the American economy since 1980 have driven traditional defined benefit pensions almost extinct for private sector workers.
Instead, during your years in the workforce, you must build your own “Personal Pension.”
Your Personal Pension payment for each and every year of your retirement is a promise you’re making to yourself, and you want those promises to be fully funded. How much will that cost?
There are several issues to keep in mind as you consider Personal Pension funding levels: longevity, target annual income, and projected investment returns.
I built a model to explore these issues, and the results are summarized in the chart below.
Most people know (at least in the abstract) that choices have consequences. Choices you make to manage your behavioral tendencies (or not) and about your investment costs may have tremendous consequences for when you can retire.
I built a model to explore the tradeoffs between retirement age, investment costs, and behavioral tendencies. Like any model, it makes necessary simplifying assumptions. Nonetheless, I think its results (summarized in the table below) are directionally useful for your own planning and decision-making.
To make this walk through the model a bit more fun, let’s frame it as a story of four college roommates: Leo, Mike, Henry, and Bill. Through age 22, they’ve made really good, really similar choices. All four have studied engineering at a moderately priced state school and obtain great jobs prior to graduation.
To keep our model simple, we assume all of them remain in the workforce until retirement without interruption: that’s right – assumptions contrary to observed reality in the American workplace – no layoffs, no disability, no mid-life crises, no leakage of retirement assets upon divorce, etc.
For fun, let’s further assume that their university had an economics distribution requirement for engineers, and that all the roommates chose a personal finance class with lecture times that allowed them to sleep in on Friday mornings after all-night lab or coding sessions (or the occasional kegger).
Successful investing presents practical and emotional difficulties. Reducing those difficulties as much as possible turns on your answers to two questions:
Do you believe markets are efficient?
Can you manage your behavioral tendencies?
After you have thoughtful answers to those two questions, it’s easier to make good decisions for you about choosing an investment style and the type of advisor you’ll work with best (if any).
The first key question is what you think about market efficiency.
The “markets are efficient” argument has been made well by many academics (notably Burton Malkiel at Princeton in his A Random Walk Down Wall Street). Generally speaking, proponents of market efficiency are very skeptical that market timing is feasible, and that beating the market on average over long periods of time is possible. They focus on obtaining access to long-term market performance as cheaply as possible, often through low-cost index funds.
Proponents of the “markets are not efficient” argument point to events like the 1987 U.S. stock market crash (down 25% in one day) and the more recent “flash crash” in 2010. They believe security selection done right can permit market-beating returns over time, and point to individuals like Warren Buffett and Seth Klarman as examples.
Still other market participants seem to take a hybrid approach that markets may be efficient in many ways over long time periods, but present near to mid-term inefficiencies that can be exploited for advantage. John Hussman and other tactical asset allocation funds are example of the hybrid approach, which focuses a lot of energy on trying to call the tops of bubbles early, and finding the right time to reenter markets after a downturn. As shown by experiences in recent memory from 2007 through 2011, rewards to making these calls correctly are very large, but the costs (including opportunity costs) of being wrong are also quite high.
The second key question is whether you can manage your own behavioral tendencies. continue reading