The Question We Should Have Asked All Along

Do I believe there is an unacceptable risk that during my retirement the economy will not look like the recent past but will suffer from a major disruption (a pandemic, 70s-style low stock returns and high inflation, a depression, etc.) that should be considered in my retirement plan?

When planning for retirement, we traditionally assume that the future will look a lot like the past. That isn’t a great assumption but it often seems like the only guideline we have.

One of the problems with this approach is recency bias, the human tendency to overemphasize more recent data. Boomers who lived through the high inflation of the 70s think it could happen again; millennials who didn’t can’t imagine that inflation will ever exceed 3.5% again because it hasn’t happened recently. We can’t both be right.

Of course, neither cohort lived through the Great Depression so the concept of another depression and deflation doesn’t typically creep into either of our thoughts. That doesn’t mean it can’t happen again, only that we can both suffer from a lack of experience and a failure of imagination.

This creeps into our retirement planning by ignoring a question that we should answer first but haven’t bothered to do so in such a long time.

Why don’t we ask? Because we intuitively believe that the risk of the future not looking like the recent past, “business as usual”, is so low that it can be ignored. We believe that because it has been true for several decades. It’s human nature. It’s behavioral finance.

This isn’t a yes or no question. The question isn’t whether we believe the risk of a very different future exists but what probability we assign to it. We might, for example, believe that we probably won’t experience a depression but assign a probability of 5% that we will. If 5% meets our risk tolerance threshold, we might decide in the spirit of taking the worst-case outcomes off the table that our retirement plan should address the possibility. If we’re comfortable with a nineteen-in-twenty (95%) probability that it won’t happen then we can build our retirement plan around the assumption that the future will look like the past.

The “D” word has become much more prevalent in the past month.

Economist, Laurence Kotlikoff, believes a depression is certainly possible.

“We have absolutely no game plan that will make any day of the next year look any better than today. Instead, we can expect each passing day to look worse thanks to all the layoffs and bankruptcies coming down the road.”

He has posted a number of columns on the topic at his website that I urge you to read, perhaps beginning with “My Stock Tip –– Sell”.  (I also recommend a more recent Kotlikoff column in REFERENCES below.)

As one would expect when dealing with opinions about the future, other economists are not as convinced that a depression is imminent or the most likely outcome, though most I have spoken with lately don’t rule it out and that is the important takeaway.

If a depression develops, then the best “risky portfolio” will not be stocks but, as Kotlikoff recommends, T bills are good, TIPS are safe. Inflation and long rates will go up. He also recommends shorting long Treasury bonds, though short sales can be challenging for the typical retired household.

Personally, I have no idea whether we are looking at a “business as usual” serious market decline and an 11-month recession or a depression. (An MIT Sloan study places the odds of a recession in the this year at a whopping 70%.) I only know that I now consider the risk of the latter as non-trivial and that I need to address that possibility in my retirement plan. You, of course, may not feel the same.

If you do now believe that a depression isn’t out of the question then you may have the wrong retirement plan based on the assumption that the future always looks like the past.

Michael Finke, PhD, at The American College of Financial Services, writes an excellent piece entitled, “How Financial Plans Must Adapt to Market Crashes“, at Advisor Perspectives. To quote Finke, “If the advisor decides not to course-correct because of faith that equity markets are going to “bounce back,” then they are guilty of subjecting their client to expectations that no longer match their current reality.”

A key issue that you will need to address is your human capital. A well-paid 40-year old tenured university professor, for example, can take tolerate a lot more financial risk than someone who is already retired and has no human capital. Economist Zvi Bodie is the expert on this topic. If human capital is an unfamiliar term, a good place to start is Bodie’s column entitled, “The Impact of Human Capital on Retirement Savings” or a little more detailed explanation entitled, “Retirement Investing: A New Approach“.
 

Let me say again, I am not predicting a depression. I am only suggesting that it isn’t an unreasonable outcome to consider in your retirement plan.

What to do now? If the risk of a severe economic downturn is one you feel you can tolerate, then stay the course with the traditional retirement plan advice. If, like me, you can’t tolerate the risk of losing a funded retirement, then consider making changes to your portfolio that let you sleep at night. Since neither of us can predict the future, it largely boils down to your personal risk tolerance, risk capacity and human capital.

The first question we should have asked all along is whether we believe there is an unacceptable risk of a future that doesn’t look like the recent past. Unfortunately, decades of good times taught us that the answer was always no.

I don’t think that’s a question we can simply ignore any longer.


REFERENCES

Group Testing Is Our Surefire Secret Weapon Against Coronavirus, a more recent post from Kotlikoff, recommends a strategy to “save potentially millions of lives and immediately restart the economy”,
exploring the inextricable link between the
Covid-19 pandemic and our economic outlook.  

 


Originally posted at http://www.theretirementcafe.com/2020/03/the-question-we-should-have-asked-all.html

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