Thursday, December 17, 2015

Avoiding the Other Road to Ruin

In Dirk Cotton’s post of December 11, Positive Feedback Loops:  The Other Road to Ruin, he draws a clever analogy between positive feedback loops (such as in a public address system) and financial ruin in retirement and illustrates his analogy with some southern story telling about a couple named Jim and Linda.  According to Dirk,

“Each year that Jim and Linda spent more than planned from their portfolio increased their probability of ruin. The continual shrinking of their portfolio value as the market fell increased it even more. Soon that probability of ruin was a lot more than the original 5%.

Their portfolio spending strategy had drifted into a positive feedback loop… wherein every year that they overspent from their savings they increased the risk of portfolio ruin, reduced their capacity to recover when the market did, and decreased the amount of spending that would be considered safe the following year, increasing the probability that they would need to overspend yet again.”

Dirk uses his analogy and example (as well as citing research by Larry Franks, Stout and Mitchell) to argue that reducing spending when investments fall significantly decreases the probability of financial ruin.  While poor investment returns can certainly pose a problem for retirees, keeping spending constant (or increasing it) during a period of poor returns is the “other road to ruin.”

Dirk’s story illustrates why I advocate a dynamic spending strategy (the Actuarial Approach) that automatically adjusts for investment experience (good or poor) as well as prior spending (over or under).  His post also ties in very well with my post of December 10, where I encourage retirees (and their financial advisors) who prefer “safe” withdrawal approaches (and the associated spending stability) to develop an action plan by kicking the tires on their spending strategy.   They can do this by using the 5-year projection tab in our spreadsheet to determine just how far away from the actuarially determined spending budget they are willing to go in their quest for budget stability before they decide they need to make a change.