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The question we should have asked ourselves all the time RETIREMENT

I believe that there is an unacceptable risk that the economy will not look like it did in the recent past during my retirement, but will suffer from a major disruption (a pandemic, low 1970s equity returns and high inflation, depression, etc.) Who should this be considered in my pension plan?

When planning retirement, we traditionally assume that the future will be very similar to the past. This is not a good assumption, but it often seems to be the only directive that we have.

One of the problems with this approach is timeliness, the tendency of people to overemphasize newer data. Boomers who have weathered the high inflation of the 1970s believe it could happen again; Millennials who could not imagine that inflation will ever exceed 3.5% again because they have not done so recently. We cannot both be right.

Of course, no cohort has lived through the global economic crisis, so the concept of further depression and deflation does not normally creep into one of our thoughts. This does not mean that it cannot happen again, only that we both suffer from a lack of experience and imagination.

This creeps into our retirement provision by ignoring a question that we should answer first, but which we haven’t bothered for so long.

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 small that it can be ignored. We believe that because it has been true for several decades. It is human nature. It is behavioral finance.

This is not a yes or no question. The question is not whether we believe that there is a risk of a completely different future, but what probability we assign to it. For example, we might think that we are unlikely to experience depression, but assign a 5% chance that we will. If 5% reach our risk tolerance threshold, in a spirit of taking the worst case results off the table, we could decide that our pension plan should consider the possibility. If we are satisfied with a probability of nineteen in twenty (95%) that this is not the case, we can build our pension plan on the assumption that the future will look like the past.

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

The economist Laurence Kotlikoff believes that depression is quite possible.

“We have absolutely no game plan that will make a day of the next year look better than today. Instead, we can expect every day to look worse due to all the layoffs and bankruptcies we face.”

He has published a number of columns on the subject on his website I ask you to read, perhaps starting with “My stock exchange tip – Selling”. (I also recommend a newer Kotlikoff column in the REFERENCES below.)

As you might expect, when thinking about the future, other economists are not so convinced that depression is imminent or the most likely outcome, although most of the ones I’ve talked to lately don’t rule it out, and that’s the important aspect.

When depression develops, stocks are not the best “risky portfolio”, but as Kotlikoff recommends, T-bills are good and TIPS are safe. Inflation and long interest rates will rise. He also recommends selling long government bonds, although short sales can be a challenge for the typical pensioner household.

Personally, I have no idea whether it is a serious “business as usual” market downturn and an 11-month recession or depression. (A MIT Sloan study The likelihood of a recession this year is a whopping 70%.) I only know that I now consider the risk of the latter as not trivial and that I have to take this possibility into account in my pension plan. Of course, you cannot feel the same.

If you now believe that depression is not out of the question, you may have the wrong pension 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 have to adapt to market crashes“at Advisor Perspectives. To quote Finke:”If the advisor decides not to correct the price because he believes that the stock markets will “recover”, he is guilty of exposing his clients to expectations that are no longer in line with their current reality. “

A key issue that you need to address is your human capital. For example, a well-paid 40-year full-time university professor can take a much higher financial risk than someone who is already retired and has no human capital. The economist Zvi Bodie is the expert on this topic. If human capital is an unknown term, Bodies column is titled “The influence of human capital on old-age provision“or a slightly more detailed explanation entitled”Pensions: A New Approach“.


Let me say again that I do not predict depression. I only suggest that it is not an inappropriate result that you should consider in your pension plan.

What now? If you can tolerate the risk of a severe economic downturn, stay on track with traditional retirement advice. If, like me, you can’t tolerate the risk of losing your retirement, you should make changes to your portfolio that make you sleep at night. Since none of us can predict the future, this largely boils down to your personal risk tolerance, risk capacity and human capital.

The first question we should have asked ourselves all the time is whether we believe that there is an unacceptable risk to a future that does not look like the recent past. Unfortunately, decades of good times have taught us that the answer has always been no.

I don’t think we can just ignore this question any longer.


REFERENCES

Group tests are our surefire secret weapon against coronavirus, a recent post by Kotlikoff, recommends a strategy to “potentially save millions of lives and get the economy going again”.
Exploring the inseparable connection between the
Covid-19 pandemic and our economic outlook.

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