A better measure of retirement security
AUSTIN — Kenneth French paces in front of the auditorium. It is entirely filled with investment advisers from all over the world. He is in the process of telling them that everything they know about risk is wrong. The real measure of risk, he says, isn’t price volatility or any of the statistical tools in common use. It’s something else.
The room is all ears — as it should be.
French is a professor at the Tuck School of Business at Dartmouth. He has worked with Nobel laureate Eugene Fama for, well, decades. Both speak at this occasion, which is the annual Advanced Conference for Dimensional Funds Advisors. The event is an investment research tour de force. I love it, even though it makes my head hurt.
So what’s the real measure of risk? “It’s living standard risk,” French says. It’s not an abstract number. It’s not your “number,” the money you need to have in savings or investments to retire. It’s what your exposure is to a major change in your standard of living during the entirely uncertain number of years you remain alive.
Living standard risk is what some call a “slow idea” — a concept that will eventually become part of the professional vocabulary of investment advisers. Think of it as Portfolio Survival, version 2.0. It took years for William Bergen’s 1994 research on how much money could be taken from different portfolios and have a 95 percent probability of survival for 30 years to become regular trade talk. It will be the same with living standard risk.
One reason it will be slow is that the financial services industry likes to focus on what it does: manage money. Living standard risk is different. It examines more than your financial assets. It considers your Social Security, your pension if you have one, your homeownership, any mortgage or other debt that you have, and your retirement savings.
The result can be a pleasant surprise for some. But it can be disheartening for others, who may appear better off than they really are. You can understand by considering examples at the far extremes:
• John and Mary Churchmouse are retired university professors. They had the good fortune to teach where there was a generous pension plan. It replaced 75 percent of their income after 30 years of service. During those 30 years they paid off their mortgage. They also earned near the top of the Social Security wage base, so Social Security benefits will replace about 25 percent of their income. As a consequence, their guaranteed incomes are all they need to cover their retirement living expenses. They have no living standard risk. They can afford, if they choose, to put 100 percent of their savings into the stock market.
• George and Jane Hotshot are retired sales professionals. They have great cars with great payments, a grand but mortgaged house, Social Security and a million dollars in savings. Social Security covers 20 percent of their living expenses. For them, a major stock market decline is the beginning of the end. Why? Because their ongoing expenses will quickly unravel their savings — unless they eliminate debt and reduce their standard of living in a major way.
Most of us are somewhere between the Churchmouses and the Hotshots. Finding our precise location between those extremes will be the next big financial planning tool. It will seem to happen quickly, but it will be slow.
How can I be confident about this? Simple. I wrote a column about it nearly 10 years ago. It was a major topic in the consumptionsmoothing book, “Spend ’til the End,” that I coauthored with Boston University economist Laurence Kotlikoff in 2008.
The roots of this idea go way back. In a 2015 Financial Analysts Journal article, for instance, M. Barton Waring and Laurence B. Siegel trace the pursuit of solving the living standard risk problem to papers by Nobel laureate Robert Merton in the 1970s.
No, you won’t have to read the papers and do the math in your spare time at home.
Just as you and I get in our cars and drive off with no knowledge of internal combustion engines (among other things), the day is coming when we’ll put some numbers into a computer, hit “enter” and calmly walk toward a retirement with less of the risk that really counts.