Phyllis has a roulette strategy – she calls it a "system" – that she adheres to rigorously. Because a fair roulette game is totally random and the odds favor the house her strategy isn't statistically profitable but that isn't something that typical gamblers are concerned with. Watching a YouTube video of a roulette game, I heard one player say he watches for trends in the random winning numbers and another say that he seems to win a lot with the number 26.
Phyllis' strategy is to place several small bets on the first spin of the wheel and to double the bets each time she loses. After a winning bet she bets the same amount on the next spin.
She places a bet on red, another bet on 36, a corner bet, and a street bet for each spin. (Watch a few minutes of this YouTube video[1] if you've never seen a roulette game. Notice the multiple bets placed by each player at each spin of the wheel.)
After each spin she calculates the revised amount of her bankroll and places another set of bets on the next round. Her strategy is to stop playing should she double her initial bankroll and, of course, she will stop playing when she is ruined.
At this point you may wonder what Phyllis and her roulette strategy have to do with financing retirement. The answer is that the mechanics of her roulette game are somewhat analogous to the way in which retirement should be played. Visualizing retirement funding as a roulette game can demonstrate the process as a whole as opposed to seeing a set of related but independent strategies for income generation, asset allocation, annuitization, and the like.
We start with a grand strategy, hopefully one that is more profitable than a roulette strategy, and play one year at a time in the same way that Phyllis plays one spin of the roulette wheel at a time. We stop playing retirement when no one in our household is still alive.
It's not a perfect analogy. Phyllis stops playing roulette when she runs out of money but, unlike roulette players, we can't stop being retired when we go broke. We have to figure out how to continue playing retirement until the end, perhaps getting by on Social Security benefits alone – not a pleasant prospect[2].
Now, let's play a game of Retirement Roulette. Over my working life, I have accumulated wealth that I can use to pay for retirement. That wealth is represented by the three stacks of chips in front of me that constitute my "bankroll."
- [Insert diagram of 3 stacks of poker chips here. ]*
The third stack of chips represents my "social capital" and includes my Social Security benefits and a small pension I earned a previous employer. I have three chips. The first represents my pension, the second represents my wife's Social Security benefits and the third chip represents my own Social Security benefits.
On the "Retirement Roulette" table in front of me lies a broad array of potential retirement bets including:
- a bet on a retirement date
- a bet on an amount to spend this year
- a bet on stocks
- a bet on bonds
- a bet on cash
- a bet to claim or delay Social Security benefits
- a bet to purchase an annuity
- a bet to purchase long-term care insurance
- a bet on a legacy for our heirs
- *[Insert diagram of Retirement Roulette table here.]
I decide to play the pension bet first because I am 65 years old and, unlike Social Security benefits, delaying my pension claim has no financial benefit. The payoff for this bet is $1,000 of income monthly for as long as I live.
I have determined that the optimal Social Security claiming strategy for our household is for my wife to claim at age 66 and for me to claim at age 70. Since she is now 66, I will bet her Social Security benefits chip now and save mine for the year I turn 70. Of course, I can decide to bet my chip sooner should I need the money.
The payoff for this bet is some immediate income from my wife's benefit and maximum lifetime retirement and survivor benefits for both of us should we live longer than an average life expectancy at the claiming age.
I won't bet the home equity chips right away in case I need those for an emergency later in retirement.
I have decided on a floor-and-upside retirement strategy so I will add a small pension bet to my wife's Social Security benefits to create the floor. I move chips from my financial capital pile to the pension bet.
After calculating the income from my floor bet, I decide that I will need to spend 3% of my remaining portfolio balance on expenses for the coming year. I move that amount of chips to the spending rate bet on the table.
I count the number of chips left in my financial assets pile and decide on an asset allocation. I move 5% of the chips remaining in that pile to the cash bet on the roulette table, 35% to the bonds bet, and 60% onto the stocks bet.
I "spin the wheel" and nature takes it's turn. A year later the results are in.
The payoff on my stock that will be about 8% with a standard deviation of about 12%, meaning that about two-thirds of annual returns will fall between a 4% loss and a 20% gain. The payoff on my bonds bet will be about 3% with a standard deviation of about 3%. My cash bet will return about the rate of inflation, or about zero in real dollars.
My pension bet will pay off $12,000 and my wife's Social Security benefit will pay off about $20,000. My cash will increase by about the rate of inflation but decrease by about the 3% I planned to spend. Of course, expenses are unpredictable and I may actually spend more or less. The "payoff" for the spending bet will be about a 3% loss.
My life expectancy and that of my wife has decreased by less than one year.Life expectancy is a key factor in many retirement decisions.
And so ends round one.
To prepare for round two I must evaluate the results of all my bets, changes in my life expectancy and my wife's, changes in our health, our expectations for the financial markets going forward, and other critical factors to decide which if any of my bets I should change for the coming round.
The game will continue as long as one of us survives. Unlike roulette, our game doesn't end if we deplete our bankroll, though our lifestyle is likely to be severely curtailed in that event.
The important perspectives of the roulette analogy are:
- Like roulette, retirement funding has a very large element of uncertainty. This includes the length of our careers, how long we will live, market returns, interest rates, annuity payouts, inflation, discretionary spending and spending shocks, which is to say all of the critical factors are uncertain. Even households who generate retirement income completely with "risk-free" assets will be exposed to expense risk.
- Like roulette, retirement funding is a series of "rounds"(typically years) during which the retiree makes a series of decisions (bets) and the universe responds. These first two characteristics define what game theorists refer to as a sequential stochastic game against nature[5].
- Retirement ends with death; roulette ends when the gambler decides to walk away or is ruined. Retirees can't walk away but may lose their standard of living.
- A round typically involves multiple bets that are separate, yet the ultimate result of the round is the sum of the bets won less the sum of the bets lost.
- Critical factors can change from one round to the next and these must be considered when placing next year's bets. Retirement funding is dynamic, not set-and-forget.
Next time, I'll tie these together.
REFERENCES
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