Courage and the Annuity Boundary

The recent sell-off hasn't rattled me...yet...but it got me to thinking about something I wrote about a while back.  Managing a retirement is, to me, a "process methodology" rather than a one-time fixed event. That "process" involves management and monitoring concepts such as, among other things, keeping track of an "annuity boundary" above which (in balance-sheet wealth terms) we might not annuitize quite yet -- because the option value of not doing so might still be such that we can potentially ratchet up lifestyle more than we might have had we annuitized all wealth earlier -- and below which we might be at risk of permanently foregoing the lifestyle we might have maintained forever, given Methuselah-like DNA, had we just annuitized our consumption when we could have done so with the wealth we had when we had it.

That boundary idea above is a pretty neat concept.  But the sell off reminded me that, like other wealth management concepts, pulling the trigger on a strategy like the annuity boundary is not as simple in real life as it is on paper.  In this case, I was reminded that the speed of change in the environment we live in might be such that there could be psychological barriers to executing what we need to execute when push comes to shove in extreme circumstances.  Me? I seriously doubt that I could quickly and decisively and efficiently sell a large percentage of my net worth on short notice -- if the speed of the movement of my balance sheet towards the boundary is high -- to fund an insurance product that might or might not be the right thing to do at that exact moment.  What if I balked, paralyzed by fear and over-thinking?  Am I screwed or might I still be ok?

Purpose Of The Post 

My main goal here is not really rigorous analysis, it is to take a simple look at what would happen if my net worth were to sail through and below the annuity boundary and I then took my sweet time to make a decision ... and in the end I were to annuitize only some of my wealth with what I had left rather than me fully immunizing consumption -- with perfect timing and anticipation -- at the exact boundary when I might have looked like a genius if I had done so.  This will be a deterministic and shoot-from-the-hip analysis without full comprehensiveness because it's too much work to do otherwise and anyway I just wanted to see what the basic shape of what I am asking about looks like.

Lear and Retirement

From today's WSJ (Shakespeare’s Uncomfortable Message for Baby Boomers):

If “King Lear” is a lesson in the unexpected results of child-rearing, it also dramatizes the vicissitudes of retirement. It captures the existential abyss that can open when a once-solid identity begins to melt, and purpose gives way to purposelessness. Lear is deprived of his retinue and thrown out into a storm, reduced to his most elemental self—a “poor bare, forked animal.” We baby boomers, aging amid a technological landscape that changes at dizzying speed, must sympathize. We, too, face a storm that can make even the most successful among us feel lost and diminished.  

Lear rages at the ingratitude of his daughters and the crumbling of his regal identity, but these are ultimately stand-ins for a greater antagonist. Now on the downward curve of life, Lear faces the reality of death. Viewers and readers of the play can grasp this only when we reach the age when death, formerly hidden by the clutter of ambition and child-rearing, reveals itself.  

At that point “King Lear” counsels us to moderate our expectations and sense of entitlement with regard to our children, to accept a diminished professional identity as we age, and to be philosophical in the face of our inevitable mortality. These are profound messages but not cheerful ones, which is why “Lear” is both a great work and an unpopular one.

Vol premium looks fat today

If I had courage I would sell vol today.  Here is a (custom hack) chart I use to look at the futures options market, this time for ES mini -- something I don't usually trade -- for Nov expiration or 21 days. 

The red line is a normal distribution (density) using price, vol and tenure. The blue line is a self-rolled function of premium that approximates what I call option price "intensity" that shows me skew and opportunity to sell volatility.  Green is delta. Blue columns are the current premium at the avg of bid/ask. The vertical dotted lines are the 1 and 2 standard deviation markers of the red line. This shows me that I could get $550 for something that is at a 10 delta and more than 2 standard deviations outside a normal distribution. I think that is a good deal. Takes courage though.

Someone talk me into it. Not sure I have the courage. This should be a no-brainer but isn't.

RH Links - 10/24/2018

QUOTE OF THE DAY

"The idea that one can trace the causal connections of any events without employing a theory, or that such a theory will emerge automatically from the accumulation of a sufficient amount of facts, is sheer illusion."   -- Friedrich Hayek

RETIREMENT FINANCE AND PLANNING

Why Winging Your Retirement is a Really Bad Idea, Cordant

But here I want to highlight, in addition to the non-financial reasons, a very important financial reason to stop winging your retirement: the sequence of returns risk.  http://blog.cordantwealth.com/why-winging-your-retirement-is-a-really-bad-idea

How to Stress Test Your Financial Plan: A Look at the Key Variables, Cordant

As any engineer can tell you, sensitivity and stress testing are important tools in determining how a system can fail and therefore, determining the safe usage for that system. When it comes to your financial life, it should be no different. Stress testing your financial plan is an important exercise in determining the health of your wealth. While this a natural inclination for engineers, it can be unclear where to start. 

http://blog.cordantwealth.com/how-to-stress-test-your-financial-plan-a-look-at-the-key-variables

Contradicting Warren Buffett: When Volatility is Risk, Cordant

Most people have neither the discipline nor the timeframe of Warren Buffett. As a result, most people cannot ignore volatility as a type of risk to manage when building their investment portfolio. On this Buffett is wrong—volatility is risky for you even if it isn’t for him. [Cordant is correct but does not go far enough. Buffet (icon, yes, but let’s ignore for now his pandering on tax policy and recent history of underperformance) has nothing to do with retiree portfolio management in the sense that (a) he has infinite horizons (a point made here) and sources capital via a corporation’s access to capital markets, (b) has no consumption constraint, and (c) he effectively manages to single period (makes one myopic on volatility and sequence risk). Give him a $1M portfolio, a 5% spend rate, an age of 50, and his own skin in the retirement game and he would no doubt succeed but his rhetoric would be very different. Oh, and remember that volatility->sequence risk->permanent loss of capital in a way.  Vol is risk for retirees ]  http://blog.cordantwealth.com/contradicting-warren-buffet-when-volatility-is-risk

What is the correct benchmark for trend following?

"What is the correct benchmark for trend following?" [1]

This is the question asked by Alpha Architect here today. I've seen this kind of thing before. I love their post and their asking of the question but I find, for myself, that the answer to this question is really really easy.   For me the answer, not to drag it out, is that the proper benchmark is one's own current portfolio design and the expectations that come from that.  I know this because I have been invested in as well as rolling my own trend following systematic alt risk program for close to 10 years and that is what I do. 

I have looked at a million ways to evaluate the choice and its marginal impact. I always come back to the: (1) do nothing or keep doing the same thing (current portfolio) vs. (2) do something different (add trend following) framework.  And in that framework it's easy.  It is always do something different (add trend following) because it is additive to the do nothing scenario.   

I say that because, as a retiree, I am not an infinite-life single-period no-consumption portfolio manager. I am a many-period short-lived consuming retiree.  With kids. And goals.  Trend following, with a similar-return lower-vol vibe, provides benefits to me that I cannot get elsewhere.  I won't prove it in this post. Just google some work by Andrew Clare on trend following and perfect withdrawal rates, or a ton of work by NewFound Research on trend following*. You can even search this blog. It (trend following) is clearly additive for people like me when we use our experience from the past data (standard disclaimer on past not predicting future...).  

So, if one were to have the wherewithal to track the month over month performance of one's own portfolio in a time-weighted fashion (to account for in and outflows) and net of any trend following positions, then I think that is the proper measure. An easier way is maybe a proxy for a portfolio similar to one's own base. If that is 60/40, for example, or close, then some index/fund based on 60/40 might work, say an ETF like AOM or maybe Vanguard VSMGX or something. Maybe there are others. But you'd have to be careful to make sure things like dividend flows and issues like advisory fees are factored in.  Bon chance!


*
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Risk Ignition with Trend Following, Newfound Research 4/23/18

Can Sustainable Withdrawal Rates Be Enhanced by Trend Following? Andrew Clare 2017

Using Trend-Following Managed Futures to Increase Expected Withdrawal Rates, A Miller 2017


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[1] I didn't realize Tadas was going to pick this up in abnormalreturns.  This was pretty a pretty casual post.  There are more formal and complex ways to express this that I have not bothered with.  The base portfolio is probably assumed to be single-period mean-variance efficient on a frontier using expected forthcoming arithmetic returns.  In addition, since we are actually multi-period retirees we also probably contemplate a geometric mean frontier that anticipates the volatility effects on returns which may create inflection points in the geo frontier at higher vol so we are somewhere between min-var and inflection on that geo frontier.  Then we also probably think about the covariance and vol-reduction considerations of adding/reallocating an nth asset such as trend following and whether it nudges the frontier out, which it often does in multi-period mode.  That's why I am looking at the baseline as a benchmark and then incrementally I'm not really looking at trend following in isolation but more likely the incremental portfolio changes after the reallocation. My guess is that it is more often than not a constructive move, a point I was being casual about above.  The question is does it help my portfolio by making the change, hence the baseline as benchmark.  I can be coached on this if I am way off...

On the The Annuity Puzzle by Elm Partners

This recent article (The Annuity Puzzle: How Big is the Free Lunch Being Left on the Table? Victor Haghani and James White, Elm Partners 10/15/2018) is a pretty good, succinct (short) cover of the annuity puzzle concept. It also introduces a little bit of the consumption utility idea, something covered here quite a bit recently.  There are a lot of ways of looking at this kind of thing but I like how they cover it here and also how they keep it simple, short and readable.  I also like the fact that they make the underappreciated point "bearing one’s own longevity risk does not offer compensation in the form of a risk-premium" along with the related, obvious but also underappreciated point that access to the longevity risk pool via annuities is something that one can't roll on one's own with any type of financial engineering.

For a little more depth on the type of model that might be used to evaluate consumption utility of different strategies over a forthcoming lifetime and the impact of annuitization on lifetime utility, one might look at two things I've done this year:

1. my Wealth Depletion Time EDULC (expected discounted utility of lifetime consumption) model

2. my post on partial annuitization, consumption utility and bequest

There are a bunch of other related posts but you'll find them listed in item 1. 

A gift from a new friend...

RiversHedge just got this this weekend from a new, awesome friend. This needs to be acknowledged in an embarrassing and public way since it is so rare and appreciated. Thanks J! I'm hoping this is only the first of many...

Last week's sell off...

Ok, so we had a big sell of last week, maybe 4% depending on what you are looking at. 4% doesn't phase me when looking at the long term and considering the future dynamism of the American economy which is not going out of business any time soon.  Even looking backwards, we are still way above trend.  I mean, look at a monthly chart!  I even had the temerity last week to sell near-dated puts on the long end of treasury futures.  In a rising rate environment that's a trade by someone with a screw loose, or maybe someone complacent, or maybe more likely: confident that it'll all work out. Basically the message is, for today, "move along there is nothing to see here."

But that is not the end of the story.  The above paragraph is written by an over-confident investor.  A retiree, on the other hand, sometimes looks at it a little differently. For that person, the week was not denominated in dollars or percentages, it was denominated in time.  For me personally, for example, the move down represented something like two years of consumption.  Divided into my remaining lifespan (a totally meaningless statistic, by the way) that's about eight percent. That did get my attention.  It's been a while but every move down makes me think about portfolio longevity in the presence of consumption and the probabilities related to remaining lifespan. This is why retirement is less a single period optimal solution kind of thing and more of a process management and monitoring endeavor.

Some random comments on random longevity in modeling

I recently read a new submission to ssrn on safe withdrawal rates (Joint Effect of Random Years of Longevity and Mean Reversion in Equity Returns on the Safe Withdrawal Rate in Retirement By Donald H. Rosenthal , Ph.D.).  The author had some worthy points on nudging the modeling approach when doing Monte Carlo simulation of retirement. The main points were that adding random longevity and a mean reversion process (a) probably mirror reality a little more closely than when they are absent, and (b) when added, they hint that slightly higher spend rates might be possible.  

Losing one's mind in retirement

I knew I was losing my mind. Here is a paper from Texas Tech (The Mental Health Effects of Asset Depletion in Retirement) Colin Slabach Texas Tech University September 30, 2018

"...few have analyzed the mental health effects of running out of money during retirement. This study examines the likelihood of having mental health issues in retirement when an individual runs out of money...The result suggests that individuals who are going to run out of money two years from now have an increase in the probability of having mental health issues. However, there is an even further increase in the likelihood of mental health issues when the individual actually has actually run out of money. The larger the drop in asset level (ex. $25,000 down to below $1,000 vs $5,000 down to below $1,000) the large[r the] probability of having mental health issues." 

My new favorite paper...

Here is another paper where, having now read it, I could probably hang up the blog and take off for a while (Sustainable Retirement Income for the Socialite, the Gardener and the Uninsured, Chris Robinson and Nabil Tahani 2007).  This is the first and only (ok "only" is a little dramatic, I have seen some of this before but it sure doesn't feel like it sometimes) paper that has directly addressed the following things I find to be essential points in playing the retirement finance game:

I shoulda quit a couple years ago

I probably could have wrapped up the blog a couple years ago if I had read and posted a quote like this since it packs in a lot of my current understanding of the retirement problem. This is from "An Age-Based, Three Dimensional, Universal Distribution Model Incorporating Sequence Risk," Larry R. Frank Sr., John B. Mitchell, David M. Blanchett (2011):

Researchers have sought a single withdrawal rate that would last the retiree's entire lifetime from initial retirement to death. The authors suggest a more dynamic model should be used where the author’s prior work demonstrates that a retiree's transient state is in constant flux due primarily to market sequences. The model in this, and the authors’ prior paper, develops a methodology to monitor, evaluate and react as necessary to those transient states as well as base the model on age specific expected longevity rather than generic, ageless or unanchored, distribution periods. [emphasis added]

and, while I'm at it, this next link is an exceptionally wise and fresh post from Darrow Kirkpatrick (How Accurate Should Your Retirement Calculation Be?) with all the common sense that I should have conjured myself a long time ago.

Another possible small future tweak to the lifetime consumption utility calc

In a recent post How I might tweak my consumption utility simulator in the future, I was casually ruminating on how I might adapt my lifetime consumption utility simulation in the future to factor in some additional considerations like bequest, spend shocks and foregone optionality. I ran across another one I might want to try when reading Davidoff et al. "Annuities and Individual Welfare" (2003) They replace the period consumption term c(t) with c(t)/s(t) where s(t) allows the modeler to shape an "internal habit" to the consumption path. To quote in order to help with the definition of this idea: 

What differentiates our more general setup from prior work is that we can vary s(t) in equation (1) so that the utility function exhibits an “internal habit,” which we can then adjust to create optimal consumption trajectories that differ markedly from the usual CRRA case. The intuition behind our utility function, taken from Diamond and Mirrlees (2000), is that it is not the level of present consumption, but rather the level relative to past consumption, that matters for utility. For example, life in a studio apartment is surely more tolerable for someone used to living in such circumstances than for someone who was forced by a negative income shock to abandon a four-bedroom house. In choosing how to allocate resources across periods, “habit consumers” trade off immediate gratification from consumption not only against a lifetime budget constraint, but also against the effects of consumption early in life on the standard of living later in life. Following Diamond and Mirrlees (2000), we model the evolution of the habit as follows:

[alpha] is the parameter that governs the speed of adjustment of the habit level. When [alpha] is zero, the habit is constant and we are back in the additively separable case. As [alpha] approaches infinity, present habit approaches last period’s consumption.