Life After Full-time Work Blog

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# 69 With Two Extreme Philosophies, Either/Or Is A Bad Way To Frame The Choice

This post expands on the notion of philosophies that embrace only the safety or only the growth end of the spectrum along which goals are placed.

Among the things that surprise me is when academics suggest that only one philosophy makes sense, in retirement finance. I’m less surprised financial professionals may split into groups that specialize in either insurance or investment; sometimes that may be the result of qualifications required in a country to practice in either field.

Let me use this post to summarize for you the debates that sometimes take place about what is an appropriate philosophy for retirement’s financial goals and the related investments. What has materialized from very erudite and thoughtful discussions is that there are essentially two diametrically opposed philosophies. I have seen them described as safety-based and stretch-seeking (think of my “safety” and “growth”), and also as insurance-based and probability-based. You get the idea, I hope.

What is also emerging from the discussions is that preaching either approach to the exclusion of the other is not helpful to those of us who are planning or living our post-work lives. And yet, as far as I can discover, the idea of “some of each” is a relatively recent one, entering the technical literature following a paper by Drs Peng Chen and Moshe Milevsky.[1]

I think that framing it as “either one or the other” is counter-productive. I don’t mean that it’s unreasonable to place yourself at one of the extremes. That’s fine when it results from an informed choice. All I’m saying is that it should surely make sense to allow some people to say “I’ll have some aspects of both, please and thank you.”

I’m going to base my summary on pieces written by Dr Wade Pfau and Jeremy Cooper.[2] Among other virtues, they came up with the brilliant notion of referring to the extremes as “the yin and yang of retirement income philosophies.” This is a reference to the Chinese names for opposites that are also inseparable, and when they come together they complement each other and form a whole that is greater than the sum of the parts. Perfect!

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First, the safety-based approach.

People with this approach are particularly fearful of the chance of something going wrong, and therefore prize predictability and guarantees above all else. That gives them peace of mind and the ability to enjoy the life that results, even if that life is less than they might originally have hoped for. That’s OK, they feel, if we make the best of what’s feasible, that’ll be pretty good, and at this stage of life we’re very happy to be able to feel that way. No worries!

Their spending is itself probably prioritized, with a distinction between essentials and “nice to have” things, the former being fully covered by guaranteed income and the latter coming after unforeseen contingencies have been looked after or allowed for via a separate reserve.

Since the biggest fear that retirees have is outliving their money (https://donezra.com/67-happiness-comes-from-certainty-about-not-outliving-your-assets/), predictable income guaranteed to last for life is a fundamental goal. Lifetime income annuities play a large part in the resulting asset portfolio, where they are available. Low-risk fixed-income investments are there for the same reason, probably tailored to match the need for income at predictable times. If a bequest is also an important goal, paying premiums towards an insurance policy is an obvious solution.

All in all, I suspect that most of us subscribe to a lot of this philosophy, and some of us endorse all of it.

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Where’s the room, then, for stretch-seeking? What’s the point?

That arises for people who feel: “Hey, if it doesn’t place too much of the future at risk, it would be really great to be able to add to the ‘nice to have’ list, particularly at a time of life we’ve been looking forward to so much. We’ve accumulated our retirement assets, and now is the time to use the freedom it gives us. Surely we shouldn’t say, ‘I don’t care how small the risk is, zero risk is the only amount I’m willing to contemplate.’” (You recognize, of course, that I’m exaggerating for effect, because even safety-first people realize that in life there’s no such thing as zero risk, no matter how much we may strive to achieve it via our lives and our investments.)

OK, then, a crucial aspect is: how much risk is too much, and how likely is it that that amount of risk will result in a bad outcome, and what will I have to cut out if a bad outcome happens? Easy questions to frame, but impossible to answer simply. That’s what retirement planning is all about. So in effect the stretch-seeking people should be into making estimates of probabilities and amounts at risk. That’s the approach that’s logical for them.

Typically, then, their goal is a lifestyle, and it probably isn’t separated into essentials and nice-to-haves. They find a way to estimate how large an annual or monthly or weekly withdrawal from their assets is likely to be sustainable, if investments (which will focus on growth-seeking types) have a reasonable return in the future. In making these estimates, they will (probably through a professional) consider what is “reasonable,” how much disappointment there might be in what actually happens, how those disappointing returns will affect their lives, and how long they are likely to live. All probability-based and risk-conscious. Almost certainly they will err on the side of caution in making their estimates, because they have no recourse if things go bad, and they’ll adjust their lifestyle if circumstances require it; but there’s a world of difference between informed caution and zero risk.

That’s the essence of their philosophy and approach.

And I’m sure that most of us subscribe to many elements of this philosophy, and for some of us it’s the only way to think.

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But gosh, isn’t it OK to include elements of both philosophies?

Like something along these lines: “I’d like to lock in some things, yes. But I’m also willing to leave some things uncertain, particularly if that gives me the possibility to do things I’m dreaming of.”

If you say something along those lines, your philosophy and goals will be somewhere in between the two extremes. Your portfolio will reflect elements of both sets of asset choices. How close you are to one extreme or the other is entirely up to you, and where you place yourself on the opportunity-plus-risk spectrum. As you can see, an informed choice is the only way to go, and there’s no “right” answer in the sense that only that answer is sensible and everything else is stupid.

The only thing to avoid is placing yourself is the hands of an expert who reflects just one of the two extremes, someone who goes solely with insurance-type solutions or someone who is purely investment-focused and won’t consider products with guarantees. That way you pre-empt the discussions that lead to an informed choice.

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Takeaway

Beware of finding yourself in a situation in which your financial professional only uses insurance instruments or only focuses on investments.


[1] Chen, Peng, and Moshe A Milevsky (2003). “Merging asset allocation and longevity insurance: an optimal perspective on payout annuities” in Journal of Financial Planning Vol.16 No. 6 (June 2003).  See also Chen, Peng, Roger G. Ibbotson, Moshe A. Milevsky and Kevin X. Zhu, “Human capital, asset allocation and life insurance” in Financial Analysts Journal, Vol. 62 No. 1, January/February 2006). 

[2]  Pfau, Wade and Cooper, Jeremy (2014). “The yin and yang of retirement income philosophies” (November 10, 2014). Available at SSRN: https://ssrn.com/abstract=2548114 or http://dx.doi.org/10.2139/ssrn.2548114.

4 Comments


I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.


4 Responses to “# 69 With Two Extreme Philosophies, Either/Or Is A Bad Way To Frame The Choice”

  1. Jason Parker says:

    Hi Don,

    I appreciate you looking at both sides of the equation. I agree that all or nothing is usually not the best course of action. In my book I talk about both the safety and growth opportunities and there is certainly an argument to be made for both. I like how you describe the essential vs discretionary expenses. One of the reasons I developed the retirement budget calculator was so that people could really understand the difference between essential vs discretionary and how inflation will impact their spending. I enjoyed having you as a guest on the Sound Retirement Radio podcast. We should have you back sometime soon.

    Thank you,

    Jason

    • Don Ezra says:

      Thanks, Jason. I hope my readers, particularly the American ones, check out your excellent book. That distinction between essential and “nice to have” expenditures is very important psychologically, isn’t it? I’d love to do another podcast on your show — perhaps after I’ve finalized and published “Life Two” — would that be OK? I’ll let you know when that happens.

  2. Ted Harris says:

    The great thing about the discretionary element is its flexibility. For instance, as for a lifestyle element, when it comes to leisure travel the frequency and style are adaptable. It doesn’t have to be either/or.

    • Don Ezra says:

      Right on! And just as some lifestyle choices are discretionary, so too it typically makes sense for financial choices to be somewhere in the middle.

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