Think about common risks in your life and the tactics you use to minimize or avoid them.
- If you're trying to lose weight then you burn more calories (read: Exercise) and consume fewer or at least better calories (quality proteins, greens, fruits & oils versus sugars, carbs & artificial or saturated fats).
- If you're taking a trip and worried about your car breaking down, you can take it in for service, check the tire pressure, top up the tank and other fluids.
- If you're worried about passing a class then you can burn the midnight oil, get help from your teacher and fellow students, search for tips and tricks online.
And so on. We counterbalance risk with compensatory actions and strategies.
In my practice, most of my clients are concerned about two possibilities:
- Outliving their income and assets
- Inflation ballooning their living costs to unmanageable levels.
How can we compensate for these two very real risks in retirement? We have two great tools (and I have Tom Hegna to thank for these concise ideas:
- Risk pooling
- Longevity credits
Let's review Longevity credits first. I don't know if this is a true story or not but there were five elderly women who like to travel together in the Summer. On New Year's day they would each put $100 in a box and save it for fun money on their trip. One year, before their trip, one of them passed away. The surviving four then had $125 each to spend on their trip. They each received a 25% longevity credit.
Is this a way to counteract inflation? Of course! (To be sure, in real life much larger groups are formed, but to similar effect.)
Cojoined with Longevity Credits- and making longevity credits possible, is Risk Pooling. We've all seen schools of fish, flocks of birds, herds of wild animals. There is great survival value in pooling the risk of predators. By gathering together, more of them are likely to survive. It's the same with house insurance. If the risk were 1 in 1200 that a house would burn down in your neighborhood each year, you could band together with your neighbors to create a fund sufficient to replace that house every year. (Ideally, it wouldn't be the same house.) So instead of having to come up with, say, $500,000 to replace your house if it burned down, you would only have to pay 1/1200 of that each year, or $416, otherwise known as a Homeowner's Insurance Premium.
Aside from being a perfect hedge against outliving one's income (we'll get to that) Risk Pooling is a relection of our better nature, like the Amish coming together to build a barn for a neighbor. Unfortunately, Risk Pooling is an insurance process and must be conducted by insurance companies under most state and federal laws. I say "unfortunately" because insurance companies get a (mostly) undeserved bad rap.
Social Security is the best current example of both these concepts. Millions of people participate and the law of large numbers, the larger the Risk Pool, means the system works more predictably the greater the number of participants. Social Security is an insurance program, it is not a federal entitlement. But wait, you say, how is that so many beneficiaries will take more in income out of the system than they put in? The answer is Longevity Credits from the funds of those who die prematurely.
Much maligned annuities are similar tools for privately pooling risk and receiving longevity credits. And they are much more flexible than Social Security: you can design cash flow just about any way you like, level, increasing with inflation, for certain period of years,just for your lifetime or for the lifetimes of you and your spouse. Annuities are like the vacation box. And that's how we account for a lot of the "too good to be true" features they provide. For example, let's take a couple with $250,000, he's 68 and she's 62. The cash flow they desire is joint, lifetime income beginning in 10 years to give them an inflation bump up. Their lifetime payout at that time would be over $25,000/yr. no matter how long the last surviving person lives. And in the meantime, unlike with Social Security, they have access to their principal if they need it.
So. The two financial pillars for 2017, the year of unpredictability (to say the least) are:
- Risk Pooling and
- Longevity Credits
Your Constructive Comments are Welcome!