Loss aversion is a term coined by psychologists Daniel Kahneman and Amos Tversky. It claims the pain we experience from a loss is twice as great as the pleasure from an equivalent gain. This means for someone to accept the risk of losing $10 in a coin flip, they would need the chance to gain $20 for winning.
With this in mind, loss aversion can be a driving force when making investment decisions. All investments, including cash, carry some form of risk you must accept. The difference between them is how quickly that risk can manifest itself.
This can lead many to focus on avoiding short-term volatility while potentially exposing themselves to longer-term risks.
Loss Aversion to Sudden Risks
When people think about “losing money” from investing, they view it as getting into a car accident. Where an unavoidable sudden shock can cause damage that can take years to recover from.
With this in mind, some may want to avoid driving altogether, to ensure they never get into an accident. However, you can see the potential accommodations you would have to make to your lifestyle by never using the motorways again.
Loss Aversion to Gradual Risks
There is another kind of risk that is often overlooked. This is the potential erosion of your purchasing power from inflation. Since this can take years or decades to occur you are less likely to feel it taking place.
This gradual loss is similar to living a sedentary lifestyle. Meaning skipping a single workout is unlikely to have much effect on your long-term health, but years of consistent inactivity can result in serious health consequences later in life.
We tend to be averse to losing and this aversion can frequently manifest itself in our investment decisions as you can see in the examples above there are different risks that are associated when investing.
The sudden risk that can occur in the stock market and the gradual risk that comes from conservative investments. In both instances, careful planning and the development of a strategy can attempt to mitigate these potential risks. This can allow you to tie your investment plan to your goals to ensure your approach is prudent given your circumstances.
The law of diminishing returns is the idea that benefits gained from something will represent a proportionally smaller amount as more money or energy is invested in it. The realms of fitness and retirement planning both provide countless examples to illustrate its effect.
Diminishing Returns with Weight-Loss
For example, in the fitness realm, weight loss is subject to the law of diminishing returns. At a very high-level weight loss can be reduced to burning more calories than you take in. This can be done by either decreasing your caloric intake or increasing your caloric expenditure. However, at a certain point, the law of diminishing returns begins to take effect.
You can only restrict your calories to a certain extent. Beyond that, it can begin to affect your energy levels, performance at work or in the gym, and increase your focus on food. Also, the more extreme your caloric deficit the shorter you will likely be able to maintain it.
Additionally, you can only exercise so much. Meaning you can only burn so many calories in a day before there are negative side effects. This can include the inability to recover, injury, and the sheer time it takes to workout can begin to detract from the rest of your life.
The Importance of a Sustainable Weight-loss Strategy
With this in mind, reasonable (sustainable) weight loss can only happen so quickly and will likely include a combination of moderate calorie restriction and greater energy expenditure. Where this can become an issue is when you want to lose a certain amount of weight in a constrained timeframe.
Often, reaching this short-term goal requires you to engage in unsustainable behavior, which could have long-term consequences. You may be able to lose a majority of all, of the weight before your deadline, but all too often the pounds are quickly regained. It is not uncommon for you to be worse off, from this yo-yo style diet than if you weren’t to diet at all.
Diminishing Returns in Retirement Planning
The law of diminishing returns can also be seen in retirement planning when someone wants to accumulate an investment nest egg sufficient enough to fund their retirement. At a high level, this requires you to spend less than you earn, and save/invest the difference in a way that allows you to transfer economic value through time.
With that being said, for someone who wants to build their nest egg more quickly, they can save/invest more. Or they could look to generate greater returns from their investing. When it comes to boosting their saving, they can either reduce current spending or increase their income.
However, frugality can only get you so far, and at some point, you are left with the basic necessities for survival. On the other hand, earning often means working more, but there are only so many hours in the day.
The Risk of Seeking Higher Returns
The other possibility is to try and generate greater returns from your investments. Greater potential returns are usually accompanied by taking more risks. This can be done by allocating a larger portion of your assets to riskier investments such as stocks.
But even a 100% stock portfolio is limited in its long-term growth potential. What also increases as the potential for return increases is the risk associated with a given investment.
This means the more risk you take, the more likely you could experience a negative outcome. Especially for those who are risk-averse, after a certain point, the extra risk they must take on for a potentially high return becomes undesirable.
Finding a Balance
Just like with weight loss, going to extremes may be tolerable in the short term, but isn’t likely sustainable in the long run. Understanding the law of diminishing returns and applying it to your situation can allow you to develop a strategy that lets you find the sweet spot between the benefits gained and the effort given.
As you enter retirement, you may be in a position where you are investing outside of your employer-sponsored retirement plan for the first time. This can often leave people feeling confused and overwhelmed.
The first is intellectually difficult, the second is physically difficult and the third is emotionally difficult.
The Intellectually Difficult Approach to Investing
The intellectually difficult way is reserved for those with superior brainpower, and a deep understanding of the markets they are investing in. Think of people like Warren Buffet, Ray Dalio, or George Simons.
The Physically Difficult Approach to Investing
The physically difficult approach requires you to outwork your competition. This is the approach many people on Wall Street take. They are known for working extremely long hours trying to get an advantage over one another.
Managing an Emotionally Difficult Retirement Investment Strategy
Assuming you are not of superior intellect, nor do you want to spend your retirement working long hours on investing decisions, you are left with the emotionally difficult route.
In order to increase your likelihood of success, you need to improve your ability to withstand emotionally difficult times in the market. This can be done by creating a long-term investment strategy that is tied to your personal goals.
For example, a primary goal for those in retirement is to fund their expenses not covered by other retirement income. Depending on the amount of income you need, your portfolio will require a certain rate of return.
Typically, the greater rate of return you need to generate, the more risk, you must take. If you are not comfortable with a given level of potential risk you may need to adjust your goals downward.
After creating your long-term investment strategy, you must then execute it. When implementing your strategy, you will need to follow an investing process where you monitor, review, and adjust your portfolio based on your changing needs.
The Role a Financial Advisor Can Play
If you struggle with this, you can seek the support of a fiduciary financial advisor. An advisor can help you develop, optimize and implement an investment strategy suited to your needs in retirement.
They can also show you have this strategy integrates with an overarching retirement plan. Lastly, they can provide an additional layer of support when making investment decisions during uncertain market conditions when emotions are high.
A successful retirement investment strategy does not require great genius nor tremendous effort, but it does require you to stick with that strategy in good times and bad.
When you enter retirement, your initial portfolio withdrawals will likely be discretionary. Meaning you will be able to decide how much you withdraw from which accounts based on your income needs.
This is true until you reach age 72. At this point, the IRS requires you to take minimum distributions (RMDs) from your employer-sponsored retirement plans and traditional IRAs. Failure to take the required minimum distribution could result in a 50 percent penalty on the amount that should have been withdrawn.
Your annual RMD is based on your age, the value of your accounts on December 31 of the previous year, and your life expectancy factor.
RMD = Prior Year-End Account Balance / Life Expectancy Factor
Required Minimum Distribution Example 1
For example, Joe Smith turned 72 on January 1, 2021, and is married to Jill Smith who is 68. Joe’s traditional IRA was valued at $1,000,000 as of December 31, 2020. Based on the current uniform life tables, Joe’s withdrawal factor is 25.6. Therefore, his required minimum distribution for 2021 is $39,062.50.
Required Minimum Distribution Example:
What is a Qualified Charitable Distribution (QCD)?
Required minimum distributions could create an unwanted tax liability for someone who does not need the income to fund their retirement. This is because the extra taxable income can bump you into a higher tax bracket, increase the taxes on your Social Security benefits or cause you to pay higher Medicare premiums.
For those who are charitably inclined, qualified charitable distributions (QCDs) may be a useful tool to potentially keep your adjusted gross income within the desired range. QCDs provide a tax-efficient way to manage required minimum distributions from a traditional IRA while benefiting a qualified 501(c)(3) charity.
A QCD, allows you to contribute to an eligible public charity and receive a tax benefit, whether you itemize or not. The annual QCD limit is $100,000 per individual given they are 70½ or older.
This means, when your RMDs begin, you can direct your RMD to charity and exclude the distribution from your taxable income. In addition, you can still give more to charity through a QCD than your RMD amount but cannot exceed the $100,000 annual limit. *
Required Minimum Distribution Example 2
Going back to the earlier example, the Smiths’ had 2020 income as follows: $5,000 interest income, $30,000 dividend income, $60,000 Pension Income; $35,000 of IRA income; and $50,000 annual Social Security benefits (of which only 85 percent, or $42,500, is considered taxable in the formula for modified adjusted gross income) for a total annual income of $180,000.
Their resulting modified adjusted gross income is $172,500, which is under the $176,000 Income-Related Monthly Adjustment Amount (IRMAA) income threshold for joint filers. In 2020, the Smiths’ were able to fund their living expenses without triggering the Medicare surcharges.
However, in 2021 Joe’s RMD was $39,062.50 while the rest of their income remained constant. This added $4,063 income would push their income above the $176,000 threshold and trigger Medicare Part B and D surcharges in two years.
One potential way to avoid this is by using a QCD. Joe could direct the first $4,063 of his RMD to a qualified 501(c)(3) charity of his choice and use the remaining $35,000 to fund their living expenses. Since the $4,063 was sent to a charity they will be able to exclude that amount from their taxable income.
This would reduce their modified adjusted gross income to $172,500. This would put them below the $176,000 threshold, and they would not be subject to the premium surcharges in two years. **
Qualified charitable distributions can be a tax-efficient way to manage required minimum distributions for those who are charitably minded. Because of their tax benefit, QCDs and RMDs should be carefully coordinated to ensure proper timing. It is reasonable to seek out help from a trusted advisor to aid you with their execution.
*A QCD must be an otherwise taxable distribution from your IRA. You cannot retroactively classify an RMD as a QCD. Also, you cannot deduct a QCD as a charitable contribution on your federal income tax return.
**These hypothetical examples are used for illustrative purposes only. Actual results will vary.
These annual limits are based on “provisional income” which is adjusted gross income + tax-exempt interest (which could be interest from municipal bonds and savings bonds) + 50% of social Security benefits.
Adjusted gross income + Tax-exempt interest + 50% of Social Security benefits
If your “provisional income” exceeds the levels shown below, you may owe federal income tax on up to 50 percent or 85 percent of your Social Security benefits. The levels are different depending on your tax filing status, but they are not adjusted for inflation.
Example of the of Taxability Social Security Benefits
For example, a married couple (filing jointly) has $1,000 interest income, $10,000 dividend income, and $4,000 tax-free interest; $30,000 of IRA income; and $30,000 annual Social Security benefits (of which only 50 percent, or $15,000, is used in the formula for provisional income to determine the taxability of Social Security benefits) for a total annual income of $75,000.
Their resulting provisional income is $60,000, which is over the $44,000 income threshold for joint filers, and they could owe taxes on up to 85 percent of their Social Security benefits*.
The Benefits of Tax-Free Income
Having a source of tax-free assets such as a Roth IRA might help you avoid taxes on your Social Security benefits. Unlike tax-exempt bond interest, qualified Roth IRA distributions are not included in the formula for taxability of Social Security benefits.
This is because you don’t receive an income tax deduction on any contributions made to a Roth IRA. Also, there are no required minimum distributions (RMDs) from a Roth IRA throughout the lifetime of the original owner.
This is unlike traditional IRAs and employer-sponsored retirement plans where you must begin taking required minimum distributions once you reach age 72. These taxable distributions may increase your annual income and could affect the taxability of your Social Security benefits once they begin.
An Example of How a Roth IRA Can Reduce the Taxability of Your Social Security Benefits
Going back to the previous example we can illustrate how the use of a Roth IRA may help reduce (and possibly avoid) taxes on Social Security benefits. The only difference to their income in this new scenario is the couple has tax-free income from a Roth IRA instead of taxable income from a traditional IRA.
As a result, their Social Security benefits will not be taxed. Their Roth IRA income is excluded from the formula, and thus their provisional income is only $30,000, which is below the $32,000 threshold for taxing benefits*.
Once you understand how your Social Security benefits are taxed, you can begin exploring opportunities to potentially reduce the taxes you pay. Depending on your income and mix of assets, you may have the ability to better manage your tax liability in retirement.
*These hypothetical examples are used for illustrative purposes only. Actual results will vary.
When planning for retirement there are many tough decisions you must make, some of them being irreversible. With this in mind, it would be prudent to have a decision-making framework to help you make the most of your retirement.
Everyone likely has the intention to make decisions that are in their best interest. What gets in the way of these decisions are what Chip Heath and Dan Heath call the four villains of decision-making.
The tendency to see things in binary, black and white, terms.
We seek information to support our current views or recent actions. We want reassurance rather than the truth.
We allow our current feelings to cloud our thinking. We can feel differently about the same choice even if the numbers haven’t changed. Think analysis paralysis.
We think we know what the future holds but we really are making an educated guess.
Making Better Decisions With the WRAP Process
By understanding what could get in the way of making better decisions, Chip Heath and Dan Heath developed a framework to combat these villains. It is called the WRAP process and includes the following four steps.
Widen Your Options
This is where you broaden your search when looking for the possible options available to you. Narrow framing can cause one to be blind to your choices.
Reality Test Your Assumptions
You seek outside information when reviewing your options. Some of this information is meant to be disconfirming. The confirmation bias leads you to only seek self-serving information.
Attain Distance Before Deciding
You try to look at the bigger picture and how your choice fits into it. Short-term emotions can cause conflicted feelings and tempt you to make a bad choice.
Prepare to be Wrong
This is where you plan for possible future outcomes and how you will react to those events. Overconfidence can lead us to believe things will play out in a specific way.
An Example of How the Four Villains’ Can Creep into Your Retirement Planning
Someone who is approaching retirement and is considering how they should invest their portfolio.
They ask themselves “Should I invest in the stock market or not?” (Narrow Framing)
They believe the stock market is too risky for a retiree and seek information to validate their beliefs. (Confirmation Bias)
When making their choice they choose to let their intuitive feelings drive their decision when their situation hasn’t changed. (Short-Term Emotions)
They are certain the stock market will not serve them now or in the future. (Overconfidence)
An Example of How to Use the WRAP Process
If they instead used the WRAP process when making the same decision as above:
They ask themselves “What are the possible ways I could invest in the stock market? How could I manage the risks I take when investing better?” (Widen Your Options)
They review information on the long-term historical returns of stocks and other asset classes. They also seek expert advice and options to understand the pros and cons of investing in the stock market. (Reality Testing Assumptions)
They look at the long-term potential of investing in the stock market and how that impacts their retirement plans. They place less weight on short-term market volatility. (Attaining Distance)
They test their investment allocation using software that runs their portfolio through many hypothetical future scenarios to see their likelihood of success. They determine if they are comfortable with the probability of things not going as they had hoped. If they aren’t they would need to make adjustments before they make their final decision. (Preparing to be Wrong)
The WRAP process can be useful when making decisions when planning for retirement. While you can still have bad outcomes, the focus is placed on the analysis rather than the results.
When you retire, this will likely be the first time you are using your personal savings to generate an income. Due to the lack of experience you may, justifiably, choose to proceed with an abundance of caution. This caution may lead you to be more conservative in your approach than you otherwise could be with smart planning.
Advancements in Engineering
Matt Parker discusses a similar phenomenon in his book Humble Pi: When Math Goes Wrong in the Real World. In this book, he discusses the evolution of bridge design as a result of increased mathematical knowledge and better tools for engineers to use when they are doing their calculations.
He notes the differences in the design of nineteenth and early-twentieth-century structures, built from large stone slabs and massive steel beams. In short-everything was ‘over-engineered’ in an abundance of caution since they were relying on intuition rather than mathematics.
By leveraging calculations and planning we can build structures beyond our intuitions and come closer to the edge of possibility. Certainly, this is not without some risk. As a result, governing bodies establish building codes to ensure there is a sizable margin of safety built-in.
These third parties review and approve the design prior to construction. They take into consideration the demands to be placed on the structure and possible adverse conditions that could be imposed.
Advancements in Retirement Planning
Similar advancements have taken place in the area of retirement planning. Modern software allows you to perform stress tests, run various hypothetical scenarios, optimize the claiming of retiree benefits, and see the impact of the changes you make to your plan.
Unfortunately, unlikely with engineering real-world structures these calculations cannot be made with certainty. While math and physics include scientific certainties and outcomes, the direction of any investment cannot be anticipated, as such, there is no definitive way of knowing whether the predicted outcome will be realized.
Leveraging Retirement Planning Software
When you are approaching retirement, you want to make the most out of the resources you have available to you. By leveraging software you can better prepare yourself to see if your current strategy is feasible or needs adjusting.
While no software or strategy will ensure an outcome with certainty, they can assist in your overall decision-making process. There are many versions of this kind of software available on the internet, and some of them are even free to use.
Often, many of these programs are ‘black boxes’ and you are not able to see the underlying calculations. This then requires you to be certain your inputs are both accurate and reasonable given your circumstances.
Implementing Your Retirement Plan
Once you create your plan, you must then begin doing what the software suggests that you do. This could mean changing your investment allocation, begin saving, or spending X amount of dollars. You will also be responsible for implementing any insurance, estate, or tax planning recommendations, which will often require working with a third party of some kind.
After the upfront heavy lifting is finished, you would then regularly monitor your plan, and make adjustments to your plan when necessary.
Outsourcing Your Retirement Planning
An alternative to creating your own retirement plan is deciding to work with a financial advisor to create one with you. Working with a financial advisor can help ensure your calculations are correct and your plan is feasible. They can also help to implement the recommendations in the plan and provide ongoing monitoring.
A financial advisor can also share their experience with those who they have helped before you. They can help you avoid common pitfalls and provide you with actionable insights about your specific situation.
Retirees today have access to more free information and resources than ever before. The issue today is not access but rather the accuracy of the information and mistakes can be costly. Understanding the information and actually implementing the recommendations from that information are two different skills.
If you do decide to go it alone, proceed with caution and a healthy level of skepticism.
*Investing involves risk and the potential for loss of principal. No one plan will ensure your outcome is favorable. As such it is important that you understand the risks involved in your plan.
The rule of 25 is a commonly used financial heuristic for calculating how large of a ‘nest egg’ you should save for retirement. To determine your nest egg, you multiply the annual income you will need for retirement by 25. It then assumes you draw 4% from that pool of assets annually.
This idea is based on some retirement research that looked at what a ‘sustainable’ withdrawal rate would be for a hypothetical portfolio with a 30-year time horizon.
This withdrawal rate is not appropriate for everyone, but it is a good place to start when ballparking the size of your nest egg. I will not go into detail on all the factors you should consider when determining your withdrawal rate but have listed some of them below:
What Will Your Annual Income Needs be in Retirement?
Calculating Your Expenses
In order to know what your income needs will be, you will likely need to look at what you plan your expenses to be in retirement. I have provided a worksheet you can use to calculate your current monthly expenses and what you expect your monthly expenses to be in retirement.
The expenses are broken up into two categories, essential and discretionary:
Medical & Healthcare
Entertainment and Recreation
It is very likely that there will be differences in these expenses between what they are now and what they will be in retirement. The closer you are to retirement, the more you should know what these expenses should be.
Once you have an idea of what your monthly expenses will be you can multiply that number by 12 to get your annual income need in retirement.
Subtract Retirement Income from Your Expenses
From there you can subtract your income you plan to have in retirement:
The annual amount supplied by ‘certain’ sources of income (Social security, pension, annuity, etc)
The annual amount supplied by other income sources (work, rental property, etc.)
*Note these sources can be used when calculating your income required but should not be relied on since they could fluctuate.
Filling the Remaining Income Gap
If your retirement expenses are more than your retirement income, the remaining ‘gap’ needs to be filled by income generated by your personal savings.
You then multiply the annual gap by 25 to calculate the assets needed to generate enough income for a 4% withdrawal rate.
Comparing the Assets Needed to Your Current Assets
You then subtract the assets needed by your current assets to see the difference.
If your current assets are below the assets required, you can see the assets needed to reach that number.
Rule of 25 Example
Below is an example of someone with $1,000,000 in assets seeing if they meet the rule of 25.
As you can see having a $1,000,000 portfolio doesn’t necessarily make you wealthy. It takes a large pull of assets to generate a sustainable source of income in retirement that could last decades.
Your assets are only one factor in the calculation. Having additional sources of retirement income or reducing your annual expenses are both ways you could reduce the need for additional assets. If you could reduce your need in retirement by $100/mo., that reduces the assets you need by $30,000. But the math works both ways, if you want to spend $100/mo. more in retirement your nest egg will need to be $30,000 larger.
The Rule of 25 is far from perfect, but it can be a good way to get a rough figure on the size of the nest egg you will need for retirement. The more interesting point for me is that it shows that the amount of assets you have is only one part of the equation, and lowering your expenses or optimizing your other sources of retirement income, can reduce the size of the nest egg you need in the first place.
Knowing that there is no one correct answer to the question, allows for the opportunity for smart planning and a more nuanced discussion of how you can fill the income gap in retirement.
The Challenges of Reaching the Average Person in Sports Nutrition
In the field of sports nutrition, they face two challenges when developing new products.
Finding ingredients that work.
Packaging those ingredients into a product that the consumers understand and are willing to buy.
It is possible for consumers to read the latest scientific research and implement their findings by purchasing the ingredients online. The average consumer is not likely to do this because the individual ingredients are unflavored and relatively expensive.
This results in a limited audience for these ingredients because their benefit does not justify the time and effort required to study and source them.
This means new ingredients are not widely utilized until they can be packaged in a way that is appealing and cost-effective to the average consumer. Sports nutrition companies must create a product around the new ingredient and communicate the benefits in a way the average person understands.
They also must ensure their product is effective, reasonably priced, and tastes good to maintain their credibility as a brand.
The Challenges of Reaching the Average Person Planning for Retirement
Something similar happens in retirement planning. There are strategies that can be beneficial to your retirement plan but are not widely adopted. This can be due to a lack of understanding of the benefits or an uncertainty of how to implement them.
Unless they are working with a trusted advisor who can explain these concepts in a way they understand, the average retiree will forgo these strategies. An advisor can show how these strategies are combined into an overarching retirement plan and allows them to make informed decisions after seeing the potential benefits.
The whole is greater than the sum of its parts
Four Undervalued Retirement Planning Strategies
1. Global Diversification
A globally diversified portfolio is often unappealing given the recent outperformance in the US stock market. This trend could continue, but there is benefit in looking to invest in companies outside of the United States.
There is a high probability you or your partner may need some form of LTC. But people are often hesitant to buy something they may not need or use.
4. Estate Planning
Ensuring your affairs are in order. This may seem obvious, but many people postpone estate planning because they do not want to come to terms with things. It is an advisor’s job to help them through this process.
These items may not be appealing but can be beneficial when incorporated into your retirement plan. Even if you decide against using these strategies it would be prudent to explore their potential benefits. Following a financial planning process ensures you review your earlier decisions and determine if your position in any area has changed.
With a retirement that could last 30+ years, the world could look very different at the beginning of your retirement than it does at the end. Taxes, regulations, government benefits, healthcare, and investing could all look vastly different than they do today.
The rulebook for retirement may change, and current strategies could lose their merit. At a personal level, your life will not remain static, people will age, relationship dynamics may shift, and new challenges will present themselves.
The future ain’t what it used to be. – Yogi Berra.
Positioning not Predicting
Instead of trying to predict what will happen in the future, we should focus on positioning ourselves to be able to react as events unfold. By engaging in the process of financial planning, you know in advance how you’re going to handle new obstacles as they present themselves.
A plan can keep you grounded in your values and guide decisions under changing external circumstances.
Seeking Professional Guidance for Your Retirement
Professional guidance through this process is not necessary but can be very valuable. There are many major decisions surrounding retirement, some of which can have lasting implications for both you and your loved ones.
Someone who is versed in the retirement landscape provides for a more informed journey by educating you on the options available to you and sharing their experiences with serving those whom they have worked with before.
Embracing the Uncertainty
We have no idea what the future will hold or what the economy will look like but the core principles and saving, investing, and prudent preparedness will remain the same. The tools and tactics you use may look different than they did when you started, but that is okay.
A financial plan can provide you confidence in the uncertainty of retirement. Where you know you do not what will happen but have a framework to guide your future decisions in a manner that is aligned with your core values.