While it is usually amusing and sometimes personally gratifying to point out the nonsense that I see and hear by those who should know better, that is not the primary purpose of this feature. The main goal is educational, to enable you to separate the wheat from the chaff, be able to have a better understanding of all the “information” you get, and, most importantly, make better decisions about your financial affairs. Accordingly, I sometimes withhold the names of the perpetrators when they are not well known or are hardly unique in the particular transgression. That will be the case this issue.

The lesson from this gibberish is to get as complete a picture as possible and to make sure that nothing important is left out of the analysis. My example comes from a column by a well-respected writer for a specialty magazine sent to money managers who also offers his own advisor services to this audience. He wanted to make the point that portfolios for retirees generally need an equity component to protect against inflation and should not be invested solely in bonds. That is likely good advice in most cases, but a blanket assertion to that effect is shortsighted, and his illustrative example leaves out an important aspect of the analysis.

He takes the case of a couple, both aged 65, who are entering retirement and have sold off a business that leaves them with $8,000,000 to invest for retirement income. (He ignores what Social Security will provide, but that is not critical in this case.) He goes on to assume that they have a current life style that requires $200,000 a year of after-tax income to maintain, which is the couple’s desire. Further, he makes the reasonable (at the time) assumptions that tax-free municipal bonds yield 5% and inflation will be 3% a year. That means $400,000 a year of tax-free income, so things look good. Not according to the writer because the couple should assume for planning purposes that one or both may live for another thirty years. At that point, $400,000 will be the equivalent of about $165,000 in today’s dollars, due to inflation, so the bond portfolio won’t provide enough income. (Using the “rule of 72,” the inflation-adjusted income need will double in 72/3 = 24 years. After that point, the bonds would not provide the desired amount of income.)

But wait! Something very important is missing here. What happened to the extra $200,000 that was not needed by the couple in the first year? Apparently, it just disappears because the writer never says a word about it. Using his assumptions, if they invested the income they did not need to support themselves in the same bonds and kept reinvesting that unneeded income every year, their bond portfolio would easily grow by enough to produce all the income they required and then some. This is so because the after-tax rate of return on the half of the portfolio that produces income that will not be consumed is greater than the rate of inflation.

As long as we are on the topic of planning for retirement income, it is important to point out that assuming fixed rates of return or fixed inflation rates is not a good idea. These do fluctuate considerably over time, and there are scenarios that can knock a plan based on fixed rates out of kilter quite quickly. The 1970s provided a good example when we saw higher inflation than the long-term average and lower returns on stocks than the historical averages. The way to handle planning with fluctuating rates is “risk analysis.” This involves making some reasonable assumptions about the probabilities of having various inflation levels and rates of return for some investment alternatives. Then a Monte Carlo simulation incorporating these assumptions for a proposed portfolio is performed. The simulation may allow withdrawal of assets to make up for income shortfalls. It randomly generates a large number, 1000 to 10000 is typical, of cases using the specified probabilities and produces estimates of the probability of meeting certain goals. Typical goals are being able to have a certain level of inflation-adjusted income for a specified period of time and being able to leave a certain amount to one’s heirs.

While I am not an expert on the subject of risk analysis, I am fairly knowledgeable and have the software ability to perform it for reasonably sophisticated and realistic analyses. As usual, please feel free to discuss this with me.

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