Prophets and losses for retirees

THEY say that at every stage of life the baby boomers reach, the world changes to accommodate them. So now the boomers are starting to reach retirement, it's the investment advisers' turn to lift their game.

The signs that financial planners are working to improve the advice they give retirees seem clear from a recent speech by Dominic Stevens, of the annuities provider Challenger.

Stevens made extensive use of an article by Joseph Tomlinson, A Utility-based Approach to Evaluating Investment Strategies, published in the US Journal of Financial Planning. I'll be drawing on both sources.

To date, most advice to retirees has focused on "asset allocation" how their investments should be divided between shares and fixed-interest securities and on setting a safe rate at which money can be withdrawn and spent without it running out before the retiree dies.

Tomlinson's objective is to provide advice that is less one-size-fits-all, encompasses more eventualities and incorporates the insights of behavioural economics.

Remember, no one knows what the future holds. Who knows what will happen to the sharemarket or any other financial market? So advice is based on reasonable assumptions and on averages, and advisers seek to estimate expected returns.

The first issue is the "risk-return trade-off". The higher returns some investments offer shares versus fixed-interest, for instance usually reflect a higher degree of risk: risk you won't get your money back, and risk that returns will vary a lot from year to year. It's generally accepted that old people who need to live off their savings cannot afford to run the same degree of risk as young people with many years to recover from sharemarket setbacks.

These days more attention is being paid to "sequencing risk". Say you need to live off your savings for 15 years and it's reasonable to expect there will be two bad years for the sharemarket in that time. Just when those two years occur makes a big difference.

If they come late, it won't be so bad, if they come early you could be almost wiped out. This suggests retirees need to hold more of their savings in fixed-interest than many do.

In any case, most people are "risk averse". Consider this: which would you prefer, the certainty of earning $100, or a 50 per cent chance of earning nothing and a 50 per cent chance of earning $200? If you were "rational" you wouldn't care either way, because both options have the same "expected value".

If you much preferred the certain $100, that makes you risk averse (and normal). If you fancied the chance of walking away with $200, that makes you a "risk-seeker".

At present, the main objective in setting your withdrawal rate is to ensure you don't suffer "plan failure" run out of money before you die. The alternative is to die with money left the "bequest amount".

Conventional economics assumes that, dollar for dollar, your pain at having your money run out before you are ready to die would be equal to your pleasure at knowing you will be leaving a bequest to your rellos. But this seems highly unlikely. As Stevens argues, if a retiree was living on $30,000 a year and that dropped to $20,000, it would have a more profound negative effect than the positive effect of income increasing to $40,000.

The two psychologists who pioneered behavioural economics, Daniel Kahneman and Amos Tversky, call this "loss aversion" (as opposed to risk aversion). They found that most people hate losing $100 about twice as much as they like gaining $100.

Since running out of money before you die is a much bigger deal than losing small sums while you're working, it is likely that retirees' loss aversion is a lot greater than the usual rate of 2:1. Some early surveys suggest it might be as high as 10:1.

If so, this means retirees' desire to avoid running out of money (and having to fall back on the age pension) is a lot stronger than investment advisers' conventional calculations assume. And this, in turn, suggests retirees' choice of investments ought to be a lot more cautious than it often is.

Tomlinson argues that particular retirees' degree of loss aversion ought to be taken directly into account when determining the best investment strategy to meet their needs. When you do so, the bottom line of the calculation is not the average expected return on savings, but the average expected utility from those savings. His refinement takes account of the possible size of plan failure, not just whether or not failure is likely.

It also acknowledges that the size of bequests is likely to suffer from diminishing marginal utility. Each extra dollar gives you less satisfaction than the one before.

Shifting the focus from expected returns to expected utility could make investment advisers' advice a lot more realistic and thus a lot more helpful.