What Are the Odds Telling You?

How much is enough?

A big concern when starting retirement is knowing if the income goals are sustainable. This question largely depends on two factors: longevity and the amount of money available for retirement.

Assuming your planning horizon is long enough, say age 95, market returns are then the deciding factor that will determine your odds.

This is because over time the amount of money saved for retirement becomes a smaller piece of lifetime assets. As your assets grow, the amount of investment income becomes greater than the capital invested (your contributions each year toward the retirement nest egg).

Most of the investment returns depend on how capital markets perform, much less from investment manager outperformance. In other words, investment returns are mostly explained by the allocation of funds between the main asset classes.

A lot of sophisticated modelling (including our own) can help determine whether the income goals are affordable and sustainable.

Here are a few thoughts related to modelling in general.

Should we save as much as we can for retirement?

Capital markets are volatile. This means that the range of potential outcomes from any model of future investment returns will be wide.

Any realistic model is going to produce a number of disaster scenarios.  When combining a large range of possible outcomes with a reduced ability to generate more capital during retirement, we can often end up with uncomfortably high odds of running out of money early.

Planning for more savings or a lower lifestyle are foolproof ways to improve our odds.

How can I spend my last dollar on the day I die?

The range of outcomes not only include disastrous possibilities. On the flip side, there is a chance that you will reap spectacular returns over the long run.

If you experience this as you get older, you can revisit income goals and apply windfalls to improve your lifestyle going forward.

It's better to be conservative at first and increase spending later if the money is on the table than the other way around. This way you take advantage of a windfall if it occurs, and keep spending conservatively if it doesn't.

Why not take risk away and invest in GICs?

You can remove the unpredictability of returns by getting guaranteed investments returns. For example, if you invest in GICs, you will know what you can earn and your range of outcomes will be much narrower.

But your retirement plan may no longer be affordable. The magic of investing part of your assets in equities is that the portion of lifetime assets coming from investment returns greatly exceed the capital invested for retirement.

Why trust a model when the future is unpredictable?

A model shows us what might happen. We cannot predict future investment returns, but we know that annual returns will form a pattern of good and bad years.

Outcomes from a model depend on assumptions, in particular those for expected returns and volatility. Volatility is the amount of variability that can occur for each asset class and is used to reproduce the unpredictable swings in equity returns.

With these ingredients, the model will produce a  range of potential outcomes. The range can be frustratingly large, but its value lies in providing insights into the sustainability of the retirement plan.

A model will determine the odds of success and failure.

But for the model to be even more useful, we can monitor results regularly as they unfold by re-evaluating our financial position and recalculating the odds.

Monitoring the trend will give you peace of mind, so update your plan every quarter or six months and make sure the odds remain on your side.

By: RetireWare / Equisoft On 9:10 PM

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What are the Risks of Leveraged Investing?

An age old strategy

Borrowing to invest has been around for a long time. The hope is to leverage profits and the risk is leveraging losses.

Taking out a loan to invest means investing other people's money, typically the bank's money. Being risk averse, the bank will want you to dig in your home equity by taking a secured line of credit.

Many view the spread between the cost of borrowing and expected returns from fixed income investments as too small or non-existent to make this worthwhile. So this is mostly done to invest in equities.

If the money is invested in a non-registered account, loan interest is deductible. Investing in stocks or equity mutual funds are also taxed favourably: dividends have lower income tax rates, and units or shares are taxed only at time of disposition at the capital gains tax rate.

If this strategy applies to a registered retirement savings plan (RRSP), the interest on an RSP loan is not tax-deductible, but there will be tax deductions from the contributions.

Over the long term, markets have historically outperformed rising inflation and interest rates. If you have good cash flow to make regular interest and principal payments, this strategy can work: investment returns over the long-term can be significantly higher than loan interest.

Risk capacity and risk appetite

In addition to having the risk capacity to absorb a negative outcome, an investor needs a risk appetite: understanding that there is a possibility to end up poorer if market returns or specific investments earn less than the interest paid on the loan.

One also needs the stamina to stay the course when - not if - there is a market meltdown, as it invariably occurs every few years.

This has to be a long-term strategy, preferably over a period of 10 or 20 years. It is not appropriate if you are close to retirement. This is because you need to manage your market risk and sequence of returns risk, and one approach to tackle both risks is to gradually reduce exposure to equities.

Proceed with caution

Often these loans are made to "kickstart" an investment portfolio. Someone without any portfolio usually lacks investment knowledge, and is more prone to sell quickly if the investment performs poorly, instead of riding market fluctuations.

Getting a loan means renegotiating a home mortgage and converting it into a line of credit that can be used to invest, making the interest on borrowed money tax-deductible. Penalties to break the mortgage should be considered when comparing the potential return to the total cost of borrowing.

If the loan is large, it makes it difficult to repay over the short-term. So future income has to be predictable in order to make it fairly certain that regular loan payments can fit in the budget on an ongoing basis.

It also has to be possible to unwind the strategy without incurring a cavalcade of fees and penalties both on the investing and debt sides.

Magnified gains and losses

Suppose you have $100,000 and you invest it. After two years, the value of your investment declines to $80,000. You sell your units or shares for an investment loss of $20,000 and are left with $80,000.
Now suppose that in addition to this investment, you borrow another $100,000 to invest. Your initial investment is $200,000. You sell your investment after two years and receive $160,000. You repay the loan plus the interest of say, $110,000. You are now left with $50,000.

If everything went well and the investment went up 20%, you would have doubled your gain: $40,000 with leverage compared to $20,000 without.

The downside is larger than the upside because of the interest on the leveraged loan.

Cost of investing

This applies also without leveraging, but you should understand all costs, fees, penalties and commissions of the products you are purchasing. Costs you pay will reduce your investment return. Often investors are not aware or don't understand sales charge when purchasing mutual or segregated funds, including penalties at time of disposition.

When to avoid

If you are uncomfortable or have difficulty managing debt, have a history of poor financial discipline or lack a steady flow of income this strategy is probably not suitable.

Investment loans are not a good solution for emotional or impulsive investors. Avoid any Investment that can give rise to a margin call. It can and usually does occur at the worst possible time and can result in a disastrous outcome.

Also avoid if your future circumstances are hard to predict. If cash flow is prone to change significantly or a large unforeseen expense is possible in the future, being unable to unwind the investment and loan quickly will make this even more challenging.

With the interest not deductible on a RSP loan, a longer term for the loan means that the interest paid may largely offset the value of the tax deduction received from the RRSP contribution.

Shrewd advice

The Ontario Securities Commission has great information on leveraged investing. They recommend investing for the long-term because the risk of leverage declines as the time horizon grows. As well, they suggest paying interest and principal on the loan, not interest only, so the smaller amount owing at time of settlement reduces the chance of loss. Finally, they emphasize the importance of adopting a disciplined investment strategy, avoiding fads and ignoring short-term market fluctuations.

• Important information about the risks of leveraged investing and costs of investing
• Borrowing to invest
• Should I borrow money to buy investments?

By: RetireWare / Equisoft On 3:35 PM

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RetireWare Not Affected by "Heartbleed" Vulnerability

There has been extensive media coverage recently on the vulnerability dubbed “Heartbleed”, which is a security concern for secure communications using OpenSSL, a widely-used open source cryptographic software library.


It can allow attackers to read the memory of the systems using vulnerable versions of OpenSSL library.


The RetireWare Website and applications run on Microsoft Web servers, which use their own encryption libraries for secure communications, not the OpenSSL library.


Accordingly, secure communications on the RetireWare Website are not at risk for the "Heartbleed" vulnerability.


For more information, please contact RetireWare Product Support.

By: RetireWare / Equisoft On 4:52 PM

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Making Decisions when Facing Uncertainty

A way to think about risk

Using an example, I'd like to show how risk theory can help us manage our uncertain future. Risk theory is a branch of mathematics that provides a framework for making decisions with uncertain outcomes.

When it comes to retirement, we are facing the unknown: we don't know how long we'll live and what will be  the rates of investment returns earned on funds used for retirement income. Also, expenses are unknown because of future inflation and the possibility of health-related and other expenses such as long-term care down the road.

Knowing the range of possible outcomes is our starting point to manage uncertainty.

Framework

The starting point of risk theory is the set of possible uncertain environments. Decisions we make influence the results we get in the environment that prevails.

Decisions + Environment = Results

For each decision there is a probability distribution. Making the best decision means choosing the "best" distribution of results among those available.

Example

Suppose I am retiring with a nest egg of $1 Million.

Decision

I am considering two withdrawal options:

• Spending $50,000 per year  (5% of my initial capital), or
• Spending $70,000 per year  (7% of my initial capital).

In both cases, my annual withdrawal will increase each year by the rate of inflation, so my purchasing power is preserved.

Environment

My environment is an uncertain future with unknown longevity, rates of investment returns and inflation. I will run out of money if the returns are too low, the inflation too high, or if I live too long.

This may happen whether I decide to spend 5% or 7%, but it is more likely if I decide to spend the higher amount of 7% annually.

Results

Let's define a simple range of possible results that can occur for my retirement:

Awful	I ran out of money and spent several years penniless
Bad	I ran out of money at the end of my life while curbing my spending throughout retirement
Good	I didn't run out of money but had to curb my spending
Excellent	I didn't run out of money and enjoyed a good standard of living

We can calculate odds for each decision that we make. Let's go with the probabilities below for our example. They're in line with these types of calculations and will be sufficient for our purposes.

Probabilities for 5% spending decision

Awful	Bad	Good	Excellent
0%	30%	70%	0%

Probabilities for 7% spending decision

Awful	Bad	Good	Excellent
70%	0%	0%	30%

So for the 5% spending decision, I have a 70% chance of a "good" result and a 30% chance of a "bad" result. With 7%, results are more extreme: the higher spending rate decision will be "excellent" if I live just the right number of years and earn decent returns under moderate inflation. But if things go wrong, I will be poor and destitute and it will be truly "awful".

Utility

My optimal decision means that I must choose the probability distribution that has the best overall outcome for me.

A common approach consists in assigning an "utility" to each result, and calculating the expected utility of each decision. I then choose the  decision that has greatest expected utility.

I will assign a rating from 0 to 10 to the utility of each possible result. The rating is arbitrary but one with which we are familiar.

Value	Utility
Awful	0
Bad	3
Good	6
Excellent	10

And the winner is...

Now we have all the ingredients to calculate the "expected utility" of each decision.

Decision	Calculation	Utility
Spend 5%	0% * 0 + 30% * 3 + 70% * 6 + 0% * 10	5.1
Spend 7%	70% * 0 + 0% * 3 + 0% * 6 + 30% * 10	3.0

Not surprisingly, the 5% middle of the road approach is more sensible. The odds of "excellent" are too low to add a significant utility to this decision.

This is sensitive to the rating and the odds we assign to each result. You can see that I'll need a 50% chance of success with the 7% spending decision to match the utility of the lower spending decision. But even at 50% it is still a big gamble.

What if

What if I have lifetime income, say public pensions and an annuity that are sufficient to cover my essential expenses? Now my nest egg is only for discretionary expenses such as travel, leisure and bequest.

My results will be different: if I run out, it's not so "awful", it's just bad! My life will just have less leisure but I won't be destitute.

7% spending decision

Awful	Bad	Good	Excellent
0%	70%	0%	30%

And here's my new utility with the 7% spending decision:

0% * 0 +70% * 3 + 0% * 6 + 30% * 10 = 5.1

Now both spending decisions are just as good.

Theory and practice

This framework is a way to apply some logic to help us take decisions. It can help with any type of situation.

With retirement, we cannot know how the future will unfold, and in spite of the uncertainty we need to make decisions that involve risk. Results of our decisions are influenced not only by our decisions, but also by the range of outcomes.

By keeping our options open and monitoring our progress, we can take corrective action mid-course to mitigate the damage if our decisions turned out to be not "bad" but "awful".

By: RetireWare / Equisoft On 10:08 AM

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Monte Carlo Details

Question:

How are the economic scenarios used in the Monte Carlo simulations generated? Are they generated within the software, or does the software contain a set of hundreds of scenarios that are used when necessary?

I am trying to understand the stochastic projection component of this software better.

Any more information on this aspect of the software would be appreciated. Thanks.

Answer:

The random scenarios are generated assuming rates of returns of each asset class follow a lognormal distribution. Expected returns and standard deviations are based on historical information adjusted for current trends.

Random numbers are generated using Microsoft's random number generator. Each time the program runs a set of simulations the returns are generated based on the random number generator.

There is a blog post about Monte Carlo simulation:

http://retireware.blogspot.ca/2012/05/monte-carlo-simulation-is-mathematical.html

You will also find some information in the RetireWare help files:

https://secure.retireware.com/web/mc_help.aspx?language=en-CA&node=108&id=res_MChelp2.htm

On a related matter, this is a blog post about risk analysis and our approach:

http://retireware.blogspot.ca/2013/12/quantifying-risk.html

By: RetireWare / Equisoft On 10:42 AM

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Special Expenses

Question:

I have been using RetireWare to elaborate several files to plan our retirement. I have been trying to include the sale of our actual house in two years, for example, and buy a new one at a higher price in the same year.

I cannot find any place in any of the topics where such a financial exercise is possible. Il could also be the sale of a house and the purchase of a sailboat or a motor home or whatever and its sale several years later.

Maybe another way to look at it would be to add a section where we can simulate an important withdrawal from a particular sources of cash. There is already a section where you can indicate a source of additional assets.

Answer:

Please note that in the Forecast page you can enter special periodic expenses on the Retirement Income Target tab. If it is a one-time expense, enter "0" as the frequency. Frequency of 1 means annual, 2 every two years and so on.

These can be used for one-off items purchased as part of your retirement budget.

Also, in 'Budget Information', you can set up a short-term or medium-term non-retirement savings plan for acquiring a new asset or purchasing some expensive goods such as a boat.

If you want to model the purchase of a more expensive home, keep the current residence and add the difference as an 'Other Property' on Financial Information page. For example, if your house is worth $500,000 and the next house is $600,000, enter $100,000 as 'Other Property' (and the extra mortgage if any).

By: RetireWare / Equisoft On 10:41 AM

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Pre-retirement Budget

Question:

When doing a pre-retirement budget for a couple I enter the budget under one of the individuals and it still shows a budget for the other spouse. Why?

Answer:

For pre-retirement, each spouse has their own budget relative to income. In your case, you put the budget under one spouse and have not completed a budget for the other spouse.

In cases where there is no budget, the program assumes a default budget equal to after-tax income less savings. So for pre-retirement, it's best to complete a budget for each spouse commensurate with their income, or complete no budget for either spouse.

By: RetireWare / Equisoft On 10:40 AM

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