One of the hardest elements in risk management strategy was outlined in our blog post on Robert C. Merton’s endowment strategy for universities. Merton explained how “non-endowment assets” like alumni contributions and faculty salary expenses have to be taken into account in order to arrive at the optimal allocation of endowment assets. In the same way, risk management for individuals has to take into account the values and cash flows associated with what bankers would call “off balance sheet assets and liabilities”:
Your return on human capital, your ability to earn a living
- Medical expenses
- Educational expenses
- Housing-related expenses
- Other “quality of life” expenses
The other complications come from life changing events like
O-man’s story above illustrates how complex these issues are and how a common thread that affects all of the expense categories and some of the probabilities: inflation.
As O-man very correctly observes, the inflation in housing expenses has only a very loose correlation with the changes in the consumer price index, medical expenses, educational expenses, and so on. For purposes of this note, let’s simplify and assume that changes in these costs are 100% correlated. We can relax the assumptions later. Turning back the clock, and traveling back in time, how can we rescue O-man’s grandparents from a sad retirement? Let’s assume that we had a crystal ball and a perfectly accurate forecast of the longevity of both grandparents. O-man’s grandmother lived 31 years to age 93, and O-man’s grandfather lived 10 years to age 75. Let’s further assume that the U.S. Treasury’s inflation protection TIPS bonds existed at the time. How can we help O-man’s grandparents if they had $Z in liquid assets after selling their house?
As we described in Risk Management Strategies for Individual Investors, Part 2, the first step in the analysis is to work backwards from 1996, laying out the cash needs for the ideal life style for the couple. We figure out how many TIPS need to be purchased in 1965 to provide for O-man’s grandmother in 1996. We note that the “1996 TIPS” will also provide income in each year from 1966 to 1995 also. Taking that into account, we then calculate how much in tips we need to provide for Grandmother O in 1995, 1994 and so on back to 1975. We then add in investments we need for 1974, 1973, etc. to 1966 for both Grandfather and Grandmother O. How much money do we need to follow this riskless, conservative strategy? If it’s less than Z dollars, then Grandfather and Grandmother O can make the investment and life a happy life without worrying. If it’s more than Z dollars, then the couple either needs to trim their planned expenses or to continuing working for longer than they had hoped.
Now let’s add some real world complications. What if you are not sure how long Grandmother O will live, and there is a significant chance that she will live to 103? That’s where annuities come into play. It can be impossible to self insure, to be positive that you have enough financial assets to be comfortable at 103. By buying an annuity and taking advantage of the age-related diversification that insurance companies can provide, this “age insurance” can become more economical. What if there is a chance of illness with an unexpected cost of $100,000? Again, medical insurance provides diversification but it comes at a price—roughly 10% of medical insurance premiums go to the overhead to maintain the insurance system. If you had 1 million lifetimes to enjoy, you would save this 10% excess by self-insuring. Cats have 9 lives, but 1 million is too much for any of us to hope for.
Finally, let’s assume that after doing all the right things, the cost to Grandfather and Grandmother O is exactly Z dollars. Should they divert their investments from TIPS in the hopes that they’ll get a huge windfall in the stock market that would allow them to live out their retirement in a more luxurious way?
This is the ultimate risk management dilemma, and it’s very personal—how do you trade off the chance of a better life versus the increased odds that things go wrong and you end up living a very hard life in what should be your golden years? It’s our view that younger investors underestimate the downside of a risky investment strategy and end up with too much of their savings in real estate and common stock as an “inflation hedge,” even though their salary is roughly inflation adjusted also.
Please let us know at firstname.lastname@example.org if we can be of help on these issues.
O-man, thanks so much for telling your sad story. I am sure it will help many people to plan better for their future.
Donald R. van Deventer
Honolulu, May 21, 2009