Being certain of anything isn’t easy. But the quest for certainty has a gigantic upside, if we can just open our eyes to it. One of those upsides is a better retirement income than expected.
I learned this from Dr. Marlena I. Lee. Dr. Lee is one of the Ph.D.s that occupy the gleaming office presence of Dimensional Fund Advisors along the Capital of Texas Highway to the west of Austin. Her research shows we don’t need to replace as much of our income when we retire as conventional wisdom dictates. She also showed that many people are saving close to the necessary amount, not pathetically below it.
Now, a close examination of trying to achieve certainty shows that many people, perhaps most, will do much better than they expect when they retire.
Here’s why: Dr. Lee built her model for retirement after calculating that most working Americans — the large majority of folks who earn less than $100,000 a year — need to save enough to replace about 40 percent of their earning power at retirement. The remaining income would be provided by Social Security. Also, some income wouldn’t need to be replaced, such as funds devoted to pre-retirement savings, paying off debts that won’t be around forever and income taxes that will be lower in retirement. But she also wanted to be nearly dead certain that investment results would get the job done.
So she honed her statistics to provide a 95 percent certainty that the goal would be achieved.
Therein lies the wondrous upside!
If there is only a 5 percent chance that you will fail to reach your goal, it’s also a lead pipe cinch that you have a 95 percent chance of meeting the goal, or better. Perhaps even wildly better.
How much better can it be? Well, that’s like life, a matter of chance. But if there is a normal distribution of outcomes, 95 percent will do better than the minimum goal. More important, those in the top 50 percent (above the median result) are likely to retire with higher purchasing power than they had while working. Indeed, a model that is for illustration purposes only indicates that the median worker would retire at 130 percent of pre-retirement income.
I call that a very positive upside, one with enormous implications not explored in the DFA research. Here are a few:
• If you save enough for a 95 percent chance of replacing 40 percent of your earning power, you may be able to retire earlier due to above-minimum results.
• If you save enough for a 95 percent chance of replacing 40 percent of your earning power, you may be able to save less as you approach your goal.
• If you save enough for a 95 percent chance of replacing 40 percent of your earning power, you will be better prepared to cope with life’s more unpleasant surprises — such as a period of unemployment, major illness or divorce.
All of this can happen for a simple reason: the pursuit of certainty bottles up and hides the 95 percent of outcomes that will be better. Equally important, the upside isn’t a fortuitous event. It is a certainty.
And while the DFA research is focused on the task of accumulating retirement assets while working, the same positive upside can occur when we do our investment planning for living in retirement. Most financial planners focus on a goal most of us share: We want to be pretty certain that we won’t run out of money during our retirement.
As a consequence, a 65-year-old couple is likely to seek certainty that they will not outlive their money for a period of 30 years, which is five years more than their joint life expectancy. So while they are seeking a 95 percent probability of not running out of money, the reality is there is an 84 percent chance that both of them will be dead well before they have a 5 percent chance of spending all their money.
If we invest (and spend) in a way that gives us only a 5 percent chance of failure and a 95 percent chance of not running out of money, we’ve virtually guaranteed a 95 percent chance that we will die with more money than we ever intended, simply because we’ll die with some amount of money 95 percent of the time.
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