Post Date: Wednesday, January 22, 2020
|Few would argue that gambling is a sure-fire way to prepare for retirement (although I have a family member who, after a few “wins” with the state lottery, called his gambling habit “investing”—he’s lost enough since then to stop, however). Yet, clients with a laser focus on Return on Investment, or ROI, tend toward riskier investments, especially when approaching or in retirement. Such a singular focus on investment returns alone can increase risk to high-levels, sometimes approaching gambling!
I’d like to change the discussion from “Return on Investment” to “Retiring on Investments”—a new ROI that focuses on more than just return percentages. Replacing it with goals-based investing which helps ensure one doesn’t outlive savings.
The Casino Model
One way to explain the difference between the two ROIs is The Casino Model. I like to ask potential clients two questions:
1. In a casino operation there are two “investors”—the house and the gambler. Who is guaranteed to win over the long term?
I always get the correct answer: the HOUSE. The second question is a bit tougher:
2. Why does the house win long term?
Most folks have never thought about the second question, but the answer is simple: the casino wins long term because they’ve done the math. Casino owners know the odds of every game in the place and the odds are built to be in their favor. All that is needed to win long term is for their marketing efforts to fill the space at every table and gaming machine, then balance out the costs of operations with the income gained. Casinos reduce their risk by knowing their odds and managing operations.
It is not a perfect analogy, but it does bear some similarity to how we invest during our two main stages of life.
BR—Before Retirement—is the time most of us spend creating wealth. Risk can be higher in this stage of life. Return on Investment is a good and effective measure here. Normally this is done in a job or as a business owner. BR is very similar to the “investors” in the casino model mentioned above. Higher risk usually brings more reward. Losses from losing a job or business can be worked out over time. Plus, the higher rewards from winning compound over time so one can pay down debt or reinvest in another business.
Many are tempted to think that their job or business isn’t risky. However, since 100% of work income is directly proportional to one’s effort, work income losses are dramatically impacted by illness, accident or downsizing. That’s risk!
AR—After Retirement—is the time when we preserve the wealth created during the BR stage. AR is characterized by the need for higher security and lower risk. In the AR stage most of us want to pursue other activities (travel, family time, hobbies) that don’t create an income stream. So, we need to live off of the wealth created from BR. Sometimes, we don’t get a choice to transition from BR—health or job challenges force AR on us. However, in every case our money focus changes when transitioning from BR to AR.
Different Goals for Different Stages
Financial goals are crucial during both life stages, but goals change in the transition. During BR, Return on Investment is a primary focus for successful wealth creation. In a job we trade time for wages. As we gain experience our ROI rises because we return higher value due to greater experience and education.
A July 2018 article by McLeod Brown and Chris Kolmar on Zippia.com reported that the lifetime average income varies from $1.2 million for the lowest “dead-end” job to over $4 million for a career in law. Pretty impressive ROI for either path in life. Entrepreneurs trade time and risk for revenue. Return on Investment is calculated using the cost of capital and the return received for the business value added. In a business, this ROI is directly related to marketplace value.
Regardless of working as an employee or employer, the financial goal in this stage of life is accumulation as income exceeds expenses.
In AR, goals change to attrition since we begin spending the nest egg built in the first stage. Risk must be lowered and to ensure that expenses don’t outrun the wealth created in BR. Return on Investment takes a back seat to Retiring on Investments. Still ROI, but a completely different focus.
Many clients stay fixated on the former ROI after retirement (because, well, that’s all they’ve known). While Return on Investment is important, keeping it as the primary focus creates stress and takes time away from retirement priorities. ROI-only focused AR clients can constantly worry about news that might impact investments, tend to be overly critical of financial performance or constantly on the lookout for the next great investment. Quality of life can suffer exactly when it should be getting better.
Instead, Bright Wealth Management uses a goals-based approach to identify priorities during the attrition phase of AR. Return on Investment is used to lower risk and keep account levels high enough so that clients have a solid financial future in retirement.
During BR, more risk can be acceptable because time is on our side. We’re also aggressively creating more wealth so that income exceeds expenses and builds the surplus needed for AR. There is a focus on investing and saving, but more risk is acceptable because we can earn our way out of any negative financial impacts. Returns are important for BR investments because higher returns generate more savings over the longer investment period, even in times when markets fall.
This was illustrated when Leslie, age 26, inherited an IRA from her grandmother. We moved the investments from 100% bonds and dividend producing equities in the original portfolio (appropriate for one in AR) into a much higher percentage of growth-oriented equities (since Leslie is in BR). While volatility is higher, Leslie can tolerate the larger valuation swings while she is earning income. As Franklin Parker, Chartered Financial Analyst® and Bright Wealth Management Chief Investment Officer explains, “If I’m two to four decades away from retirement, I can afford a 2008 in my portfolio, but if I’m retired and living on my savings, I probably can’t.”
Financial Planning is Key
Unfortunately, many people in retirement are just one financial emergency away from disaster. To avoid this, a financial advisor can help position clients to be the house, rather than the gambler. Successful investing during retirement requires the following:
1. Diversification. The combination of investment sources and types (e.g. pensions, equities, bonds, insurance, etc.) in appropriate amounts.
2. Downside Consciousness. Understanding how market drawdowns affect your plan.
3. Liquidity. Both planned expenses (average monthly costs and long term expenses such as travel or big purchases like vehicles) and unplanned expenses (usually health-related or family needs) will require access to your cash. Having money tied up in an illiquid investment is functionally the same as not having the money.
4. Communication. Regular contact with your advisors to monitor and adapt the plan as life progresses.
A solid financial plan will need continuous updates as one ages in retirement. Minimally, meet with a professional financial advisor annually. In addition, there should be absolutely no resistance to more frequent meetings and discussions when pressing financial issues occur throughout the year.
While returns are an easy measure to focus on, it is a measure that can lead to poor financial decision-making in retirement when viewed by itself. Instead, work with your financial advisor to develop long term life goals, like travel, family, healthcare, etc. Once these goals are in place then returns can be adjusted to minimize risk and help ensure a long and fully-funded retirement. ■