Room for Error and Retirement
Do you have wiggle room in your retirement? Seriously, how much “room for error” do you have in retirement?
While retirement planning is as much art as science, we all need some wiggle room!
Let’s look at what wiggle room means to you and your retirement plan. Should you plan on having some room for error?
Wiggle Room in your Retirement Plan
I came across the idea of room for error when reading Morgan Housel’s book The Psychology of Money (affiliate link). While Morgan is an accumulation focused guy, it struck me that room for error is even more important in retirement than it is during accumulation. After all, usually you don’t get to un-do the retirement decision—you’d better make sure you get it right the first time!
If you have to get a decision correct the first time, you’d best build in some latitude—some room for error or wiggle room in your retirement!
Let’s see how Morgan first introduced Room for Error:
Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right. Room for error—often called margin of safety—is one of the most underappreciated forces in finance. It comes in many forms: A frugal budget, flexible thinking and a loose timeline—anything that lets you live happily with a range of outcomes.
The Psychology of Money Morgan Housel (emphasis mine)
Anything That Lets You Live Happily with a Range of Outcomes
Let’s define wiggle room. Is it “anything that legs you live with a range of outcomes?”
While that definition is great for accumulation, it is the less accurate in retirement!
Sure, having the ability to be flexible in your thinking can be important in retirement. But defining room for error as the ability to decrease spending is not ideal. Nor can you have such a loose timeline in retirement. Sure, you can gradually cut back on work, but at some point you pull the plug on “work income” and start living off your nest egg.
Living in Retirement with “a range of outcomes” is not a safe bet. The risks in retirement are just different than those you face during accumulation. While you should not plan on being “exactly right” when facing known retirement risks, you do need to address them.
What are the risks in retirement for which we need wiggle room?
Retirement Risks and Wiggle Room
What are the risks in retirement for which you might consider building in some wiggle room?
Sequence of Returns Risk
One of the ways you can mitigate sequence of returns risk is via flexible spending. The real wiggle room from sequence risk, however, is to oversave for retirement. A lot of problems can be fixed by oversaving! If you don’t oversave, then having 3-5 years of “safe money” when you retire and delaying social security are likely the best solutions. (Again, be careful with financial advice as it needs to fit both your risk level and your fundedness).
What does wiggle room mean in terms of cognitive decline? We will all become more mentally frail as well age, to a greater or lesser extent. Having family conversations and good estate planning (especially for disability needs) is key to allowing you to meet your slow-go retirement goals and to age in place. Wiggle room in this setting assumes that, yes, you, YOU will have cognitive decline in retirement. Plan on it.
Inflation is a sleeping dragon and, perhaps, the most difficult risk for which to build room for error. Aside from just oversaving and investing in equities, there are TIPs which may help with unexpected (but not expected) inflation. Inflation is to be expected over a long retirement, however, and planned for. Certainly, social security (with its cost-of-living adjustments) must be optimized, but there are few other inflation-adjusted products out there in the world. Inflation can become catastrophic if you have longevity.
Longevity is the central theme for wiggle room planning. After all, every other risk is multiplied by longevity. While there are products intended as Longevity Insurance, the best idea, again, is to oversave.
Long-term care insurance is a tricky subject.
Of all the places where there needs to be room for error, believe it or not, taxes are the least important. You should not plan on wiggle room for taxes! Let’s talk about it separately.
Taxes and Wiggle Room
You don’t need to build in wiggle room for taxes. Yes, there is legislative risk that taxes might go up in the future, and almost certainly they will, but how much do you think taxes will go up?
Don’t get me wrong: you need to plan for taxes, but that is the whole point of the Tax Planning Window!
As taxes are not infrequently a retiree’s largest expense, you don’t build in wiggle room for taxes, you just assume the worst!
How bad can it get? Let’s look at this graph of past effective tax rates.
Above, you can see the top federal marginal tax bracket in Blue. See how it changes over time?
But more importantly, look at the average effective tax rates for the top 1% (green) and for all earners (yellow). Despite massive changes in the top marginal tax rate, the effective tax rate (how much you actually pay in taxes per year) is relatively stable. Make sure you understand the difference between marginal and effective tax rates.
If you are a top 1%er, just assume you will pay 30-40% effective taxes and move on. You don’t need to build wiggle room into your tax projection.
Wiggle Room vs Being Conservative.
Let’s get back to Morgan and his writing. His quote goes on:
It’s different from being conservative. Conservative is avoiding a certain level of risk. Margin of safety is raising the odds of success at a given level of risk by increasing your chances of survival. Its magic is that the higher your margin of safety the smaller your edge needs to be to have a favorable outcome.
The Psychology of Money Morgan Housel
So, in retirement, room for error is not avoiding a certain level of risk. It is increasing the odds of success at a given level of risk. How can you increase your odds of success? By thinking probabilistically in a deterministic world.
Probabilistic Thinking in a Deterministic World
We are actually quite good at this in medicine.
We understand that not everyone we treat will have benefit. For example, say that though it is only a 20% chance that your breast cancer is metastatic, you will get chemotherapy. By definition, 80% of folks will have no benefit from this treatment (and only side effects), but if you are one of the 20% that might have metastatic disease, you just may have your life saved.
A priori, it is “known” if you will have metastatic disease in the future (maybe only be the cancer cells themselves), but currently we human doctors only have a probability estimate. There is a chance you might be affected, so you get treated as if you are.
So, too, with wiggle room and retirement. It is “known” now what will happen in the future (see my bit on Chaos Theory and Investing) but you personally just cannot know it. So you have to plan for the known risks, and the known unknown risks, but you cannot plan for the unknown unknown risks.
You just have to assume there are unknown unknown risks and plan for them by building in wiggle room to your retirement plan. Plan for your plan to fail!
It will probably happen. If it doesn’t, then you overplanned, but either way you will be just fine.
Planning on your Plan not Going According to Plan
Morgan says you stay rich by being guided by a “some combination of frugality and paranoia.” His book is not about financial knowledge, it is about behavior.
To get rich: “save like a pessimist and invest like an optimist.” He suggests you have enough pessimism in order to be able to be optimistic about the future. Have room for error in the short run, because you need to plan on your plan not going according to plan.
To stay rich, you need to have both short-term pessimism and long-term optimism as well. Unknown risk will be there in the long haul, but if you plan on being flexible through the short term, then you live another day to fight. Remember, never interrupt compounding growth. You do that by having the ability to stay invested.
“Worship room for error. A gap between what could happen in the future and what you need to happen in the future in order to do well is what gives you endurance, and endurance is what makes compounding magic over time.”
Summary: Wiggle Room in Retirement
There you have it. While you need to understand your glidepath in retirement and understand when it is time to go conservative to prevent sequence of returns risk, Morgan says that you don’t need to be conservative (as in avoid a certain amount of risk), rather you need to live to fight another day by controlling your downside for a certain level or risk.
“The wisdom in having room for error is acknowledging that uncertainty, randomness, and chance—’unknowns’—are an ever-present part of life. The only way to deal with them is by increasing the gap between what you think will happen and what can happen while still leaving you capable of fighting another day.”
He suggests that you need to be ok not knowing what the future will be like, and to stop listening to folks who claim they know for sure how things will turn out.
Next, avoid ruin which not infrequently means to be careful with leverage. Don’t get caught in a (even very unlikely) scenario where if it goes south, you will be ruined.
His solution in retirement is to use lower future return expectations. He suggests 1/3rd lower.
I suggest you oversave. Same difference, just different time perspective!
Finally: “few financial plans that only prepared for the known risks have enough margin of safety to survive the real world.” Build in wiggle room in your retirement plan by having some room for error.