The “Great Deflation,” or “Great Sag” as it was called, was not last week’s game between the Patriots and the Colts; it actually refers to the period of time between 1870 and 1890 when global prices dropped by 2 PSI (pounds per square inch)…er…I mean 2%…annually.
In today’s world, there are many experts working to stave off various forms of deflation (as well as inflation): these include plastic surgeons, referees who maintain an appropriate level of air in NFL footballs, and the Federal Reserve.
In some respects, the equivalent of higher or lower PSI in the financial world is standard deviation, or S.D. Apparently, changes in PSI (and S.D.) can make a big difference in final outcomes. Just as a referee can increase the PSI of a football to the point where it will eventually explode, investors can expand the S.D. of a portfolio to the point where it could also backfire.
Why is this relevant to retirement health care costs?
We need to start with the recognition that these costs are going to be a very significant portion of retirement expenses, so we need to encourage pre-retirees to save for them. In fact, InsuranceNews.net just ran an article highlighting the fact that planning for and controlling these costs is a big opportunity for advisors. http://insurancenewsnet.com/innarticle/2015/01/23/controlling-medical-debt-a-big-opportunity-for-advisors–a-586762.html#.VMZbn2B0xow
For a bit of serious fun, the following is a PSI/quarterback-based “glide path” for a health care savings program for a 50-year-old couple retiring at age 70.
Since they have a twenty-year pre-retirement time horizon, I’d take the Aaron Rogers (quarterback of the Green Bay Packers) approach to early success. He prefers to overinflate his footballs; in investment terms, this would mean an increase in risk, and history is on the couple’s side.
Over the past 20 years, stocks have generated a compounded annual return of around 10.25%; bonds averaged 5% to 6%, and cash came in at 2.8%. Surprisingly, the recent 20-year returns are consistent with average returns by category going back to pre-Great Depression times. Our imaginary couple should then slowly transition to a “Tom Brady” approach and deflate the risk as they get closer to full retirement, making for a controlled stable landing.
This couple will need $365,000 (in today’s dollars) to cover health insurance premiums in retirement, which means they will need to allocate approximately $100,000 in a lump sum, or $9,000 annually, for 20 years. This total is separate from other household necessities. (I firmly believe it is important to maintain separate portfolios for healthcare, required living expenses such as housing food and taxes, and discretionary spending in retirement.)
Why separate portfolios? Living expenses are somewhat variable and the distribution requirements are significantly different from those related to health care. For example, you can decide to live in a less expensive home or drive a less expensive car, which will change distribution requirements. Health care costs have very little (if any) variability, and will likely be growing at 6% to 7% annually. Therefore, segregating saving strategies by component allows you to better manage the outcome, as you will be in a better position to determine the percent of savings available for discretionary expenditures, such as annual trips to Paris. Finally, unlike healthcare and general living expenses, discretionary expenses may actually decrease over time.
Back to our glide path. The equity allocations below are diversified between large, mid, and small cap stocks. Historically, mid and small cap stocks have outperformed the S&P 500, and the fixed income allocation is laddered from short to long-term bonds. Portfolios may be populated with mutual funds, ETFs, annuities, and life insurance products based on investors’ profile. (Note that the three-year PSI of the S&P is 9.10.)
Projected Annual Return: 8.9%
85% Stocks, 10% Bonds, 5% Cash
I would not be opposed to a portfolio consisting of 100% equity at age 50 if the investor can handle the “pressure.” Trust me, the actual securities populating the three slices of the portfolio are probably less important than the asset allocation.
Projected Annual Return: 8.4%
75% Stocks, 20% Bonds, 5% Cash
Projected Annual Return: 7.7%
65% Stocks, 30% Bonds, 5% Cash
Projected Annual Return: 6.8%
40% Stocks, 55% Bonds, 5% Cash
Projected Annual Return: 5.7%
20% Stocks, 75% Bonds, 5% Cash
Notice that equity exposure in the glide path above declines up to the point of retirement—or the distribution—phase of life. Why? Because, as this couple leaves the workforce, they are no longer in a position to make up market-based losses, and may find themselves deflating their savings to pay for health care expenses.
Imagine retiring in 2008 and being vested in 100% stock. You would have lost around 35% of your savings, which would presumably cause drastic changes in your lifestyle choices. To avoid this, it is recommended to slowly reduce equities as you get closer to retirement.
Here’s the bottom line: Brady modifies the PSI of his game balls (within the rules) based on a number of factors, including weather conditions. Similarly, as displayed above, you should modify your portfolio’s PSI as your pre-retirement timeframe changes so that you can deflate your risk when it comes time to pay for healthcare expenses.
Enjoy the Super Bowl.