Thursday, April 12, 2012

Mike Zwecher: They Each Get Only One Whack at the Cat

The following is a special guest post by Michael Zwecher, Ph.D. He is the author of the highly worthwhile book, Retirement Portfolios: Theory, Construction and Management (Wiley Finance). This book explains the process for seemlessly shifting from the accumulation to the retirement phases and constructing a retirement portfolio that first provides an income floor and then seeks upside potential. In a lot of ways, the following essay provides a succinct summary of his book. This essay is something I plan to cite in my own writings, so I am glad to help bring it to public attention. Michael is also a co-author with Francois Gadenne of the curriculum book for the Retirement Management Analyst (SM) designation.

They Each Get Only One Whack at the Cat

by Michael Zwecher

I’ve only heard this expression used in the Midwest, Wisconsin to be precise, but I love it for its shock value and for the simple way that it conveys a truth: Each client gets only one chance at retirement, and they want to preserve a lifestyle.  Statements about portfolios that contain phrases like ‘on average’ or ‘expected returns’ or ‘expectations’ or any such terms should trigger a wary posture if they omit hard stops on losses. If I were going to be able to play a game repeatedly I’d be happy to know that the odds were on my side and if I lost a round I could come back. But if I only get one turn, one whack at the cat, then I want to make sure that losing doesn’t break me, no matter how favorable the odds. To put it another way, even a single round of Russian roulette is not for me, no matter what the payoff.

Most of modern portfolio theory contents itself with discussions of risk and return.  But clients don’t usually build portfolios just for show. Most have their portfolios as a means for preserving their lifestyle in later life. Preserving that lifestyle means preventing outcomes that reduce the portfolio below the lifestyle-preserving level.

In the realm of Practice, retirement portfolio strategies usually fall into one of two basic types, 1) those that work probabilistically, either based on historical returns or based on projections of future returns under some probability distribution, and 2) those that work with probability one, by construction. It’s important to recognize that just because something works in the typical case or has always worked in the past, it will do your client no good if they are in the unlucky tail of the distribution. With risky prospects, the word risk is there for a reason.

It’s easy to take this one step too far and think that this means that one must be prepared for a doomsday scenario, but it’s not that dire. Treasury strips, insurance annuities, municipal fund yields are all things that may not be riskless in the absolute sense, but relatively speaking, the risks are low; for an American holding Treasury strips the risks are vanishingly small.

For retirement when we say build a floor and expose the client to upside, we mean that for each period of retirement, the client should be able to count on a known minimum level of income, coupled with the potential that spending power will likely be above that level, but not below. For someone familiar with the graphical representation of a call-option’s payoff, it means that at each period you’re creating a call-like profile for the client.

Without the floor, clients are exposed to more two-sided risk. One can dampen the volatility of 2-sided risk with a greater reliance on, say, bond funds, but that tends to lower the probability of missing by a wide margin. Put another way, the odds of drowning don’t much change, what changes is how far underwater the client is when they run out of oxygen/money.

At the Retirement Income Industry Association, RIIA, there is a cottage industry in exploring all of the myriad ways of creating portfolios that have both floors and exposure to upside. The important thing to remember is that for retirement it’s not just about risk and return, it’s about risk, return and maintaining a minimum lifestyle. You have many clients, but each of your clients gets only one whack at the cat.


  1. That's a good summary by Mike Zwecher. I like the "one whack at the cat" analogy. It reminds me that, in Daniel Kahneman's recently published book, he makes the point somehwere that decisions he demonstrates be be irrational in a "many whacks at the cat" environment, are not necessarily irrational when there is "one whack at the cat." Also, one can apply this same analogy in terms of pooling of risk by purchasing annuities or various types of insurance--in effect turning "one whack at the cat" prospects into the types of outcomes one would expect with "many whacks at the cat."

  2. Thanks Joe. I think, in general, Modern Portfolio Theory is designed under the assumption that you will get many whacks at the cat (what an expression).

  3. I am a recent retire. How can I get more information about the book?

    1. Hi George,

      Amazon has a lot of info about the book, including user reviews and the table of contents, etc.

      Link to Amazon page on book

    2. George,

      You did ask about Mike's book rather than the RMA curriculum book, right? I don't think the RMA curriculum book is publicly available at this time.

    3. The RMA curriculum book is available on the US Senate website (maybe unintentionally?)

    4. Yes, you are right. I think that is version 2, and it is unintentional on RIIA's part. RIIA just recently released version 5 of their book, which has expanded quite a bit.

  4. While I'll stipulate that treasury strips are low risk for a US investor in nominal dollars, insurance annuities seem at least an order of magnitude more risky. Measured against a diversified portfolio which invests less than 1% of the portfolio in any single stock or bond other than US Treasuries, the "claims paying ability" of an insurance company seems far from risk free.

    An examination of municipal fund yields just since the "Great Recession" suggests they are hardly risk free, especially once adjusted for inflation.

    Am I missing something here? I'm just an amateur, not a professional in the investment field.

    1. William,these are good points, thank you for sharing.

  5. For the wealthiest 10% or 20%, that floor-plus-upside approach makes sense, and for them it’s good that approach is being studied and advanced.

    But it’s the rest of the people who need help most. For them, putting ALL their money into TIPS and such for a floor would lead to sunset years in abject poverty.

    For them, I think our probabilistic approach is better, offering tradeoffs with good chances of decently funded retirement years. I cheer for Wade’s advances in clarifying those options, and for similar work by Joe Tomlinson cited in current and prior post on this blog.

    Dick Purcell

    1. Thanks Dick,

      One of the approaches I recently reviewed which I think shares the spirit of your suggestion is the Russell Investments Personal Asset Liability Model.

    2. Wade –


      I hope my first paragraph did not appear negative. I think that for those with enough wealth, the floor-plus-upside approach makes loads of sense.

      But it does seem to me MOST IMPORTANT, for actually BEING responsible and APPEARING responsible, that the “retirement industry” must offer appropriate guidance for the majority of folks of modest means as well as those with enough to enjoy floor-plus-upside. I think this is paramount for the RMA, for both actual service to the public and appearance/reputation.

      In a Bogleheads reply to you a spell ago, BobK said the two approaches are incompatible, but I don’t think that’s true at all. For at least two decades, this field has been stuck in the sinkhole of confused misapplication of MPT. And that’s a result of a more general problem – the tendency to create complexity and use it to take decisionmaking away from people and give it to behind-the-curtain theorists. That manufacturing of complexities is what makes various approaches conflict.

      (Based on just a cursory look at the Russell approach you cited, it appears to me that one also has a little too much manufactured complexity. I say just talk people language, probabilities for their future dollar-value needs and goals.)

      I think the most important of all guidelines for how we deal with this field is to focus on being EDUCATORS, INFORMING people (investors and also their advisors) so THEY can make informed decisions. IE, keep it focused on probabilities for the people’s purpose, dollar value for future needs and goals. I think your work in developing universal guidelines stands out as fitting this educator approach well, and Joe’s does too. I like to think that I am doing the same thing the other way – rather than universal guidelines, just address the individual’s resources/plans/needs/goals and for each person, compare alternatives in probabilities for the future dollar goals they need, seek, and understand.

      I think that when this field is approached with the purpose of educating and informing, rather than complexifying, the floor-plus-upside approach for the wealthier and a simple straightforward probabilistic approach for the majority of less-wealthy are completely compatible, indeed have much in common. I think it’s REQUIRED to offer both.

      Dick Purcell

    3. Dick, about floor/upside, what matters is what your consumption needs are as a percentage of your wealth, and not what your absolute wealth is. For the very well to do, the floor/upside approach may not have much relevance because their implied withdrawal rate is so low that they can basically withdraw from a volatile portfolio without worrying much about failure.

      For people with a very high required withdrawal rate, well they are going to have a problem no matter what. Perhaps the best thing for them is to make sure they optimize their Social Security decision, think about whether they can maintain some parttime work, and then decide on a personal level whether to annuitize or to take their chances with systematic withdrawals from a volatile portfolio.

      It is the people in the middle ground, with implied withdrawal rates of 3-7%, perhaps, who stand the most to gain from thinking about floor/upside. It may make the most difference for them.

      About the Russell Investment approach, their dynamic asset allocation is certainly complex, but that can be left out and I think the basic idea makes a lot of sense. Just periodically check how much you would be able to annuitize with your remaining wealth, and if that annuitized income stream is getting to be on the low side relative to your desired spending, then think seriously about annuitizing. This provides some protection to go ahead with the probabilistic approach you are recommending while still keep a flooring level in the back of your mind. What do you think about that?

      P.S. Please be sure to see my newest blog entry as hopefully this is moving in a direction of greater realism for withdrawals.

    4. Wade --

      Thanks. I like that reply.

      Your Russell paragraph illustrates your doing just what I advocate when I urge educate don't obfuscate. This field has too many high priests who prefer to obfuscate so they can play mathematical mumbo-jumbo in black boxes behind opaque curtains.

      I like your division of the population into those three groups, too, and agree with your summary of decision needs of each. But I'd point out that in terms of percent of population, the group you call middle is maybe roughly the second wealthiest 10%, while what you classify as the bottom group is maybe 80% of everybody -- and in most need of help.

      So my concern remains. I think we are neglecting the bottom 80%. I don't think this conflicts with floor-and-upside for the second richest 10%, because if we maximize education and minimize obfuscation -- ie, talk probabilities for dollars -- the approach is largely the same for both groups.

      Dick Purcell

    5. Thanks Dick.

      That breakdown about withdrawal rate groupings actually is from the RIIA. I forgot to mention that. I think it makes sense.

      About helping that bottom 80%, what exactly do you have in mind I could do with my style of research?

    6. Wade –

      I think your style and direction of research are superb, and are highly relevant and valuable for the “bottom 80%” as well as those of greater wealth.

      To clarify my concern, I need to distinguish approaches to this field into two types: UNIVERSAL, which reveals insights and tradeoffs and decision guidelines generally applicable to everyone; and INVESTOR-SPECIFIC, which addresses the particular cash flow plan and goals of the particular investor.

      I think of your work as in the former, Universal. And to repeat my opening sentence, I think your work is relevant and valuable for everyone. Downright terrific!!

      It’s in the Investor-specific approach that I am asking for something better for the bottom 80%. In investor-specific analyses, for two decades investment education and mass advice have been stuck in the sinkhole of misapplication of modern portfolio theory. It appears to me that especially for folks in what you called the middle group, the second wealthiest 10%, the floor-and-upside approach is a great advance out of that MPT sinkhole. But in investor-specific analysis, the bottom 80% are still left in the MPT sinkhole. So in the investor-specific approach, along with floor-and-upside for that 10% I think we need a corresponding advance out of the MPT sinkhole for the bottom 80%.

      I don’t mean this as criticism of floor-and-upside. I mean only to request that it have a partner, or be broadened, so that in the Investor-specific approach we are advancing things for the bottom 80% too.

      Dick Purcell

  6. As someone in conversations with his financial planner, I find this article to be very helpful, providing deeper insights into how to approach long-term savings. Thank you for posting.

  7. Excellent article and subsequent comment discussion. Thank you.

  8. The median 401(k) balance for a household currently approaching retirement age was recently $78,000. That will generate about $3,500 a year using the badly flawed SWR strategy, and about the same payout (4.46%) from a TIPS ladder, according to William Sharpe.

    The vast majority of the 80% you describe have virtually no retirement savings. About half literally have no retirement savings.

    They are going to suffer a decline in standard of living after they retire. I agree with Wade that part-time employment, maximized Social Security benefits and the like are their upside.

    Solving their problems with stock investments doesn't strike me as a rational approach. Portfolio survivability is a rich man's problem.

  9. I've had many cats in my life so the idea of a taking a "whack at the cat" is a bit disturbing to me. But, to give cats their due, anyone who takes a whack at a cat will likely miss!

    None the less, this is an excellent article. As a recent retiree I was vaguely uneasy with my portfolio without knowing why. I was doing everything right: low cost index funds, reasonable asset allocation, but I still felt exposed. Running across the the life-cycle literature (floor+upside) was a revelation. I am still studying the best way to implement. (So far it seems I need to do nothing different except keep SPIAs as an option a few years down the road.)

  10. Retirement income planning (decumulation phase) is so different from retirement planning(accumulation phase). It seems the former deals with modern retirement theory that is being feverishly discussed since 2006 with the creation of RIIA and the latter goes back to Harry Markowitz who is the father of modern portfolio theory(1952). As a retiree with average know I find this discussion enlightening and hope that advisers can keep it simple for people like me.

  11. "Each Get Only One Whack at the Cat" - that is life, your whole life is like that. Your life itself is based on chance. If you do this floor thing and buy a SPIA, then die 5 years later...

    Just use common sense, and be flexible, and most importantly, enjoy what you have now, and take your chance.