So, when can we start calling it the “old normal”?

Stocks have gone nowhere in ten years. Not even dividends have made it better. Sure, you might have had a bit of a gain if you stuck your money in emerging markets at the right time or gold or any of the other asset classes that turned slightly positive. But on the whole, buy-and-hold investors had it pretty crummy.

And yet, we still get this from Dave Ramsey (hat tip to All Financial Matters for noting the clip). On slide 12 of an otherwise smart little video on not rushing out to buy a new car, Ramsey throws out this line (paraphrased): “But instead of spending that money, you’ve invested it in a mutual fund earning the average stock market return of 12%.” Bwahahaha.

A 12 percent stock market return is so 1998. We know now that 12% is wildly optimistic. Eight percent might even be optimistic. What’s more reasonable? Take this sobering assessment from Bill Gross in Money Magazine this month: “Instead of 10% returns for stocks, look for five or so. And instead of the past 20 years’ returns on bonds, which are actually better than stocks — close to double digits — it’s 4% going forward.” Oof.

Gross, and his colleagues at bond investment shop PIMCO, call this low growth period for investments and the U.S. economy the “new normal.” It’s hard to say PIMCO is “talking its book“, because it doesn’t see bonds as faring all that well either.

There seems to be a general consensus that PIMCO is more right than Ramsey is. But I don’t think the implications of changing stocks’ rate of return from 10% to 5% have sunk in. We acknowledge that stock returns will be poor, and yet all of our retirement advice—save 10% of your income…withdraw 4% in retirement—stays the same. So, for your viewing pleasure, here are a couple math problems.

How your savings rate changes.

Scenario: 45-year old making $90,000 per year. Plans to retire at 65. Holds a $200,000 portfolio.

In real life, this guy would slowly shift his money from stocks to bonds, but to keep it simple, let’s just assume he puts it all in stocks. Since we’re using an “average” rate of return, rather than the volatile real-life returns he’d really get, we’re being generous.

Old math: If he saves 10% of his income per year (pretty standard advice), his portfolio grows to $1.86 million. Using the flawed-but-ubiquitous 4% rule, in his first year of retirement, he could afford to withdraw $74,400. Combined with Social Security, that’s not a bad income.

New math: But what if his portfolio only returns 5% per year, as Gross predicts? If he held steadfastly to saving 10% per year, at age 65, he’d have $828,253. That would leave him with an income of just over $33,000 plus Social Security. That’s less than half of the old math scenario.

Unacceptable, right? So what does he have to save instead? Please don’t cry. That 45-year old, trying to achieve a $1.86 million portfolio with only a 5% return, would have to save forty-four percent of his salary per year. If he was willing to work until age 70 instead, he could save 28%. But still, that’s a huge difference. I used the simple calculator here for all the calculations.

How your withdrawal rate changes

Oh, and about that 4% withdrawal rate. I’ve written before about how writers and planners twisted the findings of a few Trinity University professors into a mantra that at least one of the professors doesn’t believe. But the 4% rule gets even more off base when you start to assume stocks grow more slowly than they have in the past.

Why? Well the Trinity guys used stock returns between 1926 and 1997 to inform their results. That’s a time period that saw the United States rise from upstart nation to global superpower. Do we really think the pattern of returns we saw then is going to repeat itself going forward? As financial columnist-turned-money manager Scott Burns notes, when you start to factor in the sad truths of modernity—like lower interest rates, lower dividends, and, yes, lower stock returns—the rules developed by probability studies that were done just a couple decades ago don’t seem to apply any more.

Shutting down in the face of uncertainty.

I don’t save 44% for retirement. Not close. I don’t save 28% for retirement. Still not close. In the face of numbers like that, it’s no wonder that we’d rather hear about magical 12% rates of return on stocks that no one believes anymore.

The good news is that if you’re young, you have time. And while you can’t control what your investments do, you have a couple other dials you can turn to give yourself a chance to retire. One, is the aforementioned savings rate, no doubt the most painful of the bunch.

Option number two: Retire later. You’re likely going to live to an age older than your parents anyway, and I’m sure you’ve had it in the back of your mind that it was never reasonable to work 40 years and then have a 40-year retirement anyway.

And option number three—the most fun option—is to earn more money. With a higher salary, you can save 28% but maintain the standard of living you had when you were earning less and saving 10%. Unless you have a defined benefit pension—and few private sector employees do anymore—this is the only truly guaranteed way to have a reasonable shot at early retirement.

Just a small prediction: You’re going to be hearing a lot about earning more from me and personal finance authors in the coming years. Because we’re finally starting to realize that investing well and being frugal just isn’t going to be enough anymore.

More important: How long can you afford to live?

Imagine living to the age of 122. That’s the oldest recorded age of a human, achieved by frenchwoman Jeanne Calment. Calment died in 1997. Just last week, scientists claimed to have discovered genetic markers that can predict, with 77% accuracy, who’s destined for extremely long life. Interestingly, the markers have nothing to do with the other discovered traits that are linked to certain forms of cancer and other diseases. The extremovives (I made that word up) had those “bad” markers in the same proportion as the general populace. Their “good” markers just trumped them.

Now, fear of dying—thanatophobia—is a pretty common thing. I’m happy to say I don’t suffer from it. Either there is an afterlife, which is my personal belief, or there’s not. And if there’s not, it doesn’t seem like death would feel like much of anything. I’m not afraid of nothing.

But anyway, if you did live to an old age, it seems like there would be something to fear: Going broke or becoming a burden to your children.

Why this is a good possibility

I’m happy to say that a lot of the better retirement calculators have begun to assume that you’ll live to age 95, which is a pretty ambitious target. The T. Rowe Price retirement income calculator (not perfect by any means, but about as good as you’ll get in a calculator that only requires a couple inputs) is one of them. But if you wander aimlessly through calculator land, it’s easy to fall across seemingly legitimate alternatives that default your expected age of death to 85 or even earlier. The AARP Retirement income calculator uses life tables from the National Center of Health Statistics to estimate age of death. Of course, the problem with that is that retirement planning should be about worst-case scenarios (or at least, probable worst-case scenarios), not simply about averages. Tell the calculator that you’re a 30-year-old male, and it only plans out to age 76. That’s pretty optimistic (or pessimistic…depends on what lens you’re looking through, I guess).

So what age should you plan to?

Well, let’s just assume that you’re not going to live longer than Ms. Calment. I’ve already said that age 75 is pretty conservative. So we know the answer is somewhere in between, but that’s a pretty wide range. How do we nail down the exact figure?

For one, you know your health problems, and you know your relatives. There’s a strong correlation between the age your parents lived to and your dying age.

More specifically, according to the study I just linked to, if a father died between the age of 45 and 65, there was no predictive effect on his son’s life. But for each extra year a father lived above 65, a son’s average age of death would grow by two months. So, for example, if a father lived to the age of 70, on average, his son could expect to live 10 months longer than a similar kid whose dad died at 65.

For each year he lived above age 85, the son’s life increased 3 months on average. Genetics weren’t the only reason. The researchers found socioeconomic factors played just as large a role.

So starting there, if your parents died old, you’re more likely to die closer to that 100-year mark. And if you improved your socioeconomic conditions from where your parents stood, you have an even greater chance of living longer.

But let’s turn to those troublesome life tables put together by the Social Security Administration. It’s real easy to misread these suckers. Under age 30, you’ll see that a male is expected to live another 46.89 years on average—that is, until age 76.89. But go to age 66, and he’s expected to live until the age of 82.28.

Since I’m saving for retirement, and I don’t plan to retire until age 66, I’d assume that my savings need to last me until age 82, at a minimum. To be conservative, in my own planning, I’ll probably knock that up to age 90.

Now what about that age 95 figure that’s becoming so popular in financial planning circles? It seems that planners are trying to get you to save for an almost worst-case scenario. In the SSA tables, someone living to age 95 would have more than a one-in-four chance of dying within the next year. That might still seem reasonable to you, but in my mind, that’s too extreme to be worth planning for.

Planning for a probable-case scenario

I can just hear a planner saying it now: “If you plan for age 90, you’ll be sorry when those last five years of your life are miserable!” But that ignores the common problem with pretty much any retirement calculator or professional financial planning software you run into. It assumes you’ll pick a spending rate and spend that inflation-adjusted amount right into the ground, no matter what happens in your portfolio.

I made the same silly assumption in my first guest post for Consumerism Commentary. You’d better invest conservatively in guaranteed investments!—I said—Or if you fall into that rare 5% failure rate of your risky investments, you’ll be sorry!

That argument is as seductive as it is absolute. And it’s true, according to the math. But the math ignores the human race’s awesome ability to adapt. If you see your portfolio take a huge knock after you retire, you’ll tamp down your spending. Likewise, if you come up on year 80 and still feel pretty darn good, you’re not going to keep spending as if you’ll die on your 85th birthday. In effect, you don’t have to plan for your worst-case scenario when you’re 30 or 50 or whatever age you are, you can plan for it as it becomes imminent.

What’s the risk of this? That the worst-case, long-life scenario arrives, and you have to spend less between the ages of 90 and death (or whatever) than you planned. But I’d rather be a pauper at age 95 than be a rich man who never lived because he was saving for an improbable, worst-case scenario.

Note: I added a sentence about the father-son longevity study to clarify the study’s results.

Making future goals seem immediate

Whenever I see a bunch of academic research or articles by economists “sponsored” by a major investment company, my Spidey-sense starts to tingle. Rarely does a company hire a scientist who makes a conclusion contrary to the company’s business practices. I suppose it might happen, but I doubt we ever see the resulting research, and I wonder if that economist or scientist gets hired again next time the company wants to publicly prove something.

So when I opened up a report put out by Allianz Global Investors, I was prepared to read a bunch of research supporting the sale of annuities, mutual funds, and other products the company peddles. The paper was ostensibly created in response to a U.S. Treasury Department request for ideas to improve workers’ retirement prospects. Basically, retirement savers tend to make really dumb decisions with their investments—like taking a penalty-laden distribution from their 401ks when they leave a position, rather than a penalty-free rollover into an IRA—and the Treasury wants ideas to save us from ourselves.

When I read the report, I was actually pleasantly surprised. Rather than conduct new research, Allianz had gone to more than a dozen major behavioral economists to ask them what they would do, based on research the economists had already conducted. Together, their answers give a great summation of every mental quirk that hinders our financial decisionmaking. Here are some of the ideas Allianz, and the economists it solicited, came up with.

Don’t call it an “investment”. Call it “future income.”

Imagine you’re over age 50 (approaching retirement) and I give you two investment options to chose from. In category one, we have an annuity that will pay you $650 per month until you die. Behind door two is a traditional savings account containing $100,000 and bearing 4% interest.

It turns out that which one you choose depends a whole lot on how I ask the question. If I talk about the annuity as giving you a $650 per month income until you die, 70% of you will choose the annuity. If I talk about the $650 as a guaranteed investment return, only 21% of you will select it.

The actuarial value of each option is identical. That means that the $333 or so you’d get in interest from the $100,000 savings account, combined with the amount you’d withdraw from the principle each year, is about the equivalent of the $650 from the annuity. But that framing of the annuity as an income generator, rather than as an investment—in which you “lose” $100,000 if you die early—is crucial to determining which one you prefer.

What does that mean for savers? Instead of talking about “your number” as the ING Direct advertisements go and some mammoth, obscure, multimillion dollar savings target, what if we talked about our savings in terms of your monthly income when you retire? So instead of having saved, say, $100,000 for retirement right now, we could say you’ve saved about $4,000 per year in income. Yeah, that’s using the academically shaky 4% withdrawal rule of thumb, but at least it makes a $100,000 nest egg much easier to digest.

Picture your future self…no, seriously, literally picture it.

Economists Hal Ersner-Hershfield, Jeremy Bailenson, and Laura Carstensen ran an experiment in which test subjects entered a virtual reality environment and made retirement investment decisions. Side note: I can’t help but think those test subjects were disappointed. You’re going to be in this virtual reality machine. “Yay!” You’re going to be making retirement decisions. “Oh.”

Inside the VR environment, they’d see themselves in a mirror. Half the participants would see their current selves. The other half would see age-morphed, “older” versions. Then, the testers would ask the participants to allocate money to a pretend retirement savings account. In the end, the guys who got the “old” mirror allocated twice as much money to the account!

I don’t know where this naturally leads. Should we make savers play a retiree version of The Sims? Is it as simple as putting an age-enhanced photo on the log-in page of your 401k? Whatever the solution, making the far-off seem more tangible makes us heed future consequences.

Retirees hate loss. But they hate annuities, too.

In previous posts, I’ve written about “loss aversion”—our tendency to hate losing money about twice as much as we enjoy making it. That principle was established way back in the 1970s.

More recently, the AARP sponsored a study to see if retirees, specifically, were more or less attuned to loss aversion. Retirees were asked whether or not they would take a gamble in which they had a 50% chance to make $100 and a 50% chance to lose $10. Statistically, the gamble should be taken, but nearly half of retirees refused it, suggesting that retirees hate losses ten times more than they love gains.

You’d think that’d mean products like fixed annuities, which guarantee you an income for life in exchange for a large lump-sum payment, would be loved by retirees. But you’d be wrong. Retirees who showed such “hyper loss aversion” (as the Allianz report calls it), also were less likely to respond favorably to annuities. It turns out, they viewed that large upfront payment like a guaranteed loss. Yet another example where framing—emphasizing guaranteed incomes from annuities rather than the investment—could help us make better decisions.

People with dementia make bad financial decisions.

This one fell into the category of “duh” for me. But the older we get, the more likely we are to make poor financial decisions. A study of adults older than age 60 asked them to identify which set of odds represented the greatest risk for catching a particular disease: 1 in 10, 1 in 100, or 1 in 1000. Twenty-nine percent of them got the answer wrong.

This, and other studies, suggest that as we get older, our abilities to rationally calculate odds, understand investment devices, and make good decisions disintegrates. And could indicate that we should be forced to make some decisions—such as buying an annuity, Allianz would say—before our cognition starts to go. I’m sympathetic to the view that a company that sells annuities wouldn’t come to any other conclusion, but there’s a definite argument to be made that people with dementia and other mental problems need some sort of protections from themselves and salespeople who would take advantage of them.

Labeling an account can make us save better.

Parents will save twice as much in an education account labeled with their kid’s pictures than they will save in a generic “education” account. Or at least so goes a study conducted in 2009.

Some economists think that could have major implications on how we should treat retirement accounts. Your “401k retirement savings” account simply doesn’t have the ring to it that a “My food in 2030″ account would. Maybe we shouldn’t have one retirement savings account at all, but multiple accounts that we could label for various needs we’ll have when we retire—much in the same way that you might separate “travel” and “new iPad” savings accounts.

All of it drives toward the same, build-a-retirement-picture theme.

There’s more in the report, and it’s well worth checking out if you have the time.

You can’t fit a square peg into a round hole.

Ragging on equity-indexed annuities is a favorite pastime of the media, financial advisers, and state attorneys-general all over the place. The reason is pretty clear. Ever since equity-indexed annuities were invented, unscrupulous salesmen have pushed the worst versions of them onto seniors who don’t understand their implications. Over time, their sales tactics became tied tight with the product—and something that might have actually had use to some investors became a producto non grata (no idea what the Latin word for “product” is).

Thing is, when you strip away all of the ugliness equity-indexed annuities have brought on, you’re left with an investment vehicle that doesn’t look nearly as bad as the blind criticisms make it out to be. That doesn’t mean they’re right for you. But how about we give equity-indexed annuities a fresh shot to see in what circumstances they might make sense.

I’m getting ahead of myself. Here’s what an equity-indexed annuity is for those unfamiliar.

Striking a deal with an insurance company

At its heart, an equity-indexed annuity is an insurance contract. You fork over an investment to an insurance company, and it promises to grow your money at a certain rate of return. Equity-indexed annuities tie their returns to a stock market index, like the S&P 500. But unlike if you simply invested in the stock market directly, the insurance company promises a minimum rate of return, say 2% or 3%, that you won’t dip below. You won’t lose money.

Obviously, the deal wouldn’t be worth it to the insurance company if that were it. As part of the deal, your return also won’t go above a certain limit. Sometimes, the company gives you a hard cap. For example, you can’t earn more than 7% in a year. Sometimes, the company has you participate in a percentage of the S&P’s return. For example, you’ll get 70% of the return—if the S&P rises 5%, you only get 3.5%. If that weren’t complicated enough, different versions also calculate the return in different ways. Sometimes it’s a simple price change. Sometimes it’s the average of the monthly returns…don’t ask…you’d be forgiven for observing that these are made to be impossible to understand.

And one of the most powerful deterrents to an investment is that you’ll pay a hefty penalty for investing in one of these suckers and withdrawing your money quickly. Most of them have a surrender charge if you withdraw your money within the first three to ten years. And because salesmen often get higher commissions the longer they’re able to lock you in, they push the contracts with the worst penalties. It turns out, some of the sales practices annuities salesmen use are heinous enough to bring down the wrath of lawmakers and Dateline NBC. But just in the interest of giving equity-indexed annuities a more-than-fair shake, let’s set all that aside for a moment. Are they, apart from the tactics, useful products?

The weak criticism of an equity-indexed annuity

Most of the time, when I read criticisms of these things, they focus on a couple, pretty weak arguments. The arguments all stem from the same, false comparison: “Equity-indexed annuities make less money than a balanced portfolio of stocks and bonds.”

Equity-indexed annuities most often don’t include dividends in their computation of the S&P 500′s return. In that way, they won’t perform as well as a simple index fund. I’ve seen some advisers show graphs that show—properly, I might add—that the annuities end up with a smaller return than a stock/bond portfolio over long periods of time.

But both of those arguments are pretty weak. Why? Equity-indexed annuities are a practically no-risk investment. Of course you won’t make as much money as a stock/bond portfolio. A stock/bond portfolio can lose value, whereas this product can’t. You pay for that safety with a lower return.

So in that way, it’s much more fair to compare the returns of equity-index annuities to that of risk-free investments, like CDs, money market accounts, and Treasury bonds. Stacked up against those guys, the returns of many equity-indexed annuities actually don’t look so bad.

One, big caveat: some of these contracts let the insurance company change the returns caps to reflect market conditions, meaning the cap you started with might not be the one you have next year. Not comforting.

The good case against them

Maybe they’re not a bad product in and of themselves. But the question becomes this: How many people should put a significant amount of their retirement savings in an illiquid, risk-free investment? The answer: Not many and maybe no one.

Retirees would benefit from owning a risk-free investment. But they wouldn’t be suited to the 10-year-plus surrender charges that keep them from accessing their money soon.

Young people wouldn’t have to worry about the surrender charges. They have plenty of time to ride those out. But they also wouldn’t be suited to saving a significant amount of their nest eggs tied up in a risk-free investment. Since they’re young, they’re supposed to take risks on the stock market for the higher return it makes possible. Having them invest a lot in an equity-indexed annuity is akin to putting half a 27-year old’s nest egg in Treasury bonds. He’d have to save a helluva a lot of money to make retirement happen that way.

Which is kind of where equity-indexed annuities leave us. Not evil (though maybe salesmen take things too far), but not quite the right fit for anybody.

There’s a reason it’s called a retirement plan.

When you go to a financial planner or try out a quickie retirement calculator, it’ll often come back with a result that reads something like “Sticking to this allocation and savings plan, you’ll have a 90% chance of meeting your retirement needs.” A good financial planner will translate that for you, but a retirement calculator will just leave you hanging.

Is a 90% chance of meeting the target high? Is it low? Is a 10% chance of not meeting your target particularly high or low? Who knows?

The invention of the 4% rule

The “4% rule” is a common rule-of-thumb used to guide retirees when they’re getting ready to tap their nest egg. Let’s say you retired with $1 million. The rule says that in the first year, you can withdraw $40,000 (4% of $1 million). In year two, you can withdraw $40,000 plus a slight adjustment up for inflation. And so on.

You might not be as familiar with how that rule started. In 1998, a trio of professors at Trinity University penned a study looking at historical returns, withdrawal rates, and life expectancies. A table in the study broke down probabilities of success based on a 2% withdrawal rate, 3%, 4%, 5%, and so on. Four percent was simply the highest withdrawal rate where, most of the time, the probability to success was near 100%. So, all the media folks and financial planners turned it into mantra.

But was that what the professors intended? Not at all. In fact the study concludes: “For stock-dominated portfolios, withdrawal rates of 3% and 4% represent exceedingly conservative behavior.” Why did everybody gravitate to 4%? They were mesmerized by that 100% success rate.

How retirement really works

I wrote something recently for Consumerism Commentary that basically argued a 7% chance of not meeting your target is pretty high. I mean, it doesn’t seem high until you’re part of the 7%. Then you’ll wish you had invested as if you had a 99% or 100% success rate.

I still agree with what I wrote a little while ago, but I think I’m guilty of committing a wonkish mistake. You see, if you deal with these kinds of calculators and statistics and historical returns and probabilities long enough, you start to forget how people actually act. It’s like getting so caught up in batting averages and ERAs that you forget what a game looks like when it’s played.

I can set up a retirement plan for myself that the calculator says will give me a 100% chance of meeting my retirement income goal, but in the end, that ends up being a pretty useless exercise. Retirement calculators necessarily make you plan out 40 or 50 years of your life, but they don’t take into account humans’ abilities to adapt.

If someone saw their account balance drop dramatically in 2008, they probably ratcheted back their spending. On the other hand, if someone hits age 85 and still has millions in the bank, they probably decide to splurge a bit. We don’t set a plan at age 65 and blindly follow it as if nothing has changed for 30 years. That’s just stupid. (And that’s what a retirement calculator assumes.)

Your plan is more flexible than you think.

Where does that leave you and your retirement calculator? You could set up a plan that’s effective 100% of the time. Your calculator will tell you that you have to save a ton of money or work well beyond age 65. But in exchange, you’ll sacrifice a lot — maybe too much — of today’s standard of living to get those extra percentage points of certainty.

So next time I use a retirement calculator, I might not panic if it says I only have an 85% chance of meeting my retirement goal. Even when I enter retirement, I might try a 5% withdrawal rate, which according to the Trinity study, would give me an 80% chance of not outliving my money. As time goes on, I’ll adjust up or down depending on what life and the market throws at me.

After all, in 2020, I know I won’t look at the plan I wrote in 2010 and keep following it blindly. So why should I plan as if I will?