In last month’s post, I explained a new procedure for how to estimate the risk that you will come up short of a particular savings goal using one of the best retirement calculators currently available on the internet: FIREcalc. In the earlier July post, I gave you some guidance you can use to decide whether the resulting shortfall risk estimate is either too large, too small, or just right. In the latter case, you can simply implement your savings/investment plan “as is” (and then return to FIREcalc every one or two years to see if you need to tweak your plan to stay on track).
But what if you’re not comfortable with the shortfall risk estimate you got from FIREcalc? How can you best improve your plan to obtain a shortfall risk you can live with? To illustrate how to optimize your savings/investment plan, we’re going to return to the example we covered in the August post. In this example, we supposed that you were trying to save a total of $50,000 over the next 10 years. You’ve already saved $10,000 towards this goal, and you are planning to save $3,000 more per year. You plan to invest the savings in a 60/40 investment portfolio (that is, a portfolio split 60 percent stocks and 40 percent bonds). You’ve tested this initial plan using FIREcalc, and estimate that you run a 7.4 percent risk of coming up short of your $50,000 goal (see the August post to learn how this estimate was obtained using FIREcalc).
When we developed this example back in August, we didn’t specify why we want or need the $50,000. But let’s now suppose that the money is needed for your child’s college education. Given this goal, we’ll further suppose that you are very uncomfortable running a 7 in 100 chance of coming up short of the $50,000. Given the likely importance of a college education to your child’s future, you’ve decided that you are unwilling to accept any risk larger than a 1 in 100 chance of coming up short of the goal. How, then, can you best improve your savings and investment plan to hit a 1 percent shortfall risk target?
When optimizing a savings and investment plan, you have many different possible options. You can:
- Change your savings goal (e.g. in our example, you could reduce the goal from $50,000 to a lesser amount);
- Change the amount of money you intend to save per year (e.g., increase your annual savings from $3,000 to, say, $3,500);
- Change the timing of your goal (e.g., increase the number of years you give yourself to reach your goal from 10 to, say, 12);
- Change your mix of investments (e.g., use a 70/30 portfolio instead of a 60/40 portfolio); or
- Make some combination of the above changes.
Now, each of the above options will likely be more or less palatable to you depending on a variety factors, including, for example, the nature of the goal you’re saving towards, the importance to you of meeting that goal, and the degree of discomfort you have with market volatility. Therefore, as a first step in optimizing your plan, you should rank the above options from most to least palatable. Since in our example the goal is a college education for your child, you might find the first option above (reducing your $50,000 goal) unacceptable, as you’re worried that could shortchange your kid’s future. You might, however, be willing to increase the amount of money you save per year, particularly if you can accomplish this gradually over time. Specifically, you could try to increase the amount you save each year by the rate of inflation, under the assumption that your salary will keep up with inflation.
An even better alternative, though, might be to change the timing of your goal. We’ll assume that your child will be ready to begin her freshman year in 10 years. But you will not have to spend the entire $50,000 in her first year. You could, instead, set of goal of having $12,500 in 10 years, another $12,500 in 11 years, a third $12,500 in 12 years, and the final $12,500 in 13 years.
Finally, let’s suppose that you are highly risk-averse (or, to be more precise, volatility-averse), and unwilling to increase your percentage allocation to stocks above 60 percent. But what if the risk you face, in our example, could be reduced by increasing your allocation to bonds? This would actually reduce your portfolio’s volatility, while simultaneously reducing your shortfall risk—a true win-win. And while shortfall risk for longer-term goals is minimized only when the allocation to stocks is large, for shorter-term goals a large allocation to bonds is needed. Will increasing the bond allocation work for our example, with its 10-year time horizon? This is a question that cannot be answered without some work. But we have nothing to lose, and everything to gain, by testing this option in FIREcalc. If we can manage to reduce the shortfall risk below 1 percent solely by increasing our bond allocation, then this is clearly our best option. If it doesn’t work, our next best option will be to change the timing of our savings goal, as described in the preceding paragraph. And if that doesn’t get our shortfall risk down to the desired 1 in 100 level, we will test increasing our savings amount by the rate of inflation.
Now that we’ve ranked our various options from most to least palatable, the next step is to test each option, in order of their ranking, in FIREcalc until we reduce our shortfall risk to the desired 1 percent level. Our most favored option is to try increasing our allocation to bonds. Therefore, using the same procedure described in the August post, I tested a 50/50, a 40/60, a 30/70, a 20/80 and a 10/90 portfolio as alternatives to the 60/40 portfolio. There were improvements in the shortfall risk for each increase in the bond allocation, up until the 30/70 portfolio. However, once the bond allocation was increased to 80 percent or more, shortfall risk increased. Therefore, it appears that the 30/70 portfolio (30 percent stocks and 70 percent bonds) has the lowest shortfall risk, coupled with a lower volatility than the 60/40 portfolio (due to its heavier reliance on bonds, which are less volatile than stocks).
Unfortunately, though, the 30/70 portfolio yields only a slight reduction in shortfall risk (from 7.4 percent for the 60/40 portfolio to 5.2 percent). Switching to this portfolio would still leave us well short of our 1 percent risk target. Therefore, in addition to adopting the 30/70 portfolio, we will need to try the second-best option in our ranking: changing the timing of the $50,000 goal. To test this option in combination with the 30/70 portfolio, I changed the amount to be spent (the “Spending” input on the “Start Here” page of the FIREcalc website) from $50,000 to $12,500—the amount that you will need in each year of your child’s four-year college education. Then, I increased the number of years for the “Years” input from 11 to 14.
When I reran FIREcalc with these changes to spending and the time horizon, and the 30/70 stock/bond portfolio, the results indicated 100 percent success—or, in other words, zero percent failure and therefore a zero percent risk of falling short of the goal. As this example illustrates, once you have a way to measure shortfall risk (using FIREcalc), you can use that method to optimize a savings/investment plan for any financial goal you may have. First, test an initial plan in FIREcalc. If you are happy with the test result, there is no need to change the plan. But if you are uncomfortable with the resulting risk estimate from FIREcalc, the next step is to rank the various options available to you—changing the size of your savings goal, the amount of money to be saved annually, the timing of your goal, your stock/bond mix—from most to least palatable. Then test the options in FIREcalc, until you find the combination that yields a shortfall risk you can accept. It’s that simple. You will need to revisit FIREcalc every year or two to see if you’re plan is still on track—we’ll tackle the re-testing process in a future post.