Actuaries versus Financial Independence Smackdown!

Do you know what is driving me crazy at the moment? It’s trying to figure out why common FI thinking is so different to the retirement establishment. By “establishment”, I mean the institutional investment industry and the actuarial profession that advises on all aspect of retirement risk. I’m interested in why this thinking is so different; is one way of thinking better than the other, is one group simply wrong?

Actuary, finanacial indepence

So c’mon! Let’s explore whether one group’s thinking needs de-bunking or whether they can coexist, or more interestingly whether they can be synthesized to come up with a better solution entirely. You know you want to join me on this!

Bold Ideas

A case in point is a white paper released by one of the big actuarial consultancies on “Bold ideas for mending the long-term savings gap”.

I won’t be covering the whole paper here, but this is a bold paper setting out bold ideas (see what I did there?). Surely this should be of interest to, and resonate with, the FI community? After all this paper addresses the profound questions of the challenges and solutions to retirement.

The Challenges of Retirement

Today I’m only going to focus on the first two pages of the paper that describe a number of “challenges contributing to the long-term savings gap threatening public and private pension systems and individuals” and look at how establishment thinking diverges from FI. We are going to take each of the five challenges to retirement that have been identified in the paper and look at what the paper says and compare it with current FI thinking.

  1. Longer lives combined with lower old-age support ratios

The first point the paper makes is that people are living longer and will outlive their means. This, the paper identifies, as the key challenge of retirement.

However FI thinking conveniently sidesteps this issue by advocating an accumulation of wealth so that expected investment returns are sufficient to meet a calculated spending rate in perpetuity. If your expected return on your assets is 4% and your withdrawal rate is no more than 4% then there is a reasonable chance you will be safe.

But the FI community has some contingency plans if the above strategy implodes. If there is a recession or a market correction then FI has three fallback tactics: spend less, tighten your belt and be more frugal, over-save by having more in your savings than you forecast, or geo-arbitrage where you go and live somewhere cheap for a while until any market disaster blows over. So this first challenge seems to fall by the wayside with FI thinking.

But hang on, let’s reflect on this a moment, because this is quite odd. As identified by the establishment

The. Number. One. Retirement. Challenge. Is life expectancy.

But this is almost never identified by FI proponents as an issue. When have you seen a FI blog post detailing the latest life expectancy improvements and agonizing over the adequacy of savings? I would say that you are one hundred times more likely to see a FI blog post about identifying what makes you happy than anything on outliving your pension pot. This is such a big disjoint in thinking it deserves a post in its own right, so stay tuned.

  1. Lack of easy access to pensions and savings products

The paper bemoans the lack of employer sponsored workplace savings plans, and the increasing prevalence of workers in non-traditional employment (like blogging I guess). the second point is that we are creating a workforce with little or no institutional retirement savings, or access to traditional retirement vehicles.

What would the FI community think of this?

I just don’t think this is an issue with FI, I don’t see any assumption from FI followers that financial independence is predicated on having an employer or government sponsored retirement/savings plan. FI is simple; you earn money by whatever means you can, make sure you live below your means and save the rest. If you have the tax benefits of a retirement system, then take full advantage of it, but FI is not dependent on access to traditional retirement products.

  1. Individuals ill-prepared for greater responsibility

There is no doubt that this is a huge challenge for a large chunk of the population, but does FI recognize it as a challenge? I don’t think so. The FI community has built a large infrastructure around advising it’s members on issues such as spenddown strategy, tax minimization, and investment strategy. This knowledge is freely available and quite accessible for the non-expert. The paper goes on to describe a key issue as “it is actually very difficult for individuals to project how much money they will need to sustain themselves through retirement”, but this flies directly in the face of one of the most popular FI articles “The shockingly simple math behind early retirement

So is retirement calculation “very difficult” or is it “shockingly simple”? I’m not going to get sidetracked with this here, other than to note another key discrepancy between the FI community and the Establishment.

  1. Lack of trust in financial markets and products

The thesis here is that individuals who mistrust the financial markets are investing in sub-optimal portfolios of cash or poorly diversified real estate investments. I don’t think the FI community views this as a significant challenge since they have adopted portfolios based on passive investment vehicles and are fervent promoters of Vanguard. However it remains to be seen from market experience whether the passive highly weighted equity, or property-heavy portfolios adopted by some FI proponents will prove to be robust in the future.

  1. Low growth environment

I actually think this is perhaps the one area that the FI community and the establishment agrees upon. Low interest rates and low growth forecast for equities based on current valuations will make it harder to realize financial independence and retire early.

So there we have it, five key challenges identified by the retirement establishment. But they are not the key challenges that a student of FI would identify as important. I’m being slightly unfair to the paper since they are trying to address retirement challenges on a global scale for all participants including employers, governments and individuals. Whereas FI is predominantly concerned with individuals (mostly) in the US. However we have some major disagreements over the main challenges we face, and plenty of interesting avenues to explore in the future.  

 What do you think?

So where do you stand on this? Do you think the establishment has something worth contributing to FI thinking here? Do you think I’ve been unfair to either (both?) sides? Drop me a note!

3 thoughts on “Actuaries versus Financial Independence Smackdown!”

  1. I think much of #1 in the FIRE community is wrapped up in the definition of financial independence itself. I.e. the idea that you aren’t really FI unless you can fund your minimum standard of living in perpetuity. I look forward to reading your thoughts.

  2. Fascinating comments.

    I am one of the no pension, made a big lump, saved half my dough types. I use a financial advisor for reasons of planning and access to funds not commonly accessible to retail clients but would be accessible to pension funds. I do believe in the concept of diversity, but my reading of Marcowitz is not that it is just about owning everything, but how everything you own (or don’t own) improves a portfolio’s efficiency, reduces volatility and in what proportions. I kind of visualize it as a portfolio is like an elastic circle, and the area of the circle is the value. My vision is there are vectors extending in different directions expanding the perimeter of the circle. The vectors represent non correlated investments. So while owning large cap, small cap, foreign, value, growth, may sound diversified it’s really just a stock vector which hits the circle across a small arc instead of a point. If the market craps all of those vectors are retreating, so it’s not really diversity. Bonds form another vector, maybe REITS, maybe commodities, maybe other credit risk instruments, maybe alternatives like the ARQ long short equity fund which tends to be uncorrelated, but also requires a 10M minimum investment (hence my access through an advisor, maybe a few single issues. All of this tends to give a portfolio with a smaller volatility. When the market goes down 20% I go down 15% so I only need 30% to be made whole etc.

    So maybe you have an opinion on optimized portfolio diversity and how to construct one. That would be a useful marriage between actuarial skill and the FI community., or even an intelligent discussion of what diversity is. Asset allocation is kind of treated as religion in the FI community. Also considering drags like taxes and protection like long term cap loss harvesting I bet there are a lot of things in that Venn cross section to write about.

    Thanks for this blog it’s very provocative and well worth my time.

    1. Gasem – sincere apologies for the delay. I like your circle analogy, there is a lot to unpick here. I also like how you pointed out that reducing the downside means that you have a smaller hill to climb when you bounce back.
      I think there is work to be done on asset allocation in the FI community. Most look at the Trinity study and use that to justify a very high equity allocation. Unless you really have to shoot or bust then there is a better portfolio mouse-trap available. So let me come back on that one at some point.
      I’ve got a couple of posts coming on withdrawal rates (a favorite of FI!) but then a good portfolio construction post would be good.
      Thanks again for such thoughtful interaction.

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