How not to torture your retirement numbers – the best interest

The honest Abe Lincoln had a riddle he would tell. He would ask an audience: “How many legs does a dog have if you count its tail as a leg?”

That’s a strange question, you might think. But because you don’t want to make a fool of yourself in front of the president, you might stutter: “Well…four plus one would give you five legs. Is it five legs, Abe?”

And Abe would yell at you: “Idiot! I fooled you! Don’t you know anything about dogs!?!?”

And Abe calmly said: ‘Just because you call it a leg doesn’t make it a leg. The answer is four.”

You got ’em, Abe.

He pointed out the tension (sometimes coincidental, sometimes purposeful) between labels, perceptions, etc., versus the real underlying reality.

Comedian George Carlin was known for his linguistic bits. In particular, he spoke and joked about words “that hide the truth, that hide reality, euphemistic language.”

Warning – just a few swear words…

And Charlie Munger, one of my personal favorites, believed that all people are susceptible to this behavior.

For example, he once said: “The nature of human psychology is such that you will torture reality to fit your models.“

When we are confronted with a harsh truth that changes our fundamental beliefs, an innate instinct is to deny that truth or fit it into our preconceived reality.

Lying with numbers

In one financial example, Munger was an outspoken and harsh critic of “creative accounting.” Too many people lie too often using numbers.

Munger would point to a derivatives trade between two major Wall Street firms. Each company’s accountants then track that trade in their internal books, and each company’s accountants…show a profit?! How can both gain? This kind of behavior is surprisingly common, although, as Munger would say, “It violates the most basic principles of common sense.”

But why? Why does this happen?

Because in this case, the employees at each of these companies have incentives to make their transactions appear profitable. Show me the incentives, I’ll show you the results.

Can this problem be solved? Speaking specifically about public accounting, Munger says: “Oh. You’re talking about a problem so deeply ingrained in human nature that you won’t live long enough to see it. If it gets solved 20% of the time in your remaining life, you’ll be a happy man.”

Torturing pension numbers

Why am I bringing this up? Who cares “torture numbers?”

Because I think it’s important that we avoid this pitfall in our personal financial planning, our portfolio decisions, our retirement planning, etc. It can be all too easy to torture these numbers. Sometimes by accident. Sometimes to avoid painful realizations. Mostly, though, because we just don’t know any better.

Here are some great examples:

Using “Average Return” as the only model

Unfortunately, this does not apply to your “average return” when you retire almost just as important as the specific set of returns you experience.

What will your order be? That’s difficult to answer. My crystal ball is just as foggy as yours.

But simulating different ranges (from rosy to scary) provides much more information than using an average.

Bad basic assumptions (in both directions!)

If you want to use 4% as your future inflation assumption, you better have a good reason why.

If you want to use 12% as your average stock market return, you better have a reason why.

I got some criticism for saying I use 8% for stocks (5% if you include inflation)… but I Doing I think I have some good reasons why that is the case.

When we use numbers that are unrealistic and unjustifiable – too optimistic or too pessimistic – we may not be bending reality, we are breaking it.

Not understanding longevity data.

If you’re planning to retire, you need to understand your longevity data. But retirees make two common mistakes with longevity data.

The first concerns “conditional probabilities.” A simple example – notice the subtle difference between these two statements:

• “The average life expectancy for all men is….”
• “The average life expectancy for men who reach the age of 60 is…”

We could rewrite the first statement as: “The average life expectancy for all men, included those who die before the age of 60…”

…and now the difference in those statements is quite large. One includes all premature deaths. The other doesn’t. We expect these two life expectancy averages to be very different.

For retirees, only the second statement matters! You care about your potential lifespan depending on the fact that you have already reached that point in your life.

Now, the second Common longevity mistakes involve benefits. This graph may look a little weird, but let me explain it simply:

First, it shows data on men born in 1954 who had reached the age of 62 in 2016. In other words, it is the “good data” we just discussed, that is “depending on surviving to the present age.”

The horizontal/x-axis shows future age. That’s quite simple.

The green line corresponds to the left vertical/y axis. It says: “For this group of 62-year-old men, what are the chances that you are still alive? at this specific age?”

70 years? About 90%.

80 years? About 65%.

100 years? About 5%.

The red bars correspond to the right vertical/y axis. These red bars say: “For this group of 62-year-old men, what is the probability that you will die? at this specific age?”

70 years? About ~1.8% of the group dies at age 70.

80 years? Approximately ~3.0% of the group dies at age 80.

100 years? About ~1.0% of the group dies at age 100.

For this cohort, there is a ~1/3 chance of being dead by age 80.

There is a ~1/3 chance that you will live to be over 90.

And the last 1/3rd part concerns death between the ages of 80 and 90.

Lifespan is not one number. It’s a spectrum of numbers. That makes it a real challenge to plan around. But you cannot and should not torture longevity into a single number.

This article could probably go on forever, but I don’t want to torture the idea much further. Numbers can easily fool us if we’re not careful.

“It’s remarkable how much long-term benefit people like us have gained by consistently not being stupid, rather than being very intelligent.”

Charlie Munger

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