In June of 1812 and the height of French military power, Napoléon Bonaparte crossed the border at the Niemen River and launched an ill-fated invasion into Russia. Commanding an army of 680,000 French soldiers and conscripts, Napoléon by some estimates started with the largest and most powerful military force ever assembled. Ironically, at the start of his campaign Napoléon had no real intention of marching on Moscow. A few quick battles, near the border and it would be over. As every schoolchild now knows, things didn’t quite work out according to plan.
So how did the Tsar’s peasant army manage to neutralize a force whose power vastly exceeded its own? As the war stretched on, it turns out the Russians had two enormous structural advantages: the French supply lines became overstretched with each advancing step towards Moscow, and the bitter cold of the Russian winter turned lethal for a French army that was unprepared. The fatal flaw in Napoléon’s campaign strategy was not that he picked the wrong battles, it was he deployed his forces against one foe when in reality there were three.
When it comes to sustaining a successful investment planning campaign, the challenge of recognizing the threats hiding in plain sight are remarkably parallel to those that confronted Napoléon. Ultimately, every investor needs to understand there are three disguised threats to their financial security and devise a plan that confronts all three simultaneously.
Whether it’s the myriad of choices that constantly compete for our attention in modern society (You’ve got mail!) or a somewhat innate inability to think abstractly about our future selves, our species is one that displays a remarkable tendency to dwell in what’s been described as the “eternal now”. This is the root cause behind undersaving and overspending.
For Napoléon, capturing more and more territory as his army advanced undoubtedly felt good in the moment. But the resources necessary to sustain his forward momentum and consolidate gains extracted a heavy toll that went unnoticed until it was far too late. Similarly, the ability to think abstractly about the downstream financial impact of thousands of small purchase decisions is frequently short-circuited by our brain chemistry that administers a tiny dose of dopamine in the here and now. We’ve all heard the term “opportunity cost”, but few of us take the time to think a 7 ½% opportunity cost means that each $3.49 McCafe Iced Frappe Mocha purchased when you’re 30 years old compounds to $50.70 if saved until retirement at age 67. You may deserve a break today, but with an opportunity cost that exceeds $50 bucks a pop, how many trips through the drive-through can you really afford?
While no one should plan to live forever, it’s a safe bet that longevity risk (i.e. the risk of outliving your financial assets) is generally not something you’ve spent much time thinking about. With advances in health care, human life spans are stretching longer and longer and there's little reason to think that train is going to stop rolling anytime soon. Underestimating your functional investment time horizon is a second major source of undetected risk.
In financial planning terms, this is an incredibly big deal. For most families, the golden years have an increasing likelihood of extending well into the platinum years and beyond. Unfortunately, this means your financial supply lines probably need to be extended to nourish an investment time horizon that’s significantly longer than what you (or anyone else) originally thought. Since risk aversion shows a tendency to increase with advancing age, the costs associated with a longer time horizon will either require additional savings throughout your working years or any expectations regarding the size of the estate you’re able to pass on to heirs will need be more modest. While the road surely won’t go forever…it could be a lot longer than you think.
Like gradually dropping temperatures require an ever-growing expenditure of energy just to keep warm, inflation is the relentless chill that almost imperceptibly siphons purchasing power and makes your savings worth far less than you think. Albert Einstein is reported to have said compound interest is the eighth wonder of the world. Most people think of this as only impacting the asset side of the equation. Big Mistake. When compound interest is applied to the growth of expenses over time, the impact can be shocking.
What’s perhaps even more problematic, is that inflation will almost certainly have a disproportionate impact on some future expenses (e.g. assisted living, nursing care, & higher education) while price increases for other more immediate expenses (e.g. groceries, cell phone usage, gasoline) may inch up at a much slower rate. Unfortunately, the expenses having the highest probability of getting hit the hardest by rapid inflation are also those expenses that won't enter your cash flow stream until a more distant point in time. This makes it easier to overlook planning gaps because your current day to day cash flow experience seems to show expenses align more or less with expectations. Out of sight shouldn't automatically translate into out of mind.
If all this causes you to roll your eyes in frustration, you're not alone. Unless you’re in line to inherit a medium sized fortune, it’s best to keep in mind it’s unlikely that you’ll ever be able to live off investment income alone. A more realistic goal is to aim steadily toward reaching asset sufficiency. Asset sufficiency is achieved when the combination of social security income, defined benefit pension payments, passive income from the investments, plus periodic distributions of principal are able to meet all customary living expenses (indexed to inflation) over your projected life span…plus a little extra just to be safe.
While you may think your plan is on a smooth trajectory and everything will work itself out just fine, it’s always a good idea to have your math reviewed independently. Experienced practitioners will insist on rigorously testing your plan’s durability by modeling scenarios that expose it to any number of adverse conditions that may or may not materialize over the life of the plan.
And it turns out the real world is often a lot lumpier than most base plans assume. For example, what if health care costs continue to accelerate at double digit inflation? What if the sequencing of investment returns cluster a bunch of negative returns early in your retirement cycle (think about retiring in 2008) and it subsequently takes a long time for expected returns to revert back to normal? What-if one spouse dies prematurely and the survivor lives 10, 12, or 15 years beyond standard life expectancy? What-if all three of these scenarios occur in the same plan?
This isn't just idle speculation that's morbidly obsessed with manufacturing doomsday scenarios. Quite the contrary, these are responsible inquiries that help identify the boundaries between financial reality and mere wishful thinking. After all, drawing a contingency map to help navigate around life's financial obstacles may be the only thing that prevents you from coming up short and left out in the cold.
Michael Reid, CFA is a Managing Director and Partner at Exchange Capital Management who hears bumps in the night, occasionally sees monsters under his bed, and sleeps with one eye open. The opinions expressed in this article are his own.