Expectancy theory proposes that an individual will behave or act in a certain way because they are motivated to select a specific behavior over others due to what they expect the result of that selected behavior will be. Wikipedia
Expectancy is odds making. The human is very keen on odds making. The human brain is sub-cortically wired toward risk avoidance. It is a survival mechanism and it happens without thought, but can be affected by memory and other cortical and subcortical structures. The site of risk analysis seems the Cingulate cortex. It sits next to the center of memory, the Hippocmpus. Other sites are involved like prefrontal cortex but the point is risk aversion happens automatically below the level of thought.
Risk aversion is wired in the human at a level of 4:1 biased in favor of aversion. Given a situation you are 4 time as likely to chose the risk averse outcome. Risk aversion can be modified towards more risk by other sub cortical structures, and is part of the reason an otherwise responsible adult becomes addicted to cocaine, or someone pays 10 grand to go on a Sandel’s vacation to have the time of your life.
So what’s this got to do with expectancy? Humans given rational choices can modify the risk adverse behavior bias towards something more likely to succeed if presented with the right data. The reason people sell in a panic is because of 4:1. If you’re presented with “the data” you close your eyes and hang on. There is a whole huge Social Psychological literature devoted to this kind of game analysis.
David Graham MD wrote recent articles HERE and HERE that looks at the expectancy of keeping or quitting disability insurance at various points in portfolio accumulation. The bet is what is the likelihood of becoming disabled vs what is the cost of insurance with the presumption of “financial independence” (whatever that means) . He uses statistics to game out the statistics of cost vs benefit for keeping vs quitting. The analysis is specific but also global in how to think about risk analysis. I highly recommend the articles. A major conclusion is do not base your decision on sunk cost, the money history of what you have paid. Base your conclusion on the future cost vs the probability of need and the amount of payback.
Part of David’s discussion presumes “financial independence” but as we all know FI is a slippery number. It can be whatever you want to call it up to the very day you retire. When you retire is when the rubber meets the road. The dice will be cast and your future will unfold from there. It’s no more a “slippery” number, it is nailed down and there is no W2 to cover your risk.
My tact will be to look at the outcome on portfolio longevity if you are forced to “retire early” perhaps earlier than you intended with a presumption of “financial independence” People tend to believe they are FI and therefore bullet proof (FU Money) without actually doing the analysis. So I’m going to game out an analysis and see what disability insurance really is, it is not disability insurance at all, it is portfolio protection insurance. Sometimes when you FU you are the one who gets F’d. Earlier retirement (greater portfolio longevity) and early SORR are killers to future wealth and success in retirement. So let’s add a little earlier retirement and SORR to the analysis.
I’m going to use a BH3 portfolio, a common portfolio used by accumulators. I’m going to use 4% WR a common WR used by the presumed FI crowd and I’m going to vary the nest egg size based on a retirement earlier than expected, and I’m going to include medical expenses since permanent disability often includes considerable medical expense and the expense occurs up front. That is the actual scenario of someone forced to go out on disability say 5 years early or 10 years early and tap their FU money before expected. I’ll use Monte Carlo to do the statistical analysis. Follow along with the narrative!
Scenario 1 Drop the disability and save 6K/yr
We have a 60 yo WM Physician in good health who expects to retire at age 65. At 65 he expects to have 2.5M in the bank in a BH3 portfolio and he intends to spend 100K/yr in retirement, the typical 4 x 25 and claim SS at FRA. That’s his plan. He goes skiing the back country of Telluride and destroys is right leg and hip to the extent he will require extensive and multiple surgeries and rehab. He is forced to retire but he let his disability insurance lapse because he believes he has “FU money”. He read it on a blog.
Since he expects 2.5M at 65 he has 1.6M in his portfolio now, and adds 65K/YR which will equal 2.5M at 65, so he’s not really Fat FI but thinks of himself as FI. He is expecting Medicare to pick up his health care risk, and he could claim SS at 65 as a backup plan. He is forced to retire early which means his portfolio must cover a longer period. His portion of the out of pocket medical expense in the first year is 100K and 50K the second year and he has an ongoing 25K/yr ACA plan plus a 10K deductible each year.
I’m going to model the upfront cost as a bad initial SORR for 2 years on the portfolio since that is what the medical cost represents bad SORR and I’m going to keep his 100K living expense outlay constant to start (6.25% WR).
YIKES no scenario survives unscathed. Even at 90% best return, 80% of the money is gone at 35 years.
Lets readjust to 4% of 1.6m. He now lives on 64k/yr (a 36%reduction in life style) and can just qualify for ACA subsidy.
Only 57% of the portfolios last 35 years and remember the ACA, he barely meets the subsidy.
He decides to take SS at 62. His SS at FRA is 35K. His age 62 SS is 80% of FRA SS, or 28K /yr. We add 28K + 64K he now makes 92K/yr but he is still running out of money before he reaches 33 more years, 43% of the time! So he further reduces his WR to 55K/yr
He barely makes 30 years on 55K/yr WR in the worst case. If you include SS plus his 55K retirement income at age 62 he lives on 55K +28K or 83K/yr. His portfolio has a 90% chance of survival. Not a terrible life but he’s not swimming in the dough either. It’s definitely a downgraded future but he does have a future. He still has the ACA insurance costs to pay from his 83K, until medicare kicks in. So much for FU money.
Scenario 2 Disability intact
Our skier has a 10K/mo policy which kicks in till 65. So he will receive 600K tax free over the next 5 years. He still starts with 1.6M in the bank and the 100K and 50K year 1 and 2 medical expense and the ACA cost of 25K and 10K deductible. He scales his living expense back to 80K/yr (a 20% reduction in life style). His first year cost is 100K + 25K + 80K = 205K. His income is 120K from insurance so he has to tap his nest egg for 85K. His nest egg remains constant at 1,600,000 that year despite the 85K tap. Not advancing, but holding even despite the bad SOR (medical expense)
The next year he has a 50K medical expense so his cost is 50K + 25K + 80K= 155K and his income is 120K so he needs to tap his retirement for 35K and his nest egg grows to 1,672,000 in the second year. The next 3 years his medical expense plummets but he is left disabled and continues to receive 120K tax free. He stays at 80K/yr living expense plus 25K ACA but his medical expense is way down so his cost of living is 105K and he puts the extra 15K in his portfolio to grow, because he knows the gravy train is going to end and he is now acutely aware of whatit means to own your own risk and not offload it on an employer or insurance company.
At 65 his portfolio is worth 2M. He retires at 65 on 2M and takes medicare which drops his medical expense to 260/mo or 3120/yr. He continues to live on 4% of 2M or 80K/yr for 2 more years until FRA. At FRA (67) he takes his 35K/yr SS, so his income becomes 115K/yr. He adjusts his living to 100,000/yr of which 35000 is SS so his portfolio WR drops to 65K/yr or 3.25%. His portfolio Monte Carlo’s to:
His portfolio success is now 96%. He lives on his anticipated 100K/yr. He no longer skis. He walks with a cane, but his brain is intact. He writes a financial blog about what it means to be FI. He can reach in his accounts and snatch out 25K for his daughters wedding and he will hobble her down the aisle. His disability costs was $6000/yr. As you can see his disability insurance was really portfolio insurance because it protected his portfolio. It is true he may never have injured himself and wasted an extra 30K on unused insurance. That means he would have wasted an extra 30K to protect the portfolio’s growth to 65. That unused 30K would have guaranteed the extra 500K at full retirement. (2M vs 2.5M)
You can draw your own conclusions regarding FU money and the value of disability to protect your portfolio. Your subcortical structures have already analyzed the reality and the 4:1 risk management bias is kicking in. Do not under estimate your vulnerability with your heady belief in your invincibility. The numbers will humble you in a heart beat.
Disability Insurance in this case is like owning a 5 year alternative 600K portfolio at the cost of 6K/yr. It protects the main portfolio when the main portfolio is at it’s most vulnerable. Portfolios take a long time to disintegrate, typically decades and a wrong move early, like thinking you are more financially independent than you really are, can be devastating despite all the blogoland noise about the joy and power of being FI. The Disability Insurance protected against SORR, for this is also a study of SORR and it’s dangers. The DI also re-indexes the main portfolio to a more sustainable state before withdrawal begins in earnest. The portfolio begins to be emptied at 65 instead of 60 except for a little dab up front for medical expense. In effect the DI is the equivalent to my “fuse portfolio”I’ve written about before. an extra $17,000/yr (1500/mo) makes a lot of difference in the relative luxury of a given retirement.
This post still looks at expectancy. It compares 2 scenarios and the cost of each scenario and the payout of each scenario statically using a Monte Carlo engine. The thing about retirement is it lasts a long time and the effects needs to be analyzed to the end not just to the middle.
6 Replies to “Expectancy Theory”
Thanks for a great analysis and improving my intuitions about risk. I had been tempted to drop DI in the past due to costs and a growing portfolio, but I like your idea of portfolio insurance.
I read in a previous comment you had used Liberty Healthshare for your family? Is the insurance product robust enough? Do you recommend this for those who retire early and lose employer sponsored coverage?
Liberty is OK if you are healthy. There is stuff it doesn’t cover like drugs but good RX does a credible job for that if you can use generics. You still have to pay out of pocket for things like office visits. My healthy wife and 2 early 20 year old kids were about 500/mo 500 deductible. My daughter split off when she graduated college to her own policy. She had a 24 hour admit for a ruptured ovarian cyst and generated a 10K bill. She had to jump through some hoops like getting the self pay rate but Liberty paid. Like pretty much any insurance it was bureaucratic and annoying. If you have pre-existings or mental health issues it takes 3 years to time out the pre-existing and mental health is never covered. So it’s a mixed bag depending on your needs. It fits my needs given the size of my portfolio. It’s basically high dollar coverage and I pay the rest out of pocket.
My analysis is just a scenario but it demonstrates the tools and logic to do your own analysis for your given situation. We lost a hospital contract when I was 58. I had “enough” but I was far from bullet proof we could have eeked by. I had 2 kids heading into college and had that pretty much covered but there is always something. There is a law called Hofstadter’s Law, if you’ve never heard it, states: “It always takes longer than you expect, even when you take into account Hofstadter’s Law.” The law refers to complex problems like the complexities of computer programming. The corollary (mdonfire’s law) can be applied to financial planning that it always takes more dough than expected to assure your portfolio doesn’t fail. The 50% line is average but if your retirement isn’t average and you misjudge you run out of dough before you run out of breath.
Like the comparing scenarios you listed and the striking differences in outcomes because of carrying DI.
I actually dropped my private DI this year. I did so because I still have group DI (which you cannot opt out of) so I am not going completely bare.
Hi XRAY. This is just an article, an example, not an incitement of what “needs to be done”. It’s a method to judge between choices projected as logical probable outcomes. Fire is sold as “sure fire” and “simple” but that’s just selling and unfortunately we are sold a lot and not all of it is sound advice. The impulse to drop disability is from the notion it’s somehow frugal to get rid of that bad old insurance and save 6 grand. “Look at all the money I already wasted and never used it, why if I had invested that money…” It’s a false flag. All risk is future directed not historical, and the decisions you make today either increase your risk or reduce your risk. You may choose to increase if you understand the consequence. It’s the same as the notion DIY is ALWAYS superior because it’s “frugal-er” and we all know frugality is the MMM holy grail, without stopping to game out the consequences or even knowing there are consequences. The bottom line is protection costs money and expertise costs money. If you think your FU money is so big and you’re so smart have at it. (not you personally but the generic you)
Have you posted any opinions on using annuities as “portfolio insurance” (I like that term you referenced)?
I’ve read all the negative blogs about annuities. The one thing I never see really addressed (or maybe I’m missing it), is I see it as portfolio insurance.
Say, for example, you had 5M at age 65. If you purchased a 1M immediate annuity, it would pay out roughly 5K/month over your life expectancy (roughly a 6% WR over 20+ years). That money, combined with SS would be a pretty solid guaranteed “bottom” when retired. And of course your 4M could stay invested in a market stock index without too much worry of what happened with the market. It seems to me that 4M invested in the an index would outgrow a “safer” 50/50 stock/bond portfolio on the full 5M. Make sense?
Any thoughts on using an annuity as “portfolio insurance”?
If you want to leave your money to an insurance company annuities are OK. I think properly planning works better. If you have 5M why would you stick 1M in an insurance company? You know the actuary and break even is stacked against you. It’s like walking into a Vegas casino and sitting down at the black jack table. The house is going to win 9 times out of 10 in a long series of hands. If you’re good enough to win at black jack you’re good enough to manage your own risk instead of leaving your money to AIG. Some “experts” who tout annuities are basically bag men for insurance companies. These experts know who pays their bills and it ain’t you.
Self insurance is the reason I break my portfolio into different accounts, brokerage Roth TIRA Cash and tax loss harvest. TLH makes the brokerage behave as a Roth. You can extract money tax free so why would I own an annuity and get inferior returns? Roth is an account that grows tax free. If I never need it it grows tax free forever. If I do it coughs up it’s money on a PRN basis. Living on cash isn’t much different than living on an annuity. Lets say I have 500K in cash and spend 50K/yr mixed with 45K of SS. That’s 95 K of income, paying taxes only on SS which you would pay anyway. SS is tax advantaged to 85% so the extra 15% income pays for the taxes SS generates. In fact you could put the 500K in a 2% bank account and have enough to pay for 10 years effectively tax free and the 2% would account for inflation so you would loose no purchasing power. Do that conversion to cash twice in a 20 year retirement and you cover the cost of 20 years. If you make your TIRA small and make it mostly bonds it will grow slowly and will RMD only a small amount keeping you in the 12% bracket for a long time. You would pay a little more in taxes but not much. Since RMD is progressive the amount you get each year increases similar to inflation so once again your income is inflation adjusted (more or less). So I don’t see the advantage of owning insurance when it’s pretty easy to DIY for greater returns