Understanding The Black Swan… Thy Name is Retirement
Photo courtesy of Barry Sacks, J.D. Ph.D.
If you’re at or near retirement age, or concerned with retirement for whatever reason, you absolutely NEED to come to understand the significance of “The Black Swan,” and Black Swan events, because these events will have the biggest impact on anyone’s retirement years.
Black Swan events are the events that are considered rare and unpredictable, and that have an extreme impact on our lives. They are the events with which we need to be most concerned about during retirement, because when they happen, they’ll cause the most damage to our lives during a time when we are least able to recover from their impact.
The concept of the Black Swan event was most widely introduced in 2007, by Nassim Nicholas Taleb, in his book, “The Black Swan,” which was described in a review by the Sunday Times as “one of the twelve most influential books since World War II.”
As of February 2011, The Black Swan had sold roughly 3 million copies, spent 36 weeks on the New York Times Bestseller list, been translated into 31 languages, and was credited with predicting the banking and economic crisis of 2008.
At its core, the book, The Black Swan, is about the significance of unpredictable events, and here are Taleb’s three criteria for judging a Black Swan event:
- The event is a surprise.
- The event has a major effect.
- After the first recorded instance of the event, it is rationalized by hindsight, as if it could have been expected.
Think about your own experience with saving and investing for retirement. If you’re over 45, then you’ve probably experienced three significant bubbles, and when I use the word, “experienced,” perhaps I should say, “endured.” Consider how your 401(k) account has been impacted by the norm, versus how its been diminished by Black Swan events.
In normal, relatively uneventful years, chances are your balance went up moderately, maybe by 8 or 10 percent on a good year, or maybe even down by a few points during a bad one. But how did you do in 2000 or 2001? Chances are your balance in those years went down by 20 percent or more.
In 2008, the S&P 500 fell by 38 percent, so to make up for that kind of loss, you’d need to earn 76 percent on your account balance. If that happened to your account during the early years of your retirement, chances are… you went back to work
Consider that to make up for a 20 percent decline, you need to make 40 percent on your investment account, and it becomes obvious that the catastrophic down years have a much greater impact on our savings than the normal years.
The Black Swan event we’re most familiar with today, involves the meltdown in home prices that began in 2007 and left tens of millions of American homeowners “underwater,” or in other words, owing more than our homes are worth. That Black Swan event derailed the retirement plans of countless Americans who had all counted on their home’s value as being a major part of their retirement savings plan.
What are your plans for retirement?
Today, when I ask people at or near retirement age about their plans for retirement, a disturbingly high percentage reply saying the same sort of thing: “I’m just going to work until I drop dead.”
That’s a clever phrase, I always think to myself, but I’ve learned watching my own parents and in-laws age that real life actually doesn’t offer us that as an option very often. Very few of us will be perfectly healthy until the day we die… rather, something will happen to us along the way that will prevent us from working or significantly reduce our potential to earn the income we were used to earning in prior years.
Now, I’m only 53 years old, so I’m not going to claim to know everything about what it’s like to retire, but there is one thing about one’s retirement years that I know for sure is true: Running out of money at 83 and living until 93… would be horrible.
That’s about the worst outcome to an otherwise successful life that I can imagine… to spend one’s last ten years in abject poverty with no appreciable way to change things for the better.
That outcome is what we all need to avoid at all costs, and that doesn’t mean worrying about what happens in normal years… you know, the kind of years you or your financial planner can forecast. To protect our lives from that horrific outcome means making them Black Swan event-proof, because those are the events that will make whatever planning we’ve done look like we barely planned at all.
Photo courtesy of Barry Sacks, J.D. Ph.D.
I’m not sure anyone can actually plan properly for decades of retirement…
We should all take a moment to realize that the idea of retirement lasting for 20-30 years is a fairly new one… it’s certainly not something generations before us have had to deal with, at least not without the safety net of a defined and guaranteed pension plan. In point of fact, the baby boomers are the first generation in this country attempting retirement based largely on a combination of Social Security, home values, and stock market returns… and I’m just not sure true preparedness even possible.
The idea that anyone can accumulate enough wealth to maintain a lifestyle for 20-30 years… a lifestyle that was difficult enough to maintain while bringing home a paycheck every two weeks… I mean, well… maybe you can, but short of accumulating countless millions, would you ever really know you had enough to withstand the Black Swan events likely to occur over 20-30 years or longer?
If the noteworthy Black Swan events of the last 30 years are any sort of guide, that would mean being financially prepared to make it through the stock market crash and Savings & Loan crisis of the late 1980s… the recession and home price decline of the early 1990s… the dot-com boom and crash of 2000… the attacks of 9/11… the financial meltdown and spike in unemployment that started in 2008… and the housing market meltdown of 2008 – 2012, that in truth continues today… all without any income from work?
Come on… assuming I don’t have the sort of mega-millions that for the most part, can never be exhausted… is such a thing even possible? Maybe you can plan for what you foresee as potentially happening by diversifying your investments, or saving conservatively, or by being diligent about living according to a carefully calculated budget. Maybe you can protect your life from the normal threats, but none of those plans are likely to protect you from a true Black Swan event coming to pass.
If the dollar were to lose its stature as the world’s reserve currency, for whatever Black Swan event inspired reason, what would happen to our economy?
Well, for one thing, dollars would flood back into the U.S. as countries stopped them in reserve, and that would mean prices here would rise. By how much… we don’t know, but we do know there are about as many dollars held outside the U.S. today as exist inside the country so it wouldn’t be insignificant, by any means.
Let’s say that gas prices spiked from $5 to $10 a gallon, as a result, what would the impact be on interest rates… the stock market… the bond market… unemployment… commodity prices and futures… inflation? Could that sort of thing throw us into a depression? Would we react in time to mitigate the damage and if not, how long would it last and how bad could it get?
What if the European Union were to default on its debt? What if a country actually used a nuclear bomb during wartime? What about the potential for a virus to cause the same sort of damage seen as a result of world wide influenza epidemics of the past?
And just as importantly, on a personal level, what about needing hundreds of thousands of dollars for medical care not covered by Medicare or other insurance? Or, the potential for another Katrina-type storm occurring wherever you may live… or a loved one being unjustly accused of a crime and requiring a seven-figure legal defense… or finding yourself or someone you love the victim of a violent crime… or to be left as a paraplegic after being hit by a drunk driver or simply slipping and falling while taking a bath?
Over the last eight years alone… I’ve had a best friend commit suicide, a spouse diagnosed with cancer, a drunk driver hitting me from behind at 105 MPH, a brand new car totaled while parked in a parking space, my 401(k) turn into a 201(k), and my home’s value cut by a third or more.
Of course, during that same time, I’ve also see my phone become capable of first taking and then sending 10 megapixel photos around the planet in seconds… I’ve seen my daughter get into U.C. Berkeley… my in-laws requiring several years of in-home care… and things in business and in our society as a whole change 180 degrees.
In California, we’ve all been told countless times to expect a devastating earthquake to reoccur at some point, but how many of us even have emergency water that would keep us alive for a week, should no other source be available? I don’t know the answer to that question, but I’d bet money it’s a low number.
So, what are you prepared for during your retirement years?
Understanding the lessons of Taleb’s “Black Swan,” and the relevance of the concept to our retirement years, means understanding that what you don’t know is likely to be far more relevant to your life than what you do know. In fact, he explains that many Black Swans are caused and then exacerbated precisely by their being unexpected.
Had the tsunami in the Pacific back in December 2004 been expected, he explains, it would not have caused nearly the damage it did… an early warning system in place would have dramatically changed the loss of life and the subsequent lives of untold millions.
As Taleb puts it… “what you know cannot really hurt you.”
Taleb rants about how “… we produce thirty-year projections of social security deficits and oil prices without realizing that we cannot even predict these for next summer. Our cumulative prediction errors for political and economic events are so monstrous that every time I look at the empirical record I have to pinch myself to verify that I am not dreaming. What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it.”
When the metaphorical phrase “Black Swan” first became part of the English lexicon… swans, in all cases were defined as being white. No one had ever seen a black swan, so it was presumed that black swans simply did not exist… just as if one had said, “purple cow.”
Then an event occurred that forever changed our perspective on swans and their pigmentation potential. What was it that happened? Well, someone saw a swan… that was black, of course. You could say it was a “black swan event,” if you get my meaning.
In 2001, Nassim Taleb’s wrote his first non-technical book, “Fooled by Randomness,” which was about the underestimation of the role of randomness in life, and focused on events in the financial markets. It was selected by Fortune as one of the smartest 75 books known. Then, in The Black Swan, Taleb extended the metaphor to events beyond those occurring in financial markets.
Click image to buy “Fooled by Randomness” on Amazon.com
On the subject of business in particular, Taleb is highly critical of the widespread use of various models used to calculate risk. For example, he cites a paper produced by academics at Oxford University that, based on data from 1,471 IT projects, showed that although the average cost overrun was only 27%… one in six of the projects had a cost overrun of 200 percent.
In his New York Times article of April 2007, Taleb explained that his concern was with our willful blindness with respect to randomness. He asked: “Why do we, scientists or nonscientists, hotshots or regular Joes, tend to see the pennies instead of the dollars? Why do we keep focusing on the minutiae, not the possible significant large events, in spite of the obvious evidence of their huge influence?”
He goes on to explain…
“It is not so hard to identify the role of Black Swans, from your armchair (or bar stool). Go through the following exercise. Look into your own existence. Count the significant events, the technological changes, and the inventions that have taken place in our environment since you were born and compare them to what was expected before their advent.
How many of them came on a schedule? Look into your own personal life, to your choice of profession, say, or meeting your mate, your exile from your country of origin, the betrayals you faced, your sudden enrichment or impoverishment. How often did these things occur according to plan?”
What you do not know, and cannot predict… is what’s most likely to hurt you.
Our inability to predict Black Swans, coupled with a general lack of awareness as to this state of affairs, means that certain professionals… although they believe they are experts… don’t actually know significantly more about their subject matter than the general population. Taleb acknowledges, however, that they are much better at narrating… and also more likely to wear a tie.
Taleb teaches that because Black Swans are unpredictable, rather than try to predict them, we need to accept their existence and “build robustness against negative ones that occur.”
He illustrates two possible ways to approach unpredictable events:
“The first is to rule out the extraordinary and focus on the ‘normal.’ The examiner leaves aside ‘outliers’ and studies ordinary cases.”
“The second approach is to consider that in order to understand a phenomenon, one needs to first consider the extremes… particularly if, like the Black Swan, they carry an extraordinary cumulative effect.”
As Taleb says quite candidly…
“I don’t particularly care about the usual. If you want to get an idea of a friend’s temperament, ethics, and personal elegance, you need to look at him under the tests of severe circumstances, not under the regular rosy glow of daily life. Can you assess the danger a criminal poses by examining only what he does on an ordinary day? Can we understand health without considering wild diseases and epidemics? Indeed the normal is often irrelevant.”
Black Swan… Thy Name is Retirement.
This past year, I’ve spent researching and writing about reverse mortgages and reverse mortgage programs, and after talking with literally hundreds of Americans at or near retirement age, I’ve come to the conclusion that for a number of reasons they are the most misunderstood financial product ever offered in this country. It’s actually safe to say that no one has a complete understanding of how the various reverse mortgage programs can or should be used by almost everyone qualified to use one. Without question people need more information on reverse mortgages.
But, most of the time, when I ask a retiree why they aren’t taking advantage of what a reverse mortgage would offer them in their situation, I hear the same sort of reply: “We’re okay financially, we don’t need a reverse mortgage… yet, anyway.
They’re saying that they don’t feel the need to borrow money at that moment, but the reality is that whether you need money or not at any given moment, is the least of all reasons for considering opening a reverse mortgage. In fact, not needing it is one of the best reasons I can think of for having one, how’s that for a statement that sounds like it cannot be correct… but is?
It doesn’t matter how prepared we think we are for retirement, because there’s simply no such thing as being truly prepared for 20-30 years without income. And while Black Swan events that hit us during our working years are difficult enough to overcome, those that impact our lives during retirement have the potential to be cataclysmic. We simply cannot recover without income, with fewer years ahead, and with less tolerance for risk.
The reverse mortgage as a line of credit…
Opening a reverse mortgage as a line of credit is simply adding a safety net from which you can draw tax-free cash when you need additional funds during our retirement years, but it’s also a source of funds that increases in value by the amount of the interest rate every year you don’t use it… regardless of what happens to the value of your home.
In other words, your home may go down in value over five years, but your line of credit can only go up, and it will go up by whatever the interest rate is for that year. If the interest rate were 5 percent, for example, your available line of credit would increase by 5 percent that year… and every year just like that until you needed to use the available funds.
So, in 10 years, if your line of credit were to increase 5 percent each year, your line of credit would have gone up by 50 percent over that time, even if your home’s value stayed flat or even went down. Why every homeowner over 62, who owns his or her home free and clear wouldn’t have one of those is frankly beyond me, if for no other reason than to act as a hedge against their home’s value decreasing or remaining flat.
There are homeowners in Las Vegas, for example, whose lines of credit on reverse mortgages are $200,000, while their homes are only worth half that amount. And a reverse mortgage line of credit can never be cancelled as so many Home Equity Lines of Credit (HELOCs) were in 2008 and 2009.
Switch to a reverse mortgage to pay-off your home during retirement…
Many who are over 62 today still have mortgages they are attempting to pay-off, and almost all are still working at least part-time as a result. Many in this group will also say they don’t need a reverse mortgage, because still working… they’re able to make their mortgage payments.
These people are all at risk of foreclosure, although they are most assuredly unaware of the threat. In truth, they are playing a homeowner’s version of Russian Roulette, gambling that nothing bad will happen to them before they’ve paid their loans in full. They are betting against the Black Swan affecting their lives, even though if they’d stop to think about it more carefully, they’d realize that betting against The Black Swan is no way to bet during one’s retirement years, because that’s precisely when such an event is most likely to be devastating.
Were they to simply transfer their traditional mortgage to a reverse mortgage, they could continue paying it off, but in the event something did happen to curtail their income in such as way as to prevent them from comfortably making their mortgage payment, they could simply skip making their payments for as long as needed without any negative impact to their credit score or their otherwise financially secure lives.
Again, why everyone over 62 with a mortgage balance that could be transferred to a reverse mortgage wouldn’t, is beyond me. The only rational answer is that they haven’t taken the time to learn about and consider why a reverse mortgage makes complete sense.
I mean, why would you want a mortgage that required you to make payments on a certain day each month, or risk your credit score being cut, or under more extreme circumstances, that could result in your home ending up in foreclosure… when you could have a loan that allows you to skip payments whenever you want or need to without any negative result?
A reverse mortgage makes your retirement portfolio last longer…
Numerous academics and other financial experts have written papers showing how, by accessing a reverse mortgage line of credit, you can extend the life of your retirement portfolio that’s invested in equities. My personal favorite is one written by brothers, Barry H. Sacks, J.D., Ph.D., and Stephen R. Sacks, Ph.D. (By the way, you can listen to what Barry has to say about the matter on the next Mandelman Matters Podcast.)
Barry is a practicing tax attorney in San Francisco, California. He has specialized in pension-related legal matters since 1973 and has published numerous articles in legal journals, while Stephen is professor emeritus of economics at the University of Connecticut. He maintains an economics consulting practice in New York and has published articles on operations research.
The idea is quite simple really… by accessing the funds made available by a line of credit tied to a reverse mortgage, you don’t have to take money out of a retirement portfolio during the years the market falls, thereby exacerbating the negative impact of those down years.
The result is that your portfolio recovers from those years faster and therefore lasts longer than were you to have withdrawn the funds you needed from your investment account during those down years. Barry and Stephen’s paper, which is totally worth reading, is titled: “Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income.”
Then there’s the HECM for Purchase… buying a home using a reverse mortgage.
The Home Equity Conversion Mortgage or HECM for short, is the reverse mortgage program made possible by Congress, regulated by the Department of Housing And Urban Development, and insured by the FHA. Among many other uses, the HECM for Purchase actually allows someone over 62, to purchase a home using a reverse mortgage.
To keep things simple, let’s say you were to put $200,000 down. You could them expect to purchase a home for at least $400,000, depending on your age, and have no required mortgage payments until you and your spouse passed away or you decided to sell or no longer live in the home.
That’s not to say that you couldn’t decide to make interest only payments or principal and interest payments, because you certainly could do either. But, what it is saying is that you wouldn’t have to make payments if you didn’t want to… or whenever you didn’t want to.
And it’s worth mentioning, in these days of strict income requirements in order to qualify for any type of bank loan secured by real estate, qualifying for a reverse mortgage doesn’t require any sort of credit score or income requirement to qualify (assuming you can continue to afford to pay your property taxes, insurance and normal home maintenance.)
And again… why everyone over 62 doesn’t know about and/or take advantage of such a program when buying a home during their retirement years… well, it’s truly a tragedy for many, that’s for sure.
Only the beginning…
Those are only a quick overview of why a reverse mortgage can be so important to those attempting to make it through 20-30 years of retirement… hoping against hope that all their years are normal ones, even though that’s never been true about any other 20-30 years period through which they’ve lived. I could think of a dozen other examples of how reverse mortgages can be used by retirees without any strain.
Too many retirees today will say they’re fine. But no one’s fine, because it’s just not possible to be fine without income for two or three decades at a time.
Who is Nassim Taleb?
Nassim Nicholas Taleb earned his B.S. and M.S at the University of Paris, his MBA from Wharton and his Ph.D. also at the University of Paris. He has been a professor at several universities, and is currently Distinguished Professor of Risk Engineering at New York University Polytechnic School of Engineering and Distinguished Research Scholar at Said Business School, University of Oxford.
He was Visiting Professor at London Business School and the Dean’s Professor in the Sciences of Uncertainty at the Isenberg School of Management at the University of Massachusetts Amherst, Adjunct Professor of Mathematics at the Courant Institute of New York University, and affiliated faculty member at the Wharton Business School Financial Institutions Center.
Finally, lest you think of him as lacking real life experience, he has also been a hedge fund manager,a derivatives trader, and is currently a scientific adviser at Universa Investments and the International Monetary Fund.
He criticized the risk management methods used by the finance industry and in 2007, and subsequently profited from the late-2000s financial crisis. In 2007, in The Black Swan, Taleb offered the following warning about the coming crisis. Reading it today is nothing short of chilling…
“Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails, they all fall.
The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur …. I shiver at the thought.
The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deem these events “unlikely”.”
That warning was offered more than a year before both Fannie Mae and Freddie Mac had to be taken under conservatorship by the federal government in order to prevent their collapse, which would have impacted over $5 trillion in debt securities held by financial institutions all over the globe.
Click image to buy “The Black Swan” on Amazon.com
The solution is to embrace Black Swan thinking…
The phrase “black swan” derives from a Latin expression, “rara avis in terris nigroque simillima cygno,” which means “a rare bird in the lands and very much like a black swan,” and the importance of the metaphor is found in its analogy to the fragility of any system of thought.
Taleb’s work, beyond showcasing the potential for Black Swan inspired problems, also offers real life solutions. He advocates what he refers to as a “black swan robust” society, which he defines as “a society that can withstand difficult-to-predict events.”
And to the extent we can create them, we should all have Black Swan robust retirements.
It’s not that we can hope to predict Black Swan events, but we can build our lives to protect them against negative ones occurring… because we may not know then when or the what, but we all should know by now that they will occur. And when they do, while we can be sure that we won’t be nearly as ready as we would have liked… we should at least be as ready as we can.
You can continue to ignore the reverse mortgage, but increasingly you will find yourself alone. The point is not to wait until you need one… the point is that by having one you’ll protect yourself from the next Black Swan event. And that sort of protection, we should have all learned by now, can be nothing short of invaluable especially during our retirement years.
Feel free to contact me for questions, further discussion… or to have a debate about reverse mortgages, should you think I’m wrong. I’m not, but I’d love to hear whatever you have to say, or help you understand how and why you might look at a reverse mortgage in your specific situation.
Send your email to: Mandelman@mac.com