Dan Ariely writes about financial behaviour:
Typically, a financial adviser takes 1% of assets under management—annually!—to balance a portfolio, and makes investment decisions on the basis of our answers to two questions: (1) “How much of your current salary will you need in retirement?” (2) “What is your risk tolerance on, say, a 10-point scale?”
Frankly, I think highly trained monkeys could do the same basic job given answers to those two questions. Certainly algorithms can do it, probably with many fewer errors. This is just not something for which we should pay 1% of assets under management. But the real reason we should not pay for it is that those questions don’t help optimize our portfolios.
To prove this, I asked many people those two questions. The most common answer to the first one was 75%. After some probing, I learned that most people named that amount because they’d heard it as a rule of thumb from financial advisers and from the media. You can see the inane circularity: Financial advisers are asking customers a question that the customers are answering with what the advisers have told them is the right response.
When I changed the question to “How do you want to live in retirement?” and costed out where people wanted to live, what they wanted to do, and so forth, I discovered that they would actually need almost twice as much: about 135%. (Think about how much money you would need if you had nine extra hours a day in which to spend it.)
I also asked people the risk question, varying the labels on the ends of the scale. I told some that the low end was 100% in cash and the high end was 85% in stocks and 15% in bonds. I told others that the low end was 100% in bonds and the high end was 100% in derivatives. Regardless of the labels, people chose somewhere near 5, depending on whether they felt slightly more or slightly less willing to take risk than what they thought of as average.
So what do we have? A service that costs 1% a year and is based on two not very useful questions.
Emphasis mine, of course.
I agree with him. 1% of AUM to answer these two basic questions is highly inappropriate. 1% of AUM to answer ANY such questions is highly inappropriate.
But the important thing is that such questions are always going to be subjective, that you can’t have standard formulas, that the concept of planned retirement is a myth. In that context I invite you to read my own myth: How much do I need to retire?
You will never really know, until you retire, what your real costs are. I know people who spend a lot lesser. And I know those who spend more; from an office car to having to pay for petrol and driver, paying more for groceries because they have more meals at home, and of course, the desires of retirement like larger screen TVs and more air conditioning. Retirement is a state of mind; for all practical purposes, my current life seems like a retirement. However, I’m spending lesser than I did when I was employed, and even that is likely to change next year. I could have hardly predicted this.
We assume 6% inflation – it could be much more or less. We assume stocks will return 12% over a long term – in the US, the last 10 years have returned less than that IN TOTAL. In fact, from 1996, when Greenspan said “Irrational Exuberance”, the Dow has returned approximately 75%, a pathetic 3.9% per year. In India, the Nifty over the same term has given us around 10% per year, most of it in the few years since . 15 years is a long enough term; people at 45 now need to wonder if the next 15 will reflect the US.
We assume lower risk taking abilities even for ourselves, after retirement. But for a person whose needs are satisfied, the risk taking ability is substantially higher; if my mother had sold my dad’s stocks after he passed away, she would be left with about 2x that money rather than the 25x his stocks returned. (Note also that the index gave just 5x since then) Risk is not something you can quantify even you were bitch-slapped in the face.
(In that sense, the Ariely experiment was flawed. If you ask people how much risk they want to take after retirement, they will choose the politically correct answer.)
If I had constructed a plan with utmost care 10 years ago, I would have been wrong about nearly everything. About when I wanted to retire, about how much money I needed to spend, about how inflation would affect me. If I construct it now, I will be wrong. The only thing I can think of is: make a plan, and then adapt as you go along.
So the right answer to “How much should I save for retirement” is: it depends. And even for that, you can’t charge the 1% of AUM, unless of course, you choose to live in the real world, where if you put TV ads showing people playing with their grandchildren despite having white hair, people will throw money at you. We live in the dirty world of instant gratification, and we’re willing to pay 1% of AUM for that.