When mountain biking with my wife and friends, we often remind each other of a very important concept–the penalty of failure*. There is nothing quite like a big drop off the side of the trail to change the risk-reward equation when encountering a particularly technical, rocky section. Without the potential of a long, painful fall that could seriously impact our ability to enjoy future outings, we might otherwise ride the section with confidence…or at least give it a sporting attempt. It is that relatively small possibility of tumbling down a steep hillside into a rocky creek that overwhelms the depleted testosterone levels of the 50-somethings I choose to ride with. Humility is our friend.

I used to joke that helmets messed up my hair. That was before the brain surgeons shaved my head and then closed up the suture with stainless steel staples. – Comment on blog discussing the bicycle helmet debate

Considering both the penalty of failure and the probability of failure is important in personal financial planning. If they are severe enough, the consequences of our potential failures are often more important than the probability of our success or failure. This is why we buy fire insurance for our homes, and life insurance while we are young, healthy and raising children. Although we know we will likely never cash in on the policies, the downside is just too much to risk.

Retirement planning is a key area where we should be concerned not only with the probability, but the penalty of failure. We don’t just want to know what will happen if things go well, but how will we fare if things go bad. Your financial projections may look great, assuming you get reasonable returns on a consistent basis, and you don’t live much beyond your life expectancy. However, what happens if market returns are significantly lower for an extended period of time, or you simply have the back luck of encountering a bear market right when you start to take large withdrawals from your retirement accounts? What happens if you (or your spouse, or both) happen to live long beyond your average life expectancy–say to age 95 or 100? In addition, what are the consequences if one of you (or both) needs expensive long term care services?

We can’t eliminate all of the risk in our lives or financial plans. However, we can often mitigate the consequences of failure or bad luck. We can lessen the potential penalty of failure by implementing different strategies to secure a healthy, guaranteed minimum floor of retirement income that will last for a lifetime. For example:

• Maximize your Social Security benefits, which will give you (and your spouse) inflation adjusted benefits for across both your lifetimes.
• Consider forgoing the lump sum benefit, and take your employer pension (if you are fortunate enough to have one) as a monthly annuity with survivor benefits.
• Use some of your retirement savings to purchase low cost immediate annuities to create your own lifetime income stream–a do-it-yourself pension. Although it adds to the cost, consider buying these with inflation protection.

Even if you think the probability of needing expensive long term care is low, consider the penalty of failure. Will you have sufficient income and assets to pay for care, even if the markets don’t cooperate? If the penalty of failure is simply a smaller inheritance for your children, this is an acceptable risk for most of us. However, if the penalty of failure is leaving your spouse financially insecure or destitute, than the risk is simply unacceptable. If the penalty of failure is relying on government assistance (Medicaid) you should strive to avoid it by proper planning. Although we may not eliminate this risk, we can mitigate the consequences by purchasing a reasonable level of long term care insurance, or by dedicating sufficient assets to pay for any necessary care.

If you study enough financial planning literature, you are bound to come across references to Pascal’s Wager. Blaise Pascal was 17th century French philosopher, who reasoned that although it was impossible to prove the existence of God, it was a smart wager to believe in Him when a person considers the consequences of the decision. When you weigh the costs, benefits, risks and rewards, it is certainly a much better bet to put faith in God than to join with the non-believers. Although I suspect that financial writers have taken considerable license in adapting Pascal’s reasoning to modern day risk management, that isn’t critical for our purposes. The key point is that in making decisions, avoiding unacceptable outcomes (e.g. eternity in hell or moving in with your in-laws) should be a top priority.

When making our personal plans, we would all be wise to consider the sage advice of respected author, investment advisor, and former Oregon neurologist William Bernstein: “Always consider Pascal’s Wager: What happens to my portfolio–and my future–if my assumptions are wrong?” You can count on him for a consistent reminder that, “The name of the game with retirement planning is not to get rich. Instead, the goal is to not be poor.”

You can also bet he has a strong opinion on wearing bike helmets.

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*Miles lived to ride another day. See him after the crash.