Solving for the “Nastiest, Hardest Problem in Finance” — What William Sharpe Says
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As a Nobel Prize winner and professor of finance, emeritus at Stanford’s Graduate School of Business, William Sharpe is a big deal in the world of finance.
He has spent the majority of his life thinking about financial risks. He was instrumental in developing the capital asset pricing model and the Sharpe ratio, which measures risk-adjusted investment returns. In other words, when he has some things to say about retirement, that means it’s worth paying attention to.
The Nastiest, Hardest Problem in Finance
The Nobel Prize-winning professor did an interview with Barron’s magazine regarding what Sharpe dubbed as “the nastiest, hardest problem in finance”- which is to run out of money during retirement.
Sharpe has created a computer program that covers a large number of possible scenarios, with virtually every possible mathematical combination of lifespans and investment returns that could happen to a retired couple. You can get a copy of this program in his free eBook, Retirement Income Scenario Matrices.
Retirement Planning Outcomes Are Hard to Predict
However, it’s still hard to create an effective income plan for retirement even if you know all the angles. After all, you still don’t know which scenario will turn out to be the one for you.
In the interview, Sharpe admitted that the most difficult problem in finance is knowing how to strike a balance between having enough income to meet current needs (and wants, assuming someone has saved enough) and having enough to get you through your lifetime.
He said that there was no easy solution to this dilemma. That being said, he did say that he knows of a few concepts that can help people plan for the future.
Barron’s asked Sharpe about why he decided to undertake a project (his computer program) of such magnitude at this point in his life. Sharpe said that since most of his earlier work was geared toward helping people to accumulate money, it was only natural to help people plan their incomes during retirement.
Two Major Uncertainties in Retirement
Barron’s asked about why it’s so difficult to create a sustainable stream of income in retirement. Sharpe explained that there were two major sources of uncertainty involved, and that it is possible to reduce only one of them.
These two uncertainties are investment uncertainty and mortality uncertainty.
If someone puts money in an annuity with cost-of-living adjustments, then they can reduce the variability of investment returns. If they invest in virtually anything else, then they are subject to variability of investment returns and mortality.
This double uncertainty has the potential to derail even the most carefully laid retirement income plans.
Other Retirement Planning Highlights to Keep in Mind
A couple of other major takeaways from the discussion include:
1. Social Security Is One of the Big Issues of Our Time
Many retirees will rely on Social Security as a primary income source.
As Sharpe observes, Social Security benefits have been increasing with cost-of-living adjustments while “contributions” to the Social Security trust fund haven’t risen in proportion. One question will be how we handle the growing demands of this program in the future.
Without any real policy changes, SS benefits may be reduced in decades ahead. And beneficiaries might receive a roughly somewhere in the neighborhood of $0.80 or less for every dollar of payments promised to them with the reduction.
However, experts also say Social Security is one of the most well-managed programs by the U.S. government. Cash-flows from workers into the Social Security system would help maintain a stability of payments for decades and decades thereafter.
2. Annuities Are Evolving
Annuities are being reimagined and evolving with consumer needs and in response to the demand for “longevity coverage.” Coronavirus has had an impact on life expectancy. But people are still living longer than what they were a half-century ago.
Annuities have received some criticism for confusion and, in some cases, cost. At times, this has been justified. But in the same breath, it’s incorrect to paint all annuities as having expensive costs.
There is an entire universe of many types of annuities, products, and contract designs. This is like saying that all mutual funds are high-cost.
Cost-Effective Annuity Alternatives Available
Many fixed-type annuities come with low or even no fees. Many firms offering annuity products to their clients are compensated by the insurance company. Your entire initial premium goes to work for you from Day 1 inside your fixed annuity contract.
Dr. Wade Pfau, a leading research authority on retirement income strategies today, has even said that the costs of securing a guaranteed lifetime income from an annuity are low today. Especially when you consider that the demand for these products will grow and grow with people living longer!
Quick Thoughts from a Nobel Laureate on Annuities
Sharpe offered two good insights into the nature and purpose of annuities during his interview. They can be summed up as:
“In its most basic form, an annuity is a way to spread the risk of longevity. I don’t know how long I’m going to live. You don’t know how long you’re going to live. Annuities are a vehicle for pooling that risk. We who have been on the investments side have been babbling about pooling investment risk all our lives. Diversify, diversify, diversify. And yet, when we retire, longevity risk is at least as big a risk as investment risk, and you really should consider pooling some of that, particularly as you get into the later stages of retirement.”
“The insurance and investment industries are beginning to come together and provide products where you can take some investment risk and also pool longevity risk. Of course, that’s what produces a plethora of complicated products. I’m not advocating it particularly, but I think it’s interesting, and I think you’re going to see more products that cross over.”
Some Final Thoughts
Sharpe’s interview ultimately points to the fact that no single retirement income plan can possibly cover all contingencies even if there is no variability of investment returns. But that doesn’t mean that you will unable to plan for your future with confidence.
If you are trying to map out your own retirement income plan, you might consider enlisting the services of a qualified financial planner or experienced financial professional.
It might be worthwhile to complement this with your own research guided by that advisor’s input. You can explore retirement planning resources and software programs such as Sharpe’s eBook and computer program.
Above all, make sure that your income plan has some flexibility built into it to account for the unexpected. And it’s always better to have any type of plan than no plan at all.
Looking for Someone to Help with Your Retirement What-Ifs?
An experienced financial professional can help you in many ways. First, they have dealt with other client situations, and they know many of the unique problems, roadblocks, and opportunities that come up in a retirement financial picture.
They will have dealt with these issues in different market cycles, economic conditions, and personal circumstances. That background can bring knowledge and expertise that is valuable for your situation.
Finally, a good financial advisor who is still in business can indicate that they are a problem-solver. At the end of the day, knowing your problems and potential risks is wise, but it’s just as important to have a plan set to solve and avoid them.
If you are looking for an experienced financial professional to guide you, many independent financial professionals are available here at SafeMoney.com.
You can request an initial appointment to interview someone and explore a potential working relationship. Get started by using our “Find a Financial Professional” section to connect with someone directly. Feel free to ask any questions and discuss your situation during your initial meeting. If you need a personal referral, please call us at 877.476.9723.
