By Gary Brooks, CFP®
This article was originally published on July 16, 2017, in the Tacoma News Tribune.
In nearly 60 years of high-level academic work, Bill Sharpe has contributed enough to the evaluation of investment risk and portfolio construction that he was awarded the 1990 Nobel Prize in economic sciences.
And yet, as sophisticated as the math and modeling is behind Sharpe’s breakthrough work, what really vexes him is a common financial challenge that applies to most retirees.
“It’s the nastiest, hardest problem I’ve ever looked at,” Sharpe said in a recent Bloomberg Masters in Business podcast. This assessment comes from someone who started his teaching career at the University of Washington in 1961 and is now an emeritus professor at the Stanford Graduate School of Business.
What could be so nasty that it keeps an 83-year-old sharpening his pencil and his programming skills in search of a better answer? Sharpe’s attention is fixed on helping retirees draw down their assets to fund their longevity and their lifestyle preferences in the most efficient way, reducing investment risk and the risk that they may run out of money.
“Here is a really important problem, a problem that is appealing because it affects ordinary people,” Sharpe said. “And it’s really nasty. … It’s a multi-dimensional problem. It’s good and juicy in terms of hard to do.”
Sharpe is enthusiastic about the work and has brought together computing and brainpower at Stanford to pursue it but remains unfulfilled. “I can’t say I’ve found some magic solution because I haven’t,” said Sharpe.
It’s a clunky word, but decumulation is what Sharpe calls this phase of a financial life. By comparison, accumulation of savings and investments over a working career is relatively simple. Decumulating savings in the most efficient way requires elements of investment performance, life expectancy, inflation, personal tolerance for risk and many inter-related factors that, when combined, produce a problem more intricate than the work which won Sharpe the Nobel Prize.
“There is no way that we can deal with all the complex details of any given situation, let alone cover all the possible situations in which retirees may find themselves,” Sharpe said.
For people who are serious enough about understanding their financial security and their spending flexibility in retirement, there are sophisticated retirement income tools that go well beyond a calculator to determine the probability of how long your money could be expected to last, or how much it could grow.
These models address the type of multi-factor problem that Sharpe calls nasty. At the very least, they require understanding the following:
Income need – What is your required baseline income to cover essential needs and how will that change over time? What are your discretionary spending preferences and how flexible are these expenses? Do you have the ability, or the discipline, to reduce them when investment returns are lower than expected?
Income sources – The more income you generated in your working career, the less your Social Security benefits are meant to replace. Pensions are a declining source of retirement income which has caused more people to utilize personal savings/investments, annuities, rental real estate, part-time work, and home equity. The makeup of your income sources can lead to varying results in long-term financial security.
Inflation – Outside of health care, the cost of living for retirees typically declines. While inflation is often referenced as a national figure, seemingly applying to everyone, it is not universally applicable. Cost of living is dependent on how you personally spend money. Inflation could have a different impact on your personal finances than your neighbor’s.
Investment returns – Do you know what investment return is necessary to fund your goals? How much exposure to market fluctuations is too much when you are making regular withdrawals from investment accounts? For investment performance to have less influence on your short-term spending, it is often wise to keep enough savings to fund the next couple years of expenses away from stock market. While investment returns are important, it is likely to be more important to make sure that your personal investment behavior doesn’t harm your return potential. The psychological tug-of-war between fear and greed and how it influences your confidence is one of your largest risks.
Life expectancy – This is especially important to understand if savings needs to support two lives with varying longevity.
These might be the five nastiest of the retirement income variables but they are followed by many others that are also important:
- What are your bequest motives to family or philanthropy?
- Would long-term care insurance be helpful to manage risk?
- Do you and your spouse have similar feelings about how to invest and what to do with your money?
- What are your options for being more tax efficient with your assets and income?
If you can address these topics, you will be as prepared to manage your retirement finances as a Nobel Prize winning economist.
Gary Brooks is a certified financial planner and the president of BHJ Wealth Advisors, a registered investment adviser in Gig Harbor. Reach him at email@example.com.
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