William Sharpe Tackles Retirement’s Biggest Challenge
Nobel Prize winning economist William Sharpe is truly a legend in the economics of investing. Now 85 and retired, he is now focused on the issue of outliving your money.
Planning for retirement properly and successfully is no small task. There are many variables involved, including how much you can comfortably save, what sort of returns you will need or should pursue, how you will manage risk along the way, how much you are going to need, and how long you will need it for.
Anyone who has studied managing risk with investments to any real degree will be familiar with the Sharpe ratio of an investment, which is a way to measure its risk to reward ratio, which is important to know. What this basically does is examine past returns, anything from a buy and hold approach to short-term trading, and assign a certain risk-reward ratio, or Sharpe ratio, and then allow us to compare the Sharpe ratio of various trading and investment strategies.
This is a very useful calculation, and especially since the amount of risk that we take with certain strategies is not always that clear. It’s plenty clear with a buy and hold strategy, as you just take on unlimited risk with no exit plan or even any strategy at all other than doing nothing, but this approach has a Sharpe ratio as well because various returns are involved, and we can see how this stacks up to other approaches where we define our risk in various ways.
The Sharpe ratio was devised by economist William F. Sharpe, whose resume also includes playing a leading role in the capital asset pricing model, as well as lending his talents to the business of pricing options. In his later years, he has also become fond of approaches that use recent market data to further define risk and returns, called adaptive asset allocation, which allocates assets in better harmony with present conditions than a static model ever could.
Sharpe also holds the 1990 Alfred Nobel Memorial Prize in Economic Sciences, and is truly a legend in the field of economics and investment. Sharpe’s career has spanned almost 60 years, which is still ongoing, and he now focuses a lot of his work on trying to help people manage their retirement better.
While many academics pursue ideas that are based upon faulty principles and inferior assumptions, some have a better grasp of the field than others, and William Sharpe does get this more than your average professor to be sure, even though this doesn’t mean that we should just take his advice without any question. Seeking knowledge is all about taking what we know and refining it, and he does plenty of that himself, although we need to join him in this quest.
Few would even consider looking to possibly improve on the ideas of such an astute and perhaps even brilliant economist. Whether we actually accomplish such a thing or not, we will never be able to if we do not at least leave ourselves open to the idea that this may be possible. A real key to advancing our understanding is not so much in the act of attempting such things, it is more about just having the belief that we may, in other words not imposing limiting beliefs upon ourselves.
We will not be holding any such beliefs here, not that any of us should ever hold them, and will take a critical look at Sharpe’s insights on how we may manage our retirement better, to see what makes sense and what we may question or refine.
The problem that a lot of people have in doing this, aside from their limiting beliefs, is the inability to think outside the box. We could be examining a very technical topic like the ones that occupy Sharpe’s mind, and although our understanding of the topic at this level may be sparse, there may be some things that have been missed by the original analysis that only require enough clarity of thought to unravel.
The theme of this article is therefore about self-empowerment as much as it is about economics of investing, and if we insist on selling ourselves well short of our real potential, this lower potential will serve as a ceiling for us. When we look up, we see the sky in its true state, unlimited, and while we can only see so far up, with some of us having the ability to see further than others, keeping our heads down is no way to do this.
We Always Want to Vet Our Ideas by Considering the Alternatives
Sharpe has sought out matrices to compare between various courses of action, and the idea of doing that would only occur to someone who is truly accomplished. We’re lucky if most people compare just two scenarios, and usually only just look at one, the one that they have been told is the right way which they have come to believe.
A simple example of this would be the idea that we should buy and hold until we get close to retirement, and then gradually move our money over to bonds as we approach retirement age and beyond. This is so ingrained in our investment culture that many do not even question this, and with the great majority of those who dare to, they just assume that other alternatives are either unworkable or too difficult to achieve, and close their analysis with this.
There are a lot of other things that we could be doing besides this, and we can’t just stop at one or two of them if there are worthy ones out there that remain unexamined. When we read the word matrices here, we know that we’re dealing with someone who is genuinely inquisitive, and Sharpe is nothing if not this. You also can demonstrate the appropriateness of your ideas much better if you have examined many others and not just one or two or even none.
Sharpe, in his usual style, ran 100,000 variations of how a retirement plan may be approached, to seek to learn what works best overall. Although this only singles out the best among the pool, this is a huge pool and is testimony to the level of comprehensiveness that Sharpe is known for.
Sharpe believes that the most critical issue with retirement is running out of money, and this at least has a lot of merit. Our only concern here is that by raising one of the several issues to this level, we may not pay enough heed to the other ones. Worrying about running out of money I retirement is not even necessary if you don’t have any money in retirement to run out of for instance.
It is true though that we need to measure our retirement risk not only in monetary terms but in terms the impact this has upon our lives as well. If there will be a significant portion of our life expectancy that may be expected to have us living in squalor, this will in itself represent a significant portion of the amount of pain that we may be subject to overall in the years ahead.
Sharpe expresses the real challenge as seeking the right balance between the present and the future, and this is indeed at the heart of the matter. Even knowing with mathematical precision what the optimal way to use our retirement savings won’t help us much if we don’t manage to save enough to make the idea work.
A balance is what we need, and the ideal approach would be to seek out a constant level of satisfaction, and to the extent that we miss this target, we will lose marginal utility because we get less for the extra money or happiness above the mean than we lose when it is below the mean.
The further we move down from the mean, the greater the loss, as each incremental move downward costs more than the last. We can get to the point where a certain amount is needed to just stay alive, which is disproportionately much greater than what we could get out of the same magnitude of change if we are very well off already.
Being out of retirement savings is a big step down from actually living off of them, and this will only become a bigger issue as social security benefits become cut back in the coming years out of necessity.
Locking Up Stocks is Far from the Ideal of Seeking Optimal Risk/Reward
This sets the backdrop for Sharpe’s practical advice for investing with the goal of managing your retirement, where he has devised a very interesting strategy of allocating your assets as the years go by while retired.
This is at least in principle better than what we usually do, which is basically to take our age and use what ends up to be a pretty aggressive transition. This not only does not account for people’s differing circumstances, it isn’t even based upon any kind of science or even any genuine rationale, apart from some very overbroad and relatively ill-considered analysis involving math so simple you could do it in your head.
Sharpe recognizes that there are two main types of risk involved here, investment risk and mortality risk. Mortality risk here doesn’t mean the risk of dying, it is the risk that you will live too long. Sharpe believes that while we are in retirement, mortality risk is at least comparable to investment risk, although that would depend on the types of investments, but may be true if we take the investment mix people of this age group typically use.
He then points out that we need to particularly manage mortality risk, the risk of our running out of money, and this is best done by purchasing annuities along with other investments which will raise the bar in the further out years where this risk lies.
This is not just about cashing out to buy annuities though, as that would fall well short of the richness of approach that Sharpe seeks, and the recommendation is to set aside an annual allotment of assets in what he calls a lockbox, one for each coming year, where we open a box each year and sell off the assets.
We fill the boxes at the outset, so this does not involve any transition with asset allocation. This does expose the variable assets in the boxes to more risk, but perhaps this is a limitation of the model as this would add a lot more complexity, although the situation is indeed a lot more complex.
This will not produce a steady stream of income due to the variability of some of the assets, and during a bear market we may end up falling short of the mark and dipping into the future. While it is noble to show us how this scheme may help us in our later years if we follow it faithfully, this is a faith that can be pretty fragile in times of real need, which is not uncommon among the elderly.
Locking up the boxes also prevent us from managing our investment risk at all, and while mortality risk may be as important, investment risk still counts for a lot. We’re sailing in whatever direction the wind blows here, which potentially includes hitting the rocks, close enough to the end of our journey that we can do no more than weep and pray.
Another issue is the fact that not everyone is typical and some may require more aggressive approaches than normal. Given the masses of people who will fail miserably at this task, this includes a lot of people indeed.
The returns that can be achieved by using these lock boxes are very modest, and one of the key factors in deciding how to invest is to account for the type of return you need. The further you are behind, the greater your needs.
If we buy an annuity which will provide us with far less than we need, it makes sense to be willing to take more risk than those who will have enough by doing this. We also need a strategy that is actually able to adjust to changing circumstances, rather than being set in stone and locked up.
Overall, Sharpe has a very interesting idea here that really stands out from the mob of tired old ideas. This is at least a novel one, and among a certain segment, those who likely will live comfortably throughout their lives regardless but could benefit from eliminating the risk of running out and thereby assuring their comfort, this may even be worth considering, as it can eliminate this risk.
This does come at a price though, in both lower returns and higher investment risk, and there is no approach as risky as locking your stocks in boxes like this. The tethered stocks deliver the risk, while the annuities lower returns.
Annuities certainly can have their place, and it is up to us to ultimately decide how much weight we want to put on them, locking your stocks up like this is where this breaks down. As dubious as this is at the best of times, it becomes less and less appropriate over time and especially in the end game.
Sharpe is obviously very bright and his attention to detail is superb, but ultimately, this idea is much more limited in scope than he realizes. Mortality risk may be the most important thing for someone, but it is proportionate to what is actually at risk, with higher amounts of course being at greater risk. With smaller amounts, the risk of going broke is much closer at hand and cannot be solved very well by smoothing your savings over what is left of your life. It must be dealt with in a manner that focuses our attention on seeking much more optimal investment risk/return ratios than this scheme could ever provide.
The majority of people do not enjoy the level of comfort that this plan requires to make sense of it, and are not on a path at all resembling success with or without doing this. Sharpe’s lockbox idea may be a decent enough idea for some, but for the rest of us, setting for a combination of low yielding annuities and stocks locked in boxes might not be such a good idea when we need so much more help.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
Topics of interest: News & updates from the Federal Deposit Insurance Corporation, Retirement, Insurance, Mortgage & more.