Finding the Retirement Income Balance

Economist William Sharpe is best-known for helping to develop the capital asset pricing model, a formula used by investors to calculate an expected return on a security. His eponymous Sharpe ratio describes risk-adjusted return. He won a Nobel Prize for his contributions in 1990.

More recently, however, Sharpe has turned his attention to studying retirement – specifically the balance between income to live off of and savings to last long enough.

For the latest issue of Barron's, Sarah Max sat down with the Stanford University professor of finance, emeritus. He spoke about findings from his latest book, in which he ran 100,000 retirement-income scenarios based on different combinations of life spans and investment returns for a retired couple.

Here are a few highlights:

Why is creating sustainable retirement income such a hard problem?

You’ve got two big sources of uncertainty, and you can diminish one but not the other. If you invest your money in almost anything except an annuity with cost-of-living adjustments, you’re going to be subject to two kinds of uncertainty—investment uncertainty and mortality uncertainty. When I’ve asked investment-advisor friends, “What do you do about longevity?” they often say, “We assume people will live to be 100.” That seems kind of crude.

Annuities are criticized for their cost and complexity. Is it deserved?

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.

Your book outlines a strategy that you call a “lockbox.” Can you take us through it?

The idea is that you segment your money. It’s similar to using “buckets” but with a time component. A retiree might have a box for 2020 and a box for 2021, and 2022, etc. In each box, you have a combination of safe assets, such as an annuity or TIPS [Treasury inflation-protected securities], and a market-based portfolio, such as one with stocks and bonds. You have the key if you need to access the funds, but the idea is that, once a year, you would sell the assets in that year’s lockbox. You put all your money in locked boxes to begin with, and you just happily open locked boxes. If you’re dead, your partner opens the lockbox, and if you’re both dead, your estate opens all the lockboxes that are left.

Find the rest of Sarah's Q&A with William Sharpe here.