William Sharpe, laureate of the Nobel Prize in Economics and emeritus professor of finance at Stanford University’s Graduate School of Business. The Sharpe Ratio, an indicator of an investment strategy’s overall attractiveness, was named after him. He has also invented the retirement lockbox technique and done substantial work on retirement income strategies.
He has written a computer program that considers over a hundred thousand potential retirement income outcomes, all based on varying assumptions about longevity and investment performance.
Huh? Fear not, for we shall elucidate all of this below.
We have condensed (and simplified) some of Sharpe’s greatest retirement investing and income advice and methods culled from various interviews he has done over the last 15 years to help you retire with enough money to meet your necessities and have enough left over to last your entire career.
1. Retirement income is fraught with Uncertainty due to two primary factors
Sharpe ran so many what-ifs because there’s a lot of room for error when projecting out retirement income.
Sharpe was quoted in Barron’s as saying, “You’ve got two big sources of uncertainty, and you can diminish one but not the other.” There are two types of risk associated with investing money outside of an annuity that provides for cost-of-living adjustments: investment risk and death risk.
When discussing investments, the phrase “investment uncertainty” describes the reality that predicting the value of your portfolio in the future is impossible. Furthermore, not knowing your exact lifespan is what we call “mortality uncertainty.”
2. Death longevity risk is a major issue due to uncertainty
When it comes to their savings and assets, most people consider the possibility of loss. And most people try to lessen the blow by investing in a diversified portfolio.
Fewer people seriously consider longevity risk and how to address it. Sharpe notes that a couple has over 900 possible permutations throughout a 30-year retirement period only due to longevity, and that doesn’t even take into account the plethora of investment opportunities available.
One typical strategy for dealing with the possibility of outliving one’s financial resources is to save enough to retire at age 100.
3. Lowering your exposure to longevity risk with a lifetime annuity can be smart
To Sharpe, “Annuities are a potent and sensible instrument.”
An annuity can provide you with a consistent source of income for the rest of your life in exchange for a single investment. This payment will continue as long as you do. There is widespread agreement among financial advisors that everyone should make it a priority to secure enough money to last comfortably in retirement. No matter how long you live or what happens in the stock market, guaranteed income will always support your family. Some sources of income, such as Social Security and certain pension plans and annuities, are guaranteed for life.
4. Consider index funds instead of managed or individual stocks
Sharpe said that for a larger predicted return, “the only way to be assured of it is to own the entire market portfolio.” Using index funds is a simple method to feel like you have a piece of the entire market.
He answered, “Hope springs eternal,” when asked why more people didn’t invest that way. We all believe that we are either better than average or that we can choose better-than-average people to handle our finances. What makes markets work is the belief that one individual has more information than another, which leads to the dissemination of data and the establishment of a new stock price. Those of us who have chosen to invest in index funds would like to express our gratitude. We benefit without effort from the sincerity of others.
5. There are certain attractive features of variable annuities
Many financial advisors recommend fixed lifetime annuities because they provide retirees with a steady stream of income for life.
Contrarily, variable annuities are looked down upon.
Because an index annuity offers the investor higher income (though with increased risk), Sharpe believes that variable annuities with guaranteed lifetime withdrawal advantages can be advantageous.
6. Lockbox strategy
Sharpe developed the lockbox concept to help people prepare for retirement and reduce risk exposure.
Similar to bucket systems is the lockbox approach to retirement income. The lockbox tactic, on the other hand, has a time element. The lockbox technique aims to separate funds in preparation for retirement in specific years. In a typical retirement portfolio, safe assets sit alongside riskier ones in separate “lock boxes” for each year of retirement.
For example, Sharpe told Barrons, “In each box, you have a blend of secure assets, such as an annuity or TIPS [Treasury inflation-protected securities], and a market-based portfolio, such as one with stocks and bonds. If necessary, you can use the key to get at the money, but the plan is to liquidate the assets stored there once a year.
All your money is in locked boxes, to begin with, and you have no problem breaking into those. After your death, the lockbox is opened by your spouse, and after both of your deaths, the remaining lockboxes are opened by your estate.
7. A clear idea of your retirement spending goals is essential when developing a withdrawal strategy
The best way to invest your money depends heavily on knowing how much you need to spend and when.
If you haven’t already, you need to start thinking about your retirement plans right away.
8. An investment advisor can be of great help
Sharpe told Barrons, “Choosing one or more such strategies, along with the associated inputs, seems almost impossible to do because of the range of possible future scenarios from any retirement income strategy.” Older people will want assistance, at the very least. Here comes the financial planner.
To help clients find strategies that are appropriate for their situation and preferences, a financial advisor needs to “ideally” have a strong background in the economics of investment and spending approaches, sufficient analytic tools to determine the ranges of likely outcomes from different strategies, and the ability to work with clients to find approaches that meet their needs.
9. Diversify, save money, make it your own, and put it in context: these are the hallmarks of sound financial advice
According to Sharpe’s interview with Money Magazine, the fundamentals of sound financial advice may be summed up in four verbs:
Increase your projected return relative to your risk level by increasing your diversification level until you hold the complete market portfolio.
Save money by not paying excessive fees for managing your investments or buying and selling shares.
Customize your approach by factoring in the specifics of your position, including any dangers you may face that aren’t related to the financial markets. Consider the extreme case of subsisting solely on chocolate bars. That’s why you should buy additional candy company shares; a price increase by the manufacturers will increase your food costs and stock value.
Remind yourself that there must be a good reason for you to believe that market prices are inaccurate [by placing a large bet on a particular stock or industry] rather than the market. Aliens do not set the value of assets.
10. Watch fees
According to Sharpe, even modest asset management expenses of 1 percent could chip away at a retiree’s standard of living.
As he explained to Wealthfront, his calculations look like this: To what extent do prices vary? Here’s a case in point: If you invest more than $10,000 annually, Vanguard’s Total Stock Market Index Fund will charge you 6 basis points. That works up to 6 cents per $100. The average expense ratio for a diversified, actively managed U.S. stock fund is 1.12%, or $1.12.
“Many individuals could ask, ‘What’s another 1 percent or so?’ However, they overlook that a typical return on such a fund would be around 7%. One-seventh, or 8%, is the appropriate ratio. The impact could be devastating in the long run.
Feeling Confused? I Have a Proposal
It isn’t easy to figure out how to best invest your money and extract it after retirement. Numerous alternatives are available to you.
The most effective measures will consist of the following:
- Calculate your expected retirement income and carefully record your expected retirement expenses.
- Compare your projected retirement income with your projected retirement expenses.
- Fill the gaps with well-planned investments and withdrawals that minimize fees and taxes.