Barry Ritholtz talking about the thorniest problem in finance.
Consider some of the most challenging problems in finance: the equity-premium puzzle; binomial-option pricing models; do zero interest rates spur inflation or damp it; are stocks cheap or overpriced?
Challenging as those may appear, none compare to what Nobel laureate William Sharpe, 82, calls “decumulation,” or the use of savings in retirement. It is, he says, “the nastiest, hardest problem in finance.”
Why is planning for retirement so difficult? Saurabh Mukherjea explains the two key challenges.
Longevity Risk: None of us know how far we will live. What we do know is that with each passing year, improvements in medical science are likely to increase our lifespan thus increasing our cost of retirement. Even if we assume that most of us will die between the ages of 70-100, there are at least 30 possible outcomes with regards to our own longevity.
However, for retirement planning purposes, we also have to factor in our spouse’s longevity – after all, after I am gone, my better half’s lifestyle still needs to be funded properly. Since, even for your spouse there are 30 possible longevity outcomes, for a couple there are at least 900 possible longevity outcomes.Investment Risk: Assuming that most retirement portfolios are a mixture of bonds & equities, the blended return of the portfolio through the retirement years and in the decade immediately preceding retirement could range anywhere from low-single digits to low-20s. Why? Because the world’s large stock markets have seen extended periods of ZERO returns. For example, from1967-84, the S&P500 gave zero returns. Between 1993-2003, the Sensex gave no returns. Then, again, from Jan 2007-Jan 2014, the Sensex gave close to zero returns. In fact, for half the years in the past 3 decades, the Sensex has given annual returns which are close to zero – see chart below.
Assuming however, that a mixture of bonds and equities, gives a retirement portfolio long term returns anywhere between 5% and 25% and taking intervals of 0.20%, there are at least 1000 different return possibilities to consider for your retirement portfolio.
Now, given that there are 900 possible longevity outcomes (30 for you & 30 for your spouse) and there are 1000 possible returns outcomes, there are at least 90,000 possible retirement outcomes for you to consider even before we add the next important layer to this problem.
He then adds two additional risks that a developing economy like India needs to consider.