Why retirement planning is one of the hardest problems in finance

22 March 2019

When thinking about the hardest problems in finance, most people are likely to think of something extremely complicated and technical, the sort of problems that can only be addressed by models with jargon-dense names like the Black-Scholes Options Pricing Model, Quantum Binomial Pricing Model and Brownian-motion derivatives pricing.

However, the hardest problem in finance is instead something quite common and applicable to many of our lives. It’s the problem of decumulation, or knowing how much to draw down on your portfolio when you retire.

Nobel laureate William Sharpe called this the “nastiest, hardest, problem in finance”. It’s so hard because solving it requires answering questions that are simply not possible to answer. What will the inflation rate be in 10 years? What future returns can you expect? Most importantly, how long will you live?

If you knew the answers to those questions, retirement planning would certainly become a lot easier. You would be able to plan ahead to ensure you will have enough to last the rest of your life, instead of needing to depend on guesswork. As it is, live too well now and you could find yourself broke and suffering in your old age; scrimp too much now and you might pass away before you get to enjoy the fruits of your labour and self-control – which might end up inherited by your least favourite relative who then blows it all away on a year of wild living.

Most DIY retirement planning websites and even most financial planners rely heavily on assumptions to fill in those gaps. The resulting models are often simplistic and do not take into account each person’s unique circumstances, including life expectancy, health, relationships, and spending habits. Furthermore, future major events like wars, medical epidemics or new medical discoveries could significantly shorten or prolong your life, as well as impact the market in good or bad ways. The problem is further compounded if there are additional people such as family members to consider, as you would then have to take into account the potential outcomes based on who dies first and what financial impact that would have on the survivors.

Many people also underestimate the power of inflation to adversely affect the quality of their retirement lifestyle. While one standard is to use a fixed inflation rate to plan for retirement income, inflation in real life is never that predictable nor static. What if you get hit by double digit inflation for several years early in retirement? That could cause a higher than anticipated drawdown of your retirement savings and severely reduce the available balance for your later years. Similarly, a sudden inflation spike in your later retirement years could quickly drain whatever little balance you have left.

Then you have the question of investment returns. You can’t predict what returns you would have in the 20-40 years of your retirement. A prolonged bear market or recession (like in the Great Depression years) could impair your portfolio and derail your plans, especially if you succumb to fear and sell out at the lowest point. But just in case you decide that investing is too risky, putting everything in the bank would make them vulnerable to inflation. (One way around this is to isolate your essential funds from wild market swings by putting them in the bank, while investing the remainder in enhanced indexing investments.)

Putting all your trust in so-called guaranteed income products may be sorely misguided. Insurance annuities, CPF Life and so on may promise guaranteed payouts, but who can guarantee that they will be sufficient to last through your retirement? Also, while the probability of failure may be remote, it is by no means zero. As an example, public (government) pension plans in the United States, the largest economy in the world, are in danger of collapsing.

We are in an age where pensions have all but disappeared, and each of us is responsible for our own retirement planning. Yet public education on basic finance and investing is still sporadic and rarely reaches those who need it most. While Singapore’s CPF retirement schemes like CPF Life have pushed our public pension ranking to the first in Asia and seventh globally, many still have difficulty comprehending how it all works for them.

If this all seems confusing, you are in good company. The questions raised do not have ready answers. Even William Sharpe admitted to not being able to solve the problem of decumulation, and exhorted his peers in academia to help solve it, saying, “The need is great, and the stakes are high.”

That said, not all is lost! Some planning is still definitely better than no planning. Beware of simplistic retirement planning solutions and evaluate whether the assumptions they make will be relevant to you throughout your retirement stages. Always ask what might happen if some assumptions don’t pan out, for example if your retirement funds do not achieve the desired rate of return or if the inflation rate rises.

You’ll have to accept that there will be many things about retirement that you can’t control. Investment returns, inflation, prices of goods and services in the future, your lifespan – these are all out of your hands. So just focus on the things that you can control, such as your savings, spending and asset allocation.

If you find this too complicated to manage, it might be worth your while to engage a financial adviser to help you navigate and deal with the uncertainties as they come. A good financial adviser should be keeping a watchful eye on both your retirement plans and the development of new decumulation models that could help reduce some of the uncertainty on your future retirement income.

Life is complicated enough. Don’t make it tougher by fretting over things you cannot control. As we have written before, there are also many factors that determine retirement happiness more than money does. So, even if your future finances are not what you hope they will be, your retirement could still be a happy and fulfilling one.

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