Bill Sharpe on Retirement Planning
October 14, 2014
by Robert Huebscher
William F. Sharpe is the STANCO 25 professor of finance emeritus at Stanford University's Graduate School of Business. He joined the Stanford faculty in 1970, having previously taught at the University of Washington and the University of California at Irvine.
He was one of the originators of the capital asset pricing model and also developed the Sharpe ratio for investment-performance analysis, the binomial method for the valuation of options, the gradient method for asset-allocation optimization and the returns-based style analysis for evaluating the style and performance of investment funds.
He received his Ph.D., M.A. and B.A. in economics from the University of California at Los Angeles. He is also the recipient of a Doctor of Humane Letters, Honoris Causa from DePaul University, a Doctor Honoris Causa from the University of Alicante (Spain), a Doctor Honoris Causa from the University of Vienna (Austria), a Doctor of Science, economics, Honoris Causa from the London Business School and the UCLA Medal, UCLA’s highest honor.
Along with Harry Markowitz and Merton Miller, he was awarded the 1990 Nobel Prize in economics.
I spoke with Dr. Sharpe on Oct. 7 in San Francisco, in connection with the Tiburon CEO Executive Summit.
At the CFA Institute’s annual conference in May, you said that retirement-income planning is the most complex problem you’ve analyzed in your career. Why is that so?
The simple way in which most people have characterized the accumulation phase is to say: You’re going to invest, maybe you have a glide path, but the thing you’re going to produce is the probability distribution of the value at retirement. You can draw it on a flat piece of paper. It’s a probability of distribution of one outcome.
When you are talking about retirement-income strategies, you’re discussing probability distributions of what your income will be next year and every year thereafter. You’ve got 40 or 50 dimensions, even if you only do annual joint-probability distributions.
To think about what one of those problems looks like boggles the mind. To compare an outcome with another two, three, four or 10 outcomes to decide which one you like best is a nasty, nasty problem.
The question is how you cut into that. There are ways, but they involve – at the very least – coming up with 50 or maybe 100 coefficients for preferences and risk aversion vis-à-vis income at age 81, opposed to 82, etc.
Then you add in consideration of whether you are alive along with your partner, or just one of you, or if it goes to the kids and the charities after we die. Right there, you’re already up to 100, 200 parameters that you’ve got to somehow or other nail down before you can think about finding an optimum strategy.
The dimensionality is overwhelming, and the behavioral issues are of course, very difficult.
What is the appropriate role and value of annuities in a retirement portfolio? If possible, address the three major types of annuities: single-premium immediate annuities (SPIAs), deferred-income annuities (DIAs) and variable annuities (VAs) with riders.
First, you can create an annuity based on almost any strategy, of which you’ve mentioned three. The big issue is to insure against living a long time.
If you attach no utility (to be semi-formal) to leaving money to your heirs, then why wouldn’t you buy an annuity? Especially if you could buy it with any kind of crazy investment strategy that you might want. However, there are serious behavioral issues if you characterize an annuity as betting with the life insurance company as to how long you’re going to live. You might argue, “What if I die next year? Then, I’ve lost the bet. The kids don’t get anything. The charities don’t get anything.” People will likely react differently depending upon how you frame the trade-offs.
But as a practical matter, if you’ have sufficiently low savings and income, you may have no choice but to buy an annuity. In such a case you can’t afford to spend in a way that will almost certainly leave something to your estate.