The hardest problem in personal finance
No one wants to run out of money during retirement. That is why the most common question I get asked is, “do I have enough?”
Retirement income planning: the ‘nastiest, hardest problem in finance’.
No one wants to run out of money during retirement. That is why, as a financial planner, the most common question I get asked is, “do I have enough?”
To use a skydiving analogy, intuitively we all understand the risk of either pulling the chute too early or perhaps packing the chute incorrectly. Your preparation or lack of preparation could be one of the most important financial decisions you make. And just like skydiving, you’ve only got one chance to get it right.
Unfortunately, I find some advisors are perhaps myopically focused on investment fees or rate of return. Don’t get me wrong, these are important, but not as important for a retiree as one may think.
The challenge of generating the optimum amount of sustainable lifelong income was once called ‘the nastiest, hardest problem in finance’ by Professor William Sharpe, a Nobel Prize winner in Economics.
The problem sounds simple at first, “What is the maximum amount of stable income I can have for the rest of my life?” As Sharpe suggested, solving for this problem is far more difficult than it appears.
Why? Because we are trying to solve an equation where 6 key variables are unknown.
How long will you live and need income for?
What will your average return be on your investment assets during this time?
Will you be lucky (good returns) or unlucky (big losses) in early retirement?
How will your expenses rise with inflation every year?
What will future tax rates be?
What unexpected lump sum expenses will you face?
A slight change in any of these inputs can drastically alter the output. What if your assumptions are far too optimistic and without even knowing it, you begin a path to early depletion?
It is therefore imperative that you approach retirement planning with caution. Just like skydiving it’s advisable to have an experienced individual double or triple-check your parachute before taking the leap.
Unlike skydiving, this isn’t a “one and done” process. A retirement plan needs ongoing safety checks and adjustments. This isn’t just about deciding when to jump out of the plane – it’s also about steering away from obstacles and choosing a soft landing.
Be proactive, pragmatic, and seek out professional advice. A good retirement planner will work with you to build a strategy that works for you.
Hope is not a good retirement strategy. Remember, you only get to pack the chute once.
