The Nobel Laureates' Guide To Retirement Planning

Summary

• The views of Nobel prize winners in economics offer a roadmap for retirement planning.
• Academic debates aside, we can extract some practical takeaways from these experts.
• The biggest obstacles to implementing the roadmap may be our own human weaknesses.

Every major (and many a lesser) financial institution is offering retirement services these days. Sometimes it's hard to separate advice from marketing. Sometimes the advice you get is contradictory. It's like standing in the middle of Times Square trying to get directions to the Bronx.

Instead of asking the Naked Cowboy, I thought I'd see what the anointed royalty of the realm have to say on the topic. These being the winners of the annual Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.

Caveat: I did not undertake a comprehensive review of all 76 winners' collected work. Not even close. I welcome hearing about other relevant insights.

I had the following takeaways from my review:

• If you are not saving for retirement, start today. If you are, save more.
• Make a plan (simple is better than none).
• Try to secure a minimum level of inflation-adjusted income in retirement, taking into account Social Security and any pensions. I like I-Bonds and TIPS. Annuities may be appropriate here.
• Find a level of risk that suits you - dial in equities and other risky assets as your portfolio permits. Adjust over time.
• Don't obsess, and stay the course.

Here is the blow-by-blow (year of Nobel prize in parentheses.)

Franco Modigliani (1985)

Franco Modigliani developed the life-cycle theory of consumption in the 1950s¹, which put retirement savings at the center of individuals' economic activities, with the now simple-sounding proposition that people save for retirement to even out and maximize consumption over their lifetime. It's a rational and straightforward framework. Why, then, do Americans seem to save too little, too late?

Robert Shiller (2013)

Robert Shiller, a devotee of behavioral economics, believes that human foibles result in wildly divergent savings rates among individuals and among nations. The psychological traps we fall in, such as "framing," take us off the rational path. The result: as a whole, Americans don't save enough, and surveys show that we know it. We don't seem swayed by the simple math - that due to the power of compounding, even modest savings over long periods can secure a healthy retirement portfolio. Instead, our savings rate is mired in the mid-single digits. Contrast this with China, for example, where the reported rate is regularly in the 30% range.

Perhaps it is the lack of a plan. Shiller notes experiments that have found savings patterns to be haphazard and, in many cases, disconnected from even basic financial planning. He cites a study by Anna Maria Lusardi and Olivia Mitchell which showed that only 31% of Americans over the age of 50 had ever attempted to make a financial plan, and of that 31%, only 58% had actually done so.²

Robert Merton (1997)

How should we approach planning? Robert Merton argues that focusing on asset values and investment performance is inappropriate when planning for retirement: "If the goal is income for life after age 65, the relevant risk is retirement income uncertainty, not portfolio value."³ Traditional portfolio theory compares the performance of risky assets (stocks, bonds, etc.) to the "risk-free" asset that is U.S. Treasury bills. Merton argues that for retirement planning, the "risk-free" asset should be an inflation-adjusted annuity that begins paying out at retirement. Asset fluctuations in the interim should be ignored.

Inflation-adjusted annuities as envisioned by Merton don't exist as products⁴, but a hypothetical market value can be estimated using the prices of Treasury Inflation Protected Securities ("TIPS"). In other words, we can track how we are doing. Meanwhile, Series I Savings Bonds ("I-Bonds") and TIPS allow us to lock in guaranteed income for several decades, but may fall short in the event of an unexpectedly long lifespan.

Peter Diamond (2010)

Most working Americans do, of course, have a guaranteed inflation-adjusted annuity: Social Security. Depending on your income bracket, Social Security will replace about 25-50% of your pre-retirement earnings⁵. This raises a question, especially for Millennials and Gen Xers: will Social Security be there when they retire? At least three Nobel winners - Milton Friedman (1976), Paul Samuelson (1970) and Paul Krugman (2008) - have called Social Security a Ponzi scheme where the current generation subsidizes retirees, with the implication that it will collapse under its own weight.⁶ Peter Diamond seems the most level-headed: an expert in the field, he has, for many years, argued that Social Security as configured today is not financially sustainable.⁷ Some combination of revenue increases (read tax hikes) and benefit reductions will ultimately need to be made. The longer the delay, the more draconian the measures will need to be. The house is not crashing down, but conservatism in planning is advisable.

Angus Deaton (2015) and Daniel Kahneman (2002)

So how much more income should we target? Angus Deaton and Daniel Kahneman provide a handy guidepost. Based on analysis of 450,000 survey respondents, they found that beyond an annual income of about $75,000, more earnings added little "emotional well-being." This term "refers to the emotional quality of an individual's everyday experience - the frequency and intensity of experiences of joy, fascination, anxiety, sadness, anger, and affection that make one's life pleasant or unpleasant."⁸ Incomes lower than $75,000 tended to amplify negative experiences, such as divorce, ill health or loneliness.

That's not to say higher income doesn't increase happiness, but it's more of the right brain variety. Deaton and Kahneman call this "life evaluation," which refers to a person's thoughts about their life as captured in responses to questions such as "How satisfied are you with your life as a whole these days?"

This suggests that income of $75,000 - or $83,000, when adjusting for inflation since their study - might be one way to set an annual income objective for retirement. Of course, this is well beyond the median household income of about $53,600 reported by the Census Bureau for 2014, so a majority of retirees will need to target lower.

If we accept that the bogey for retirement planning is income, how should we invest to give us the best chance of success?

Harry Markowitz (1990) and Eugene Fama (2013)

Harry Markowitz, in his 1952 article "Portfolio Selection," gave us one of the fundamental tools of asset allocation: a practical way to trade off risk versus return along an "efficient frontier."⁹

Eugene Fama, often labeled the "Father of modern finance," built on Markowitz's framework with extensive empirical analysis and is closely associated with the efficient market hypothesis. His advice is unwavering: you cannot beat the market, therefore invest passively. Active management is a fool's errand. Markets are efficient, and at any moment, reflect all available information.¹⁰

This is where we return to Robert Shiller, who could not disagree with Fama more. Shiller contends that the volatility of financial market returns is inconsistent with efficient markets. Instead, markets overshoot and move haphazardly, driven by investor psychology. "To pretend that stock prices reflect people's use of information about those future payoffs is like hiring a weather forecaster who has gone berserk. He lives in a town where temperatures are fairly stable, but he predicts that one day they will be 150° and on another they will be -100°... He would make more accurate forecasts on average if he did not predict that there would be any variation in temperature at all. For the same reason, one should reject the notion that stock prices reflect predictions, based on economic fundamentals, about future earnings. Why? The prices are much too variable."¹¹ Shiller believes there are times to be in the market and times to be out of the market. Recently, for example, he has argued that stocks are overvalued based on his 10-year cyclically adjusted price earnings ("CAPE") ratio.¹²

The debate between Fama and Shiller is instructive. It suggests beating the market is likely impossible in the short term, but could be possible over the long term. Other research suggests, however, that finding an active manager that can consistently outperform by more than his or her fee is a long shot. Prudence suggests sticking with passive investments.

What modern portfolio theory and the efficient market hypothesis do not do is recommend a specific retirement portfolio. They simply underscore that to increase returns, you must increase risk. There are many efficient portfolios - some very safe, others very risky. Retirement planning must therefore be done through lens of risk: i.e., how much are you willing to lose? When do you need to draw down your assets? Are you protected against adverse surprises?

William Sharpe (1990)

These are the issues that led William Sharpe to comment that the complexity of retirement planning problems can "boggle the mind." Sharpe is no slouch - he gave us the Capital Asset Pricing Model (think "beta") and the Sharpe ratio. Yet, he believes these pure investment questions pale in comparison to the complexity of retirement planning.

Less explicitly than Merton, Sharpe also views annuities as a "floor" and considers them most appropriate for lower income levels that cannot sustain the risk of a volatile portfolio.

For those who do invest in risky assets, "it's not cost-efficient to have a strategy in which the amount you get, say, 10 years after you've invested depends not only on how the market as a whole did over that period, but also on how it got there. In short, the amount of money you have after 10 years may well depend on how the market did over the period, but the path the market took to get where it got shouldn't matter."¹³

Sharpe used this as an argument against target date funds. But the implication is broader: stay invested, whether your portfolio is up or down.

The takeaways from this review of Nobel winners are not complicated. Putting them into practice is likely to be a test of mental fortitude for most people: ramping up savings, taking investment risk and not selling when the markets are down all call for discipline and clarity of purpose. Through their personal achievements, these qualities are on display among all the laureates - in the end, perhaps that is the biggest lesson they have for us.

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¹ For an overview, see Angus Deaton, "Franco Modigliani and the Life Cycle Theory of Consumption", Research Program in Development Studies and Center for Health and Wellbeing, Princeton University, 2005.

² George Akerlof and Robert Shiller, Animal Spirits, How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton University Press, 2009, p. 213.

³ Robert Merton, The Crisis In Retirement Planning, Harvard Business Review, July-August 2014.

⁴ Deferred income annuities (DIAs) exist that provide an inflation-adjusted income stream starting at a future date, but there is no inflation adjustment prior to the beginning of the income payments.

⁵ Up to the Social Security maximum. See here.

⁶ Is Social Security a Ponzi Scheme? Alas, the shifting political winds appear to have changed Krugman's view. In a New York Times op-ed on April 10, 2015, he called Social Security a "shining example of a system that works."

⁷ Peter A. Diamond and Peter A. Orszag, Saving Social Security, Brookings Institution Press, 2005.

⁸ Daniel Kahneman and Angus Deaton, High Income Improves Evaluation of Life but Not Emotional Well-Being, Proceedings of the National Academy of Science, August 4, 2010.

⁹ Harry Markowitz, "Portfolio Selection", Journal of Finance, March 1952.

¹⁰ See this evisceration of a roomful of pension fund managers by Fama http://www.top1000funds.com/featured-homepage-posts/2015/12/11/investors-from-the-moon-fama/.

¹¹ Akerlof and Shiller, p. 228.

¹² http://www.thinkadvisor.com/2015/09/03/shiller-ditches-us-stocks-says-its-a-dangerous-tim.

¹³ "Robert Huebscher, "Bill Sharpe on Retirement Planning", Advisor Perspectives, October 14, 2014.

Analyst’s Disclosure: I am/we are long TIPS AND I-BONDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.