Retirement planning can be boiled down to seven key questions advisers should ask their clients.
At InvestmentNews' Retirement Income Summit last week in Chicago, keynote speaker Moshe Milevsky, associate professor of finance at York University, encouraged advisers to back away from black-box models that merely spit out a number to be used in planning for retirement.
Rather, it's all about the assumptions that advisers use to determine that income level in the first place.
“Retirement income planning is more than just a math problem, but you can't avoid the numbers entirely, either,” Mr. Milevsky said. “We want a slightly deeper appreciation for who's behind it and where it comes from.”
Citing the work of eminent mathematicians and economists noted in his new book, “The 7 Most Important Equations for Your Retirement” (John Wiley & Sons, 2012), Mr. Milevsky suggested that answers to the following questions will aid advisers in creating a viable retirement income plan.
Question 1. How long will your money last if you stop working today, invest your nest egg as safely as possible and try to maintain your current standard of living?
A basic building block of retirement planning, mathematician Leonardo Fibonacci's equation to determine the present and discounted value of money gives the number of years a lump sum will last if an investor spends a given amount per year, assuming a certain rate of return for the principal.
Question 2. How many years will you live in retirement, and how random is that number? Benjamin Gompertz, one of the first actuaries, determined that the death rate for a given age cohort rises each year by about 9%. Accounting for factors such as wealth and health, plus higher odds of longer lives as a person ages, investors are generally expected to spend a long time in retirement.
Question 3. What is your pension annuity worth, and how much does it cost to buy more lifetime income? Astronomer Edmond Halley essentially discovered that the value of a pension depends on age and discount rates: A pension annuity is worth more at a younger age and less when older.
Question 4. What is an appropriate spending rate from a nest egg, and on what economic factors does it depend? Economist Irving Fisher wrote about longevity risk aversion. Investors typically prefer to enjoy more of their money earlier in retirement, realizing that the odds that they'll make it to 100 are much lower than the chance they'll make it to 70.
Question 5. What's the proper mix of stocks versus bonds in a retirement portfolio? Economist Paul Samuelson brought the concept of human capital — a measure of an individual's potential future earnings — into the financial planning equation. Human capital tends to fall as people age. Generally, the more secure an investor's human capital is, the more investment risk they might take.
Question 6. How important is leaving a financial legacy, and what is it really worth? Insurance economist Solomon Huebner demonstrated that the value of a death benefit may not be much at a younger age, but rises as an insured individual ages and life expectancy shortens. It's worth even more when interest rates are high.
Question 7. Taking everything into account, is your retirement income plan sustainable? Mathematician Andrey Kolmogorov came up with the lifetime probability of ruin, which posits: “Will I run out of money before I run out of life?”
Pulling together all of the answers to these questions, advisers can try to determine not just a portfolio's sustainability but how to make decisions about annuitization.
“There are some basic equations that all financial advisers should be aware of,” Mr. Milevsky said. “Retirement income has its own important equations.”