Chapter 7. Balancing Mortality and Modeling Risk
In a 1997 paper called "Financial Planning in Fantasyland," William F. Sharpe neatly laid out the eventualities for retirement income. "Prior to retirement the account grows regularly due to new contributions and the unvarying rate of return on assets," wrote the Nobel laureate and professor of finance at Stanford University. "After retirement the account eventually begins to diminish as spending overtakes the rate of return, which remains resolutely constant. Eventually one of two things happens. Either you die (right on schedule) with money in the bank or you run out of money before you die."
Sharpe was assessing the mechanics of retirement-planning software calculators. Basically, you chose an expected rate of return, an expected inflation rate, and the year you're expected to die. The calculations performed will tell you if the desired consumption stream from your nest egg can be attained. Choose the wrong numbers and you run the risk of either outliving your nest egg or leaving a large unintended bequest.
In fact, for many people, the costs of choosing wrong were relatively small before 1997. That's because the vast majority of wealth dedicated to retirement at that time was annuitized, in the form of either Social Security benefits or defined-benefit pension plans. Since distribution issues are primarily relevant to nonannuitized wealth, guessing wrong would not have had an enormous impact on the potential ...