The Lockbox Strategy and Other Retirement Income Tips

Editor's Note: This story originally appeared on NewRetirement.

William Sharpe is a Nobel Prize-winning economist and professor of finance, emeritus, at Stanford University’s Graduate School of Business.

His Nobel was awarded for developing the Capital Asset Pricing Model (CAPM, a mathematical model for predicting investment risk).

He is also well known for the Sharpe Ratio, a number designed to summarize the desirability of an overall investment strategy. He has also done extensive work on retirement income strategies and developed the lockbox strategy for retirement.

He has created a computer program covering no less than 100,000 retirement income scenarios based on different combinations of life spans and investment returns. (The program is available in a free e-book, Retirement Income Scenario Matrices.)

Huh? Don’t worry, we’ll explain it all.

We have summarized (and simplified) some of Sharpe’s best retirement investing and income tips and strategies — gleaned from multiple interviews he has done over the last 15 years — for having enough income to meet your needs while ensuring you have enough to last your lifetime.

You Can Strategize for Retirement Income in a Variety of Ways

In the following we focus on ideas that come from Sharpe, but here are 17 other different ways to construct retirement income.

Sharpe’s ideas are highly rational, but may be overly complicated for most people’s needs. Let’s explore.

1. There Are Two Key Sources of Uncertainty With Regard to Retirement Income

One of the reasons Sharpe ran so many different scenarios is because there is a great deal of inherent uncertainty in predicting retirement income.

Sharpe told Barron’s, “You’ve got two big sources of uncertainty, and you can diminish one but not the other. If you invest your money in almost anything except an annuity with cost-of-living adjustments, you’re going to be subject to two kinds of uncertainty — investment uncertainty and mortality uncertainty.”

Investment uncertainty refers to the fact that you can not predict the future value of your investments. And, mortality uncertainty is the fact that you don’t know how long you are going to live.

2. Mortality Uncertainly (Longevity Risk) Is a Big Deal

Most people think about risk with regards to their money and investments. And, most people also try to mitigate that risk with the right mix of investments.

However, fewer people think carefully about longevity risk and how to deal with it. Sharpe points out that for a couple, longevity alone results in over 900 different combinations over a 30-year retirement, never mind the myriad investment options.

A common way to plan for longevity risk is to simply plan on how to make your money last until you turn 100.

The downside of planning till 100?

If you want a financial plan that keeps you financially solvent till 100, but you only live until 85, you may have missed out on optimizing your savings.

Planning to live till 100 means that you could be missing out on growth opportunities for your money and reduced income.

3. Lifetime Annuities Can Be a Good Way of Reducing Longevity Risk

Sharpe says, “Annuities are a potent and sensible instrument.”

A lifetime annuity is a guaranteed lifetime paycheck that you purchase with a lump sum of money. You get the income no matter how long you live. Many experts highly recommend that everyone strive to guarantee retirement income to cover their mandatory expenses.

Guaranteed income is income that is going to be coming into the household no matter how long you live or what is happening in the financial markets.

Social Security, some pension plans, and some annuities are examples of guaranteed lifetime income – you’ll earn it no matter what.

You can model the use of a guaranteed lifetime annuity as part of your overall retirement plan in the NewRetirement Planner. Estimate how much income your money can buy now (or in the future).

4. Use Index Funds — Not Managed Portfolios or Individual Stocks

Sharpe told Money Magazine “The only way to be assured of higher expected return is to own the entire market portfolio.” An easy way to own the entire market is to invest in index funds.

When asked why everyone doesn’t invest that way, he replied: “Hope springs eternal. We all tend to think either that we’re above average or that we can pick other people [to manage our money] who are above average.”

“That’s what makes markets — when one person thinks he knows more than somebody else, information is exchanged and a new stock price is set. And those of us who put our money in index funds say, ‘Thank you very much.’ We get to free-ride on other people’s convictions.”

Bonus: Index funds are easy to invest in and own. They are low-fee and can be purchased and managed on your own, without using a financial adviser.

5. Variable Annuities Can Have Their Charms

Many financial experts endorse fixed lifetime annuities as a good way for retirees to guarantee lifetime income.

Variable annuities, on the other hand, are frowned upon.

However, Sharpe thinks that variable annuities with guaranteed lifetime withdrawal benefits can be useful because an index annuity gives the investor the possibility of higher income (though with more risk).

6. The Lockbox Strategy

Sharpe developed the lockbox strategy as a way to manage risks and create retirement income.

The lockbox retirement income strategy is similar to bucket strategies. However, the lockbox strategy uses a time component.

The point of the lockbox strategy is to segregate assets by retirement year. Typically, each retirement year lockbox would consist of a combination of assets — some that are relatively safe and others that are riskier.

Sharpe told Barrons: “In each box, you have a combination of safe assets, such as an annuity or TIPS [Treasury inflation-protected securities], and a market-based portfolio, such as one with stocks and bonds. You have the key if you need to access the funds, but the idea is that, once a year, you would sell the assets in that year’s lockbox.”

“You put all your money in locked boxes to begin with, and you just happily open locked boxes. If you’re dead, your partner opens the lockbox, and if you’re both dead, your estate opens all the lockboxes that are left.”

Advantages of a Lockbox Strategy

Sharpe described the advantages of a lockbox strategy to Barrons.

He said, “The buy-and-hold aspect of the lockbox is better than the glide path [gradually changing the allocation of the overall portfolio], and that has to do with capital asset pricing.”

“With the traditional glide path, the money you’re going to have in 2030 is going to be a function of both how your portfolio did overall and the path it took to get there; there’s an added risk that’s not rewarded with higher expected returns.”

“Bottom line is that bucketing your assets in annual increments with different initial asset mixes in the lockboxes can provide a more efficient production of retirement income over time.”

The most important feature of a “lockbox” is that it is a withdrawal strategy that completely defeats sequence-of-returns issues.

What Are the Disadvantages of a Lockbox Strategy?

Setting up and managing lockboxes can be incredibly complex.

7. More About the Lockbox Strategy

In a Stanford University Thought Leader Interview, Sharpe gave another description of the lockbox strategy:

“The idea is to assess the individual’s preferences for various amounts of consumption in each future year, his or her risk tolerance vis a vis spending at various times in the future, current wealth and other sources of income, and then determine an overall plan.”

“Part of this plan involves allocating current funds to a series of ‘lockboxes,’ each of which is designed to provide spending in a given future year.”

“Thus, one might put $20,000 in a lockbox for the year 2026. The box would also include instructions for the management of the money from the present to the terminal year. Different boxes could well have different investment management strategies as well as different amounts of initial funding.”

You might want to think of lockboxes as an investment strategy and investment policy statement (a document outlining what to do when different things happen) for different time periods in your future life.

8. Knowing What You Want To Spend Is Key to Any Retirement Withdrawal Strategy

Knowing how much you need to spend (and when) is a critical part of knowing how your money should be invested.

If you haven’t yet created a detailed retirement budget, now may be the time.

9. A Financial Adviser Can Be Very Useful

Said Sharpe to Barrons: “Comprehending the range of possible future scenarios from any retirement income strategy is very difficult indeed, and choosing one or more such strategies, along with the associated inputs, seems an almost impossible task.”

“At the very least, retirees will need some help. Enter the financial adviser.”

“Ideally, [the financial adviser] will have a deep background in the economics of investment and spending approaches, sufficient analytic tools to determine the ranges of likely outcomes from different strategies, and an ability to work with clients to find approaches that are suitable, given their situation and preferences.”

10. The Hallmarks of Good Financial Advice: Diversify. Economize. Personalize. Contextualize.

Sharpe told Money Magazine that four verbs summarize the principles of good financial advice:

• Diversify: The closer you come to holding the entire market portfolio, the higher your expected return for the risk you take.
• Economize: Economize by avoiding unnecessary investment expenses, especially management fees and trading costs.
• Personalize: Personalize by taking into account the things that make your situation unique, especially the risks you face outside the financial markets. As an extreme example, imagine that all you eat is chocolate bars. In that case, you’d want to invest more in the stock of candy makers so that if they raise prices, your food will cost more but your stock will go up.
• Contextualize: Remember, if you bet that market prices are wrong [by investing heavily in a single stock or sector], you have to be able to justify why you’re right and the market isn’t. Asset prices are not determined by someone from Mars.

11. Watch Fees

Sharpe estimates that asset management fees of only 1% will ultimately eat up one-tenth of a retiree’s expected lifestyle.

Here is some of his math as told to Wealthfront: “How different are the costs? To take an example: The Vanguard Total Stock Market Index Fund costs you 6 basis points a year if you have more than $10,000 invested.”

“That’s 6 cents per hundred dollars. The average actively managed, broadly diversified U.S. stock fund costs 112 basis points, or $1.12 per hundred dollars.”

“Many people say, ‘What’s an extra 1% or so?’ But they forget that the average return on such a fund is likely to be 7%-8%. The relevant ratio is 1 out of 7, or 8%. Over the long term, the hit is likely to be profound.”

Feeling Overwhelmed? Here Is a Plan

Creating the right retirement investment and withdrawal strategy for you and your needs can feel overwhelming. You have a lot of different options.

The best steps to take will include:

1. Figuring out how much retirement income you will have
2. Documenting your retirement spending needs — in detail
3. Calculating the differences between retirement income and spending
4. Planning investments and withdrawals to fill those differences in a tax-efficient, low-risk way while minimizing fees.