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What makes retirement such a “nasty” problem is that it’s full of variables, few of which are certain, and that all interact with each other. Longevity, spending, rates of return, and volatility of different asset classes being the most notable. Sprinkling a pandemic that the world is trying to understand and deal with on top of that mix makes planning for retirement an even more daunting task.

But there are still many things you can do to put yourself in the best position for success. The most helpful is matching the risks of your financial assets to your expected liabilities. A process that’s called liability matching. 

Before I go further, I need to define “risk” and “liabilities”. “Risk” in this case is defined as the negative characteristic of that particular asset. For stocks it means volatility and market fluctuations,  for cash it’s the risk of inflation, with bonds falling between them. One of the key tenets of finance is that to receive a higher return on any asset, the owner must accept more risk, i.e. more volatility. You can think of this as of stocks returning more than bonds, while being more volatile in the process.

But there are still many things you can do to put yourself in the best position for success. The most helpful is matching the risks of your financial assets to your expected liabilities. A process that’s called liability matching.

Or for an example outside of finance, think of the risk an entrepreneur takes versus a government contractor. If things go as planned for the entrepreneur, he/she could become fabulously wealthy. While the likelihood that the government contractor is going to be able to afford a private jet is low. Neither of these choices are wrong, they are just different. 

The word liability in finance is generally used to describe a debt, but in the context of retirement planning it’s better to think of the word liability as “money I’m going to need to spend each year.” It’s a broader definition that encompasses debt, living expenses, trips, gifts, etc. When I meet with clients, I stress the fact that this variable, the “cost of retirement”, will by far have the biggest impact on their retirement plan. Of course, it’s impossible to know how much money you’re going to spend each year, but it’s possible to make an educated guess. And spending is the variable that is the most within our control. 

Ok, so risk and liabilities are defined, but how do those two concepts come together in retirement planning, especially in a pandemic? Every financial asset has different risks. Cash has inflation risk, but little or no volatility. Stocks have huge fluctuations in value (as recent markets have demonstrated), but historically higher returns. You also probably have a good idea of what your expenditures will be over the next 12-24 months and an understanding that over long periods of time the costs of inflation add up. So the solution is to match your short term liabilities (12-24 months) to your short term assets (cash), your medium term assets (bonds) to your medium term liabilities (3 – 5 years), and your longer term assets (stocks) to your longer term liabilities (expenses 7-25 years in the future. 

I’ve left out financial assets like pensions, real estate, etc., but they fit in the framework easily. They have their own risks such as inflation, longevity, fire, flood, etc., and just like stocks, bonds, and cash they come with tradeoffs. Understanding, managing, and working through those tradeoffs is what financial planning is all about. Only through the process of matching your assets to your liabilities are you going to have a firm understanding of how you can retire. 

While the coronavirus has increased uncertainty and added another variable to the “nastiest hardest problem in finance”, the process for attempting to solve the retirement puzzle remains the same.

Only through the process of matching your assets to your liabilities are you going to have a firm understanding of how you can retire. 

It can seem daunting to pull together all your information into a cohesive picture but working with an advisor can make that process easier and more effective. Once you have a plan in place, the “nastiest hardest problem in finance” becomes an opportunity, not a problem.