VIEWPOINT

Moshe A. Milevsky
Schulich School of Business and Graduate Faculty in Mathematics and Statistics
York University, Toronto

Its Time to Retire Ruin

(Probabilities)
For over a centurystarting with Swedish mathematicians Filip Lundberg (18761965) and Harald
Cramer (18931985)insurance actuaries have used
ruin probabilities to set premiums and manage liabilities. Broadly speaking, ruin probabilities are really
a framework that models a stochastic process subjected to random additions (i.e., premiums) and subtractions (i.e., claims). The end result is a probability
that the process will hit a barrier (i.e., zero) before
some terminal date. Regulators now place reserve
and capital guidelines within this framework. The
summary metricsalso called default probabilities
are the foundation of credit risk management, a
discipline that owes much to pioneering actuaries.
Ruin is a big business. Hundreds of academic
mathematicians continue the LundbergCramer
tradition, studying ruin under esoteric stochastic
processes. Indeed, a couple of successful ruin papers
will ensure academic tenure at any decent universitys department of actuarial sciences.
But sometime in the last decade or so, the concept of ruin probability transitioned from being a
mathematical construct used by actuaries, mathematicians, and risk management specialists to being a
very trendy metric for wealth management. In that
arena, it is called shortfall probability or failure probability, and it is now deeply embedded in the vocabulary
of the retirement income business.
Its hard to argue with the benefits of statistical
numeracywouldnt it be nice if everyone spoke
calculus fluently?but Im concerned about how
these probabilities are being used (and abused) to
simultaneously reassure and scare clients about the
viability of their retirement plans.
Although there is no doubting that many people
are not saving enough for retirement, there are misguided notions that (1) people with sizable nest eggs
will outlive their assets, (2) one can actually place a
Editors note: The author may have a commercial interest in the topics discussed in this article.
Editors note: This article was reviewed and accepted
by Executive Editor Stephen J. Brown.

probability on this event, and therefore (3) one should

manage financial assets and use insurance products to
minimize this metric. I have concerns with all three.
In particular, the presumption that a client will adhere
to a deterministic spending schedule, wake up one
morning, go to an ATM, and discover that the money
process has reached zero is silly and naive.
To be clear, my point here is not to argue with
the absurdity of assuming that people will continue
driving blindly at the same speed until they run out
of gas in the middle of the desert. People adapt to
changing financial circumstances. Rather, my quarrel
is with the paradigm of retirement ruinwhich I will
refer to here as shortfall or failureprobabilities as the
guiding risk metric for retirement income planning.
In this article, I offer suggestions on how to better
communicate the viability or sustainability of a plan
so clients can properly understand it.
I must, however, start with a confession and
admit (partial) responsibility for disseminating this
paradigm. In 1994, I wrote an article in which my
co-authors and I simulated a variety of constant real
spending strategies during retirement, searching for
the asset allocation with the lowest shortfall probabilities.1 I concede that a long time ago, I found some
value in thinking about the retirement income
problem in this wayand the mathematics were
quite coolbut this approach can get out of hand
and is subject to abuse.
Let me explain.

Problem 1. What Exactly Is a Scary

Number?
Nobody agrees on how much shortfall probability is
acceptable in the context of retirement income planning. Is 10% too high? Remember that the opposite of
failure is success. A 10% shortfall probability is a 90%
probability of achieving your goalswhich sounds
ideal. Then again, I have heard some wealth managers
declare that a 75% probability of successwhich is a
25% chance of failureis acceptable. Some argue that
a 51% chance of success is all that is needed for a good
financial plan, analogous to the evidence needed to
convict in a court of law. At the other extreme, would
you get on an airplane with a 0.1% probability of failure? Why should a retirement plan be any different?
Do you see the problem?

Viewpoint is an occasional feature of the Financial Analysts Journal. This piece was not subjected to the peer review process.
It reflects the views of the author and does not represent the official views of the FAJ or CFA Institute.

8 www.cfapubs.org

2016 CFA Institute. All rights reserved.

Its Time to Retire Ruin (Probabilities)

Another difficulty arises when two different

financial plans or strategies are compared. Plan A
has a failure rate of x%, but for Plan B the number
is (x 1)%. Ergo, the financial adviser (or researcher)
concludes, Plan B is preferable to Plan A. But is a 1%
reduction in a failure probabilityor a 1% increase
in a success ratereally that much better in the
context of personal finance? Channeling the famed
statisticians Jerzy Neyman and Egon Pearson, I cannot help but wonder at what failure rate a financial
plan should be rejected. Moreover, there are some
compelling theoretical argumentsappearing over
the years in such journals as Econometrica and the
Journal of Economic Theorysuggesting its optimal
to exhaust your investment portfolio and live off
pension income by some advanced age. If so, ruin
shouldnt be feared.

Problem 2. X Can Be Worse (or

Better) Than X
Even if the financial advice industry could agree
on acceptable thresholds, there are many different
financial plans that can generate the same failure
rate. Should a retiree be indifferent to all plans with
an equal success or failure rate? All 10% shortfall
probabilities are equal, but some are more equal than
others. In less Orwellian but slightly more technical
terms, different statistical distributions can share
the same tail probability but have distinct risk and
return profiles. Figure 1 illustrates three such curves.
It models the distribution of a financial legacy in
terms of present value, representing (very abstractly)
the amount of money left to the kids if you continue
Figure 1. Which 10% Shortfall Probability
Would You Prefer?

spending from your portfolio at some predetermined

rate. All three curves are Gaussian and very well
behaved (unlike the kids).
For Case A, the financial legacy has an average of
$100,000 and a standard deviation of $78,000. For Case
B, the legacy curve has an average of $200,000 and a
standard deviation of $156,000. For Case C, the average
is $300,000, with a standard deviation of $234,000. If
you want something more concrete to imagine, think
of a very conservative retirement portfolio (Case A), a
more balanced asset allocation mix (Case B), and a very
aggressive asset allocation (Case C). All three portfolios share the same dollar spending rate. As you can
seeand as every financial adviser preachesif you
hold more stocks, you can expect to leave more to your
kids, on average, but there is greater risk.
The bulk of the probability distribution is to the
right of zero, which means that you can expect to
leave a positive financial legacy. You might run into
financial difficultiesbut lets assume the kids will
bail you out if financial markets do not cooperate.
Yes, this assumption is questionable, but the kindness
of your kids is not my point. Note that all three curves
have the same area to the left of zero (i.e., the vertical
line). The shortfallalso known as the bailout
probability is 10% for all three, but the severity of the
potential rescue operation varies dramatically. Are
you indifferent to the plans? Are the kids?
To make things worse, it is not uncommon to
read simulation-based studies in which counterintuitive Strategy A is shown to have a higher success rate
than more intuitively reasonable Strategy B, because
the authors assume that a 9% shortfall probability
(the area to the left of zero) dominates a 12% shortfall
probabilitywhen, in fact, the entire distribution of
outcomes is quite different. In particular, allocating
more to riskier stocks has a nasty habit of reducing
shortfall probabilities while wreaking havoc on your
higher portfolio moments. You will pay for those three
extra percentage points! Shortfall probabilities are not
like LDL (i.e., bad) cholesterol; lower is not necessarily
better.

Problem 3. The World Is Not Old

Enough

400

200

200

400

600

Present Value of Your Financial Legacy ($ thousands)

Case A: Avg. = 100, Stan. Dev. = 78
Case B: Avg. = 200, Stan. Dev. = 156
Case C: Avg. = 300, Stan. Dev. = 234

There is an apocryphal story about Frederick

Mosteller, a famous professor of statistics at Harvard
University. Sometime in the 1950s, a student of
800 Mostellers was unconvinced that a six-sided die
had a precise 1/6 chance of landing on any of its six
sides, so he collected a bunch of (cheap) dice and
tossed them a few thousand times to test his professors theory. This test was perhaps one of the earliestknown Monte Carlo simulationsalbeit without
using a computer. Evidently, according to said

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Financial Analysts Journal

(bored) student, the numbers five and six appeared

more frequently than the numbers one through
four. Professor Mostellers unsurprising response
was that the student had not tossed the dice enough
times. Rest assured, the student was told, the law
of large numbers would kick in and everything
would (eventually) converge to 1/6. Undeterred,
the student continued rolling a few thousand more
times, but the fives and sixes were still showing up
way too frequently. Something fishy was afoot.
It turns out that the observed frequencies were
not quite 1/6 because the holes bored into diceto
represent the numbers themselvesshift the center of gravity toward the smaller numbers, which
are opposite the numbers five and six. Ergo, the
two highest numbers were observed with greater
frequency.2 QED.
What is my point? We do not have the luxury of
observing tens of thousands of financial data points
generated from a stable distribution. Stock and bond
dice exhibit economic biases and can be manipulated by central bankers.
Without getting too Bayesian, lets assume that
a 65-year-old retiree can look forward to 500 months
of retirement. And yet at best, we have 2,000 months
of reliable data on asset class returns. As the great
Paul Samuelson is rumored to have said, We have
but one sample of history.
I suspect that nobody in the late 1990swhen
these sorts of retirement simulations were first generatedallowed the interest rate dice to land on zero
seven years in a row. Statistically speaking, if you have
only 100 years of equity markets in which the sample
average observed real return is 5% and the sample
standard deviation is 15%, then the 95% confidence
interval for the true average real return is approximately 5% +/ (0.15)(2)/10, a range of [2%, 8%]. So,
the reported 15% shortfall probability might actually
be 25% or maybe 5%. But who knows for certain?

Problem 4. In What Black Box Did

You Make the Sausage?
My concerns tie in to a wider problem with very
long-term simulations in personal finance, which
have become ubiquitous in all financial-planning
software tools. No investment firm has been left
behind. Whether your generator is using historical
data as is or a bootstrap methodology to weigh
the recent past more than the distant past or whether
you are using a fancy forward-looking equilibrium
model, the financial engineers are implicitly making assumptions about the world in the very distant
future. The result is not a short-term 20-day value at
risk (VaR) number but, rather, something resembling
a 20,000-day VaR. Your black box is subliminally
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forecasting how interest rates, stock prices, inflation,

and mortality will evolve over the next 50 years and
how they will co-vary with each other.
There are subtle assumptions embedded in
these forecasts that have a nontrivial impact on
the outcome. Can you justify these assumptions to
your clients? Do you even know these assumptions?
Speaking from experience, I have observed some
ridiculous parameters hardwired into retirement
simulation engines, based on the mythical long
runfor example, cash that earns 3%, bonds that
are expected to return 6% when yields to maturity
are 4%, or my favorite sin: the agnostic absence of
correlation assumptions between stocks and bonds.
Yes, zero. Indeed, take a walk through your firms
kitchen. The tools user is given the illusion of control
with a handful of statistical levers, but the headoffice wizards control 20.

Problem 5. Insurance Solutions Are

Not 100%
This particular concern might sound downright
bizarre coming from someone who has advocated
for the use of annuities in retirement plans,3 but I do
worry that shortfall probabilities have been perverted
when annuities are positioned as risk-free products
with no downside risk. There is something magical
about the phrase 100% guaranteed income for the
rest of your life as long as you live, which is so much
more alluring than a mere 99.9% success rate.
But as every insurance product marketing brochurewhether for a simple life annuity or a complicated variable annuity (VA) with a living benefit
reminds us (albeit in 7-point font), all guarantees are
subject to the claims-paying ability of the underlying
insurance entity, and especially with VAs, the head
office has much more discretion than you think.
Carefully read the 2,000-page prospectus document
to find the gotchas. Moreover, insurance companies
also face a ruin probability, as first analyzed over a
century ago by the Swedish heroes who placed the
industry on a sound mathematical footing. Insurance
companies do go bust, and income is rarely 100%
guaranteed in real, after-inflation termswhich are
the only dollars I can consume.
Now granted, the odds of a well-established
insurance companys failure truly are very slim.
More importantly, the myriad benefits of a pension, life annuity, or VA are more nuanced than a
mere number, but I worryand here were getting
painfully close to my own glass housethat undue
weight is often placed on the 100% number of an
insurance solution compared with the 85% or 77% or
51% value of a systematic withdrawal plan (SWiP).
These numbers are not homogeneous apples that
2016 CFA Institute. All rights reserved.

Its Time to Retire Ruin (Probabilities)

can be mixed together and averaged in an urn. In

fact, they are really not even apples and oranges.
Ironically, ruin probabilities are being used to give
insurance products an unfair advantage.
So, what is the answer? I believe we should
pausenever forget the audience we are working
withto take a moment and go back in time.

Start with the First Moment

Here is the main problem. How do we explain to
people that they (1) are spending too much, (2) are
retiring too early, or (3) have not saved enough?
More importantly, how do we get them to act on this
knowledge? Although I do not intend to bring back
the old deterministic projections for future wealth
at death (at, say, 8%, 10%, and 12%) from textbook
exile, I will appeal to the KISS maximnamely, keep
it simple for starters.
Step 1. What Is the Longevity of Your Money
in Years? Retirees should be familiar with the concept of life expectancy, or the expected number of
years they will live. We can call this number EH
(expected horizon). At retirement, the value of EH
is somewhere between 15 and 30 years, depending
on gender, health, and (sadly) race and ethnicity.
It is measured in years and is intuitive and easily
understood, regardless of the audiences level of
technical sophistication. Moreover, everyone would
agree that more years is better than fewer years, that
having only 4 years is quite scary and having 40
years is better (but perhaps might be scary for other
reasons). Any good physician should be able to provide you with an EH, if asked. Although the random
variable H itself is obviously random, the expected
value (EH)the first momentis a valuable piece
of information.
I suggest that we start with the same language
and terminology for the retirement income portfolio.
I would like to introduce the idea of the longevity of the
portfolio (EL, or estimated longevity) as being parallel
to personal longevity. It can be measured in the same
unit of years and approximated by a function of three
explicit variables. Here is the equation I propose:
EL =

1 w/ M
ln
.
g w/ M g

There are three levers at work, which all serve

an important pedagogical role. The first variable is
the withdrawal rate, w, which is measured in dollars
per year (e.g., $50,000 or $75,000)not in confusing
percentages, which permeate the safe-spending literature. The second variable, M, is the money currently
in your nest egg. Think $500,000 or $1,000,000or
even $10,000,000 if you are lucky. The third and most
critical variable, g, is the annual growth rate of your

portfolio, measured in percentages (e.g., 2% or 3%

or 4%). It is a number that is net of management
charges, income taxes, price inflation, and perhaps
even market risk. It is a real return and makes all fees
explicit. The variable g focuses the conversation. The
equationwhich only works when you are spending
more than you earntells your client how many
years the nest egg will last.
Where did this mysterious expression come from?
By rearranging the integral for the present value of a
period-certain annuity in continuous time. The present value of a flow of w dollars from time zero to time
EL, discounted at g, is exactly M. One can show that
the limit of EL as g 0 converges to M/w, which is
what you would want intuitively. The equation itself
can be traced to Leonardo Fibonacci (11701250) in his
textbook Liber Abaci. He posed a problem of how long
a sum of money would last if subjected to constant
withdrawals and constant interest.
Yes, this is all very old school and rather trivial,
I admit, but if the recently released financial literacy
surveys are to be believed, we must explain things
using a language people can understand.
For example, suppose your client has $750,000 in
investable retirement assets. You anticipate that the
clients portfolio will safely earn 2.5%, on average,
in real termswhich is a great opportunity to discuss this number with special care. The client wants
to spend $65,000 a year (in real dollars) for as long
as the client lives. Plug these three values into the
equation. The ratio w/M is 0.08667, which appears
in both the numerator and the denominator. The
ratio within parentheses is 1.40541, and its natural
logarithmwhich is just another button on a phone
these daysis 0.34033. Divide 0.34033 by 0.025 to
arrive at a portfolio longevity of 13.6 years.
Is this result good or bad? Well, its a conversation starter. The doctor gave you 20 years of longevity (EH), and your portfolio has only 14 years of
longevity (EL). There is a mismatch. Tell your client
to do something about it.
Table 1 provides longevity numbers for alternative cases. Spending retirement in the southeast corner (i.e., Florida) leads to the highest longevity number46 years. I ignore everything but the first digit
after the decimal point. More precision is misleading.
Nowbefore you start screaming, What? Hes
just solving for N on a term-certain annuity?I
acknowledge that these longevity numbers might
be (completely) unsatisfactory to the more scientifically inclined clients who rightfully ask and wonder
about risk. We all know they will never be able to
earn a fixed, constant, and deterministic g% per year
forever. Remember that the EL is a start of a conversation, which brings me to the second of a two-step
educational process.

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11

Financial Analysts Journal

Table 1. The Longevity of an M = $1,000,000 Portfolio

(in years)
Investment Growth Rate
g = 0.5%
g = 1.0%
g = 1.5%
g = 2.0%
g = 2.5%
g = 3.0%

w = $60,000
17.4
18.2
19.2
20.3
21.6
23.1

Real Annual Withdrawal and Spending Rate

w = $55,000
w = $50,000
w = $45,000
19.1
21.1
23.6
20.1
22.3
25.1
21.2
23.8
27.0
22.6
25.5
29.4
24.2
27.7
32.4
26.3
30.5
36.6

Step 2. Move to Higher Moments If Asked.

Explain to clients that the longevity of their portfolio
is random because two (or possibly even three) of the
variables are random. There is an entire distribution
of outcomes for the longevity of their portfolio. Their
spending strategy and financial needs will change
over time. And there is much uncertainty about the
year-by-year evolution of the critical vector g owing
to the nefarious sequence of returns and so on.
Remember to KISS.
If they askand when they are readyfor a risk
sensitivity analysis, go ahead and simulate the probability that L is less than H (i.e., their portfolio will
not last as long as they do). Give them higher-order
statistics. Take them to great moments in Monte
Carlo or Atlantic City, but not before you visitand
they appreciatethe first moment.
The highly technical and subtle stochastic 2.0
lecture4 makes no sense until the deterministic 1.0
lecture is crystal clear. Just as importantly, it is very
difficult to abuse or obscure this longevity equation
without leaving (incriminating) evidence behind.

w = $40,000
26.7
28.8
31.3
34.7
39.2
46.2

What was your assumed g? Really?5

Conclusion
I will borrow the term mathyness to describe what
happens when someone who does not understand
the difference between a variance and a covariance
confidently tells a client, Your portfolio will have
an 85% probability of meeting all your lifes financial
goalsif you listen to what I have to sell and tell.
To end on a constructive note, my real message
is about how to educate clients regarding the most
important factors that influence their moneys longevity, EL. Start by providing them with an estimate of the
number of years their portfolio will lastassuming
they continue on the current pathusing a framework that you can understand, control, and explain.
Then move on to higher moments if asked.
I thank Stephen Brown, Branislav Nikolic, Franois
Gadenne, David Laster, Faisal Habib, and Nabil Tahani
for comments on earlier drafts.

Notes
1. That was the same year William Bengen published his 4%
tour de force in the Journal of Financial Planning. Our piece
was published in the fall 1994 issue of a relatively obscure
Canadian journal. I am still proud of that paper, my first publication: K. Ho, M.A. Milevsky, and C. Robinson, How to
Avoid Outliving Your Money, Canadian Investment Review,
vol. 7, no. 3 (Fall 1994): 3538.
2. Before you rush off to a casino to capitalize on this factoid,
note that todays gambling dice are crafted with greater care
(and symmetry), partly because of this fact.
3. Full disclosure: CFA Institute published a monograph of mine
in 2013 called Life Annuities: An Optimal Product for Retirement,
and I have worked as a consultant for a number of insurance
companies.

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4. Note that when g itself is randomized, the expected value of

portfolio longevity might not be defined by or even equal to
the deterministic EL. In a stochastic environment, the median
would be more suitable.
5. Personally, I would have compliance departments place firmwide restrictions on the highest risk-adjusted g that can be
used in illustrations, but that is another matter.

2016 CFA Institute. All rights reserved.