Menahem Yaari is an emeritus professor of economics at Hebrew University of Jerusalem and past president of the Israeli Academy of Sciences. He retired from active teaching over a decade ago, but continues to lecture widely and address scholarly conferences around the world. Amongst his many accomplishments and honors, he is a recipient of the Israel Prize in Economics (1987) and the Rothschild Prize in the Social Sciences (1994). Professor Yaari was educated at Stanford University, started his teaching career at Yale University, but eventually moved back to Israel to help jump-start the economics profession at Hebrew University in the early 1970s, where he was chairman and taught for over 30 years.
I recently had the opportunity, and great pleasure to have lunch with Professor Yaari and his lovely wife Nurit, on a picturesque Friday afternoon at the Israel Museum in Jerusalem. Although the conversation started with pleasantries, politics, wine and the wonderful view, it eventually turned towards retirement economics. We discussed his varied career, illustrious students and current research interests. Why this great scholar should be the topic of this month’s Annuity Analytics, will soon become very clear.
Professor Yaari has collaborated with and supervised many well known Nobel Prize winning economists during the last 45 years of his career. He has written thought-provoking, fundamental research papers in the field of microeconomics and decision-making under uncertainty.
One of the hallmarks of his philosophy – which became evident from his very careful and deliberate replies to my questions – is that the economics profession should not rush to abandon the rationality of humans. According to him, many occurrences that might seem at odds with rational decision-making can be properly explained within a classical perspective. His spirited defense of the rational ‘economic man’ was quite refreshing, given the now daily bombardments of evidence professing to show how silly we all apparently behave with our money.
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Needless to say, his writing has had a profound influence on my own thinking about economics, and more specifically about retirement income planning. Indeed, most practicing financial advisors and planners in North America might not have heard of Professor Yaari’s work, <but they should>.
Here is why.
More than 45 years ago, while still a doctoral candidate at Stanford University, he was the first economist to introduce annuities into the canonical life-cycle model. For those who want to look it up, his most famous research work was published under the title: “Uncertain Lifetime, Life Insurance and the Theory of the Consumer” and appeared in the <Review of Economic Studies>, in 1965. Fast-forward 45 years, and today every graduate student in economics and insurance is forced to read this paper, for very good reason. To put it simply, he introduced and then legitimized life annuities to all economists. He placed them in your portfolio.
You see, back in the 1960s academic economists hadn’t really given any thought to how lifetime uncertainty – the randomness of the length of retirement – affects financial planning, savings and investment behavior. I guess you can say that economists didn’t like to think about death, or its impact on economic activity. Sure, they had some vague notions that old age might make people cranky and impatient, but nothing concrete or formal.
Around the same time, modern portfolio theory – introduced by Professor Harry Markowitz – was just starting to catch on with academics (it would be decades before this reached Wall Street.) Yet, even Professor Markowitz and his noted contemporary Professor William Sharpe never addressed how the randomness of life might impact economic behavior and portfolio construction. The other giant names at the time, such as Milton Freidman, or Franco Modigliani – who first theorized that consumers like to smooth their standard of living over time, considering their lifetime resources when they do this – hadn’t said anything about mortality and longevity. In most of their models and papers, people died at a fixed and known time, denoted by the capital letter T. Now how unrealistic is that?
Enter a young Menahem Yaari writing his Ph.D. at Stanford University in the early 1960s. He started his famous paper with the following words:
<“…One need hardly be reminded that a consumer who makes plans for the future must, in one way or another, take account of the fact that he does not know how long he will live. Yet, few discussions of consumer allocation over time give this problem due consideration. Alfred Marshall and Irving Fisher were both aware of the uncertainty of survival, but for one reason or another they did not expound on how a consumer might be expected to react to this uncertainty if he is to behave rationally…”> (pg. 137)
Then, in a mathematical <tour de force>, he went on to describe how consumers would slowly spend down their wealth, in proportion to their survival probabilities and attitude to longevity risk, and gradually reduce their standard of living – rationally. But then, and here is where the light bulb went on, if you gave this same consumer the ability to purchase any type of annuities, they would not have to reduce their standard of living with age! They would, in fact, be able to hedge or insure against their longevity risk.