Tuesday, January 21, 2014

Comparison of Four Withdrawal Strategies Based on Recent Experience

In my previous post of January 16, I stated my belief that each of the three systematic withdrawal options examined in the Stanford/SoA study was inferior to the actuarial approach advocated in this website.  While I was critical of the three approaches for not even attempting to focus on total retirement income by coordinating with annuity income that the retiree may currently have or expect to have in the future, I think that each of the three approaches have shortcomings even if the retiree has no other sources of income.  In this post, I will illustrate those shortcomings with an example that uses historical investment and inflation experience from 1998 to the present. 

Let's assume that Rachel retired on her 65 birthday on January 1,1998.  At that point, she had $500,000 in accumulated savings in addition to her Social Security benefit.  Since she was single with no children, she had no desire to leave money to heirs.  She wanted to maximize her income in retirement, particularly in her younger retirement years (when she wanted to travel more).  On the other hand, she did not want to outlive her savings.  She decided to invest the assets not budgeted for spending each year 25% in large cap equities, 25% in mid-cap equities, 25% in mid-term bonds, and 25% in short-term bonds (which she rebalanced at the end of each year).  Unfortunately, Rachel died in a car accident on January 1, 2014.  She had just turned 81. 

The graph shows withdrawals under the three different strategies discussed in the previous post compared with withdrawals under the actuarial approach advocated in this website.  All amounts are shown in 1998 dollars.  In using the actuarial approach, Rachel looked at annuity purchase rates in 1998 and decided to determine her first year's withdrawal assuming 7% investment return, 4% inflation and death at age 95.  In 2004, when interest rates had decreased somewhat, she changed the assumptions to 6% investment return, 4% inflation and in 2009 she changed to the now recommended assumptions of 5% investment return, 3% inflation.  She also used the recommended smoothing algorithm. 

None of the four strategies would have been successful in meeting Rachel's objective to die with only a small amount of assets remaining.  She expected to live well past age 81 and her investments did much better than she assumed (on average).  Following the actuarial strategy, she would have died with $626,635 remaining.  But this approach was better than the other three approaches in meeting Rachel's objective, as she would have $786,436 remaining under the IRS Required Minimum Distribution approach, $804,358 under the Constant 4% approach and $827,504 under the 4% Rule.

And while the 4% Rule produces a ruler-flat inflation adjusted withdrawal pattern, it failed to maximize Rachel's desire to maximize spending.  The other two approaches also failed to maximize spending and their withdrawal patterns were much less stable from year to year than under the actuarial approach.  Based on experience from 1998 to 2014, the clear winner of the four approaches in terms of meeting Rachel's objectives is the actuarial approach.

Thursday, January 16, 2014

Systematic Withdrawal Strategies Examined in Recent Stanford/SoA Study Leave Much to be Desired

Last September, the Stanford Center on Longevity, in collaboration with the Society of Actuaries Committee on Post-Retirement Needs and Risks, released "The Next Evolution in Defined Contribution Plan Design".

The principal author of this work was Steve Vernon, who is now a Consulting Research Scholar at the Stanford Center on Longevity in addition to his many other activities, including blogging on retirement issues for CBS MoneyWatch, authoring books on retirement and running his business, Rest of Life Communications.  I have mentioned Steve and the good work he is doing many times in my blog.

The stated primary goal of this paper is "to help retirement plan sponsors, fiduciaries and managers make informed decisions about implementing income solutions [sometimes referred to in the paper as "Retirement Income Generators] that will improve the financial security of their plan participants."  Stated somewhat differently, the paper encourages defined contribution plan sponsors to take steps to make annuity and systematic withdrawal options available to their plan participants.  This is a well written paper that makes some excellent points and suggestions.  While I think that the arguments set forth for including annuity options in DC plans are somewhat more compelling than including specific systematic withdrawal strategies, the only real bone I have to pick with the paper is the choice of systematic withdrawal strategies it choses to discuss and examine.

The paper looks at three systematic withdrawal options (and three annuity options).  As indicated in Section 10, the main criteria for selection of these specific options appears to be that they are "readily available to retirement plan sponsors in today's marketplace."  In my opinion, each of the three selected systematic withdrawal options is inferior to the actuarial approach I advocate in this website.  Readers of my blog know that I have railed against the shortcomings of the 4% rule, which is the first alternative examined, so in order to keep my blood pressure down, I won't go into them again here.  The second alternative (referred to as the constant 4% strategy) is probably worse than the first.  It is similar to the strategy of spending interest on your accumulated assets each year if you expect to earn 4% per annum.  This strategy does not coordinate with any annuity income you might currently have or expect in the future, it does not consider the retiree's desire to have relatively constant inflation-adjusted income in retirement and you should expect to leave a pile of money to your heirs upon death as the annual income produced by this approach is very conservatively determined.  The third approach (which is referred to as the Life Expectancy Based Percentage Strategy [IRS Required Minimum Distribution] has a little more appeal than the first two approaches (and is practically recommended in the paper), but it does not coordinate with annuity income you might currently have or expect to have in the future, it does not consider the retiree's desire to have relatively constant inflation adjusted income, and while not as conservative as the constant 4% strategy, it still produces a lower expected pattern of withdrawals and higher probability of having significant amounts of assets remaining at death.

The paper does point out (as I have many times in this blog) that retirees looking to manage risks in retirement probably should consider combining annuity products with systematic withdrawal strategies, which is why I was somewhat disappointed to see comparisons in this paper (for the most part) between the six individual retirement income generators rather than between various combinations of retirement income generators.  I was also disappointed that my actuarial approach (with recommended assumptions and 10% corridor smoothing algorithm) was not one of the systematic withdrawal options examined in this paper.  After all, my approach is also readily available to retirement plan sponsors (Heck, it's free!), and was touted as having some "advantages" and "nifty features"  in Mr. Vernon's 2012 book, "Money for Life." 

Monday, January 13, 2014

Maximizing "Expected Utility" to Develop An Optimal Decumulation Strategy

Mark J. Warshawsky has formed a new company, ReLIAS llc, which is looking to partner with financial and insurance organizations interested in providing decumulation strategies and products to retired individuals. Mark advocates combining a systematic withdrawal approach from a portfolio of diversified assets with a laddered series of relatively small and regular purchases of single premium life annuities.  His general approach anticipates that the portfolio of diversified assets will eventually be replaced over time by the purchased single premium life annuities.  Mark has developed an algorithm which maximizes a mathematical function (the "Expected Utility) which considers (among other things) the preferences and goals of the retired household for higher income in retirement and accumulation of greater wealth, as well as the retired household's concern for risk.

You can read more about Mark's approach and his thoughts about optimal decumulation strategies in his new website.

For those who wish to "drill-down" more into his research, I recommend that you look at his recent (January, 2014) Power Point Presentation in the section which describes his approach.
I worked with Mark when he was the Director of Retirement Research at Towers Watson.  He is one bright guy.  We wish Mark well in his new endeavor and look forward to more educational material on his website on the subject of optimal decumulation strategies.