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."