Thursday, July 31, 2014

RMD Rules Don't Work Well With Longevity Annuities--Part 2

This post is a follow-up to our post of July 26 regarding coordinating your withdrawal strategy with a decision to purchase a Qualified Longevity Annuity Contract (QLAC).

Since a picture is worth somewhere between a thousand and ten-thousand words (depending who you listen to), I've decided to provide two graphs using the facts of the previous post to illustrate the superiority of using the Actuarial Approach over using the IRS Required Minimum Distribution (RMD) Rules for determining a spending budget if a retiree has purchased a longevity annuity.

As you may recall from the previous post, our hypothetical retiree purchased a longevity annuity providing $38,280 per annum commencing at age 85.  She also accumulated assets at age 70 of $450,000.  The first graph (Investment Scenario #1) below shows total spending budgets (from withdrawals plus annuity payments but before Social Security) expressed in inflation-adjusted dollars produced by the RMD rules and the Actuarial Approach recommended in this website (using recommended assumptions) from age 70 to age 90, assuming future investment returns of 5% per annum, 3% annual CPI increases and survival each year.

If the retiree's objective is to have a constant real dollar spending budget in retirement, this is clearly better accomplished by the Actuarial Approach if the assumptions for future experience selected for this graph are accurate.

Unfortunately, it is not likely that future investment returns will be constant each year.  So let's take a look at a different scenario for future investment returns (Scenario #2).  In this scenario, instead of assuming constant future investment returns of 5% per annum, we will assume a 10% return for the first year, a 10% return for the second year, a -5% return for the third year, with such investment return sequence repeating thereafter.  Recommended assumptions and the recommended smoothing algorithm were used to determine the total spending budget (withdrawals plus annuity payments) under the Actuarial Approach.

While varying the assumption for future investment experience causes undesirable fluctuations under the RMD approach, the spending budget is unaffected under the Actuarial Approach due to application of the smoothing algorithm.  Therefore, changing the assumptions for future investment experience (so that they vary up and down) simply makes it clearer that the Actuarial Approach is superior to using the RMD Rules under these circumstances and assumptions.

(click to enlarge)

(click to enlarge)