Sunday, March 22, 2015

The Annually Recalculated Virtual Annuity—Pretty Darn Similar to the Actuarial Approach

Thanks to Wade Pfau for bringing to my attention the article in the January/February 2015 Financial Analysts Journal entitled, “The Only Spending Rule Article You Will Ever Need” by M. Barton Waring and Laurence B. Siegel.  The authors believe that, “constructing a spending rule is itself an annuitization problem at heart but does not require purchasing an actual annuity…”  The name the authors give to their recommended spending rule is the Annually Recalculated Virtual Annuity (ARVA).   
I agree with most of this article, as it is basically the same as the approach I have been advocating for over ten years, the last five of which are documented in this website. 

About the only aspect of the authors’ article with which I am not in complete agreement is the authors’ aversion to smoothing of the spending budget from year to year.  The authors argue that smoothing is “the actuarial mistake that has caused so much difficulty for pension plans” and “It is important to control consumption risk with investment policy, not with accounting tricks like smoothing.”  While I agree that over-smoothing can be a problem, I believe the recommended smoothing algorithm advocated in this website does a pretty good job of balancing retiree needs to have some acceptable degree of spending stability with the need to remain on track with the correct actuarially determined value, and in my opinion is consistent with “the small amount of smoothing” described in footnote 13 of the article.  Further, I find it somewhat hypocritical of the authors to cling so steadfastly to their “no smoothing” mantra at the same time that they play fast and loose with longevity risk by stating, “As with any stream of cash flows, the shape of the cash flow payments to a retiree can be engineered to be anything the retiree wants…”.  After all, as I said in my previous post, any spending rule is designed to give the retiree a budget, and it is ultimately up to the retiree to determine how closely that budget will be followed in the current year. 

I will point out that while this article is entitled “The Only Spending Rule Article You Will Ever Need”, the article itself doesn’t provide much in the way of simple spreadsheets (like we provide in this website) to implement the rule, particularly if a retiree has other sources of retirement income such as immediate or deferred annuities/pensions with which spending from accumulated savings needs to be coordinated.