Thanks to Nelson Murphy for drawing my attention to an article in the Summer, 2015 edition of The Journal of Retirement Research, by David Blanchett, Head of Retirement Research for Morningstar Investment Management. The article is entitled, “Dynamic Choice and Optimal Annuitization.” This article is fairly technical, but I found the investment of time and energy required to wade through it to be generally worthwhile.
As a result of his analysis, Mr. Blanchett concludes that “there is a significant potential benefit to retirees who implement dynamic strategies.” He defines static strategies as those where the retiree makes decisions only at retirement (such as the 4% withdrawal rule or other types of safe withdrawal rule approaches) and dynamic strategies as those that involve intelligent changes during retirement (such as the approach advocated in this website). He also looked at dynamic vs. static annuitization strategies, but the differences in these two types of strategies was not as significant.
The dynamic withdrawal strategy used by Mr. Blanchett is approximately mathematically equivalent to the approach advocated in this website (assuming the retiree has no fixed dollar immediate or deferred annuities, no fixed dollar pension benefits and no specific bequest motive) and the same assumptions are used for investment return, inflation and mortality. If, instead of using the recommended assumptions in this website, you use Mr. Blanchett’s assumptions of 3% investment return, 2.5% inflation and life expectancy based on the Society of Actuaries 2012 Individual Annuity Mortality Table (without mortality improvement), you will develop roughly the same withdrawal rates shown in Exhibit 1 of Mr. Blanchett’s article.
Through his simulations, Mr. Blanchett also develops optimal levels of annuitization for retirees with different shortfall preferences, different bequest motives and different expected life expectancies. Of course the results of any analysis like this are dependent on the assumptions used and the assumed portfolio investment mix over the life of the retiree. The future economic assumptions employed by Mr. Blanchett include a 2.5% inflation rate, 3% bond yields, 9% per annum equity returns (with a standard deviation of 9.4%) and 50 basis point annual fee. The retiree is assumed to maintain a 40% equity/60% fixed income portfolio throughout retirement. While the optimal level of annuitization developed by Mr. Blanchett using these assumptions was lower with the dynamic withdrawal strategy than with the static withdrawal strategy, there were still some scenarios where annuitization was still optimal. Even though he assumed a 6.5% annual real rate of return on equities, on average annuitization was optimal for at least 25% of the retiree’s portfolio (in addition to Social Security) under these modeling assumptions as shown in his Exhibit 2.
Mr. Blanchett concludes that “implementing a dynamic withdrawal strategy alone (without annuities) resulted in higher levels of utility-adjusted wealth than a static withdrawal strategy that included both optimal immediate annuitization as well as dynamic annuitization.” He also concludes that delaying purchase of annuities for a while does not significantly affect outcomes for retirees compared with immediate purchase of annuities at retirement.
Bottom line: There were two things I liked about Mr. Blanchett’s research: 1) He favored a dynamic withdrawal approach very similar to the approach advocated in this website and 2) depending on their preferences and circumstances, retirees should consider investment of some percentage of their retirement portfolio in annuities.