My retired neighbor, Leon, is turning age 62 in the near future. A couple of days ago, when I was out performing what our dog believes is my primary purpose in life (being his personal bathroom attendant), Leon asked me for my thoughts about whether he should defer commencement of his Social Security benefit. Like everyone else, he had read many articles from experts who strongly recommend that retirees defer commencement of their Social Security benefits. Leon pointed me to Michael Kitces’ April 2, 2014 post where Michael said, “the decision to delay Social Security actually represents an astonishingly valuable ‘investment return’.” Leon had also done his “breakeven” calculations.
I told Leon that while deferring commencement of Social Security could be financially advantageous, I believed (and my prior posts on this subject have indicated) that deferral is not necessarily a “no-brainer.” The effectiveness of the deferral strategy depends on a number of considerations, including: 1) how long you will live, 2) how much savings you will use to “bridge” the period of deferral, 3) what investment return you could earn on your savings and 4) the rate of future inflation.
The table below shows the increase/(decrease) in the present value of a retiree’s spendable income associated with deferring a $750 per month Social Security benefit payable at age 62 until age 70 vs. commencing the benefit at age 62 assuming various ages of death. The table uses the same assumptions and hypothetical retiree as used in Mr. Kitces’ article. The calculations were performed using the Social Security Bridge spreadsheet from this website.
 |
| (click to enlarge) |
The table shows that under these assumptions, individuals who live longer will benefit financially by deferring commencement of the benefit until age 70 vs. commencing at age 62, while those with shorter lives will benefit financially by commencing the benefit at age 62. It also shows that even those individuals who choose to defer commencement until age 70 and live until age 97 are not expected to be huge winners under the assumptions used to develop this table.
The table also provides survival probabilities to the various ages based on the Society of Actuaries’ 2012 Individual Annuitant Mortality Table with 1% mortality improvement. This mortality table (and the probabilities of survival) is available in our website in the “other calculators and tools” section. It should be noted that this table represents mortality experience of individuals who purchased annuities and as such is more conservative (longer life expectancy) than general population mortality. The probabilities of survival to age 97 for both males and females were not available from the tool on our website and have been estimated by me.
One of the big differences between Mr. Kitces calculations and mine has to do with the amount of money spent by the hypothetical retiree from his accumulated savings during the eight year deferral period. Mr. Kitces assumes the retiree will spend $750 per month in the first year of deferral and $922 in the seventh year ($750 increased with 7 years of inflation at 3% per year), whereas I have assumed that the retiree does not want to have a big jump in spendable income in year 8 and will spend the same real dollar amount of $1,672 the retiree expects to receive at age 70 during each year of the deferral ($1,320 per month in the first year and $1,624 per month in the 7th year). The cost of deferrals (the present value of withdrawals from savings) under Mr. Kitces methodology is $65,258 while under my methodology, it is $114,853. This is why deferring commencement looks so much more favorable in Mr. Kitces article (if you spend less today, you can spend more later all things being equal). Of course, it would look even more favorable if the hypothetical retiree decided not to withdraw any amounts during the deferral period.
As I told Leon, I’m not going to make a recommendation one way or another on whether retirees should defer commencement of Social Security. It is an individual decision that involves many factors. If you are willing to defer and don’t spend too much of your accumulated savings during the bridge period, you can generally increase your spendable income in your later years.
This is a follow-up to our post of August 11, 2013. In that post, I included what I considered to be one of the most helpful (and most succinct) pieces of advice I have ever read regarding managing the risks involved in financial planning for retirement in today’s world. In his MoneyWatch article of August 7, 2013, my friend and fellow actuary, Steve Vernon said,
"Step 1: Plan to support the life you want, using your best estimate of the future regarding the economy, capital markets, your life expectancy and so on.
Step 2: Be prepared in the event that your forecasts are wrong."
While the simple spending budget calculation spreadsheets (Excluding Social Security and Social Security Bridge) included in this website include a Runout tab (and an inflation adjusted Runout tab) that shows future year’s expected results based on exact realization of all the input assumptions, no changes in assumptions and spending each year exactly equal to the total spendable amount, retirees who use these spreadsheets should have absolutely no expectation that these projected future year’s results will actually occur. They are primarily provided to show the user that the math works, and that under these totally unrealistic conditions, the amount left to heirs at the end of the expected payout period will equal the amount the user inputted on the input page.
The fact that the future numbers in the Runout tabs will be wrong, however, does not invalidate the approach recommended in this website to determine a retiree’s spending budget. The Actuarial Approach anticipates that a retiree’s assets and liabilities will be re-measured at least once a year to adjust the retiree’s budget for differences between actual and assumed experience, for differences between actual and assumed spending and for changes in assumptions. This re-measurement process is essential for keeping the retiree on track. I view this as part of Step 2 in the process Steve Vernon outlined above.
There are lots of possible reasons why forecasts made today will be wrong (deviate from expected results) in the future. These reasons include:
- Differences between actual and assumed investment returns
- Changes in assumed future investment returns
- Differences in actual or assumed spending
- Differences in desired amounts to be left to heirs
- Differences in actual or assumed rates of inflation/desired increases in budgets to keep up with inflation
- Differences in actual or assumed longevity
- Differences in sources of income
Each of these differences can increase or decrease the retiree’s spending budget under the Actuarial Approach. It is important for a retiree to realize that their spending budget can and will go up and down in future years depending on these changes. As indicated in previous posts, the spending budget determined under the Actuarial Approach (with or without applying the recommended smoothing algorithm) is simply one of several decision factors that a retiree can use in the process of determining his or her actual spending for the year.
Depending on the proportion of a retiree’s spending budget that is derived from accumulated savings invested in risky assets, differences between actual and assumed investment returns can have a significant effect on the retiree’s spending budget. In order to give retiree’s a sense of how such deviations from the assumed investment return can affect accumulated savings and spending budgets, we have added a new tab to the “Excluding Social Security” spreadsheet (now called “Excluding Social Security V 3.0”). The new tab is called “5-year forecast” and the only difference between the results shown in this tab and the results shown in the Runout tab are attributable to different investment returns inputted by the user for years 1-5 at the top of this tab. If the same assumed investment return is input for each of the 5 years as is input for the assumed investment return in the input tab, the results shown in the 5-year projection will be the same as those shown in the Runout tab. We have also provided two graphs which highlight the differences in beginning of year account balances and total spendable amounts (excluding Social Security and other inflation indexed annuities) resulting from investment experience different from assumed. No smoothing algorithm was applied to the results in the 5-year projection.
We encourage you play with the “actual” investment inputs in the 5-year projection to provide yourself a better sense of the investment risk you are assuming with your current investment strategy (or strategies). As discussed in recent posts, if you have separate budgets for essential expenses, non-essential expenses, emergency expenses, etc. and different investment strategies for these different categories of expenses, you can “kick the tires” on these separate investment strategies to see if you are comfortable with the risk you are assuming for each expense category.
Inspiration for this post and the resulting modification of the “Excluding Social Security” spreadsheet came from discussions with John D. Craig and from work by the Pension Committee of the Actuarial Standards Board on exposure drafts of a standard of actuarial practice regarding assessment and measurement of risk associated with measuring pension obligations. Thanks to both John and the ASB Pension Committee. Readers who are interested in John’s thoughts on Retirement Planning may find this website to be of interest.
While I encourage retirees who use the Actuarial Approach to revisit their spending budgets at least once a year, this doesn’t mean that they can’t be revisited more frequently. In light of recent equity market volatility, it may make sense to check the status of your accounts to see whether mid-year adjustments to your 2015 spending might be appropriate. This post will outline a simple way to do this and will illustrate the process with an example.
In addition to showing spendable amounts payable from accumulated savings, both of the spending spreadsheets contained in this website show the amount of accumulated savings expected at the end of the year if the investment return assumption for the year is exactly realized and actual spending exactly equals the spendable amount determined for the year (which is assumed to be withdrawn from accumulated savings at the beginning of the year). Therefore, any difference between actual and expected end-of-year accumulated savings will result from these two sources: deviations from expected investment return and/or deviations from expected spending. If you want to get “back on track”, you need to manage your spending or investments (or transfer money into or out of this account) so that your end-of-year assets in this account approximately equals the expected end-of-year value.
Example
Mary, from our June 7, 2015 post, had assets equal to $298,871 in her non-essential expenses account with a non-essential spending budget for 2015 of $19,730. Her expected end-of-year assets in this account equaled $291,702. As of September 4, Mary notes that the amount of assets in this account is only $260,000. Some of the decrease in assets in this account resulted from spending a little bit more than 2/3rds of her annual spending budget and the rest resulted from decreases in the investments in her account. As a practical matter, it doesn’t really matter the exact sources of the decrease. Her current account balance dedicated to non-essential expenses is lower than her expected end-of-year account.
What can/should Mary do about this situation?
She has a number of alternatives:
- She can make no changes in her non-essential spending for the rest of the year. She will face the issue of a potential lower spending budget next year. She can hope her investments will rebound by year end.
- She can reduce her non-essential spending budget as best she can for the remainder of the year.
- She can transfer some of her assets in other spending accounts (such as her emergency account) to her essential spending account.
- She can pursue a combination of the above actions.
Mary knows that she can spend her retirement money now or she can spend it later (or provide more money to her heirs). By virtue of going through this exercise, however, she knows that as of September 4, 2015 she was a little bit more than $30,000 under her target level of assets in this account with about a third of 2015 still remaining (including her spending for the holidays). She can use this knowledge to help her make non-essential spending decisions for the remainder of the year.
Note that Mary can use same process for years when investment return is more favorable than assumed. In those years, “excess” assets can be transferred out of her essential spending account to her emergency fund account or some other budget account.
As one who frequently advocates developing a spending budget that best meets your (or if you are a financial advisor, your client’s) needs, I was pleasantly surprised to read the August 29 article by Kenn Tacchino entitled, “Are your retirement drawdown strategies meeting your needs?”
I generally agreed with Mr. Tacchino when he said,
“Rather than just accept the financial planning decumulation strategies as gospel, you will need to customize them to your specific goals (e.g. your desire to travel or take up a new hobby), your individual need to protect against unwanted retirement shocks (e.g., the need to pay for extraordinary health care), and your unique level of tolerance for risk.”
and
“Your chosen strategy needs to be personalized so that it meets your idea of the proper balance between unnecessarily restricting current consumption and hoarding assets for future needs.”
Of course I think it is easier and more effective to use the Actuarial Approach set forth in this website rather than customize some or all of the decumulation strategies discussed by Mr. Tacchino. See my post of June 7 of this year for an example.
Michael Kitces has recently blessed us with two fine blog posts (August 19 and August 26) describing how interaction of Medicare’s “Hold-Harmless” provision and a projected 0% cost of living increase for Social Security benefits for 2016 could increase 2016 Medicare Part B premiums by over $650 for some individuals. I encourage readers of this website who do not fall into one of the three categories described below to read Michael’s posts for a very thorough discussion of how this situation developed, its implications and potential strategies. I will attempt to provide below a very brief summary of the implications.
Assuming there is no cost-of-living increase for Social Security, the current law remains unchanged and the Health and Human Secretary does not set a lower Part B premium for affected individuals, for everyone who is subject to the Hold Harmless provision, the 2016 Part B monthly premium will be the same as the 2015 Part B monthly premium ($104.90). For individuals not subject to the Hold Harmless provision, their monthly 2016 Part B premium is estimated to increase by approximately $55 per month to pay for freezing the 2016 Part B premium for individuals subject to the Hold Harmless provision. This extra premium is in addition to the extra premiums that may be required for individuals with relatively higher incomes under the Income-Related Monthly Adjustment Amount provisions of the law (IRMAA).
There are generally three types of individuals who are not subject to the Hold Harmless provisions of the law for 2016 (and therefore potentially subject to this additional $55 per month premium):
- Individuals subject to extra premiums because of higher income (IRMAA): You can fall into this category if your modified adjusted gross income for 2014 as reported on your tax return exceeded $85,000 for an individual filer or $170,000 for a married filer. For this purpose, adjusted gross income is “modified” by adding any tax exempt interest. Note that you can fall into this category for 2016 even though your income is not normally this high as a result of unusual realized capital gains, conversion of an IRA to a Roth IRA, etc.
- Individuals who are eligible for and participate in Medicare but do not receive a Social Security benefit. For example, an individual who has decided to defer commencement of her Social Security benefits but has commenced participation in Medicare. Note that this category would apply even if you could have commenced your Social Security benefit in an earlier year and you would otherwise have been eligible for the Hold Harmless provision for 2016.
- Individuals who commence participation in Medicare in 2016 with or without a Social Security benefit.
Of the three categories of individuals potentially being socked to pay for the costs not paid by the individuals benefiting from the Hold Harmless provision, perhaps the most surprising (to me) is category 2. These are the good folk who listened to all the financial experts who told them that it was a “no-brainer” financially to defer commencement of their Social Security benefit to age 70. If you fall into this category, you should read Michael Kitces’ analysis concluding that if you are planning to commence your Social Security benefit at the beginning of 2016 (and you otherwise meet the Hold Harmless requirements), you might want to consider accelerating commencement of your Social Security benefits so they start this November. Note that relatively quick action would be required to commence Social Security benefits in November of this year in order to avoid this extra $650-ish premium for 2016.
This post is a follow-up to our post of June 18 entitled, “Managing Risks in Retirement through Diversification of Retirement Income Sources.” The impetus for this post is another excellent article by Dr. Wade Pfau entitled, Evaluating Investments versus Insurance in Retirement, featured in the June 30, 2015 edition of Advisor Perspectives. And while Dr. Pfau does a fine job of presenting the advantages and disadvantages of exclusively using either investments or insurance to fund retirement, his primary purpose is to advocate combining the two approaches in retirement. He concludes that “retirement income planning is not an either/or proposition” and “the risk pooling features of insurance and the upside potential of stocks make for an effective combination for retirement income.” As this combining of retirement income sources has been a pretty consistent theme of this website for quite a while, I will take this opportunity to once again point out how intelligent Dr. Pfau is.
Of course it would have been nice if Dr. Pfau had been a bit more specific with regard to his recommendations regarding 1) proportions of each type of investment 2) timing of annuity purchases or 3) types of annuity purchases (immediate annuities or deferred income annuities, QLACs). But perhaps these recommendations will be forthcoming soon from the eminent retirement researcher.
As emphasized on our June 18 post, the Actuarial Approach advocated in this website is one a very few approaches that actually attempts to coordinate fixed dollar insurance annuities (or pensions) with withdrawals from investments when developing a retiree’s spending budget. Most other approaches assume a 100% investment approach (and/or simply ignore the existence of annuities/pensions). If a combined fixed immediate annuity (or pension)/investment approach is used, the withdrawal strategy needs to do double duty. Withdrawals from investments must not only provide supplementary lifetime income with desired cost-of-living increases on such income, but must also provide for desired cost-of-living increases on the fixed dollar annuity. If a combined deferred income annuity (QLAC)/investment approach is used, withdrawals from investments must work even harder. Such withdrawals will be the sole source of income prior to commencement of the deferred annuity (together with desired cost-of-living increases). After commencement of the deferred annuity, withdrawals from investments need to provide supplementary income (together with desired cost-of-living increases on such income) as well as desired cost-of-living increases on the fixed dollar deferred annuity income. But don’t worry. Unlike the many other commonly-advocated withdrawal strategies, the Actuarial Approach does all this coordination for you automatically.
Ever since the IRS published proposed regulations permitting Qualified Longevity Annuity Contracts (QLACs) in early 2012, I have encouraged my readers to consider these products in combination with withdrawals from their managed assets as a way to manage their longevity risk.
The market for these insurance products has become more robust as more insurance companies are coming out with QLAC products. The question remains, however, as to whether now is a good time to buy a QLAC or would it be better to wait (or perhaps never buy one). This post will provide a brief background on QLACs and will outline some of the pluses and minuses of buying one. In addition, I will also touch on the separate decision of whether it makes sense to buy one now in today’s economic environment, or possibly wait. Since I don’t recommend investments, you won’t see a recommendation here—just things to consider.
Background
A QLAC is a deferred income annuity payable from a qualified defined contribution plan or IRA that is purchased from an insurance company with lifetime benefits (generally paid monthly) commencing no later than age 85 that meets various IRS requirements. The IRS final regulations on QLACs contain lots of rules (that I will not go into here) regarding how these deferred income annuities “qualify” as QLACs for special treatment under the Required Minimum Distribution rules. For this post, I’m going to focus on a simple version of the QLAC that I refer to as a “pure longevity insurance” QLAC. Under this QLAC, a retiree buys a deferred income annuity (with a single premium) using funds from her IRA with monthly lifetime annuity benefits commencing at age 85 and no death benefits payable if she dies either before or after commencing benefits. According to Immediateannuities.com, a single premium of $70,000 today will buy a 65-year old male a lifetime monthly income of $2,882 commencing at age 85. By comparison, the single premium required to purchase that level of monthly income commencing at age 65 would be about $516,000. Because females generally live longer than males, premiums are higher for age 65 year old females to buy the same levels of income. If annuity purchase rates remain unchanged in the future (highly unlikely), waiting to purchase a QLAC that commences at age 85 will raise the premium. For example, it would cost a 70-year old male about $82,750 (as compared with the $70,000 premium for the 65-year old) to obtain the same lifetime monthly income of $2,882 commencing at age 85. There are two reasons for this: 1) the insurance company will have 5 fewer years to invest the premium and 2) it won’t have the “risk pooling” premium that would have been available if the retiree had bought the premium at age 65 and died before age 70.
I used the term “pure longevity insurance” for the QLAC described above. It is similar in concept to buying term life insurance or buying fire insurance. It pays essentially nothing if you don’t experience the contingency you are buying the insurance for. If you don’t have a fire, you will receive no payment from your fire insurance. Your premiums will be “pooled” and used to pay the fire damage claims of others who do have fire damage. Similarly, with pure longevity insurance, you will receive payments if you live past age 85 and nothing if you die prior to age 85. If you live significantly past age 85, you will benefit from the same type of insurance pooling that fire victims receive when they have fire damage. For some reason, people who have no problem at all with buying fire insurance or term life insurance don’t like the concept when it comes to longevity insurance.
Some Pluses of QLACs
- More efficient than self-funding. As I recommend in this website, if you are going to self-insure your retirement through strategic withdrawals from your accumulated savings, you are going to have to plan to live longer than your life expectancy. In this website, I recommend that you plan on living until age 95 (which is longer than your life expectancy until you get to around age 90). If you plan on living until age 95 and the insurance company assumes that you live until your life expectancy when pricing the QLAC, it will be less expensive for you to buy the QLAC to cover those last 10 years (and beyond) than to self-insure (unless you believe the risk-adjusted return on your investments will beat the QLAC investment return including risk pooling benefits). See my post of May 28, 2015 for a numerical example of the impact of purchasing a QLAC on a retiree’s spending budget.
- Less expensive than immediate annuities. As noted above, the premium required under a QLAC is much less than under a single premium immediate annuity, but the amount of longevity insurance is approximately the same. Because it is cheaper, the QLAC gives the retiree more investment opportunity and more flexibility.
- Reduces investment responsibilities in later life. Some argue that those of us who reach 85 and later years may not have the mental capacity to manage our investments appropriately. In this respect, the QLAC provides guaranteed income at a time when needed the most.
- Provides assurance that a retiree won’t run out of money (assuming they make it until age 85).
- Can reduce the size of a retiree's account that is subject to Required Minimum Distributions and therefore defer payment of related income taxes.
Some Minuses of QLACs
- Insurance company profit. Insurance companies are in the business of making money. In addition to building a profit into their premiums, they will assume that most individuals who are confident enough to purchase longevity insurance will probably live longer than average. These factors will eat into the risk pooling benefit discussed above to some degree.
- Inflation. Like most annuities sold today, QLACs generally pay a fixed dollar amount per month. Inflation will erode the value of such benefits. Depending on future inflation, the value of a benefit commencing twenty years from now may not be adequate to meet living expenses.
- May not be easy to coordinate withdrawal strategy from invested assets with benefits anticipated under the QLAC. If a retiree desires to meet essential expenses with level real dollar spending over a 30 year period (for example from age 65 to age 95), withdrawals for the first 20 years need to be such that they increase each year with inflation and then in the 20th year, smoothly glide into the QLAC income (no big jumps or decreases) and for years 21-30 withdrawals need to cover any shortfall in the QLAC income and provide for inflation increases. [Note that this coordination is one of the strengths of the Actuarial Approach advocated in this website that you won’t find elsewhere]
- Some retirees don’t like the idea that they may get nothing but insurance from a QLAC.
- Increased investment responsibility compared with immediate annuity. The retiree is on the hook for managing money for at least until age 85. Unlike with an immediate annuity, there is no guaranteed income prior to age 85 and the retiree could run out of money prior to age 85.
Is Now a Good Time to Buy a QLAC?
Investment underlying annuity contracts are essentially bond investments and for QLACs, long bond investments. If you believe that long-term interest rates and long-bond yields will rise significantly in the future, then it is probably best to wait to buy a QLAC. On the other hand, as noted above, the longer you wait, the less income you will receive from a given level of premium if interest rates remain unchanged. An alternative strategy to buying a QLAC that still involves significant longevity risk pooling benefits is to simply wait until an older age to buy an immediate annuity.
My last few posts have encouraged readers to develop a reasonable spending budget in retirement each year by aggregating specific expense components. For example, in our post of June 7, Don’t Just Tap your Savings; Develop a Reasonable Spending Budget, our hypothetical retiree, Mary, separated her total budget into the following components:
- Essential non-health-related expenses
- Essential health-related expenses
- Bequest motive/end-of-life long-term care
- Other unexpected expenses, and
- Non-essential expenses
Mary had different investment and desired payout strategies for these various components. Therefore, she treated them differently in her planning.
After our post of June 12, Good Time for Retirees to Stress Test Their Investment/Spending Strategies, in which we discussed some statistics that predict a bear market will likely be coming at some point in the future, I received an email from Colin from Massachusetts suggesting that it might be wise for Mary and other retirees to possibly “beef-up” their “other unexpected expenses” budgets during bull market periods in anticipation of future bear markets. I agree.
Even though retirement is generally a period of “decumulation” rather than savings accumulation, there is no requirement for you to spend all your experience gains during good times. The concept of having a “rainy day” fund still applies to retirees. Therefore, if you do experience gains from investment experience or from spending less than your budget, you may want to consider where you stand in the current economic cycle and put some of those gains aside in the “other unexpected expenses” component of your total spending budget in anticipation of a future bear market.
Thanks again to Colin from Massachusetts for his suggestion. I am always happy to pass along good ideas from my readers.
Long-time readers of this blog know that I have no love for the 4% Rule. It has a number of deficiencies when compared with the Actuarial Method advocated in this website, including:
- It doesn’t coordinate well with other fixed-dollar sources of retirement income such as pension income, immediate income annuities or deferred income annuities.
- It doesn’t anticipate a specific bequest motive.
- There is no spending flexibility from year to year.
- There is no adjustment process for actual experience, spending deviations or changes in assumptions about the future.
- After the initial year, it is not based on how much assets you have or on how long you expect to live.
- It is a “set and forget” strategy that requires the retiree to have faith that it will work in the future based on analysis of historical returns that may have absolutely nothing to do with future returns.
- It doesn’t accommodate a retiree’s desire to have different spending pattern objectives for different components of the retiree’s overall spending budget.
- It requires the retiree to invest at least 50% of accumulated assets in equities, irrespective of the retiree’s risk preferences.
Notwithstanding recent research from David Blanchett, Michael Finke and Wade Pfau showing that a safe withdrawal rate for a 30-year retirement based on a forward looking model (rather than historical returns) that reflects current low interest rates and relatively high price/earnings ratios in equities is closer to about 2.4%-2.8% for a portfolio with 60% equities, Michael Kitces is back with his variation of the 4% Rule based on historical returns. In his new article entitled, “Ratcheting the 4% Rule for saner retirement spending”, Mr. Kitces notes that based on his analysis of historical periods, the 4% Rule would have generally resulted in significant underspending that in most cases would leave “a huge amount of wealth left over.” As a result, he proposes that a retiree increase spending by 10% of the spending called for under the 4% Rule whenever the retiree’s account balance exceeds more than 150% of the initial account balance. He further proposes that if the account balance continues to remain high thereafter, the retiree can continue to apply further increases every three years. He indicates that these spending increases can be “ratcheted” up without much concern about subsequent declines.
Thus, rather than looking at the current economic environment, Mr. Kitces looks into his rear-view mirror and encourages a new retiree to invest at least 60% of her portfolio in equities and withdraw 4% of her assets in her initial year of retirement with inflation increases each year thereafter. She can blissfully ignore actual investment experience. If her assets become too high in the future, she can increase her spending, apparently without much concern for having to reduce spending later on.
I have no problem with dynamic spending strategies (ones that can go up or down). I advocate a dynamic strategy. If you are not going to insure a significant portion of your wealth through lifetime annuity products, and you invest in risky assets, I believe you are going to have to live with a certain amount of variability in spending. But I don’t think in today’s current economic environment, you can withdraw something like 4% of your initial accumulated savings (with subsequent inflation increases) over a 30-year period and realistically expect to never have to decrease your spending. Retirees should be very cautious about using the 4% Rule with Mr. Kitces’ ratcheting modification. The research by Blanchett, Finke and Pfau noted above showed a less than 60% success rate (i.e., a greater than 40% failure rate) over a 30-year period for the 4% Rule based on their forward looking model and 60% investment in equities, and that is before application of any “ratcheting” increases advocated by Mr. Kitces.
Many of the posts and articles on this site (as well as retirement research) suggest retirees consider managing risks in retirement by adding a combination of (i) lifetime pension/insurance annuity products and (ii) withdrawals from a managed portfolio of assets to the benefits received from Social Security. Because annuity products such as single premium immediate annuities (SPIAs) and deferred income annuities (DIAs) pool mortality risk and share mortality gains among survivors in the pool, these vehicles can be more efficient in managing longevity risk than withdrawals from a managed portfolio. These products can also be more effective in managing investment risk. On the other hand, withdrawals from a managed portfolio can preserve spending flexibility, provide liquidity to meet unplanned expenses, serve as a hedge against inflation, and can provide a bequest motive, which may not be as easily accomplished with annuity products. Therefore, depending on the relative size of a retiree’s accumulated savings, the existence or non-existence (and relative size) of a pension benefit and the amount of the retiree’s Social Security benefit, the best approach to managing retirement risks may be this partial annuity (or pension)/partial withdrawal approach.
As illustrated in several of my most recent posts, retirees may want to separate their total spending budget into several smaller components, including for example, essential health-related expenses, essential non-health-related expenses, other unexpected expenses, non-essential expenses and bequest motives/other end of life expenses. Investment and payout strategies for these various component budgets could easily vary. For example, retirees may select more conservative investment (such as annuity products) and payout strategies for assets supporting essential expenses while employing more aggressive investment and payout strategies for assets supporting non-essential expenses.
If a retiree elects to use a partial annuity (or pensions)/partial withdrawal approach and either does or does not separate total spending into smaller components, it is important that the withdrawal strategy applied to invested assets be appropriately coordinated with payments expected to be received under the pension/annuity in order to meet the retiree’s spending objectives. Note that with the exception of the Actuarial Approach recommended in this website (and possibly the actuarial approach developed by David Blanchett, John Mitchell and Larry Frank), none of the more commonly-advocated withdrawal approaches make any attempt at all to properly coordinate with fixed dollar pensions or lifetime annuity products that a retiree may have. This failure to properly coordinate is, in my opinion, a serious deficiency for withdrawal strategies such as the 4% Rule (or any of its many variations), the required minimum distribution rules (RMD), any safe withdrawal rate (SWR) approach, the Annually Recalculated Virtual Annuity (ARVA) approach or even the Guyton Decision Rules inexplicably touted by Dr. Wade Pfau, the author of the “Efficient Frontier” retirement research noted above which advocated the combined use of annuities and withdrawals.
Two recent articles got me started on this post. The first article, Government Policy on Distribution Methods for Assets in Individual Accounts for Retirees--Life Income Annuities and Withdrawal Rules, by my friend and former business colleague, Mark Warshawsky, compares historical outcomes of 100% investment in annuities vs. 100% investment in a balanced portfolio of equities and fixed income assets with withdrawals made under the 4% Rule. Based on historical simulation of asset returns, interest rates and inflation, Mark concludes that the 100% annuity strategy beats out the 100% investment strategy. He uses this conclusion to make several retirement-related government policy recommendations. For the most part, I found this to be good research, but I would have liked Mark to include comparisons of combined partial annuity/partial withdrawal strategies, and I am not a big fan of the 4% Rule.
The second article, by the aforementioned Dr. Pfau, entitled 7 Risks of Retirement Income Planning, indirectly makes a pretty compelling argument for combining annuity products and investments to address all of the risks discussed in this article.
