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.
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This is a follow-up to our post of July 19 warning our readers that it can be important to use a systematic withdrawal strategy that coordinates with your specific financial situation and objectives, such as the Actuarial Approach, or you may derail your retirement.
Readers of this blog will be familiar with the many gems of retirement planning wisdom attributed to my actuarial buddy, Steve Vernon. In his post of July 23rd, Steve outlines what he considers to be a smart way to make retirement savings last (actually a series of decisions). Steve has his hypothetical 65-year-old woman buy a Qualified Longevity Annuity Contract (QLAC), work half-time in retirement until age 70, defer Social Security commencement until age 70 and use some of her accumulated savings from age 65 until she commences Social Security to supplement her employment income until then.
At age 70 she will have a much larger Social Security benefit than if she had commenced at age 65 ($33,936 per annum in Steve's example). Despite buying the QLAC and making withdrawals over five years, her accumulated savings at age 70 is expected to be almost as much ($450,000) as when she retired. So far, so good. But then Steve inexplicably has her run off the train tracks on her smart retirement train ride by using the RMD rules to determine her annual withdrawals from her accumulated savings. The RMD rules just don't coordinate well with her decision to buy the QLAC.
So, her spending budget for her first real year of retirement is only $50,361 ($33,936 from Social Security and $16,425 from accumulated savings). Had she been real smart and used the Actuarial Approach, the spreadsheet and recommended assumptions would have indicated that she could spend $30,871 from accumulated savings in addition to her Social Security of $33,936 for a total spending budget of $64,807, or about 29% higher. And, if all the recommended assumptions been realized in the future (and she spent exactly her budget each year), she would expect her total retirement budget (Sum of withdrawals, annuity payments and Social Security benefits) to remain constant from year to year when measured in inflation adjusted dollars .
While Steve may be right that most IRA and 401(k) administrators will calculate the RMD for you, that fact by itself does not make it a particularly good systematic withdrawal strategy:
- As noted above, it may not coordinate well with other sources of retirement income such as QLACs
- It will not provide produce smooth spending budgets from year to year as it immediately and fully reflects actual experience during the previous year.
- It does not target a relatively constant real dollar spending budget from year to year
- As an IRS minimum, It tends to under-budget in the early years of retirement and over-budget in the later years, with a higher tendency to leave more money than desired to heirs.
Bottom Line: The Actuarial Approach outlined in this website is a better systematic approach to use than RMD, and while it might be slightly more complicated than leaving critical retirement decisions up to your IRA or 401(k) administrator, it definitely does not require you to be an actuary.
While many retirees worry about how much they can spend in retirement, not all retirees enjoy the same financial situation and not all retirees have the same objectives in retirement. This is why it may be important to you to use the Actuarial Approach outlined in this website and not some other approach such as the 4% Rule (or some other safe withdrawal rate) to determine your annual spending budget. This post will provide an illustration of how your specific situation and objectives can affect your spending budget.
Your initial spending budget in retirement can be affected by a number of factors including your age and health, your significant others age and health, your investment strategy, relative levels of Social Security benefits and/or pension or other annuity income (and whether such income is immediately payable or deferred), your bequest motives, any income from employment, your desire for constant real dollar income in retirement, etc. Subsequent years spending budgets can also be affected by a number of factors including actual investment return, actual inflation, actual amounts spent, changes in items used to develop your initial spending budget, etc. If you are simply spending 4% of your accumulated savings at initial retirement increased with inflation each year, you are probably not adequately reflecting your specific situation or objectives.
Let's illustrate the previous statement with an example. Assume Joe retires at age 65 with a Social Security benefit of $2,000 per month. He also has accumulated savings in an IRA of $800,000. He is not married and he has no bequest motive and no immediate pension or annuity income. Since he is worried about outliving his savings, he decides to take advantage of the new Qualified Longevity Annuity Contract regulations and takes $100,000 of his accumulated savings and buys a deferred annuity that will pay him $31,250 per year starting at his age 80 (and nothing if he dies prior to that age). This leaves Joe with $700,000 of retirement assets to invest after the annuity purchase. Joe has also read the research paper from David Blanchett which indicates that spending generally declines in real terms as retirees age. Therefore, Joe decides that instead of planning on a spending budget that will remain constant in real dollar terms, he is willing to live with a spending budget that will increase by the cost of living measured by the CPI decreased by 1% each year.
To develop his initial spending budget, Joe inputs his information into the "Excluding Social Security V 2.0" spreadsheet in this website (accumulated savings of $700,000, deferred annuity of $31,250 starting in 15 years, $0 desired at the end of the payout period) and all the recommended assumptions (5% investment return, 30 year payout period) except 2% per year desired increases rather than 3%. He still enters 3% for the expected rate of inflation to see the possible impact on his spending budget (before adding Social Security) of his decision not to have constant dollar spending budget (shown in inflation-adjusted run out tab). The resulting spendable amount (all from accumulated savings) is $43,264, or 6.18% of his initial accumulated savings of $700,000. To this amount he adds his annual Social Security benefit of $24,000 to get a total spending budget for his initial year of retirement of $67,264.
In subsequent years (prior to commencement of the deferred annuity), Joe will use the smoothing algorithm recommended in this website. He will do this at the beginning of each year by inputting his specific information into the spreadsheet to get a preliminary value to be withdrawn from accumulated savings and will add his expected Social Security for the year to get a total preliminary budget for the year. He will then increase the actual previous year's total budget by the increase in inflation less 1% and test to see that this amount falls within a 10% corridor around the total preliminary budget amount. If it does, this amount will be his total budget for the year and the budget amount to be withdrawn from accumulated savings will equal the total budget amount less Social Security.
Is the actuarial approach more complicated than simply withdrawing 4% of accumulated savings in the first year of retirement and increasing that amount by inflation every year? Yes, but in my opinion it is worth the extra 15 minutes a year it might take you to reflect your specific financial situation and objectives and do the calculation right. In Joe's case, he is looking at an initial year's spending budget that is about 29% higher ($67,264 under the Actuarial Approach vs. $52,000--$28,000 from accumulated savings and $24,000 from Social Security--under the 4% Rule).
This post is similar to our post of June 21 in that it defends the Actuarial Approach advocated in this website against those who find the approach either too complicated or too simple. In this post, we will once again defend it against those who question its effectiveness because it doesn't employ Monte Carlo modeling.
In his Retirement Café post of July 11, Dirk Cotton argues for the use of the Monte Carlo modeling approach when planning for retirement. He says, "many planners and nearly all academics prefer to use Monte Carlo simulation, instead. Monte Carlo generates many outcomes and, unlike the spreadsheet approach, shows the distribution of outcomes."
While Mr. Cotton refers to the benefits of using Monte Carlo modeling over spreadsheet (or deterministic) approaches when planning for retirement, and not specifically for determining one's spending budget, his view is somewhat typical of academics and financial planning experts who believe that Monte Carlo modeling is the best thing since sliced bread and clearly superior to deterministic modeling.
The Actuarial Approach involves using a simple deterministic spreadsheet with recommended assumptions to model future experience (Future annual spending budgets and remaining accumulated assets are shown in the run-out tabs assuming experience exactly follows the assumptions and the annual budget is spent each year). Yes, we know that actual experience will deviate from assumed experience, which is why the Actuarial Approach employs annual valuations and a smoothing algorithm to adjust the spending budget for actual investment return, inflation, spending as well as any changes in assumptions.
No matter how many simulations are examined in a Monte Carlo model, it will not be able to accurately predict the future, and its projections of future experience will be just as wrong as under the deterministic model. As indicated in our post of August 13 of last year, incorrect projections of future experience (whether our "inferior" deterministic ones or the "more sophisticated" ones developed from tens of thousands of Monte Carlo simulations) will need to be adjusted to reflect actual experience as it emerges.
Don't get me wrong. Monte Carlo modeling can be useful for certain purposes. For example, it can be very useful for testing how successful two or more different withdrawal strategies might be in meeting client objectives or even in testing how different smoothing algorithms might work for the Actuarial Approach. But, for the purpose of determining this year's spending budget, it is not necessarily superior to the simple spreadsheet recommended on this website.
Periodically I venture somewhat outside my field of expertise to tout the potential virtues of having a diversified portfolio of sources of retirement income. Most retirees in the United States are currently receiving (or will receive) Social Security benefits and most have accumulated some retirement savings (either in tax qualified plans or in after-tax investment accounts). A smaller percentage of retirees are currently receiving (or will receive) some form of lifetime income from defined benefit plans sponsored by one or more of their prior employers. Still others rely on income from employment to supplement their retirement income.
In our post of September 22, 2013, I indicated that it is not unreasonable to manage risks in retirement by diversifying sources of retirement income and compared several partial annuity/partial self-managed approaches with either using 100% of accumulated savings to buy a single premium life annuity or alternatively investing the accumulated savings and using a strategic withdrawal approach to develop annual spendable income. Last week I also blogged about Qualified Longevity Annuity Contracts (deferred life annuity products that provide more "pure" longevity insurance than single premium life annuities at generally significantly lower cost).
In his article in the July/August 2014 Contingencies Magazine, Mark Shemtob, an actuary, argues that there is no "puzzle" why retirees don't buy single premium life annuities--They don't believe the potential perceived risks justify the potential perceived rewards. The potential risks summarized by Mr. Shemtob include:
- Insurance company default
- inflation risk
- liquidity risk
- risk of dying too soon
And while I agree with Mr. Shemtob that these risks might prevent me from taking 100% of my accumulated savings and buying a single premium life annuity, I can mitigate some of these risks (and take advantage of the rewards inherent in annuities) with a partial annuity/partial self-managed approach.
How much of one's accumulated savings should be used to buy either a single premium immediate annuity, a deferred annuity or some combination of the two? And when should one buy these annuities? I don't know. This answers will depend on many factors, including expectations for current and future interest rates, amounts of Social Security benefits and employer sponsored lifetime income you receive, bequest motives, your investment risk tolerance, your basic income needs, your desire for budget flexibility, etc.
I do know, however, that you can use the "Excluding Social Security V 2.0" spreadsheet on this website to coordinate your withdrawal strategy with annuity purchase decisions you are considering to estimate the effect on your annual spending budget.
In his July 1 article for Advisor Perspectives, Dr. Wade Pfau concludes that a conservative retiree with accumulated savings invested approximately 50% in the S&P 500 and 50% in Intermediate Term Government Bonds will want to consider real rates of investment return in the 1.9% to 3.3% neighborhood when planning a spending budget. This research is consistent with the approximate 2% real rate of return (5% investment return and 3% inflation) recommended in this website. As discussed in our post of October 11 of last year and the February, 2014 article found in the Articles & Spreadsheets section of our website, our recommended investment return and inflation assumptions for the spreadsheets provided in this website are based on interest rates implied by current immediate annuity purchase rates with a small margin for more risky investments. And while it is important to use reasonable assumptions, the Actuarial Approach does provide for automatic adjustment with smoothing over time for the differences between actual and assumed experience that will inevitably occur.
On July 2, the IRS published final regulations on Qualified Longevity Annuity Contracts (QLACs). As discussed in the post of February 11, 2012 that we published shortly after the proposed IRS regulations were released, retirees may find purchase of a QLAC or several QLACs to be an effective way of managing their longevity risk.
I found the following summary of the final QLAC regulations and how they changed from the proposed regulations prepared by Davis & Harman LLP, outside legal counsel for the Spark Institute, to be thorough and relatively easy to read.
What should a retiree interested in purchasing a QLAC do now? Unfortunately, until a more robust market for these products emerges, it is probably a good idea to wait. However, I am not a financial planner or an investment professional. Also, I am no expert on annuity products. Therefore, you should not rely on my advice. As a retired actuary I can tell you that by waiting to purchase a deferred annuity, it is possible that interest rates will increase and/or the market will become more competitive and premiums for a given level of retirement income and number of years of deferral could become less expensive. However, absent such changes, the longer you wait to purchase the annuity, the lower your retirement income will be at a given benefit commencement age for a given premium (since the period of deferral will be less). Before you commit to buying a QLAC with your qualified plan money, 403(b) account, IRA or 457(b) account, you will probably want to discuss the issue with your financial planner, solicit several quotes from reputable insurance companies and make sure that whatever you buy meets the QLAC rules and will not be considered a taxable distribution at the time of purchase.
As we said in our post of October 2, 2013, you can use our Excluding Social Security V2.0 Spreadsheet to estimate how much deferred retirement income you may want to purchase or to simply coordinate your spending strategy with the QLAC or QLACs you purchase (assuming they all commence at the same age).
UPDATE: There is a mistake in this graph. See our post of April 26, 2015 for an explanation.
Dr. Wade Pfau has posted two video interviews with Michael Kitces and Jonathan Guyton that readers may find of interest.
Of particular interest is the statement by Messrs Kitces and Guyton that the 4% Rule was "never meant to be an autopilot guide to sustainable spending over 30 years." In fact in the second video, Mr. Guyton discusses his "decision rules" to adjust the 4% Rule or other safe withdrawal rate approaches. As explained by Dr. Pfau, "Guyton’s idea was to create guardrails on spending: cut spending by 10% if the current withdrawal rate (this year’s withdrawal divided by this year’s portfolio balance) increases by 20% from its initial level, and increase spending by 10% when the current withdrawal rate falls by more than 20% from its initial level."
I would caution retirees to think twice about using Guyton's decision rules to determine their retirement spending budget. As is clearly shown in the run out tabs in the spending spreadsheets in this website, if your goal is to spend most of your accumulated assets by the end of the expected payout period, your spending budget should increase significantly when measured as a percentage of your accumulated savings as you age. For example if you have no annuity income and you use the assumptions recommended in this website, your spending budget at age 80 divided by your projected accumulated savings at age 80 may be 75% higher than your spending budget at age 65 divided by your projected accumulated savings at age 65. Therefore, application of the Guyton decision rules (with spending cuts adopted when the withdrawal rate for a year increases by more than 20% over the initial withdrawal rate) will likely result in unwanted spending cuts, all things being equal.
The chart below compares annual spending budgets under the Guyton decision rules with the Actuarial Approach set forth in this website for a 65-year old Male retiree with $600,000 in accumulated savings at retirement, no annuity income and a desire to leave $10,000 in assets at the end of the expected payout period (age 95 or age plus life expectancy if later). Accumulated assets are assumed to earn 5% each year, inflation is assumed to be 3% per annum and the retiree is assumed to spend exactly the spending budget produced under the relevant approach each year. For comparison purposes, assume also that the Guyton decision rules start with the same 4.33% withdrawal at age 65 as under the Actuarial Approach and therefore trigger a 10% spending cut whenever the withdrawal rate for a future year equals or exceeds 5.20% (1.2 X 4.33%).
At age 95, assets under the Guyton approach are projected under the assumptions discussed above to be $567,754 as compared with $84,568 under the Actuarial Approach. While the large amount left to heirs in this example under the Guyton approach may be appreciated by the retiree's heirs, it may not be what the retiree intended.
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