Revisiting the Guyton Decision Rules

To err is human, and I am very human.  In this post I will issue not one but two corrections of errors made in prior posts.

In our post of April 18, 2015, we showed a graph that compared the expected pattern of future spending budgets for a hypothetical age 65 male retiree who buys a fixed income annuity (Single Premium Income Annuity, or SPIA) under the Actuarial Approach (assuming desired increases in the annual budget equal to the assumed future annual rate of inflation) with budgets produced using the Guyton Decision Rules.  Budget amounts shown were total budgets, including Social Security, payments from the annuity and withdrawals from accumulated savings. 

Subsequent to the April 18th post, I received a nice note from Dr. Wade Pfau indicating that I appeared to have incorrectly applied the Guyton Decision Rules in the example.  Instead of increasing the prior year’s budget with inflation (the preliminary withdrawal amount for the year), the Guyton Decision Rules impose a 10% reduction in the withdrawal amount for a year in which the preliminary withdrawal amount divided by accumulated savings at the beginning of the relevant year exceeds 120% of the initial withdrawal rate.  Mr. Guyton refers to this decision rule as the “capital preservation rule.”  I correctly applied this reduction, but I was unaware, however, that this capital preservation rule is not applied if the retiree is “within 15 years of the maximum planning age.”

Graph #1 below corrects the graph provided in the April 18th post by ceasing application of Mr. Guyton’s capital preservation rule at age 80.   I will also add a warning to my post of July 3, 2014 cautioning those who may visit that post that the graph shown is not based on a correct interpretation of the Guyton Decision Rules.

Graph 1 (click to enlarge)

Dr. Pfau also indicated that since many retirees like higher real dollar spending early in retirement, it wasn’t so obvious to him that the constant spending budget produced under the Actuarial Approach was more desirable.  I’m was actually a little surprised to hear this from Dr. Pfau, as most withdrawal strategies appear to have constant real dollar spending as an objective, and I was somewhat curious as what there was about buying a fixed income annuity that would significantly change someone’s spending objective.  But, be that as it may, as indicated in my previous post, it is easy to change the shape of expected future real dollar budgets under the Actuarial Approach to satisfy a retiree’s objectives.  For example, Graph #2 shows expected future real dollar spending budgets if the same hypothetical retiree makes the conscious decision to front-load his spending budget by inputting 0% desired increases in the portion of his total spending budget attributable to accumulated savings and annuity payments (the Social Security component of his spending budget would still be expected to increase by the inflation assumption of 2.5% per annum).

Graph 2 (click to enlarge)

While the spending budgets shown in Graph 2 for the two approaches are close, the important distinction between the two approaches is that the decision to front-load under the Actuarial Approach is a conscious one where the retiree is fully aware of the out-year implications if future experience is close to assumed experience on average (and the retiree is aware that he has made a commitment not to give himself inflation increases in future years, at least with respect to the portion of his spending budget attributable to the annuity and withdrawals).  The same cannot be said if he uses the Guyton Decision Rules because the retiree doesn’t know what the assumptions for future experience are under that approach.

Even though ceasing application of Guyton’s capital preservation rule when the retiree is within 15 years of the maximum planning age may improve the Guyton’s Decision Rules, I am still not a fan of them.  They are unresponsive to changes in expected future investment returns (nominal or real), changes in expected future levels of inflation (as inflation may affect fixed dollar income components of a retiree’s portfolio), or changes in expected life expectancy.   As previously mentioned, the Guyton Decision Rules do not coordinate with fixed income annuity/pensions and they do not directly consider a bequest motive.  If experience is unfavorable, the retiree can run out of accumulated savings if the rules are blindly followed.   For example, under the Actuarial Approach, a 5.5% withdrawal rate for a retiree with a 30-year expected retirement period with no other sources of retirement income is consistent with an investment return assumption of 6% per annum and an inflation assumption of 2% annum (assuming the retiree desires constant real dollar spending in retirement).  If actual experience is less favorable than these assumptions, real dollar withdrawals under the Guyton Rules will be reduced frequently prior to reaching the 15-year cut-off mark (real dollar withdrawals are expected to be reduced in the 9th year even if experience exactly follows these assumptions).  After the 15th year, there are no cut backs, but there is a risk of running out of money.  Alternatively, if experience is more favorable than these assumptions, it is unlikely that withdrawal rates under the Guyton Rules in later years will fall as low as 4.6%, the approximate threshold for increasing withdrawals under Guyton’s “prosperity rule.”  Therefore, a retiree who experiences favorable experience will likely underspend relative to his objectives.  Finally, my actuarial training causes me to seriously question any approach that doesn’t periodically match assets with liabilities (the present value of the future expected/desired withdrawals and annuity payments) under a reasonable set of assumptions about the future.

As a further illustration of how the Guyton Rules fail to coordinate with other fixed income sources of retirement income, Graph #3 shows expected future real dollar spending budgets for our hypothetical retiree under the assumption that instead of buying the immediate annuity at 65 (SPIA), he spends $150,000 of his accumulated savings on a deferred income annuity (DIA) with benefits commencing at age 80.  According to today’s Immediateannuities.com website, he would be eligible to receive payments of $40,776 for life starting at age 80 (and nothing if he dies prior to age 80) for a premium of $150,000.  Using the Excluding Social Security spreadsheet on this site and inputting the recommended assumptions, $850,000 in accumulated assets ($1,000,000 minus the $150,000 used to purchase the DIA), $40,776 in deferred annuity payments and 16 years as the deferred annuity commencement year [Note, since the retiree in this instance is age 65 in year 1, he is assumed to reach age 80 in year 16, 15 years later.  This is correction #2 of this post as I myself haGraph 1 (click to enlarge)ve made the mistake of inputting 15 years for a deferred annuity starting at age 80 or twenty years for a deferred annuity starting at age 85 for a 65 year old retiree in prior posts discussing deferred annuities/QLACs].  Finally, this graph also assumes that the retiree makes the decision to front-load spending in the same manner as for Graph #2 by inputting 0% desired increases in future spending budgets attributable to the annuity and withdrawals from accumulated savings.  

Graph #3 (click to enlarge)

Graph #3 shows that the Actuarial Approach produces an expected total spending budget pattern that is comparable to the pattern it produced in Graph #2, while the expected spending budget pattern produced by the Guyton Spending Rules under these assumptions doesn’t appear to be consistent with the retiree’s front loaded spending objectives.

Expected Real Dollar Spending Budget Shaping

As indicated in previous posts, retirees and their financial advisors can use the Actuarial Approach to provide different patterns of future expected real dollar spending budgets.  If the user of the "Excluding Social Security" spreadsheet on this website inputs the recommended assumptions and sets the desired increase in payments equal to the inflation assumption, annual future budgets (including Social Security) are expected to remain constant in real dollar terms from year to year until the retiree reaches almost age 90  (when age plus life expectancy starts to exceed 95) if all assumptions are realized, assumptions are not changed and actual spending exactly equals budgeted spending.  As discussed in our previous post,  unlike under many other withdrawal strategies, this is true under the Actuarial Approach even if the retiree has other fixed dollar sources of retirement income such as pension income or immediate or deferred annuity income. 

There is a school of thought that says that spending generally declines in real terms as we age.  See our post of July 19, 2014 for a discussion of David Blanchett's research on this subject.  In that post we indicated that developing a declining real dollar budget (on an expected basis) can be accomplished using the Actuarial Approach by inputting a smaller percentage for desired increases in payments than the expected annual inflation assumption.   In addition, the figures in the tab labeled "Inflation-Adjusted Runout" will show the expected future budgets if such an approach is used.  Note that these declining spending budget components are not coordinated with the Social Security component of the budget (which is inflation-indexed under current law), so the retiree/financial advisor would have to make appropriate adjustments if the retiree's total spending budget is desired to be declining from year to year at a desired rate. 

A couple of days ago, I received a request from a reader named Greg asking if there were some way to modify the Excluding Social Security spreadsheet so that his expected spending could remain constant in real dollar terms for the first 10 years of his retirement and then decline in real terms by 1% per year thereafter.  While the spreadsheet cannot perform this task as easily as it can for a constant percentage decrease, with some extra calculations, it can accomplish this objective on an approximate basis.  Since Greg didn't tell me his age or financial situation, I am going to make up some numbers for him for purposes of illustrating how one can go about solving this problem. 

I am going to use the current recommended assumptions of 4.5% investment return, 2.5% inflation and an expected payment period of 95-age or life expectancy if greater.  I'm going to assume that Greg is age 65 with $500,000 of accumulated savings, no fixed dollar pension or annuity benefits and no bequest motive.  For the first 10 years of his retirement, Greg is going to have to calculate an average desired rate of payment increase.  In the first year, this will be equal to 10 X 2.5% (the inflation assumption) plus 20 X 1.5% (the inflation assumption minus 1%), the result divided by 30 (or 1.83%).  He uses this percentage to determine the actuarial value in the spreadsheet and his first year spending budget.  In the second year, this average desired rate of payment increase will be 9 X 2.5% plus 20 X 1.5%, the result divided by 29 (or 1.81%).  After 10 years, he will just use 1.5% (assumed inflation minus 1%).  In determining his spending budget for years 2-10 (Excluding Social Security), he will increase his prior year budget by 2.5% and compare that result with the 10% corridor around the actuarial value he determined as described above.  For years, 11 through 30, he will increase his prior year budget by 1.5% and compare that result with the 10% corridor around the actuarial value he determines in those years.   
     
The graph below shows the shapes of the expected real dollar future budgets for Greg under 1) the constant real dollar approach, 2) the constant inflation minus 1% approach and 3) the hybrid approach Greg wanted (constant for 10 years and inflation minus 1% thereafter).  The graph assumes future experience exactly follows the recommended assumptions (4.5% investment return, 2.5% inflation, no changes in current assumptions and exactly the budget amount is spent each year).  While these assumptions for future experience will certainly not occur, the purpose of this exercise is to illustrate how the Actuarial Approach can be used to shape expected future budgets (excluding Social Security).  

(click to enlarge)

As I have said in many of my prior posts, you can spend your assets now or you (or your heirs) can spend them later.  If you want to "front-load" your spending, you can do this in several ways.  You can either decide to spend more than your constant real dollar budget in your younger years or you can develop a budget that you expect to decline in real dollar terms at some point during your retirement.  The bottom line is that this decision to front load should be a conscious one and not the result of using a particular withdrawal strategy that either starts out with too high of a withdrawal rate or, as discussed in my previous post, doesn't properly coordinate with fixed dollar pension/annuity income.  You should also have a sense of what the out-year implications may be of a decision to front-load your spending.  I believe the Excluding Social Security spreadsheet (and its inflation-adjusted Runout tab) does a good job of giving you the information you need in this regard.  If you aren't using the Actuarial Approach and you/your financial advisor aren't  adequately addressing these issues, you may wish to consider switching to the Actuarial Approach.  At a minimum, you may wish to compare the spending budget produced under your current approach with the budget produced under the Actuarial Approach and reconcile any significant disparities.   

Your Withdrawal Strategy Should be Coordinated with Other Sources of Fixed Retirement Income

If you have accumulated savings and a fixed dollar pension benefit or life annuity, your accumulated savings need to do double duty when it comes to maintaining a constant real dollar annual spending budget in retirement.  Your accumulated savings need to 1) fund inflation increases on the portion of your spending budget attributable to your accumulated savings and 2) fund inflation increases on the portion of your spending budget attributable to the fixed dollar pension or life annuity.  If you have fixed dollar sources of retirement income, the withdrawal strategy you use needs to be adjusted to perform this double duty or you will find that your annual spending budget will likely decrease over time as a result of inflation.  The higher the rate of future inflation and the larger percentage of your spending budget attributable to fixed dollar income, the bigger this potential problem will be. 

The standard withdrawal strategies like the 4% rule, any safe withdrawal rate rule, the Required Minimum Distribution (RMD) rule, or any of the variations of these rules, were not designed to coordinate with other fixed dollar sources of income.  I was therefore surprised to read that when asked in a recent Barron’s article which spending strategy has the most potential, Dr. Wade Pfau said,

“I’m leaning toward some combination of an income annuity and a method used by [Cornerstone Wealth Advisors’] Jonathan Guyton, whose model I simulated. It’s a complicated set of rules but adjusts spending based on the market, limiting the fluctuations in the withdrawal amount to only 10%, and only when absolutely necessary.”

I was not at all surprised that Dr. Pfau advocated purchase of an annuity as an investment strategy that mitigates longevity risk and enable retirees to be somewhat more aggressive with respect to investment of their remaining assets.  I was, however, surprised that Dr. Pfau advocated using the Guyton Rules for determining withdrawals from the remaining assets.  First of all, I am not that impressed with the Guyton Rules (which are basically a variation of the safe withdrawal rule approach).  Secondly, and more importantly, the Guyton rules fail to coordinate with a fixed income annuity to provide constant spending budgets in retirement.  See my post of July 3, 2014 for my cautions about using the Guyton Rules even if a retiree has no fixed income retirement sources of income.   

The graph below shows total spending budgets for a hypothetical 65 year old male retiree with $1,000,000 in accumulated savings and a $20,000 per year Social Security benefit.  Let’s assume the retiree decides to follow Dr. Pfau’s suggestion and determines that his essential income level is about $50,000.  Therefore, he decides to purchase an immediate fixed income annuity of $30,000 per year (to supplement his Social Security benefit of $20,000 per year).  At current annuity purchase rates, this purchase is expected to cost him $458,716 ($545 of monthly benefit per each $100,000) leaving him $541,284 in accumulated savings.  
 

(click to enlarge)

 
The retiree uses the Guyton Rules to determine withdrawals from his accumulated savings with a beginning withdrawal rate of 5.5%.  In the first year, his total spending budget is $79,771 (.055 X $541,284 = $29,771 from accumulated savings + $30,000 from the annuity + $20,000 from Social Security).  Under the Actuarial Approach and the current recommended assumptions, his initial spending budget would be $65,762 ($15,762 from accumulated savings + $30,000 from the annuity + $20,000 from Social Security), assuming no amounts to be left to heirs. 

Let’s further assume that actual future experience is exactly follows the recommended assumptions—4.5% annual investment return and 2.5% inflation (and exactly the budget amount is spent each year).  Under these assumptions, the Actuarial Approach produces a constant real dollar budget of $65,762 per year while the spending budget under the Guyton Rules plus annuity approach produces a declining real dollar budget from year to year.  In fact the real dollar spending budget expected under these assumptions at age 89 is only about 61% of the initial spending budget.  As noted above, this decline could be worse for higher levels of inflation or for strategies involving a higher relative portion of the budget being used to purchase the fixed income annuity. 

Most withdrawal strategies for situations that don’t involve fixed sources of retirement income have constant real dollar income throughout retirement as an objective.  It doesn’t make sense to me to change that objective just because you add fixed dollar retirement income.   At the very least, retirees should be made aware of this potential inconsistency. 

Dr. Pfau has many readers of his blog (many, many times the number who visit this site) and has published many fine articles.   He is a revered academic scholar in the retirement area.   In light of his influence, I encourage him to “lean” away from using the Guyton Rules (or any other approach that does not reasonably coordinate with the fixed income annuity) when fixed dollar annuity/pension benefits are present in a retiree’s portfolio.    

Delaying Commencement of Social Security vs. Buying a QLAC—Which Is the Better Strategy?

May 28, 2015 Note: This post has been revised to correct some minor errors.

There is no shortage of articles out there advocating delaying commencement of Social Security as a no-brainer strategy to increase spending in retirement.  Several experts have indicated that delaying commencement of Social Security is hands down the best long-term investment money can buy. These articles encourage individuals who have retired to spend what may be a significant portion of their accumulated savings during the period of deferral in order to collect a much larger Social Security benefit down the road (typically at age 70). While I have agreed in prior posts (see the post of August 9, 2014 for example) that this deferral strategy can increase annual retiree spending budgets, it does come with its own set of risks and does not always live up to the hype used to sell it. In this post, I will compare the Social Security deferral strategy to the strategy of using roughly the same amount of accumulated savings to purchase a Qualified Longevity Annuity Contract (QLAC), which I have also discussed in prior posts (see the post of February 25, 2015 for an example).

In our post of February 25, 2015, we took a look at a hypothetical retiree, Mike, a single 65-year old male with a 401(k)/IRA balance of $750,000 and a potential Social Security benefit payable immediately of $16,800 per year.  Using the Excluding Social Security spreadsheet in this website and the recommended assumptions, Mike developed a first year spending budget of $49,427. Using the Social Security Bridge spreadsheet and the same assumptions, Mike determines that if he defers commencement of Social Security until age 70, his Social Security benefit will increase to about $26,880, and his spending budget, starting at age 65 and remaining constant in real dollars for the next 29 years, will increase from $49,427 to $51,412, an increase of $1,985 per year. He also determines that he must effectively spend a present value of $114,329 of his 401(k)/IRA balance in order to implement this strategy.

Yesterday Mike went to Immediateannuities.com to check out the amount of annual payments he could receive under a deferred annuity contract commencing at age 85 (with no death benefit) with a premium of $114,329 (the same cost as the Social Security deferral strategy). The website said that his annual benefits commencing at age 85 would be almost $60,000.  Mike is a little bit skeptical of this result as it is significantly higher than the benefit amount shown on this website just a couple of months ago. He knows that the QLAC market is not yet robust, but he decides to see what the effect on his spending budget would be if he spent $114,329 on a QLAC that gave him a benefit of $52,000 (not $60,000) starting at age 85. So he enters $635,671 ($750,000 - $114,329) as accumulated assets, an annual deferred benefit of $52,000 starting in 20 years (by entering 21 in the spreadsheet) and the recommended assumptions. The Excluding Social Security spreadsheet tells him that his spending budget under these input items would be $35,409 to which he adds his non-deferred age 65 Social Security benefit of $16,800 to get a spending budget of $52,209, or $2,782 higher than his base spending budget and $797 higher than the Social Security deferral strategy spending budget. So, based on realization of all the assumptions in these spreadsheet calculations (and the slightly lower assumption for the QLAC benefit payable at age 85), the QLAC strategy appears to be the better strategy for Mike.

But, not so fast here. We know that future experience will deviate from our assumptions. Future interest rates will change, future investment returns will not be 4.5% per annum, future inflation will not be 2.5% each year, Social Security benefits may be reduced, QLAC pricing may become more robust, etc.  There is a great deal of uncertainty about the future that makes comparison of these two approaches difficult.

Both strategies involve generation of mortality credits by virtue of mortality risk pooling that you don’t get when you self-insure.  These mortality credits are used to pay larger benefits to individuals who live longer (the winners, if you will) and come from payments not made to individuals who die earlier (for lack of a better term, the losers). The bet inherent in both of these strategies is won only if the individual lives longer than average. The QLAC strategy is a bigger bet in this regard than the Social Security deferral strategy with a potentially bigger mortality credit payoff for those who live past age 85. This larger mortality credit is the reason the QLAC approach appears to be the better strategy for Mike under the spreadsheet assumptions.

On the other hand, Social Security provides survivor benefits and inflation protection not provided by the QLAC. If annual inflation is 4.5% rather than 2.5%, the Social Security deferral strategy becomes the better strategy (in terms of increasing the spending budget) as QLAC payments are fixed and Social Security benefits are indexed to inflation (under current law).

There is another hand, however, with Social Security. To digress a little here, this reminds me of the old actuary joke about the actuary who used the phrase, “on the other hand” so frequently in explaining the plusses and minuses of different approaches that her client asked her firm to replace her with a “one-handed” actuary. Anyway, like it or not, there is nothing in the current Social Security law that prevents Congress from changing Social Security law with negative effects on individuals, even those who may have elected to defer commencement of benefits. As I indicated in my post of March 1, 2015, Social Security actuaries predict that benefit payments will have to be reduced by about 23% across the board if no action is taken by Congress prior to 2033. There are experts who say that the Social Security deferral approach is still a good option even if benefits are reduced by 23%.  Of course, there is nothing that guarantees the reduction will be 23% across the board. It is possible that Congress could decide that the benefits payable to retirees with lower levels of retirement income should be protected.  In that event, reductions for more affluent retirees would have to be greater than 23%. Just yesterday, for example, Chris Christie made headlines by proposing to phase out Social Security benefits for those with retirement incomes in excess of $80,000. So an individual who chooses the Social Security deferral strategy needs to be aware that there is a possibility that future Social Security benefits could be reduced or eliminated, thus negatively affecting the expected benefits of the deferral strategy, even for individuals with greater than average longevity. 

As discussed above, the QLAC market is not yet robust. There are far too few insurers in the market at this point. In addition, if you believe that interest rates are going to rise in the future, now may not be the best time to purchase a product which essentially combines long-term bond investments with mortality credits. Higher future real interest rates will favor the QLAC strategy (assuming purchase takes place in the future) relative to the Social Security deferral strategy unless the law is changed to increase actuarial adjustments for benefit deferral.

Bottom line: Both the Social Security deferral strategy and the QLAC strategy can be used to increase retiree spending budgets. The strategy that is more effective in this regard will depend on what actually happens in the future.  Not knowing what the future holds, it is just too difficult for me to proclaim a “no-brainer” winner at this time. I do believe that both strategies are worthy of consideration by retirees and/or their financial advisors, and that those interested in pursuing the QLAC strategy should keep a watchful eye on QLAC pricing in the months ahead.

What is Your Discount Rate for Immediate Life Annuities?

This post is a follow-up to my previous post in which I stated that just because many retirees do not buy annuities it doesn't necessarily follow that they are not making rational decisions.  In response to that post I heard from another actuary, Andrew, who agreed and hypothesized that the non-annuity purchasers might have higher personal discount rates than the rates used by the insurance companies to price annuities, where personal discount rates are the annual theoretical or observed rates at which people value future payments vs. cash in hand.  Andrew noted that many (mostly younger individuals who want to consume) frequently run up credit card debt on which they pay interest of 15% per annum or more, thus exhibiting relatively high personal discount rates for purchases of some items.  Presumably personal discount rates decrease somewhat as we age (and we worry more about maintaining our lifestyles rather than buying  a lot of new stuff).  But how high does one's personal discount rate have to be today in order to make not buying an immediate annuity appear to be a rational decision?  In this post, I use the spreadsheets in this website to make an estimate.
 
Based on immediate annuity quotes from Immediateannuities.com, a 65-year old male can purchase a monthly life annuity of $545 ($6,540 per annum) today for $100,000.  Using the Excluding Social Security spreadsheet found in the Articles and Spreadsheet section of this website and entering $100,000 of accumulated savings,  a 22-year payout period (a little bit less than the life expectancy for a 65-year old male using 2012 Individual Annuity Society of Actuaries tables with 1% per year mortality improvement), a 3.8% interest rate and 0% increases in future benefits, you get annual payments of $6,540, the same amount provided under the immediate annuity quote for $100,000.  But if you self-insure your retirement, you will not be eligible to share in the mortality pooling (longevity premium) that will occur if you purchase the annuity contract.  Granted, you (your heirs) will receive benefits if you self-insure and die prior to reaching your life expectancy, but no money will be available to you after you reach your life expectancy as it would under the insurance contract.  Therefore in order to make a reasonable comparison we should adjust this 3.8% interest rate to reflect the mortality premium provided by the annuity. 

If we follow the probabilities of survival in the SoA tables for a 65-year old male (45% survival for 25 years, 24% for 30 years and extrapolate (using my estimates) down to 1% survival at 42 years, plug each scenario into the Excluding Social Security spreadsheet (using 3.8% interest) and probability weight the outcomes (assuming 100% survival prior to 22 years), you get a resulting weighted annual payment of $5,636.  This amount is approximately the same as the result you would get by inputting $100,000 of accumulated savings, a 28-year payment period and a 3.8% investment return.  As a final step, we solve for the interest rate that would give us payments of $6,540 for $100,000 in savings and a 28 year payment period to find the discount rate inherent in the insurance contract including an estimate for the longevity premium.  This interest rate is about 5.25%.

Given that individuals may be concerned about insurance company default, inflation risk, liquidity risk, risk of dying too soon, insurance company profits, risk of buying an annuity at historically low interest rates, etc. , they may be expected to increase their personal discount rate for buying an immediate annuity.  Based on the rough estimates above, it appears that a 65 year old male who elects not to purchase an immediate annuity today has a personal discount rate with respect to this purchase greater than roughly 5.25%.  Thanks, Andrew, for raising the issue of personal discount rates. 

Researchers Claim Many Individuals Aren’t Smart Enough to Manage Assets in Retirement

While I frequently advocate diversification of retirement income sources as a risk-mitigation strategy in retirement (see for example my post of July 12, 2014), I’m not a big fan of government mandated annuitization of an individual’s retirement assets.   I’d like to believe that individuals who have managed their finances during their working careers will be able to continue to do so in retirement without government involvement (see for example my post of August 31, 2014).  Understandably, however, not everyone agrees with me.  The most recent example of this is a March, 2015 research paper from the Center for Retirement Research at Boston College entitled, “Are Cognitive Constraints a Barrier to Annuitization?”

This research paper presents the results of a study of individuals who were asked to value a $100 change in their monthly Social Security benefit (both the cost they would be willing to pay for an additional $100 and the price they would be willing to receive to give up $100).  The study showed that the respondents had difficulty in valuing this change and the magnitude of their difficulty was correlated to the respondent’s cognitive ability.  Even though buying or selling Social Security benefits is not possible, the researchers use the results of this hypothetical exercise to conclude that “policymakers need to be aware that many individuals, on their own, are unable to make good decisions about managing money in retirement”, thereby supporting “US policymakers [who] have expressed interest in encouraging annuitization of balances in 401(k) plans...”

The study does not provide sufficient details to verify how the benchmark value of a $100 change in Social Security benefit of $16,855 was determined.  The paper indicates that this value was determined using “mortality and interest rate assumptions from the Social Security Administration’s Trustees,” but it does not provide the age or sex of the hypothetical recipient(s).  If we are talking about a 65 year old male with approximately a 23 year life expectancy (based on the SoA 2012 Individual Mortality Table and a 1% per year mortality improvement) and the current recommended assumptions for the Excluding Social Security spreadsheet provided in this website, we are looking at a value in excess of $22,000.  The current CORI Retirement Index value for an inflation indexed $100 per month lifetime annuity for a 65 year old is in excess of $25,000.

In any event, it looks like most of the study’s participants (and perhaps even the study’s authors) undervalued a $100 change in the Social Security benefit in comparison to the value based on current annuity pricing models.  For numerous reasons (the “annuity puzzle”) that seem to baffle academics, economists and researchers, many individuals don’t value annuities as highly as the life insurance companies that sell them.   This fact doesn’t by itself mean that these individuals “may not be making rational well informed decisions.”  Besides, from a policy perspective, if many individuals place less value on annuities than their actuarial cost, how much sense does it make to force them to buy something at that higher cost that they don’t necessarily want?

On the other hand, I have no problem if the government’s (Department of Labor’s) role in “encouraging annuitization” is limited to providing useful information to educate individuals on the potential benefits of annuitization of defined contribution balances or on the considerations in selecting annuities vs. lump sums in defined benefit plans (see my post of February 18, 2015 for examples of information that might be helpful for the latter).   I’m all in favor of making more educational material available to retirees of all cognitive ability levels. 

The Final Say on Spending Rules—Not

Laurence Siegel has followed up his provocatively titled piece, “The Only Spending Rule Article You Will Ever Need” (discussed in our post of March 22, 2015) with an article in Advisors Perspectives entitled “The Final Say on Spending Rules.”  As previously discussed, I agree with a lot of what Mr. Siegel has to say, for example:

1. “with risky investments, there is no such thing as a safe withdrawal rate (other than zero).” 
2. The “magic formula”—“It’s not a single formula, but a procedure.”
3. It is important to periodically (annually) balance the market value of the retiree’s assets with the market value of her liabilities (present value of future constant real-dollar spending), with such market value of liabilities determined on a basis that is reasonably consistent with life insurance annuity pricing.
4. Retirees who combine the purchase of life annuities (immediate or deferred) with conventional investing can benefit from risk pooling to cover some or all of their longevity risk. 

Where we disagree (other than over what I assume is Mr. Siegel’s tongue-in-cheek title, since he himself acknowledges that “there is much more to decumulation than just [the two methods he discusses in his article]:”

1. I believe developing a spending budget is part art and part science, and if the Actuarial Approach is used, it somewhat self-correcting from year to year.  Therefore, I am not distressed if the matching of assets and liabilities referred to in item 3 above is not exactly determined based on the discount rate (or yield curve) inherent in the individual retiree’s annuity purchase rate.  Additionally, I am not distressed if the retiree chooses to apply a reasonable smoothing algorithm to the budget calculated in item 3 above from year to year in a desire to avoid fluctuations or if the retiree chooses to spend more or less than the spending budget in a given year (see my previous post). 
2. Mr. Siegel’s “magic formula” isn’t very sophisticated and doesn’t coordinate with other potential fixed dollar sources of retirement income such as pension benefits or immediate or deferred life annuity income.  I’m not saying that the simple spreadsheets included in this website are particularly sophisticated either, but at least they permit a retiree or advisor to determine a spending budget that is coordinated with other sources of retirement income and the retiree’s bequest motive.  No.  The simple spreadsheets provided in this website aren’t magical.  They are just simple math and their Run-Out tabs show the components of future expected spending budgets (excluding Social Security or other inflation indexed sources of retirement income) and the expected decumulation of invested assets over the input payout period.