March 4, 2014
Follow-Up to JP Morgan Post
Several individuals took me to task for criticizing JP Morgan's conclusion that "greater lifetime income through... pensions and/or lifetime annuities allows individuals to increase both their withdrawal rates and equity allocations." While this may appear to be a "logical" conclusion, particularly for investment allocations, the math just doesn't support this conclusion as it applies to withdrawals rates. Retirees who desire reasonably constant spendable income in retirement, should decrease, not increase, withdrawal rates from accumulated assets as the amount of their fixed immediate life annuity/pension income increases, all things being equal.
As an example, Let's go to the "Excluding Social Security 2.0" spreadsheet on this site. If we enter $1,000,000 in accumulated savings, $0 immediate life annuity, 5% annual investment return, 3% per annum desired annual increases, 30 year payout period and $0 bequest, we get an initial withdrawal rate of 4.34%. If we assume 3% inflation, the inflation-adjusted run out tab shows that annual withdrawals are expected to remain constant over the expected 30-year payout period.
However, if we input a fixed immediate payment of $20,000 per year, the initial annual withdrawal rate drops from 4.34% to 3.75% to keep total annual spendable income (withdrawals from accumulated savings plus annual annuity payment) constant in real dollar terms over the expected 30-year payout period.
Finally, if instead of $20,000 per year fixed annuity payment, we input $40,000, the initial annual withdrawal rate drops from 3.75% to 3.15%.
March 1, 2014
JP Morgan's Dynamic Withdrawal Strategy
JP Morgan has recently released its research on dynamic retirement income withdrawal strategies entitled, "Breaking the 4% Rule".
As someone who has frequently ranted on this website against the 4% Rule and encouraged the use of a dynamic retirement income withdrawal strategy, I recommend this paper to readers of this blog. In many ways, the expressed goals of the JP Morgan withdrawal strategy are similar to the goals of the withdrawal strategy suggested in this website. The JP Morgan paper also combines its withdrawal strategy with an investment allocation strategy, which I do not address in this website as I have no investment expertise.
In addition to attempting to carefully balance lifestyle risk and longevity risk, JP Morgan also attempts to "maximize how much utility value investors receive from their withdrawals." This utility value maximization is also not something that I address in my recommended withdrawal strategy.
Some concerns I have with the JP Morgan Strategy:
The withdrawal schedule is significantly more aggressive than withdrawal rates recommended in this website. For example, JP Morgan specifies an initial 5.9% withdrawal rate for a 65 year old with $1,000,000 in accumulated savings and $50,000 in "lifetime income". Based on the assumptions recommended in this website and zero bequest, I get a withdrawal rate of 3.45% using the Excluding Social Security 2.0 spreadsheet if I assume $30,000 of the $50,000 of lifetime income is in the form of a fixed immediate annuity (with the remaining $20,000 payable from Social Security). The main reasons the JP Morgan withdrawal rate is so much higher is that their model assumes higher future investment returns, lower future inflation, a shorter payout period and does not anticipate using accumulated assets to provide for future inflation adjustments to fixed payment "lifetime income." If comparable assumptions are used for both models, I would anticipate results to be very similar for the initial year's withdrawal.
Additionally, the JP Morgan strategy does not appear to have relatively constant inflation adjusted retirement income as a goal. Therefore, all things being equal, their withdrawal strategy would be expected to be more volatile from year to year than the approach recommended in this website when measured in inflation adjusted dollars.
Because the JP Morgan paper was critical of the performance of the 4% Rule in volatile markets, "especially when a portfolio loses significant value during the early years of retirement" I decided to calculate spending budgets and remaining assets under the JP Morgan strategy and the Steiner Actuarial Approach (using recommended assumptions and smoothing methodology) for a hypothetical retiree where asset returns are somewhat unfavorable. The two graphs below compare retirement spending budgets (withdrawals from accumulated savings + Social Security + fixed pension) and remaining assets under the JP Morgan Dynamic Strategy with the Steiner Actuarial Approach for someone retiring at age 65 with $1,000,000 in assets, $20,000 in annual Social Security and $30,000 in fixed pension/life annuity income (for a total of $50K) of "lifetime income".
I assumed about a 0% average annual rate of return for this hypothetical retiree's first five years of retirement with the following randomly chosen rates of investment return: year 1: -15%, year 2: 2%, year 3: 5%, year 4: -5% and year 5: 15%. I also assumed 3% inflation each year. I used the withdrawal rate table included in the JP Morgan article to determine withdrawal rates and I interpolated between relevant wealth and age factors. I ignored the fact that inflation increases in the retirees Social Security benefit would increase the retirees "lifetime income" and thus perhaps slightly increase the retiree's withdrawal rate under the JP Morgan approach. I also assumed that the JP Morgan withdrawal rate tables (and the Steiner recommended assumptions) would remain unchanged for the entire 5 year period. For each approach, I assumed that the annual budgeted amount determined under the relevant approach would be spent during the year.
Comparison of Budget Amounts In Inflation-Adjusted Dollars
Comparison of Remaining Asset Amounts
The graphs show that based on this assumed investment experience, the JP Morgan strategy produces a spending budget that is somewhat more volatile (when measured in inflation adjusted dollars) than the Steiner Actuarial Approach. Because it is more aggressive than the approach in this website (based on recommended assumptions), it produces higher spending budgets each year and therefore lower remaining assets at the end of the five year period. Is the JP Morgan strategy better than the Steiner Actuarial Approach? I don't believe its use of Monte Carlo simulations or utility value maximization necessarily make the JPMorgan strategy superior. If comparable assumptions are used, results under the two methods can be comparable, and the smoothing algorithm in the Steiner Actuarial Approach results in more real dollar stability in the retiree's spending budget from year to year. The Steiner approach is also readily available on this website.
February 26, 2014
The Actuarial Approach and Withdrawal Policy Statements--Its in There!
In his February 26 post, Michael Kitces encourages the use of a written Withdrawal Policy Statement to ensure that retirees have a plan for dealing with market declines.
The Actuarial Approach described in this website automatically adjusts spending not only for market declines (or spending more than the budget) but also for favorable experience (or spending less than the budget). So like the slogan in the old Prego commercial goes--"Its in There!"
February 14, 2014
Anticipating "Lumpy" Expenditure Needs
As indicated in previous posts, I believe it is not unreasonable to manage risks in retirement by diversifying sources of retirement income. This article discusses research that explains why individuals are "more likely to select an annuity option when a 'partial' option is offered instead of an 'all or nothing' option." I especially liked the comment from one of the researchers who said, “If you anticipate lumpy expenditure needs in retirement (e.g., out-of-pocket medical expenses), you want some liquid wealth to cover those expenses."
January 21, 2014
Comparison of Four Withdrawal Strategies Based on Recent Experience
In my previous post of January 16, I stated my belief that each of the three systematic withdrawal options examined in the Stanford/SoA study was inferior to the actuarial approach advocated in this website. While I was critical of the three approaches for not even attempting to focus on total retirement income by coordinating with annuity income that the retiree may currently have or expect to have in the future, I think that each of the three approaches have shortcomings even if the retiree has no other sources of income. In this post, I will illustrate those shortcomings with an example that uses historical investment and inflation experience from 1998 to the present.
Let's assume that Rachel retired on her 65 birthday on January 1,1998. At that point, she had $500,000 in accumulated savings in addition to her Social Security benefit. Since she was single with no children, she had no desire to leave money to heirs. She wanted to maximize her income in retirement, particularly in her younger retirement years (when she wanted to travel more). On the other hand, she did not want to outlive her savings. She decided to invest the assets not budgeted for spending each year 25% in large cap equities, 25% in mid-cap equities, 25% in mid-term bonds, and 25% in short-term bonds (which she rebalanced at the end of each year). Unfortunately, Rachel died in a car accident on January 1, 2014. She had just turned 81.
The graph shows withdrawals under the three different strategies discussed in the previous post compared with withdrawals under the actuarial approach advocated in this website. All amounts are shown in 1998 dollars. In using the actuarial approach, Rachel looked at annuity purchase rates in 1998 and decided to determine her first year's withdrawal assuming 7% investment return, 4% inflation and death at age 95. In 2004, when interest rates had decreased somewhat, she changed the assumptions to 6% investment return, 4% inflation and in 2009 she changed to the now recommended assumptions of 5% investment return, 3% inflation. She also used the recommended smoothing algorithm.
None of the four strategies would have been successful in meeting Rachel's objective to die with only a small amount of assets remaining. She expected to live well past age 81 and her investments did much better than she assumed (on average). Following the actuarial strategy, she would have died with $626,635 remaining. But this approach was better than the other three approaches in meeting Rachel's objective, as she would have $786,436 remaining under the IRS Required Minimum Distribution approach, $804,358 under the Constant 4% approach and $827,504 under the 4% Rule.
And while the 4% Rule produces a ruler-flat inflation adjusted withdrawal pattern, it failed to maximize Rachel's desire to maximize spending. The other two approaches also failed to maximize spending and their withdrawal patterns were much less stable from year to year than under the actuarial approach. Based on experience from 1998 to 2014, the clear winner of the four approaches in terms of meeting Rachel's objectives is the actuarial approach.
January 16, 2014
Systematic Withdrawal Strategies Examined in Recent Stanford/SoA Study Leave Much to be Desired
Last September, the Stanford Center on Longevity, in collaboration with the Society of Actuaries Committee on Post-Retirement Needs and Risks, released "The Next Evolution in Defined Contribution Plan Design"
The principal author of this work was Steve Vernon, who is now a Consulting Research Scholar at the Stanford Center on Longevity in addition to his many other activities, including blogging on retirement issues for CBS MoneyWatch, authoring books on retirement and running his business, Rest of Life Communications. I have mentioned Steve and the good work he is doing many times in my blog.
The stated primary goal of this paper is "to help retirement plan sponsors, fiduciaries and managers make informed decisions about implementing income solutions [sometimes referred to in the paper as "Retirement Income Generators] that will improve the financial security of their plan participants." Stated somewhat differently, the paper encourages defined contribution plan sponsors to take steps to make annuity and systematic withdrawal options available to their plan participants. This is a well written paper that makes some excellent points and suggestions. While I think that the arguments set forth for including annuity options in DC plans are somewhat more compelling than including specific systematic withdrawal strategies, the only real bone I have to pick with the paper is the choice of systematic withdrawal strategies it choses to discuss and examine.
The paper looks at three systematic withdrawal options (and three annuity options). As indicated in Section 10, the main criteria for selection of these specific options appears to be that they are "readily available to retirement plan sponsors in today's marketplace." In my opinion, each of the three selected systematic withdrawal options is inferior to the actuarial approach I advocate in this website. Readers of my blog know that I have railed against the shortcomings of the 4% rule, which is the first alternative examined, so in order to keep my blood pressure down, I won't go into them again here. The second alternative (referred to as the constant 4% strategy) is probably worse than the first. It is similar to the strategy of spending interest on your accumulated assets each year if you expect to earn 4% per annum. This strategy does not coordinate with any annuity income you might currently have or expect in the future, it does not consider the retiree's desire to have relatively constant inflation-adjusted income in retirement and you should expect to leave a pile of money to your heirs upon death as the annual income produced by this approach is very conservatively determined. The third approach (which is referred to as the Life Expectancy Based Percentage Strategy [IRS Required Minimum Distribution] has a little more appeal than the first two approaches (and is practically recommended in the paper), but it does not coordinate with annuity income you might currently have or expect to have in the future, it does not consider the retiree's desire to have relatively constant inflation adjusted income, and while not as conservative as the constant 4% strategy, it still produces a lower expected pattern of withdrawals and higher probability of having significant amounts of assets remaining at death.
The paper does point out (as I have many times in this blog) that retirees looking to manage risks in retirement probably should consider combining annuity products with systematic withdrawal strategies, which is why I was somewhat disappointed to see comparisons in this paper (for the most part) between the six individual retirement income generators rather than between various combinations of retirement income generators. I was also disappointed that my actuarial approach (with recommended assumptions and 10% corridor smoothing algorithm) was not one of the systematic withdrawal options examined in this paper. After all, my approach is also readily available to retirement plan sponsors (Heck, it's free!), and was touted as having some "advantages" and "nifty features" in Mr. Vernon's 2012 book, "Money for Life."