Part 8: Thoughts On Retirement Spending
By Patrick Rau, CFA ∙ May 2016

Most of what I have written so far in this series has been about developing strategies to accumulate wealth, so now I’d like to talk about approaches on how to draw down those funds at the appropriate time. This is of crucial importance, particularly as more and more U.S. baby boomers are either in or are reaching retirement. Yet for all that has been written about growing a portfolio, there is relatively little academic research about the best methods for spending that wealth.

Nobel Prize winning economist William Sharpe, again from the Sharpe Ratio in Part 1, has begun devoting more of his attention to this subject in recent years, calling it “the hardest problem he’s ever considered,” in no small part because it is multidimensional. There are many things to consider when developing a “decumulation” plan, such as for how long do you need the money, how much do you need, how to plan for unexpected expenses, the impact of taxes, whether you wish to bequeath money to an heir or a charity, etc.

Given all this complexity, and the fact that academic research on this topic continues to evolve, let me cut to the chase and say developing a spending plan in retirement is an area where I believe it absolutely does make sense to hire an investment professional. Hold on, time out. You said in Part 6 to avoid fees wherever possible. I certainly did write that, but that applies to the accumulation period of your investment cycle, since those extra fees can really curtail the future value of your portfolio. However, once you reach retirement, making that portfolio last for as long as possible becomes extremely important, and good financial professionals can certainly help you do that. Think of the fees they charge as a form of longevity insurance, a concept that I describe more in detail below. Extending the life of your portfolio is certainly a good thing, and fees you spend to do that are likely well worth it.

The two biggest questions most retirees have, from a financial standpoint anyway, are 1.) will they accumulate enough on which to retire, and 2.) will they outlive their savings? I have dedicated much of this series of articles to addressing question #1, so I hope those will help you achieve that goal. For those of you who feel you have not or will not save enough for retirement, you can always become more aggressive in your portfolio allocation. In fact, you can run an internal rate of return calculation to guestimate the rate of return your portfolio would need to earn to reach a stated amount, and set your portfolio allocation accordingly. However, be advised that taking on more risk can work against you, especially over shorter time periods, and leave you with an even greater funding deficit than you had before. A far more prudent (and no doubt less popular, but perhaps necessary) strategy may be to delay retirement, and/or simply lower your retirement spending goals.

The second question, outliving your retirement savings, speaks to longevity risk, and I will focus on that for the rest of this article.

 
Combating Longevity Risk

Perhaps you are so wealthy that you have little to no chance of ever spending your entire fortune, and maybe you are lucky enough to work for a company that offers a defined benefit (pension) plan that will pay you a substantial sum throughout your retirement. If so, good for you. I like hearing stories like that. However, for most people, the risk of outliving one’s retirement savings is real, especially since life expectancies continue to rise. Here are some ideas for you to consider and/or for you to discuss with a financial professional on how to mitigate this risk.

1.) Maximize Social Security Benefits – Social Security is a form of an annuity, since it pays you a certain amount each month throughout retirement, based on a formula that is tied to how much you earned during your working years. It is meant to be a supplement to your retirement earnings, so the amount you save and accumulate on your own also matters. The earliest one can claim Social Security is at age 62, but the longer you wait to begin taking these benefits, the more they will pay you, up to a maximum amount by deferring these payments until age 70.

This calculator from the AARP can help estimate how much you may receive in annual Social Security benefits, based on the age at which you elect to start. I particularly like the AARP calculator, because it also shows what the average national estimated monthly expenses are, which you can adjust for your particular circumstances.

While you will receive more from Social Security the longer you wait to begin receiving those benefits, you may not want to wait too long, especially if you have to dip into your retirement savings to tide you over. This can have consequences on the future value of your nest egg, most notably if you begin taking withdrawals from your traditional IRA or 401k accounts, since the money you withdraw will no longer grow tax deferred. That could negatively impact your future income, which could more than negate the annual increase in Social Security benefits you get by waiting a few extra years to begin receiving those.

The optimal age to begin receiving Social Security is different for everyone, but a financial advisor can help determine this for you.


2.) Annuities, But Beware – Annuities long have been a go to product for financial advisors, since these products provide guaranteed lifetime income. For you still saving for retirement, you can buy a variable annuity, which offers another avenue to grow assets on a tax deferred basis after one has maxed out his or her annual contributions to a 401k and individual retirement accounts. For those that have reached retirement, you can purchase an immediate annuity that will also provide income for the rest of your years. Sounds great in theory, and they may be appropriate for some, but annuities have some very serious drawbacks: a.) they carry high fees, and generally must be held for many years for the tax deferred benefits to outweigh the added costs. By now I hope I’ve convinced you how crippling high fees are on investment returns, b.) the investment options in these annuities are generally limited, which also hurts their overall return. That is a hidden fee as well. “In many years of number crunching, I have never found an annuity that couldn’t be slaughtered by a good mutual fund,” said one financial analyst, c.) they can be tax inefficient if you don’t spend the minimum distribution, and d.) they can make it more difficult to bequeath money, or tapping into the value of your annuity to finance a large purchase.

There are several alternatives to annuities that may make sense. One is simply partial annuitization – just don’t put your entire retirement proceeds into an annuity. After all, if you put a large portion of what you would have invested in the annuity into highly rated low cost mutual funds or ETFs instead, the benefit you get from lower fees combined with what should be a better performance on your investment should give you more money at retirement, which in turn reduces the chance you will outlive your retirement funds. That lowers your need for an annuity.

Another is to adopt annuity like thinking by creating an income stream without actually purchasing an expensive or restrictive annuity. That is exactly what I do in point #4 below, but before we get to that, you need to read point #3.

If you do wish to purchase an annuity, it pays to shop around. Barron's publishes their annual Top 50 annuities list each summer, and that is an excellent starting point. It also shows ideas for deferred payout annuities, which I describe more below, making this an extremely valuable tool. You need to be a Barron's subscriber to access this list, but considering the complexity of annuities and the financial ramifications of choosing the wrong one, the subscription price is more than worth it.

 
3.) Longevity Insurance – Also known as delayed payout annuities, longevity insurance is a plan that will start to pay you at some age in the future, if you reach that age. For example, a 65 year-old can buy an age 85 policy today that will begin making payments to him or her in twenty years. Because longevity annuities do not begin paying out for years in the future, if they even have to pay out at all, they are cheaper than immediate annuities, and that frees up more money for you to spend earlier in retirement. This also allows you to access your remaining cash however you’d like before this insurance kicks in. In his article The Longevity Annuity: An Annuity for Everyone? (Financial Analysts Journal – Jan/Feb 2015), author Jason Scott notes that “for a typical retiree, allocating 10–15 percent of wealth to a longevity annuity creates spending benefits comparable to an allocation to an immediate annuity of 60 percent or more.” Moreover, he noted that “a sample calculation, with actual annuity prices, found that a 65-year-old male retiree could increase his guaranteed spending by more than 21 percent by allocating less than 8 percent of his portfolio to an age-85 longevity annuity. This spending improvement was almost seven times the spending improvement from a comparable immediate annuity allocation.” Powerful stuff, indeed.

Waring & Siegel noted that in April 2014, a nominal (non-inflating) annuity that pays $100,000 in annual income starting at age 85 could be purchased at the time by a 65-year-old male for an up-front fee of $203,046.  Not all insurance companies offer longevity insurance, but as of April 2016, there were at least five. For more information, please see this link. Also, in 2014, the U.S. government approved putting IRA and 401k funds into deferred annuities, so that is certainly good news.

Note that longevity insurance is a key component to several of the rules below.


4.) Find an Appropriate Spending Rule – The most popular spending strategy recommended by financial advisors is the 4% rule, which is based on 1994 study performed by William Bergen. Bergen’s goal is to help clients “spend as much as possible each year from their retirement accounts, while maintaining a consistent lifestyle throughout retirement.” In recommending that retirees spend no more than 4% of their portfolio value each year, Bergen assumes a 50-50 mix between stocks and bonds, and that historical asset class returns will continue into the future.

The main benefit of the 4% rule is that it is very simple to implement and to understand. However, if historical asset returns fail to materialize in the future, this would likely require a reduction of future spending, or even lead to financial ruin. The 4% rule offers no guarantee you won’t outlive your savings.

Fortunately, there are several spending rules that have been developed in recent years that better address longevity risk. One is to create a TIPS ladder and combine that with longevity insurance. You can create your own annuity that is indexed to inflation by purchasing a series of treasury inflation protected securities directly from the U.S. government for a certain number of years in the future. You would also purchase longevity insurance today that would kick in when the last of your TIPS ladder expires, which would provide you income for the rest of your life.

In the article Making Retirement Income Last a Lifetime (Financial Analysts Journal – Jan/Feb 2012), authors Sexauer, Peskin, and Cassidy advocate a strategy where one would contribute 88% of his or her available capital to a laddered portfolio of TIPS for the first 20 years of retirement, and spend the remaining 12% on longevity insurance that would begin making payments after the TIPS ladder expires. You can get an idea of what the cash flows for such a strategy would look like here.

The advantage of the TIPS ladder + longevity insurance strategy is that you have largely hedged away your risk, both in terms of portfolio loss and outliving your money. But what if you still want to invest in riskier securities, such as equities or REITs? Two options. One is to create an Annually Recalculated Virtual Annuity (ARVA), which as Waring & Siegel explain in their article The Only Spending Rule Article You Will Ever Need (Financial Analysts Journal – Jan/Feb 2015), “each year, one should spend (at most) the amount that a freshly purchased annuity—with a purchase price equal to the then-current portfolio value and priced at current interest rates and number of years of required cash flows remaining—would pay out in that year. Investors who behave in this way will experience consumption that fluctuates with asset values, but they can never run out of money.” This is a virtual annuity because you don’t actually purchase an annuity, you just use annuity thinking to determine how much to withdrawal from your portfolio mix each year. Say you have a 30- year time horizon in retirement. You can calculate how much you could spend per year based on the expected return on your portfolio. After the first year, you recalculate that annuity figure over the next 29 years. If your account balance rises, you can spend more the next year. If it falls, you spend less the next year. By adjusting your spending each year as your account balance changes, but over a defined time horizon, you virtually eliminate the probability you will ever outlive your nest egg. Of course, the downside to this strategy is your annual consumption may decline over time.

Another idea is to simply combine the TIPS + deferred annuity and the ARVA strategies. The first will insulate that portion of your portfolio, and the second will allow you to maintain some investments in riskier securities.

One other option is the Floor-Leverage Rule for Retirement (Scott & Watson – Financial Analysts Journal Sep/Oct 2013), which is geared toward retirees who can tolerate investment risk but insist on sustainable spending. The idea here is to use 85% of your wealth on a TIPS ladder, say to cover you through ages 65-85. This provides a floor on your future spending. You would invest the remaining 15% on equity exchange traded funds with 3x leverage. If historical equity returns hold over time, the 3x ETF would grow substantially more than a regular mutual fund or ETF, thus providing more assets for later in life.  Or, as the authors suggest, you could review the portfolio annually, and if the 3x ETF grows to more than 15% of your total portfolio value, sell the excess and use the proceeds to purchase more floor spending. If stocks collapse, the investor would still be covered by the length of his or her TIPS ladder.

Finally, note that these strategies can all be adjusted to allow for greater spending earlier in retirement, or to preserve a block of money for a specific purpose in later years, such as a major bequest, increased expected health care costs, or uninsured long-term care expenses.

I summarize these various spending rule strategies in the following table: