A retiree of 64 has $1 million in her 401(k) common stock fund and expects a long lifespan. Her conundrum is deciding how much she can draw from the fund every month without worrying about running out while she is still alive. Existing options for coping with the conundrum are poor.
The 4 percent Rule
Investment advisers dealing with this situation often recommend the so-called 4 percent rule, which says that it is safe to draw a monthly amount equal to 4 percent of the fund balance divided by 12, adjusted annually for inflation. The initial draw for a retiree of 64 with $1 million would thus be $3,333.
The 4 percent rule has the great virtue of simplicity. However, if the retiree is long-lived, the rule carries a low probability that the retiree's assets will become depleted while she is still alive. Conversely, if she is short-lived, the rule carries a high probability that she will leave assets in her estate that she might well have preferred to spend on herself.
For example, if the retiree of 64 thinks she might possibly live to 104, her stock portfolio must earn at least 4.6 percent over the 40-year period. At an earnings rate below 4.6 percent, her balance will hit zero before she turns 104, leaving her destitute. The best estimate of the probability of that happening is 6 percent. The estimate is based on rate of return data covering common stock between 1926 and 2012. The 40-year rate of return was below 4.6 percent in 6 percent of the 565 40-year periods within that span. The median return in that same distribution was 9.5 percent.
While many retirees may anticipate that they might live to 104, few will. About two of every five female retirees die before reaching age 86. If that happens to the retiree of my example, most of her assets will go to her estate. Even if the rate of return is only 4.6 percent, her assets at 86 following the 4 percent rule would be worth $886,613, which might well be more than she would have chosen if she had other options at the outset.
The 4 percent rule is also inflexible, in that there is no way to adjust draw amounts to changes in investment performance - other than to scrap the rule.
An alternative to the 4 percent rule should eliminate the probability of financial catastrophe at an advanced age, reduce the extent to which transfers to the estate are an unplanned artifact of mortality, and adjust draw amounts to changes in investment performance in a systematic way.
An Alternative: Combined Asset Management and Annuity
An alternative to the 4 percent rule is combined asset management and annuity, or CAMA. It meets the requirements stipulated above, at the cost of somewhat greater complexity.
With a CAMA, the retiree uses part of her nest egg to purchase a deferred annuity, and the remainder is used to live on during the deferment period. The initial draw amount is calculated at an assumed rate of return on assets and then recalculated annually based on the current balance. The asset balance is zero when the annuity kicks in.
Since the annuity runs for life, the catastrophe risk is eliminated. Since financial assets are reduced by the annuity purchase and fully depleted by the end of the deferment period, transfers to the estate occur only if the retiree dies before that period is over, and the amounts involved would be small. Retirees using a CAMA should separate any desired bequests from their retirement plan.
Discretionary Features of CAMA
Unlike the 4 percent rule, which has no discretionary features, a CAMA requires the retiree (and her adviser) to select the interest rate used in calculating the initial draw amount and the deferment period on the annuity. The decision is based on projections of what will happen to draw amounts under both favorable and unfavorable assumptions regarding the future rate of return on the retiree's financial assets. These assumptions are based on the past distribution of returns over periods equal to the individual retiree's future time horizon.
For the retiree of 64 referred to earlier, who wants her $1 million of common stock to carry her to age 104, the investment period is 40 years. She uses the 9.5 percent median return on common stock over past 40 year periods to calculate the initial draw amount, defines a favorable market rate of return as 12.2 percent and an unfavorable return as 4 percent. She can then compare monthly draw amounts using different annuity deferment periods under favorable and unfavorable outcomes.
In a favorable market, both 10-year and 20-year annuity deferment periods generate more spendable funds than the 4 percent rule. While financial assets would grow under that rule, converting that into more spendable funds would require jettisoning the rule.
In an unfavorable market using the same annuity deferment periods, the differences in favor of CAMA are even more striking. The 4 percent rule in this case runs out of funds when the retiree hits 99.
The technology required to implement CAMA will become available early next year as part of a larger system called RIS for "Retirement Income Stabilizer." RIS will include provision for other fund sources including HECM reverse mortgages. It will also provide access to multiple annuity providers and reverse mortgage lenders, assuring that retirees receive the benefits of competitive pricing.
ABOUT THE WRITER
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.