The investment business is full of theories and recommendations about how to accumulate wealth. But the field has very little to say about the best ways to decumulate, or spend down wealth.
This is an astonishing oversight, considering that the period over which wealth decumulation occurs is often as long as that of accumulation. If the turning point between accumulation and decumulation is 65 years of age, then an investor needs to plan for a potential 30 years or more of decumulation — and that planning needs to begin before age 65.
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In contrast, the period during which substantial assets are accumulated typically stretches over 30 or 35 years, starting around age 30 or 35.
The limited attention to formulating a theory of decumulation is all the more surprising, given that, with the retirement of baby-boomers, it is surely the foremost concern of more people than ever before. And it is a subject to which much more meaningful and scientific study can be applied than to wealth accumulation.
The best way to safely decumulate wealth
It is with that in mind that I will explain the surprising result of my own research.
Much of the research in this area has focused on the concept of “safe withdrawal rate.” It has produced some interesting, but limited, results.
A safe withdrawal rate is the percentage of your assets you can withdraw each year without danger of running out of money, no matter how long you live. The seminal work on the subject was written by financial planner William P. Bengen and published in the Journal of Financial Planning in October 1994.
Bengen asked the question, “What percentage of your starting assets can you withdraw yearly for the rest of your life without fear that you will run out?”
His answer, based on simulations using past history, was that you can withdraw 4% a year (adjusted for inflation).
For example, if you start with $500,000, you can withdraw 4% of that, or $20,000. If inflation in the first year is 5%, then the next year you can withdraw 5% more than that, or $21,000.
Bengen assumed a portfolio of 60% stocks and 40% bonds. Because an investor wouldn’t have run out of money given the past history of the stock and bond markets, even over a long life, Bengen declared this withdrawal strategy “safe.”
In Bengen’s words, “In no past case has it caused a portfolio to be exhausted before 33 years [after retirement], and in most cases it will lead to portfolio lives of 50 years or longer.”
But in recent years, stock and bond market conditions have changed. Interest rates are historically low. This has caused some researchers to argue that 4% is not a safe withdrawal rate anymore.
In 2013, three researchers found, using their revised stock and bond market parameters, that as low as a 3% withdrawal rate would still mean a 10% chance of running out of money — too big a chance for comfort.
Is this really the most that a retiree can spend with a high level of protection against running out of money?
The answer to this question unfortunately is, yes, the withdrawal rate from a stock-bond portfolio must be that low for an investor to be reasonably certain that she won’t run out of money (if you can call only 90% certainty “reasonably certain”).
The problem with safe withdrawal strategies from a stock-bond portfolio is that you have to keep a large percentage of your portfolio in storage as a buffer — a kind of “rainy day fund” (or to be more accurate, “rainy years fund”) — against market fluctuations, or a long life.
Chances are good you’ll leave a large portion of this fund behind you when you die. You won’t be able to spend it. If that’s not what you want — if your goal is only to spend as much as you can in your lifetime without running out — my calculations show that there’s a much better way.
A simple annuity, also called a single premium immediate annuity or SPIA, is a financial instrument that guarantees you a consistent monthly income as long as you live. It should not be confused with the much more complicated, expensive, and much less useful annuities with other names, such as variable annuities or fixed-income annuities.
Many insurance companies offer SPIAs. For example, if you’re a 65-year-old male you can pay $100,000 to receive about $6,700 a year as long as you live.
Don’t confuse that 6.7% payout rate with the rate of return on investment. It is not, because the “principal” — the amount you paid at the beginning — is not returned to you at the end. However, if you care only about lifetime income, this doesn’t matter to you.
The level of safety of this income is confidently high — much higher than 90%. Although insurance companies do occasionally go out of business, insurance industry and government supports make the probability of a default on annuities very low. And unlike the safe withdrawal rate strategy, no “rainy years fund” has to be set aside, so you can spend the whole thing.
My own calculations show that for an investor to be 95% certain of not running out of money with a safe withdrawal strategy from a 60%/40% stock-bond portfolio, the strategy would be to withdraw 3.5% of the initial investment in real (inflation-adjusted) dollars each year.
If the portfolio started with $500,000, for example, the average annual lifetime income would be $23,000. With the SPIA, the average annual lifetime income would be $33,500, and the certainty of achieving it is greater than 95%.
Thus, both the certainty of not running out of money, and the lifetime income, are much greater with the SPIA than with the “safe withdrawal” strategy. This, of course, assumes that the investor has essentially zero interest in leaving a bequest. But this is the case for many baby boomers. Their children are independent, or they want them to be, or they have no children.
In these times of relative hardship for most middle-class retirees, the majority of baby boomers in the United States are more concerned that they will not have enough money to live out their years with a degree of relative comfort than they are with leaving a legacy. Given this objective only, it’s almost impossible to beat a simple annuity.
Because an annuity’s cash flows are rigid and constant, however, one would probably want to keep a small amount of money outside the annuity as “working capital” to even out fluctuations in expenditures. But it makes sense to put the bulk in a simple annuity.