February 14, 2019

My recent article on retirement (What
Should You Look For in a Retirement Plan?) indicated
that in order to assure that a retiree will not run out of
money at an advanced age, which is a primary retirement
objective, most plans should contain an annuity.

This article deals with what
should be a second major objective of retirement plans but
is often ignored, which is to avoid leaving more or less
money in the estate than the retiree would have chosen if
she knew in advance the day of her death. To meet this
objective, a retirement plan can include a set-aside, which
is an amount targeted for the retiree’s estate.

__Bequests Under
the 4% Rule__

The 4% rule, which seems to be
the only exception to complete seat-of-the-pants management
of retirement, says that a retiree can draw 4% of her
financial assets every year, plus an annual inflation
adjustment, without ever running out. The rule in effect
sacrifices objective two in order to meet objective one.

Consider a female retiree of 62
with a nest egg of $2 million, half in common stock and half
in interest-bearing securities. If her portfolio earns a
return of 8.1%, her estate will receive $4.9 million if she
dies at 82, $8.7 million if she dies at 92, and $16.6
million if she dies at 102. The probability of a return of
8.1% or higher is about 50%, based on statistical data
covering the period 1926-2012 (see below). There is a
reasonable presumption that the retiree would prefer to
spend some of that wealth herself.

Note that in a worst case where
the rate of return falls to 3.6%, the 4% rule fails both
objectives, running dry at age 95. The probability of this
occurring is estimated at 2%.

__Bequests in
RIS: the Set-Aside__

RIS stands for Retirement Income
Stabilizer, which is the retirement planning model I have
been developing with Allan Redstone. The retiree using RIS
allocates a portion of her financial assets to the purchase
of a deferred annuity, and draws the remainder as spendable
funds during the deferment period. At the end of that
period, her assets are gone and her spendable funds
thereafter come from the annuity. Her estate receives
nothing from the plan – unless she includes a set-aside.

RIS thus forces the retiree to
decide how much of her wealth at the time the plan is
adopted, will be set aside for her estate. The set-aside
amount can accumulate interest, and the decision is not
irrevocable, as we shall see.

Charts 1 and 2 pertain to the female retiree of 62 referred to above who uses RIS to purchase a 10-year deferred annuity. The charts show her spendable funds and financial assets under 2 markedly different assumptions regarding the rate of return on her financial assets. One assumption is that her portfolio earns a return of 8.1%, which is the median return over 745 25-year periods during 1926-2012. Without a set-aside, her spendable funds are shown by the top line in Chart 1, the dotted portion showing draws from her assets and the solid portion showing annuity payments, with the payments rising by 2% a year. The bottom line in Chart 2 shows her financial assets, which hit zero after 10 years and remain there.

__Adding a
Set-Aside __

Assuming that the retiree elects
to set aside $250,000 for her estate, her monthly draw
amount will be the lower continuous line on Chart 1. The
benefit from her smaller draws is the rise in the value of
the set-aside, shown by the highest line of Chart 2. Growing
at 8.1% a year, the set-aside reaches $1 million when she
hits 81 and $2 million at 89. She would be free, of course,
to draw on some of that herself – it is her money!

__The
Set-Aside in a Worst Case__

A retirement plan should always
consider how the plan would work – or not work – in a worst
case. The worst case used here is a return on assets of
3.6%. Only 2% of the 745 25-year periods during 1926-2012
had returns of 3.6% or less. I continue to assume a
Set-Aside of $250,000.

In Chart 1, the worst case
generates a decline in monthly spendable funds during the
10-year deferment period when the retiree is dependent on
draws from her assets – see the lowest line on Chart 1. The
decline ends when the annuity kicks in after 10 years.

Chart 2 shows that the Set-Aside survives the worst case – it is the middle line on the chart. The Set-Aside does not grow the way it would with an 8.1% rate of return. Nonetheless, at age 73, the Set-Aside is $359,000 and at 83 it is $509,000.

The retiree in a worst case has another option regarding the Set-Aside. She could use it to offset the decline in spendable funds during the deferment period. If she did that, the Set-Aside would no longer go to her estate. That is a personal decision to be made when and if the worst case happens, which it probably will not.