March 26, 2020

The retiree I discuss in this article is 62 and has
accumulated $2 million of assets which must last him for the
remainder of his life. As he approached retirement, as a
cautionary move, he gradually shifted out of equities into
fixed-income securities. He is not a homeowner.

The question he now faces is determining how much
he can draw each month without fear of running out. The
question is complicated by the need to have the monthly draw
amount rise over time to keep pace with consumer prices. The
only guidance that the industry now offers is the so-called
“4% rule,” which says that drawing 4% of the asset value
every year is probably safe.

My colleagues and I are developing a tool designed
to provide a better answer. Called the Retirement Funds
Integrator (RFI), it will integrate the components of a
retirement plan that otherwise are treated separately.
This article is about integrating financial asset management
and annuities. Other articles will include HECM reverse
mortgages in the process.

An important factor that affects the monthly amount
that a retiree can draw is the rate of return on the assets,
which cannot be known with certainty. Current interest rates
are very low compared to historical standards, which over
long periods are mostly in the 4-5% range. In comparing
payments based strictly on draws from financial assets and
draws based on a combination of asset draws and annuities, I
use a 5% rate, which is biased in favor of strict asset
draws.

Nonetheless, the asset draw/combination generates
more spendable funds, as illustrated in Chart 1.

The comparisons of monthly spendable funds in Chart
1 all assume annual increases of 2% a year. The middle line
shows the monthly amount that can be drawn solely from the
assets over the retiree’s life span, assumed to be 104
years. The lower line is the amount that can be drawn
following the 4% rule. The highest line is the amount that
can be drawn if the retiree uses part of his assets to
purchase an annuity deferred 5 years. In that case, he draws
from his assets for 5 years, which is the dotted portion of
the line, and is paid an annuity for the remainder of his
life, RFI generates the seamless transition from asset draws
to annuity payments.

Why does the combination of asset-draws and annuity
result in higher payments? It is not because insurers can
safely earn more than 5% - in today’s market they can’t. But
insurers pay annuities only to survivors, who in effect
benefit from those who die early. That is what annuities are
all about.

In deciding on a course of action, retirees should
consider not only what is most likely to happen in the
future but also the bad case that might happen, For example,
suppose the anticipated 5% rate of return turns out to be
2%?

Chart 2 shows that the annuity is a life saver in
this case. Draws from assets alone drop year to year
throughout life. The 4% rule would result in rising payments
until age 88, at which point payments would cease
altogether. Payments with the asset-draw/annuity combination
decline modestly for 5 years and then jump sharply as the
annuity kicks in. The combination is clearly the better
choice.