#
Must Retirees Choose Between Destitution From Living Too
Long And Deprivation From Dying Too Soon?

The retiree of 64 has $1 million
in her 401K 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% Rule__

Investment advisors dealing with this situation
often recommend the so-called 4% rule, which says that it is
safe to draw a monthly amount equal to 4% 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% 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% over the 40-year period. At an earnings rate
below 4.6%, her balance will hit zero before she turns 104,
leaving her destitute. The best estimate of the probability
of that happening is 6%. The estimate is based on rate of
return data covering common stock during 1926-2012. The
40-year rate of return was below 4.6% in 6% of the 565
40-year periods within that span. The median return in that
same distribution was 9.50%.

While many retirees may anticipate that they might
live to 104, few will. About 2 of every 5 female retirees
die before reaching 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%, her assets at 86 following
the % 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% 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% 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 to the 4% Rule:
CAMA__

CAMA is short for Combined Asset Management and
Annuity. 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 to live on
during the deferment period. The initial draw amount is
calculated at an assumed rate of return on assets, 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% rule, which has no discretionary
features, CAMA requires the retiree (and her advisor) 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 favora ble 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%
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%, and an unfavorable return as
4%. She can then compare monthly draw amounts using
different annuity deferment periods under favorable and
unfavorable outcomes.

These comparisons are illustrated by the charts,
which also includes draws under the 4% rule. The annuity
amounts in the charts are the largest of those offered by 6
insurers rated A+ or A++ by A.M. Best.

__CAMA In a Favorable Market__

Chart 1 shows monthly spendable funds in a
favorable market using 10-year and 20-year annuity deferment
periods. Which annuity deferment period works best is a
judgment call, based partly on expected mortality, but all
of them generate more spendable funds than the 4% rule.
While financial assets would grow under that rule,
converting that into more spendable funds would require
jettisoning the rule.

__CAMA In an Unfavorable Market__

Chart 2 shows monthly spendable funds in an unfavorable market using the same10-year and 20-year annuity deferment periods. The 4% rule in this case runs out of funds when the retiree hits 99.

__Concluding Comment__

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.