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.