That’s my analogy for this way of creating lifetime income.
You’ll recall my last blog post, in which I explained that: (a) the fear of outliving one’s assets often leads to living off only the income generated by those assets; (b) there’s a simple way to encroach on the capital itself without the fear of running out of capital. Typically this results in a huge uplift to the retiree’s standard of living.
You’ll also recall the unexpected way in which this goal can be simply achieved. It’s by the formula of drawing down, each year, an amount equal to the accumulated assets divided by the average survival years for a person of the age and sex of the retiree (commonly called the future life expectancy for that age and sex).
This formula is commonly known (in the US) as the RMD approach.
Yes, there are four other ways of creating a lifetime income stream. They have desirable features, some of them superior to the RMD approach. But for the combination of simplicity of application for Defined Contribution (DC) plan sponsors (all that need to be known are the accumulated assets and the retiree’s date of birth and sex) and desirable features (ongoing ownership of the remaining assets, a solution to the longevity risk problem, investment flexibility including the possibility of seeking growth, never running out of assets), I think this approach makes an admirable default. And it works not only in a DC plan, but also for individuals outside DC plans. It is particularly helpful for lower-income and lower-savings plan members: those whose DC accumulation and other savings, when added to their government “first pillar” benefits and any defined benefit plan income, are still insufficient to support their desired lifestyle until an advanced age.
In this blog post I’ll explain what it achieves for retirees and what are its shortcomings – and why it’s still a great default, despite its shortcomings.
When I was very young I suffered from severe asthma and was sent for some years to a boarding school in the foothills of the Himalayas, to get cooler and cleaner air. Mt Everest, the tallest mountain in the world, was something we were all aware of, as it was not much more than 100 miles away. I was at that boarding school in 1953 when Everest was conquered by Hillary and Tenzing, which prompted me in subsequent years to read many books about all the attempts at scaling the peak, which is (in very round numbers) about 30,000 feet above sea level. Some years later, my family visited Darjeeling and we met Tenzing and got his autograph. Yes, I’ve been fascinated by Everest. That prompts me to use it as an analogy for the decumulation problem.
Climbers don’t start at the bottom. Instead they establish a Base Camp high up the side of the mountain. Typically it’s at least 15,000, probably closer to 20,000 feet up. Everything the climbers need is transported to the Base Camp, and they spend several days there, getting acclimatized. It’s only then that they start to focus on the peak. And that’s done in stages, over a period of time, climbing to establish Camp 1, then Camp 2, then Camp 3, then Camp 4, and finally attempting to reach the peak from Camp 4.
Good luck to them! For the vast majority of us, getting to Base Camp and getting used to life there would be more than enough!
In fact, that’s my analogy for what the RMD approach achieves.
It doesn’t get you to the peak: that’s the nastiest, hardest problem in finance, and we don’t need to solve it to live well (not to mention that nobody knows what the optimal solution is). But it gets us to Base Camp, and that’s far higher than most people ever get to. And the features of life at that level are extremely desirable.
Of the two unknowns that cause the problem of creating lifetime income (unknown investment return and unknown longevity), it solves the more substantial of the two (unknown longevity).
In my mind I imagine a very artificial health analogy. In this thought experiment (yes, I do thought experiments to see what a problem looks like in a different context), I imagine that all of us have two health conditions through our lives, asthma (that’s my longevity uncertainty analogue) and a catch-all condition (the investment return uncertainty analogue). The asthma gets worse as we age; the catch-all doesn’t. By the time we reach age 75 (male) or 80 (female) the asthma gets so bad that it’s our biggest health problem. Obviously, with this analogy, anything that gets us higher up Mt Everest is a good thing. And, in effect (continuing this asthma analogy), the RMD approach gets us to Base Camp, the asthma is now under control, and it’s now a smaller issue than the catch-all problem. The bigger of the two problems is now solved.
The RMD approach isn’t an irreversible transaction, as are annuity and deferred annuity purchases. It’s not a very expensive way of solving the longevity problem, as is self-insuring by using a very high age as your assumed lifespan or entering a longevity pool with a withdrawal option. You retain ownership of your assets. You retain investment flexibility.
Pretty good, eh?
For the majority of people, this is far, far superior to what often happens nowadays: being given your accumulated assets with no guidance as to what to do with them. That’s like being at sea level, with increasingly severe asthma as well as the catch-all condition. Wouldn’t it be great to get an automatic lift to Base Camp?
My Fireside Chat session at the P&I DC West conference only lasted 20 minutes, immediately followed by a panel session, so I wasn’t able to do any more than present the bare bones of the idea, as outlined in the previous blog post. Nor was I able to use the Mt Everest analogy. Or have time for comments and a Q-and-A session. But I did get some flavor of reaction, in two ways.
One was from my wife, who attended the session and watched the body language of the audience. She says they seemed relaxed and she noted a lot of heads nodding, in apparent agreement. That was good to know.
The other was from my one-on-one chats with others at the conference, who wanted to know what I would be saying. (My session was in the morning of the second of the two days, so I had several conversations on the first day.) And it was nice that I heard, several times, “Yes, but …” followed by pointing out a shortcoming of my proposal.
One is that the RMD formula leads to payouts that are too big at the start and too small at advanced ages. Another is that the formula has the opposite effect: payouts too small at the start and too big at advanced ages. Well, these can’t both be true, can they? Or perhaps they can. If you survive to a very advanced age, it’s true that, while the capital doesn’t run out, the payouts do tend to become smaller right at the end. Critics who focus on this aspect think there’s too little at the end. Other critics focus on the notion that you might expect that your lifestyle will require higher spending in the early years and lower spending at advanced ages; for them, relative to their ideal stream, you might indeed not get as much as you want at the start, and too much at the end. (It has been suggested that I could show projections to illustrate these effects. If this were a paper to an academic or professional journal, I would indeed do that. But for this chatty blog post, if you’re interested in the numbers I’ll refer you to Steve Vernon’s book Don’t Go Broke in Retirement.)
My response? Valid criticisms. It is certainly possible to tailor an income stream to better fit a personalized pattern that you consider optimal. You could do this, perhaps, through a financial planner. But the vast majority of people never see a financial planner, and typically planners prefer to deal with people with larger assets than the typical DC retiree. And in any case, I see those elements of personal tailoring as taking you from Base Camp to Camp 1 or Camp 2. Of course, go ahead and climb further. But that’s not a valid objection, I think, to offering free transport to Base Camp for everyone. In other words, by all means reject the default if you have personal notions about the desired path of your lifetime income stream and can give your planner details about those notions. But those
notions and personal details aren’t available to the plan sponsor, and getting everyone to Base Camp is a formidable start.
One day, perhaps, if robo-advisors become very efficient at customizing lifetime income streams to meet desired goals, perhaps they can do the job. But again, that requires personal data as well as an expression of desired goals – information that, at least today, goes far beyond what the average retiree can specify.
It became clear to me, from my conversations at the conference (and this confirmed what all my reading suggested anyway) that what bothers knowledgeable people is that my solution doesn’t deal at all with how the assets should be invested. That’s the first and biggest focal point of today’s professionals: what’s the recommended asset allocation, what about rebalancing, should there be a glide path that ties asset allocation to increasing age, and so on.
These are all excellent issues, and valid ones. They reflect the investment-oriented focus of today’s professionals. But remember my analogy: investment questions are part of the catch-all condition. After age 75 (male) or 80 (female), this condition is less important than the asthma (longevity) condition. This fact is simply unknown to the vast majority of professionals. So they naturally focus on the investment questions, being unaware of the fact that, above those ages, longevity uncertainty creates greater financial uncertainty than being 100% invested in equities, as I’ve explained before. They don’t realize that the problem they’re focused on is actually a smaller problem than longevity uncertainty.
They’re like doctors who have never diagnosed the more severe condition. They know it exists, of course – they’ve seen its effects – but they’ve never systematically measured the outcomes to realize that, if untreated, it’s more severe than the investment issue. So they do attempt to prescribe solutions (of course, they’re professionals, after all) but the notion of attacking it first and solving it isn’t their natural approach. What they’re doing, in effect, is helping their clients to climb further up the mountain, but at a level below Base Camp. I think it would help enormously if they first got their clients to Base Camp, and then spent their efforts on investment approaches that would get to Camp 1, Camp 2 and beyond.
Shortly after the P&I DC West conference I attended a meeting of financial planners. One said that, for his clients, he automatically assumes living to 110 and calculates the sustainable annual drawdown from that assumption. Well, it certainly solves the problem of uncertain longevity, but very expensively, reducing the annual drawdown very substantially. In my mountaineering analogy, this is equivalent to scaling a nearby peak that isn’t as tall as Everest; and to get back to Everest, with its two problems, you have to climb down and find a new pathway.
An observation made by a very thoughtful friend after the conference was that I might consider those with a predominant focus on an investment approach as climbing Everest from another side, and establishing their Base Camp on that other side. That’s a very nice analogy, I think. He suggests that its elevation might be difficult to measure and to compare with my default Base Camp. Also true. But I think there is one element that still holds. While a precise elevation might indeed be difficult to measure, it will still hold that the asthmatic condition will be extremely severe, and not under control, unless the level of my default Base Camp is reached. That’s because (I’m getting back to real life now, and departing from my analogy) unless the longevity uncertainty is dealt with, it will have a financial effect greater than being invested 100% in equities. In other words, you can focus primarily on the investments, but if that’s all you do, you’ve ignored the bigger problem (and you haven’t reached the elevation of my Base Camp).
All of this makes me realize that my Mt Everest analogy is perhaps a flawed one – certainly it’s far from a perfect one. It relies on the asthma condition becoming progressively worse as we age. If this were indeed everybody’s medical condition, we would notice it long before it got so severe! But in practice we don’t notice it at all; we don’t realize how severe is the effect of longevity uncertainty. So my analogy is undoubtedly flawed, in that respect.
I haven’t thought up a better one. If I do, I’ll test it out on professionals and then write it up as a blog post.
Longevity uncertainty eventually becomes a more serious issue than investment uncertainty. Ensure that you create lifetime income before you focus on asset allocation.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.