So here we are, we’ve saved and invested, and we’re ready to stop working and convert our assets from a lump sum into a flow of retirement income that can be sustained for the rest of our life. How can we do that?
Yes, “decumulate” is a real word. With a car you accelerate and then decelerate. With a pension pot you accumulate and then decumulate: you draw money out of the pot to enable you to live the retirement lifestyle you desire.
In retirement all of us want some combination of three fundamental goals. Longevity insurance: we don’t want to outlive our savings. (That’s the biggest fear of retirees, according to consistent survey results over the years.) Safety: there’s no further opportunity to add to the pot, so bad investment news is tough to overcome. Growth: for most of us, our desired lifestyles are richer than we are, so we still would like some opportunity for investment growth.
In this post I’ll explain four different approaches to generating an income that is designed to be sustainable over the rest of your lifetime. I’ll add some pros and cons, so that you can decide which of them suits you best psychologically, before you get down to the actual numbers that result from them.
- Buy an immediate lifetime income annuity.
Preferably inflation-linked; if not, the annuity starts off higher, but your purchasing power will decline by the amount of inflation each year. Many retirees accept the decline, with the implicit logic that their “propensity to consume” (as Keynes put it) declines as their age increases.
The big advantage of a lifetime annuity is that it provides longevity insurance: you won’t outlive your savings. And typically it provides the highest guaranteed income from any given size of pension pot.
But it has disadvantages. It’s a once-for-all contract, with no further flexibility. It’s essentially a 100% fixed income investment, with no growth potential. Early death makes it a gamble. (That’s what risk pooling is all about.) And of course, in principle the insurance company could go bust, though there would still probably be a high proportion of the payments made.
This kind of contract, with an income guaranteed for life, is not available in every country.
- Draw down an amount each year that is based on your future longevity at the start of the year.
This approach overcomes some of the disadvantages while retaining the longevity feature. It’s the basis of the American “required minimum distribution” rule. It’s very simple, in concept.
If this year your future life expectancy is E, and your pension pot is P, then withdraw P/E. Next year, see what P and E have changed to, and withdraw next year’s value of P/E. And so on. Since, if you’re still alive, you always have some future life expectancy, E is always a positive number, and doesn’t reach zero until the end of the mortality table (which is typically some age like 110 or 120 that you aren’t likely to have to worry about). And that, combined with the fact that you’re never withdrawing the entire balance of your pension pot, means that you won’t outlive the pot.
Meanwhile, you can invest the pot with whatever combination of safety and growth prospects fit your situation. (Talk to your financial professional about what’s appropriate for you.)
Typically this approach generates higher income early on than a lifetime annuity. But the annual drawdown isn’t a totally predictable amount; it varies as investment returns vary, and is therefore subject to some uncertainty. Also, the annual drawdown has a strong tendency to decline sharply as your age approaches the end of the mortality table.
- Assume death at some advanced age, and draw down an amount each year that is designed to last until that advanced age.
This approach is sometimes called “self-insurance.” Never mind expectancy-related calculations, just pick some advanced age, which becomes the goal for your lifespan. Typically these days financial professionals advise using something like age 100. You might want to refer to Post #12 for a discussion of this issue (https://donezra.com/12-how-long-should-you-plan-to-make-your-money-last/).
Invest the pot with the appropriate combination of growth and safety. Withdraw, each year, some systematic amount: for example, whatever amount your financial professional calculates each year as likely to be sustainable until the advanced age.
This approach typically generates higher initial drawdowns than an annuity purchase or longevity-based drawdowns. Of course, the amounts drawn down vary over time, because the investment returns vary. And there are tough spending decisions to be made if you approach the selected advanced age, because now the prospect of outliving that advanced age needs to be introduced.
A variation is to combine drawdown approaches #2 and #3. Draw down half the capital based on future longevity, and the other half based on the age at the end of the mortality table (for example, 110 or 120). The rationale is that this combination ensures that there are still growth prospects, while reducing the sharp decline in the drawdown at advanced ages.
- Buy pure longevity insurance (a deferred annuity), and draw down an amount each year from your remaining assets that is designed to last until your longevity insurance kicks in.
This is the approach I have chosen for myself: to buy a deferred annuity that kicks in if you survive to age 85 (the cost being typically in the range of 10-15% of an immediate annuity). With the rest, self-insure to age 85 (or whatever age you choose).
The rationale is that longevity insurance is secured inexpensively, and most of the pension pot is available for the appropriate safety/growth combination, with drawdowns that aren’t projected to inevitably decline.
A big practical problem is that deferred annuities of this sort aren’t typically available, except in the USA. I hope insurance companies will start to offer them. The US government recently authorised this approach as an acceptable one for US-based pension pots: it’s referred to as a QLAC (which stands for “qualified longevity annuity contract”).
All of this will, I hope, give you a logical and sensible basis to discuss your financial future with a qualified adviser. It’s important for you to choose between the approaches, because they have very different characteristics. My goal has been to explain each approach on a stand-alone basis, leaving the combined implementation to you and your financial professional.
Of course it goes without saying (but I’ll say it explicitly anyway) that you may find that you’re unable to decide conclusively between, let’s say, two of these ways. Or that you prefer one and your partner prefers another (because there’s no reason why partners should have identical mindsets, even though the risk profiles used by financial professionals typically gloss over this difference). In which case you could use both ways, dividing your assets between them.
Finally, for greater depth and insight, google two outstanding papers: NEST’s “A retirement income blueprint” and the true-to-title “The only spending rule article you will ever need” by Siegel and Waring. For the record, I know them all but have no connection with any of them.
There are four ways to generate retirement income from a lump sum: buy an annuity; draw down an amount each year that depends on your future life expectancy; calculate a sustainable drawdown until some fixed advanced age; buy longevity insurance and use the fixed period until it kicks in as the period over which you calculate a sustainable drawdown. It’s important for you to choose between them because they have very different characteristics.
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.