The Only Spending Rule Article You Will Ever Need

Abstract

After examining an array of approaches to determining a spending rule for retirees, the authors propose the annually recalculated virtual annuity. Each year, one should spend (at most) the amount that a freshly purchased annuity—with a purchase price equal to the then-current portfolio value and priced at current interest rates and number of years of required cash flows remaining—would pay out in that year. Investors who behave in this way will experience consumption that fluctuates with asset values, but they can never run out of money.

Investors have long sought a spending rule for asset decumulation in retirement that would assure them a guaranteed stable income while making sure they never completely run out of money. We show that a completely stable income is possible only with riskless investments, such as a hypothetical laddered TIPS (Treasury Inflation-Protected Security) portfolio with cash flows from the portfolio timed to match those required by the investor over his or her planning horizon (a hedge that cannot today be perfected over long horizons), or through a riskless commercial annuity (which doesn’t yet exist). With risky investments, which most investors will hold because they seek higher returns, investors can either receive guaranteed cash flows but for an uncertain period (thus taking the chance of running out of money) or receive variable cash flows (varying with the market value of the portfolio), in which case they will not run out of money if the decumulation scheme is engineered correctly.

We show that asset decumulation is an annuitization problem. That is, even though most investors do not buy actual annuities to help with decumulation, annuity thinking is required for setting the terms of the spend-down for a given level of wealth, time horizon, and interest rates. Specifically, each year the investor should spend (no more than) the amount that a freshly purchased fixed-term annuity would pay out in that year if the annuity were bought in a size equal to the then-current market value of the portfolio at then-current market interest rates and with a remaining time equal to the time over which consumption cash flows are desired to last. The annuity must be repriced every year (or on whatever periodicity the investor chooses), with a corresponding reset of spending such that the spend is always appropriate to the wealth available, which will vary with investment returns, as well as the planned time horizon and market interest rate conditions. We call a strategy based on this periodic repricing an annually recalculated virtual annuity (ARVA).

The investor that isn’t fully hedged to consumption, then, faces consumption risk—the risk of variability in what he or she can spend—that is almost exactly equal to, and caused directly by, the variability of portfolio values (and interest rates). Smoothing techniques do not help maintain consumption when portfolio values are down; one can borrow from the future only what one is willing to pay back later. There is no free lunch either from a spending rule with risky investments or from a smoothing approach attempting to avoid the consequences of investment volatility.

Fixed-term annuities assume certainty about the spending horizon, but because lifespans are uncertain, we experimented with various enhancements that take life expectancy into account. A simple rule is to set the time horizon equal to one’s remaining life expectancy, because this number grows (slowly) as one ages. However, we found that this rule front loads spending unacceptably, with spending falling off sharply in old age to the great disadvantage of those who attain such longevity. One attractive rule turned out to be to set the time horizon equal to the average of (1) one’s remaining life expectancy and (2) the outer limit of one’s possible lifespan, which we assumed was age 120. But the “shape” of one’s spending over time is a matter of personal preference, and there is an infinite number of ways to speed or slow one’s payout from a given amount of wealth.

An ARVA strategy is not the only way to protect consumption for one’s entire life. Here are some other options:

1. Annuitize through life insurance company commercial annuities.

2. Create a blend of deferred life annuities and conventional investing using an ARVA strategy.

3. Use insurance riders for lifetime income, such as a guaranteed withdrawal life benefit or a ruin-contingent life annuity.

We also propose some market-focused reforms in the commercial annuity industry, in order to create better and safer annuities for retirees in the future and a larger and more profitable annuity marketplace for the issuers.

Annuitizing one’s whole portfolio through commercial insurance company-provided annuities is unpopular because of illiquidity, credit risk, and concerns about adverse selection and fair pricing. Some investors commercially annuitize part of their portfolio and manage the rest using conventional investments.

A blend of deferred life-income annuities and conventional investments managed using an ARVA strategy has many attractive features, although any commercial annuity portion is still subject to credit risk and other concerns.

In conclusion, investors can only spend what they have. There is no magic formula that will stretch dollars available to equal dollars “needed.” However, one can improve tremendously on current practice. A strategy that makes full or partial use of the ARVA concept will succeed where other approaches, such as a fixed percentage (e.g., 4%) of peak assets withdrawal rule, can easily fail if investment returns are disappointing or if the investor should enjoy a long life.