In an environment where the primary source of retirement income is shifting from defined benefit plans to defined contribution plans, retirees are now faced with a new decision: How much do I withdraw from my defined contribution accounts?
The first step is to encourage retirees to develop a withdrawal plan, in contrast to withdrawing money in an impulsive manner based solely on immediate spending needs. Retirees may have a feeling of wealth when they see their account balance, but not realize how little it provides when converted to an annual income. To help ensure a retiree does not run out of money, a systematic withdrawal plan is preferable to no plan at all.
A withdrawal plan should be developed with attention to the following risks that increase the likelihood of running out of money:
- Longevity Risk
- Investment Risk
- Inflation Risk
- Liquidity Risk
- Standard of Living Risk
- Behavioral Risks
There are a limitless number of withdrawal plans available to retirees, but we will focus on those that have gained at least some acceptance and usage and, most importantly, are rules based. These withdrawal plans fall into three categories, including investment earnings, systematic withdrawals and annuities.
Under this method, interest and dividends are withdrawn and form the basis of retirement income. The principal of the assets is left intact. A variation of this is to also withdraw the realized capital gains. This strategy can be managed by the retiree or an adviser.
This is a rules-based approach that is managed either by the retiree or an adviser. These strategies generally fall into three categories.
- Constant dollar amount – A dollar amount is determined at retirement usually based on a percentage of the retiree’s assets that he or she commits to the strategy. This fixed dollar amount can be adjusted annually for inflation or other rules-based adjustments.
- Endowment method – Each year a percentage of assets is withdrawn. This percentage does not change over time.
- Life expectancy method – Annual withdrawals are based on the remaining life expectancy of the retiree (or joint life expectancies of the retiree and partner).
Annuities are a series of payments at fixed intervals guaranteed for a fixed number of years or the lifetime of one or more individuals—and the options available to retirees are plentiful. There are immediate and deferred annuities. There are annuities that pay a constant amount and annuities that have a variable payment. Some annuities have an inflation adjustment component. There are annuities with a guaranteed minimum withdrawal benefit (GMWB), a hybrid product that has characteristics of both an annuity and a systematic withdrawal plan. There are annuities with a death benefit. Finally, there are Qualified Longevity Annuity Contracts. These allow retirees to move 25% of plan assets (up to $125,000) into an annuity that commences payments no later than age 85 and the amount is not subject to the minimum distribution rules.
Which of the three withdrawal strategies should a retiree choose? There are advantages and disadvantages to each and the tradeoffs can be analyzed across four dimensions:
- Is the level of income provided adequate?
- How predictable is the income amount?
- How liquid are the retiree’s assets?
- What level of advice or guidance does the retiree want?
Given the above, we can quickly dismiss the investment earnings strategy as it does not address any of the risks.
The systematic withdrawal approaches offer liquidity, flexibility, upside potential in favorable markets and inflation protection. Also, systematic approaches have lower fees than annuities, usually just investment management fees. The two significant downsides are limited protections against both longevity risk and investment risk. Also, behavioral risks are not curbed under systematic withdrawal approaches, although if the systematic program is managed by an adviser, behavioral risks can be minimized.
Annuities offer exceptional protection against longevity risk and investment risk. Variable annuities do provide some upside potential during periods of favorable investment performance. Annuities also eliminate most of the behavioral risks. On the downside, annuities provide no liquidity and are subject to high fees. Most annuities provide no inflation protection, except if the retiree purchases an inflation rider, but these can be expensive. Finally, there is solvency risk, the risk of the insurance company going bankrupt.
As both annuities and systematic withdrawal approaches offer their own unique advantages, one solution is to combine the two. The retiree divides his or her retirement savings between an annuity and a systematic withdrawal approach. The split depends on the tradeoff between the desired level of protection against longevity risk and investment risk and the desired liquidity and flexibility. Also, Social Security should be factored into this decision as that may be a significant source of annuity income.
Note from the editor:
Thomas H. Dodd, Executive Director, Pavilion Advisory Group Inc., in Chicago, oversees relationship management, guides investment strategy and leads business development at Pavilion Advisory Group. He has 43 years of investment and actuarial experience and is a CFA charter holder and a member of the CFA Institute, the CFA Society of Chicago and a Fellow of the Society of Actuaries.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Asset International or its affiliates.
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