Making Retirement Income Last a Lifetime

To enable investors to spend down the assets in their defined contribution accounts more easily, the authors propose a decumulation benchmark comprising a laddered portfolio of TIPS for the first 20 years (consuming 88 percent of available capital) and a deferred life annuity purchased with the remaining 12 percent. This portfolio can be used directly by the investor (akin to indexing) or as a benchmark for evaluating the performance of a more aggressive strategy.In the field of personal finance, a great deal of attention has been paid to asset accumulation, but much less attention has been paid to asset decumulation, which is the planned spending down of one’s accumulated savings in retirement. We designed a prototype strategy for post-retirement investing and used the cash flows from that strategy as a decumulation benchmark. Because this benchmark is most likely to be applied to a defined contribution (DC) savings plan, we call it the DCDB (defined contribution–decumulation benchmark). We believe that a well-engineered DC plan should be experienced by the participant in much the same way as the participant experiences a defined benefit plan.Our benchmark is intended to embody the lowest-risk strategy available for converting accumulated capital into post-retirement income while satisfying two essential conditions: The strategy must protect the investor against longevity risk and be appealing enough that it is likely to be used by a broad cross section of investors. Immediate life annuities achieve the first condition but not the second. The apparent reason that investors shy away from immediate life annuities is that the loss of liquidity from transferring one’s capital irrevocably to an insurance company is too onerous. Thus, the benchmark strategy preserves most of the investor’s liquidity while achieving the goals of longevity protection and minimal investment risk.The strategy that forms our benchmark is to buy, with most of one’s capital, a portfolio of laddered Treasury Inflation-Protected Securities (TIPS) out to the latest TIPS effective maturity date, currently about 20 years. The remainder of the capital is used to buy a deferred annuity that begins its payout when the cash flows from the TIPS ladder end. The proportions invested in each asset class—TIPS and a deferred annuity—are set in such a way as to make the first deferred annuity payout equal to the last TIPS payout (plus an allowance for inflation). The resulting benchmark differs from ordinary benchmarks by consisting of a set of future cash flows produced by a given amount invested. As of 30 September 2010, a single 65-year-old male who invests $100,000 in the benchmark portfolio can expect to receive a first-year payment of $5,118, increasing at the U.S. Consumer Price Index (CPI) rate until Year 20. Thereafter, the deferred life annuity pays $7,332 (in today’s money) annually until the participant dies. This schedule of expected cash flows can be compared with the those from other post-retirement investment strategies to determine which one a given investor might prefer. We evaluated three alternatives to the benchmark strategy: an immediate, real life annuity purchased from an insurance company; a target-date portfolio of risky assets; and an immediate, nominal life annuity purchased from an insurance company. The immediate real annuity pays $4,856 in the first year, almost exactly the same as the first year’s payout in the DCDB. The cash flows from both strategies inflate at the CPI rate until the 21st year, when the DCDB stops inflating but the inflation-indexed annuity continues to inflate. Thus, over any life span, the inflation-indexed annuity either matches or dominates the DCDB if the investor does not care about liquidity or counterparty risk. But most investors are strongly averse to such risks, potentially tipping the choice to the benchmark strategy.The target-date portfolio produces cash flows that cannot be accurately forecasted. Given today’s low yields, however, these cash flows are likely to be much lower than those from the benchmark in the initial years. Over time, however, the target-date portfolio should yield more than the benchmark owing to growth in earnings and dividends. The participant must thus decide which cash flow pattern she prefers: front-loaded (the benchmark) or both more uncertain and more back-loaded (the target-date fund).The immediate nominal annuity pays $6,811 (nominal) every year. The participant must weigh this certainty—and high current income—against the likelihood that inflation will erode his purchasing power unacceptably in later years.The benchmark strategy is not only useful as a measuring stick for evaluating alternatives but is also potentially an investment in itself, akin to indexing. Such an investment would have to be offered by an entity that can issue or sell deferred annuities as well as conventional investment portfolios.Reprinted from Financial Analysts Journal, vol. 68, no. 1 (January/February 2012): 74–84. Author affiliations are accurate as of the original publication date.