This article describes a retirement plan feature that, when properly integrated into the plan, avoids leaving too much or too little to the retiree’s estate.

Another Desirable Feature of a Retirement Plan: a Set-Aside

February 14, 2019

My recent article on retirement (What Should You Look For in a Retirement Plan?) indicated that in order to assure that a retiree will not run out of money at an advanced age, which is a primary retirement objective, most plans should contain an annuity.

This article deals with what should be a second major objective of retirement plans but is often ignored, which is to avoid leaving more or less money in the estate than the retiree would have chosen if she knew in advance the day of her death. To meet this objective, a retirement plan can include a set-aside, which is an amount targeted for the retiree’s estate.

Bequests Under the 4% Rule

The 4% rule, which seems to be the only exception to complete seat-of-the-pants management of retirement, says that a retiree can draw 4% of her financial assets every year, plus an annual inflation adjustment, without ever running out. The rule in effect sacrifices objective two in order to meet objective one.

Consider a female retiree of 62 with a nest egg of $2 million, half in common stock and half in interest-bearing securities. If her portfolio earns a return of 8.1%, her estate will receive $4.9 million if she dies at 82, $8.7 million if she dies at 92, and $16.6 million if she dies at 102. The probability of a return of 8.1% or higher is about 50%, based on statistical data covering the period 1926-2012 (see below).  There is a reasonable presumption that the retiree would prefer to spend some of that wealth herself.

Note that in a worst case where the rate of return falls to 3.6%, the 4% rule fails both objectives, running dry at age 95. The probability of this occurring is estimated at 2%.

Bequests in RIS: the Set-Aside

RIS stands for Retirement Income Stabilizer, which is the retirement planning model I have been developing with Allan Redstone. The retiree using RIS allocates a portion of her financial assets to the purchase of a deferred annuity, and draws the remainder as spendable funds during the deferment period. At the end of that period, her assets are gone and her spendable funds thereafter come from the annuity. Her estate receives nothing from the plan – unless she includes a set-aside.

RIS thus forces the retiree to decide how much of her wealth at the time the plan is adopted, will be set aside for her estate. The set-aside amount can accumulate interest, and the decision is not irrevocable, as we shall see.

Charts 1 and 2 pertain to the female retiree of 62 referred to above who uses RIS to purchase a 10-year deferred annuity. The charts show her spendable funds and financial assets under 2 markedly different assumptions regarding the rate of return on her financial assets. One assumption is that her portfolio earns a return of 8.1%, which is the median return over 745 25-year periods during 1926-2012. Without a set-aside, her spendable funds are shown by the top line in Chart 1, the dotted portion showing draws from her assets and the solid portion showing annuity payments, with the payments rising by 2% a year.  The bottom line in Chart 2 shows her financial assets, which hit zero after 10 years and remain there.

Adding a Set-Aside

Assuming that the retiree elects to set aside $250,000 for her estate, her monthly draw amount will be the lower continuous line on Chart 1. The benefit from her smaller draws is the rise in the value of the set-aside, shown by the highest line of Chart 2. Growing at 8.1% a year, the set-aside reaches $1 million when she hits 81 and $2 million at 89. She would be free, of course, to draw on some of that herself – it is her money!

The Set-Aside in a Worst Case

A retirement plan should always consider how the plan would work – or not work – in a worst case. The worst case used here is a return on assets of 3.6%. Only 2% of the 745 25-year periods during 1926-2012 had returns of 3.6% or less.  I continue to assume a Set-Aside of $250,000.

In Chart 1, the worst case generates a decline in monthly spendable funds during the 10-year deferment period when the retiree is dependent on draws from her assets – see the lowest line on Chart 1. The decline ends when the annuity kicks in after 10 years.

RIS Monthly Spendable Funds without with and without set-aside

Chart 2 shows that the Set-Aside survives the worst case – it is the middle line on the chart. The Set-Aside does not grow the way it would with an 8.1% rate of return. Nonetheless, at age 73, the Set-Aside is $359,000 and at 83 it is $509,000.

RIS Financial Asset Balances with and without set-asides

The retiree in a worst case has another option regarding the Set-Aside. She could use it to offset the decline in spendable funds during the deferment period.  If she did that, the Set-Aside would no longer go to her estate. That is a personal decision to be made when and if the worst case happens, which it probably will not.

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