November 5, 2021

*“I recently retired at 65 with $500,000 of
financial assets – I was never very good at saving money and
don’t own a home. My income from here on out will be social
security plus whatever I can squeeze out of the $500,000 of
assets before it is all gone. How do I do that without fear
of running out?”*

You are not alone. About 10,000 people reach age 65
every day and at least half of them face the same quandary
as you. Our existing retirement system is focused mainly on
retirees who are wealthier, because that is where the hefty
commissions are.

**Rate of Return on Assets Is Critical**

While the return on your assets in the future is
not known, we can make educated estimates of the rate that
is expected or most likely, and the rate that would be a
“bad case”. It is wise to base your plans on the first while
protecting yourself against the second.

I base these estimates on historical data that show
distributions of returns over periods of various length, for
asset portfolios with different mixes of common stock and
fixed-income securities. In the table, the expected rate of
return is defined as the median rate in the distribution of
returns while the “bad case” is defined as the rate that was
exceeded in 98% of the periods.

Given your age, the more conservative asset
portfolio is appropriate, and I use 10-year periods for
reasons that will be explained below. The rates I use in
evaluating your case are thus 6.1% as expected, and 2.8% as
a “bad case”.

**Spendable Funds Comparisons: Expected Versus
Bad-Case**

The traditional way to convert a current asset
value and interest rate into a payment stream is to assume a
terminal date at which point the financial assets are
exhausted and the payment stream ends. The stream can be
level or graduated to reflect rising prices. In your case, I
assume you live to age of 104 and that payments will rise by
2% a year until then. The top line on Chart 1 shows
spendable funds on those assumptions when the expected 6.1%
rate of return materializes.

The declining line on the chart is based on the
assumption that the bad-case rate of 2.8% materializes. The
probability is low but you want to avoid it if you can.
Financial advisors sometimes recommend dealing with this
risk by basing payment amounts on what is called the 4%
rule.

**The 4% Rule Eliminates Payment Shortfalls – If You
Don’t Live Too Long!**

Using the 4% rule, the initial monthly payment is
calculated at 4% of your initial assets, divided by 12, and
that amount increases by 2% every year. The lower of the
upward trending lines in Chart 1 shows payments using the 4%
rule if the expected 6.1% rate of return materializes. In
the bad case, the pattern is identical until your assets are
exhausted, at which point the payment drops to zero. This
happens when you reach 93.

In sum, so long as you allocate all of your assets
to monthly payments, the risk of a shortfall is unavoidable.
The remedy is to allocate some of your assets to the
purchase of a deferred annuity.

*Deferred Annuity Reduces Risk at Small Cost*

An annuity is the only financial instrument that is
specifically designed to provide payments until death. I use
a deferred income annuity on which payments are deferred for
10 years, and you receive nothing if you die within that
period. On October 9, this would cost you $296,194. You will
draw the remainder of your $500,000 nest egg during the
10-year deferment period, which will be fully exhausted when
the annuity kicks in. [Note: The annuity cost is calculated
to provide a seamless transition from asset draws to annuity
payments, using a program developed by my colleague Allan
Redstone.]

Charts 2 and 3 show your monthly spendable funds,
pre-programmed to increase by 2% a year, with and without
the annuity, using the expected rate of 6.1% and the
bad-case rate of 2.8% respectively. With expected rates,
spendable funds are very slightly smaller with the annuity
than without – initially about $39/month (the difference
increases to $48/month at age 80). That difference can be
viewed as the cost of avoiding the risk of a bad case.

However, in a bad case scenario the results are
very different. In this case, available draw from financial
assets without the annuity decline for life, whereas
payments from the annuity begin at age 75 and increase for
life. At age 80, the difference between the two options is
$1,039/month – this is shown in Chart 3.

In sum, by purchasing an annuity that reduces your
spendable funds by $40-50 a month, you avoid the risk of
losing about $1,000 a month – and this amount grows as you
age. The only downside is that the annuity reduces your
estate value.

**Selecting the Annuity Deferment Period**

Increasing the deferment period until the annuity
payment begins reduces the median rate of return on assets
but increases the bad-case return. This is because
variability in asset returns is smaller over longer periods.
While the bad-case decline in payments is smaller, it lasts
for a longer period.

Chart 4 shows the bad-case using deferment periods
of 5, 10 and 20 years, and illustrates why I selected 10
years. The-10-year deferment period avoids the sharpest drop
in spendable funds during the first 5 years and provides the
largest amount during the ensuing 10 years. But this is a
judgment call and your preference could be different.

**Concluding Comment**

Someone in your financial position would do well
consider using a significant part of their financial assets
to purchase a deferred annuity. If consulting a financial
advisor whose fee is based on a percent of assets under
management, which is the most common pricing method, keep in
mind that an annuity purchase will reduce their fee.
Further, they will have no means for advising you on the
amount of annuity purchase and the deferment period which
would best meet your needs. For that, visit my new web site RFI Retirement
Plan.

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