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## The Mortgage Professor: Retiree's dilemma: Deprive self or risk destitution?

Jack Guttentag, The Mortgage Professor on

Published in Business News

A retiree of 64 has \$1 million in her 401(k) common stock fund and expects a long lifespan. Her conundrum is deciding how much she can draw from the fund every month without worrying about running out while she is still alive. Existing options for coping with the conundrum are poor.

The 4 percent Rule

Investment advisers dealing with this situation often recommend the so-called 4 percent rule, which says that it is safe to draw a monthly amount equal to 4 percent of the fund balance divided by 12, adjusted annually for inflation. The initial draw for a retiree of 64 with \$1 million would thus be \$3,333.

The 4 percent rule has the great virtue of simplicity. However, if the retiree is long-lived, the rule carries a low probability that the retiree's assets will become depleted while she is still alive. Conversely, if she is short-lived, the rule carries a high probability that she will leave assets in her estate that she might well have preferred to spend on herself.

For example, if the retiree of 64 thinks she might possibly live to 104, her stock portfolio must earn at least 4.6 percent over the 40-year period. At an earnings rate below 4.6 percent, her balance will hit zero before she turns 104, leaving her destitute. The best estimate of the probability of that happening is 6 percent. The estimate is based on rate of return data covering common stock between 1926 and 2012. The 40-year rate of return was below 4.6 percent in 6 percent of the 565 40-year periods within that span. The median return in that same distribution was 9.5 percent.

While many retirees may anticipate that they might live to 104, few will. About two of every five female retirees die before reaching age 86. If that happens to the retiree of my example, most of her assets will go to her estate. Even if the rate of return is only 4.6 percent, her assets at 86 following the 4 percent rule would be worth \$886,613, which might well be more than she would have chosen if she had other options at the outset.

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The 4 percent rule is also inflexible, in that there is no way to adjust draw amounts to changes in investment performance -- other than to scrap the rule.

An alternative to the 4 percent rule should eliminate the probability of financial catastrophe at an advanced age, reduce the extent to which transfers to the estate are an unplanned artifact of mortality, and adjust draw amounts to changes in investment performance in a systematic way.

An Alternative: Combined Asset Management and Annuity

An alternative to the 4 percent rule is combined asset management and annuity, or CAMA. It meets the requirements stipulated above, at the cost of somewhat greater complexity.

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