Exhausting retirement capital
2. The second withdrawal strategy takes a fixed percentage of the fund each year
Despite the fact that most actuarial consensus would be that an increasing income is more appropriate, in practice annuitants choose the higher level annuity. For completeness, the results assuming a level annual withdrawal are also shown in Tables 5 and 6.
Test statistics
The outcomes for each investment and withdrawal strategy and for initial percentage withdrawal rates ranging from 2% to 10% in steps of 1% were examined. Also an initial withdrawal percentage of 6.5% is shown for comparison purposes. This latter is the amount of inflation-linked annuity that could be purchased by a 60-year-old male using the initial assumptions of the model and the mortality table that is used throughout the analysis. This is a conceptual figure since in Ireland, because of the lack of index linked gilts, true inflation-linked annuities have not been readily available. The annuity as so calculated has no guaranteed period and is for single life only. An annual expense charge of ¼% is allowed for in calculating the 6.5% annuity rate.
These are the test statistics examined:
• The probability of the fund “bombing out” (before death). In the case of the second withdrawal strategy of course, the fund can’t actually fall to zero since it is being reduced by a percentage each year. In this case "bomb-out” is defined as the income falling at any stage to less than 50% of its initial level in real terms.
• The amount of inflation-linked annuity that could be purchased at age 75 is also examined. In the interests of simplicity, the annuity rate used at age 75 is not adjusted for improving longevity or for possible changes to pricing. The implicit assumption is that the gap between inflation and long interest rates that underlies the annuity calculation would be stable.
• The average amount paid out on death is also shown. This is expressed as a percentage of the initial fund and is again adjusted for the modelled inflation.
Exercising the new retirement options
Results
Table 1: Fixed Real Withdrawal – % Bombout and Payment on Death
In the above table an initial cash withdrawal, expressed as a percentage of the initial fund, is increased each year in line with the modelled inflation.
Thus the same income is drawn irrespective of fund choice or of unfolding fund performance and so the differences on these counts will be manifested in the chances of the fund running out before death, the “percentage bombout” in the above table, and the average amounts paid on death. This latter is shown in the above table as a percentage of the initial fund adjusted for the modelled inflation.
Some observations can be made about the above table:
♦ At very low withdrawal rates, a gilt fund is actually less likely to bombout than an equity fund, though the differences appear immaterial.
♦ At middle withdrawal rates, the equity-based approach is more likely to last the course than a gilt based one, though interestingly at higher withdrawal rates, the equity based approach is almost as unsustainable as the gilt version. This is the effect of early bombouts on the more volatile equity based approach offsetting the generally more favourable long-term outlook for equity investment.
♦ On this withdrawal strategy the real benefit of the equity based approach over gilts is in the higher expected payouts on death across the range of withdrawal rates. However, at high withdrawal rates this advantage, whilst maintained, is on a much lower amount and so is of reduced significance. In fact, a rather surprising result was that at very high withdrawal rates the advantage of equity investment over gilt investment is fairly immaterial as judged by either criterion – the chances of sustainability and the amounts payable on death. This is due to the shorter duration of the strategy since, at the extreme, 100% withdrawal is equal as between equity and gilt.
♦ Not surprisingly, if the initial withdrawal amount is set at the level of a conventional inflation linked annuity then the chances of bombout are high – 48% for the equity fund and 59% for the gilt fund.
♦ This brings us to consideration of the equity-linked annuity. Clearly, by definition, there is no payout on death and obviously the chances of bombout have been significantly reduced. However, if the initial withdrawal was set at the conventional annuity level, there
Full Equity Fund Full Gilt Fund Equity Linked Annuity
Initial Percentage Average Percentage Average Percentage Average Drawdown Bombout on Death Bombout on Death Bombout on Death
2.0% 0% 155% 0% 101% 0% 0%
3.0% 2% 122% 1% 76% 0% 0%
4.0% 11% 91% 13% 52% 1% 0%
5.0% 25% 65% 34% 35% 6% 0%
6.0% 41% 45% 52% 24% 16% 0%
6.5% 48% 37% 59% 20% 22% 0%
7.0% 55% 31% 65% 17% 30% 0%
8.0% 66% 22% 74% 13% 45% 0%
9.0% 74% 16% 80% 10% 59% 0%
10.0% 80% 13% 84% 8% 69% 0%
Exercising the new retirement options
Table 2: Fixed Real Withdrawal Rate – Analysis of position at Age 75
This table analyses the situation at age 75, again concentrating on a withdrawal strategy that attempts to maintain real income. The thinking behind this table is to examine what would be the prospects for securing the chosen income by means of a conventional annuity at age 75.
Three statistics are analysed. The lower and upper quartiles (LQ and UQ) for the percentage of the initial withdrawal, adjusted for modelled inflation, which can be secured and the percentage chance that the annuity at age 75 would be greater in real terms than the initial withdrawal amount. [For example: the LQ for 2% withdrawal and Full Equity Fund is 154%.
That means that for 75% of outcomes the annuity that can be secured at age 75 is at least 154% of the initial withdrawal in real terms i.e. is at least 3.08% of the initial fund adjusted for 15 years inflation.]
In order to illustrate the wide range of outcomes, negative funds have been illustrated. In other words the model continues to project withdrawals and fund values after the fund has been exhausted.
Some observations can be made about the above table:
♦ In some ways, Table 2 paints a much more dramatic picture than Table 1. Not surprisingly, all statistics are very sensitive to the level of initial withdrawal chosen. This is a double sensitivity, firstly because the funds are higher after lower withdrawals but also because the results are being expressed in terms of the initial withdrawal.
♦ What is very stark is the huge inter quartile range, no matter which investment strategy is chosen and for all withdrawal rates.
♦ The advantage of equity investment over gilt investment can be quite clearly seen to be in enhancing the upside potential. Measured against the downside risk as exemplified by the LQ, gilt investment is, if anything, superior.
♦ Consider an initial withdrawal rate of 6.5%, the amount of a conventional real annuity that can be secured initially by a 60 year old. Equity investment has a LQ of 11%. The UQ is 120% and in only 32% of situations is it possible to secure the initial withdrawal level at age 75. This does not give much encouragement to the strategy of deferring annuity purchase in the hope that equity out-performance will compensate for mortality drag.
♦ So what about the equity linked annuity? Of course, all percentages are much higher but again lets concentrate on that 6.5% withdrawal rate. As before the range of outcomes is enormous with an LQ of 55% and an UQ of 224%. The chances of being able to purchase an annuity at least equal to 6.5% in real terms are 61%.
Table 3: Fixed Percentage Withdrawal – % Bombout and Payment on Death Full Equity Fund Full Gilt Fund Equity Linked Annuity
Initial Lower Upper % Lower Upper % Lower Upper %
Drawdown Quartile Quartile Greater Quartile Quartile Greater Quartile Quartile Greater
2.0% 154% 311% 93% 145% 215% 98% 242% 481% 99%
3.0% 123% 267% 83% 116% 180% 89% 202% 423% 96%
4.0% 91% 227% 71% 86% 148% 62% 160% 366% 90%
5.0% 59% 181% 56% 57% 115% 33% 118% 308% 80%
6.0% 26% 139% 40% 27% 81% 16% 77% 249% 67%
6.5% 11% 120% 32% 12% 65% 10% 55% 224% 61%
7.0% -6% 100% 25% -3% 48% 6% 34% 195% 51%
8.0% -41% 61% 15% -33% 15% 2% -10% 142% 37%
9.0% -75% 25% 8% -64% -18% 1% -56% 93% 23%
10.0% -110% -10% 4% -95% -50% 0% -100% 45% 15%
Exercising the new retirement options
In this table and the next we change the withdrawal strategy from being a fixed real income to being a fixed percentage of the fund. In general, for withdrawal percentages in excess of the real growth on the funds, the fixed real income is a higher level of withdrawal in the long run than a fixed percentage of the fund and vice versa.
Of course, a fixed percentage withdrawal cannot actually bombout and so for the purpose of the above table bombout has been defined as the income falling at any time to less than a half of the initial income in real terms.
Having defined bombout in this way Table 3 now looks quite similar to Table 1. The higher average payouts on death at higher withdrawal percentages reflects the fact that a high percentage of the fund is a lesser long term income than the same amount maintained in real terms, as already noted above. Otherwise this table has little to add to our observations. Of more interest is the next table.
Table 4: Fixed Percentage Withdrawal – Analysis of position at Age 75
Full Equity Fund Full Gilt Fund Equity Linked Annuity
Initial Percentage Average Percentage Average Percentage Average Drawdown Bombout on Death Bombout on Death Bombout on Death
2.0% 14% 145% 3% 102% 4% 0%
3.0% 24% 118% 9% 84% 7% 0%
4.0% 36% 97% 26% 70% 11% 0%
5.0% 48% 80% 48% 58% 18% 0%
6.0% 61% 66% 65% 49% 25% 0%
6.5% 67% 61% 71% 45% 31% 0%
7.0% 72% 55% 76% 41% 37% 0%
8.0% 79% 46% 82% 35% 49% 0%
9.0% 84% 39% 86% 30% 62% 0%
10.0% 87% 33% 89% 26% 72% 0%
Full Equity Fund Full Gilt Fund Equity Linked Annuity
Initial Lower Upper % Lower Upper % Lower Upper %
Drawdown Quartile Quartile Greater Quartile Quartile Greater Quartile Quartile Greater
2.0% 159% 299% 96% 152% 213% 99% 239% 447% 99%
3.0% 137% 257% 92% 131% 185% 97% 206% 386% 99%
4.0% 118% 222% 85% 113% 159% 90% 177% 333% 97%
5.0% 101% 191% 76% 97% 138% 70% 151% 287% 94%
6.0% 86% 165% 65% 83% 118% 47% 129% 247% 89%
6.5% 80% 153% 59% 78% 110% 35% 120% 230% 85%
7.0% 74% 141% 52% 71% 101% 27% 111% 212% 82%
8.0% 63% 121% 38% 61% 87% 14% 95% 182% 72%
9.0% 53% 104% 28% 52% 75% 5% 80% 156% 60%
10.0% 45% 88% 18% 44% 64% 2% 68% 133% 47%
Exercising the new retirement options
This table bears interesting comparison with Table 2.
♦ At low withdrawal percentages the results are very similar. This reflects the level of underlying real after charges growth which would be in the range 2% to 3%.
♦ At higher withdrawal percentages, this table looks much more stable than Table 2, and in particular it is not possible for the fund to run out as a result of the percentage withdrawal approach.
♦ Because of the volatility in income withdrawals prior to age 75, due to fluctuations in fund values, there is a less volatile projected fund at age 75 but the range between LQ and UQ is still high, particularly for the equity based fund.
• The equity-linked annuity appears to be much more credible on this withdrawal strategy.
Consider the 6.5% withdrawal once more. There is an 85% chance of securing a higher annuity in real terms at age 75 and a greater than 25% chance of securing one more than twice as big as the original. However, it must be noted that the income drawn up to age 75 would in the first place be volatile but also would not have on average maintained its real value since real growth is on average much less than 6.5%. Thus this apparent endorsement of the equity-linked annuity is in fact an illusion.
Despite the fact that actuarial consensus would be that an increasing income is more appropriate, in practice annuitants choose the higher level annuity. For completeness, the results assuming a level income withdrawal are shown in Tables 5 and 6 below. The highlighted annuity is the level annuity of 8.4% that could have been purchased at age 60. In Table 6 the annuity which can be purchased at age 75 is compared with the original withdrawal rate without adjustment for inflation.
Table 5: Fixed Level Withdrawal – % Bombout and Payment on Death
Full Equity Fund Full Gilt Fund Equity Linked Annuity
Initial Percentage Average Percentage Average Percentage Average Drawdown Bombout on Death Bombout on Death Bombout on Death
2.0% 0% 169% 0% 112% 0% 0%
3.0% 1% 143% 1% 92% 0% 0%
4.0% 3% 117% 4% 73% 0% 0%
5.0% 9% 93% 11% 56% 1% 0%
6.0% 18% 71% 22% 40% 5% 0%
7.0% 30% 53% 37% 29% 11% 0%
8.0% 43% 38% 52% 21% 21% 0%
8.4% 48% 34% 57% 18% 25% 0%
9.0% 55% 28% 64% 15% 33% 0%
10.0% 65% 21% 73% 12% 46% 0%
Exercising the new retirement options
Table 6: Fixed Level Withdrawal – Analysis of position at Age 75
Conclusions
♦ The ARF option is so different from the conventional annuity option that comparisons of how long ARF funds may last or how much income can be taken on various deterministic growth projections could be dangerously misleading.
♦ The range of possible outcomes is so wide that no-one should be given an impression that somehow the ARF withdrawal option will work out better than the conventional annuity, if this latter is the more suitable for their needs.
♦ Thus, for example, investment in equity based funds is not the panacea. Yes, it is superior to a gilt based ARF, but if the conventional annuity was what was really needed the risks in terms of final bombout and range of outcomes at age 75 are so high as to negate any upside potential.
♦ Nor does the concept of an equity based “longevity” or annuity product seem to hold much promise. The volatility and uncertainty still remains. A higher income might be enjoyed but the volatility that is taken on board by going this route rather than the conventional annuity route would seem to easily outweigh any upside potential.
♦ The conclusions above are not to say that the conventional real annuity is the only possible option that should be put before investors. Different investors, depending on their circumstances, will have differing needs for some level of real income secured for life. For those with substantial assets, either of the ARF variety or just general third pillar accumulations, that real income might be expected to be always available by “drawdown”
on their assets in any foreseeable circumstances. For these individuals, it would not be necessary to secure the minimum real income by purchase of a conventional annuity as they can in effect self insure the risks involved.
♦ For the majority, though, for whom their retirement funds will be their sole or main provision for retirement, it will be highly advisable that the required minimum level of life real income is secured by purchase of a conventional annuity. It is for these people that the illustration of the ARF alternatives to securing that minimum income can be the most dangerous.
The analysis and conclusion raise a number of issues:
♦ Whether access by retirees to the new retirement options should be subject to a
“secure income” test, to filter out those who cannot financially afford the risks and volatility associated with ARF withdrawals. We have already proposed that the current
Full Equity Fund Full Gilt Fund Equity Linked Annuity
Initial Lower Upper % Lower Upper % Lower Upper %
Drawdown Quartile Quartile Greater Quartile Quartile Greater Quartile Quartile Greater
2.0% 208% 447% 97% 200% 340% 96% 323% 683% 100%
3.0% 175% 400% 93% 166% 299% 93% 281% 621% 99%
4.0% 142% 352% 88% 134% 260% 86% 239% 554% 97%
5.0% 110% 303% 79% 102% 223% 75% 193% 492% 92%
6.0% 75% 253% 67% 69% 183% 62% 150% 426% 86%
7.0% 42% 206% 54% 37% 142% 42% 105% 360% 77%
8.0% 9% 158% 39% 6% 104% 27% 59% 291% 65%
8.4% -3% 138% 36% -6% 90% 21% 44% 269% 60%
9.0% -27% 111% 27% -27% 65% 14% 17% 228% 51%
10.0% -63% 65% 18% -60% 27% 6% -32% 171% 38%
Exercising the new retirement options
♦ The type of information that should be given by QFMs to retirees investing in ARFs for regular withdrawal, and the manner in which the information should be presented. QFMs have a responsibility to present ARF withdrawal in a manner that is not misleading. Questions that arise include:
♦ What information or Illustrative tables can best alert retirees to the risk of bombout in their individual case in a manner that is understandable and not misleading?
♦ Should QFMs impose a maximum withdrawal rate, possibly related to age and asset class? The danger with this suggestion is that the retiree could then draw the not unreasonable conclusion that any rate of withdrawal up to this maximum rate is
“safe”, i.e. will not lead to bombout. However if the initial withdrawal rate is set at a reasonable level, say 4% p.a., for equity or gilt backed investment, then the risk of bombout is reduced substantially.
♦ Should QFMs, in illustrating ARF withdrawal, be required to show only “real”
withdrawals, e.g. increasing at, say, 3% p.a., or always be required to show “real” in addition to level illustrations?
♦ The need for QFMS to conduct regular reviews of individual ARFs where withdrawals are being made regularly, as an “early warning system” to detect bombout risks on the horizon. QFMs might be required to suggest remedial action in such cases to the retiree, such as reducing the withdrawal or temporarily suspending withdrawals entirely.
Squandering retirement capital
There are two points of view on whether retirees exercising either of the new retirement options should be “protected” from themselves in some manner:
♦ The paternalistic viewpoint, which would only allow the new retirement options to individuals with very substantial retirement and other assets, and
♦ The non-interventionist viewpoint, that individuals who have accumulated retirement funds will not suddenly dissipate them in retirement, and even if they do then that is their choice.
The Minister for Finance, in introducing the new retirement options, said: “I do not subscribe to the view that pensioners cannot be trusted to invest their savings wisely and prudently.”16The Minister then went on to suggest that maybe five out of 100 retirees might behave irresponsibly with their retirement capital. He then said: “ Are we then to provide that the other 95 are discriminated against and have no control over their lives? This is nonsense perpetrated by many people of goodwill who are out of touch with reality.”
Two measures might provide some level of safeguard against the risk of rash use of retirement capital:
♦ If QFMs were required to deduct tax at source on all taxable withdrawals from ARFs and at retirement under the “take it as cash” option and a retiree were therefore faced with receiving, say, an immediate £54,000 instead of £100,000 gross, it might dissuade him or her from making a rash withdrawal decision.
♦ The proposed “secure income test” for retirees wishing to exercise either of the new retirement options would ensure that even if the retirement capital is squandered, the retiree will still have a “base” level of financial support for life, somewhat above the minimum Social Welfare level.
16 Committee 2nd Stage, Finance Bill, 16th February 1999
Exercising the new retirement options