Today’s classic withdrawal rate study is Moshe A. Milevsky and Alexandra C. Macqueen’s 2010 book, Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income for Life. Though the book was written specifically for Canadian audiences, it is fairly accessible for all once you figure out a few Canada-specific acronyms for retirement planning.
As The Economist recently said quite eloquently, “defined-benefit, or final-salary, pensions are going the way of the dodo.” These pensions guarantee lifetime income, but fewer and fewer employees have access to them anymore. And even many employees who did have access to them found out that their employers have cancelled their promises. A defined-contribution pension is not the same thing, because employees bear all the investment risk with these.
This book has one simple message: in order to have a more comfortable retirement with less worries about money matters, it is important for retirees to “pensionize” at least part of their nest eggs. This means that rather than relying only on systematic withdrawals from their retirement savings (which has been the subject of all my past research), retirees must decide how much of their nest egg to annuitize. Macqueen’s employer holds a trademark on “pensionize,” which they define as using a part of your savings to create a guaranteed monthly income that lasts for the rest of your life. Though the term “pension” now applies to many things, the authors argue that a true pension involves a binding contract, a guarantee, and a pledge. As fewer people have these through their workplaces anymore, the point of the book is to explain why it is so important that retirees make the effort to purchase a true pension for themselves from a respectable insurance company.
To see this better, understand that retirees face three main risks, and they have access to 3 types of products. The risks are:
1. Longevity risk: you don’t know how long you will live and while it is great to live longer, it is also costly.
2. Sequence-of-returns risk: Retiring at the start of a bear market is very dangerous because your wealth can be depleted quite rapidly and your ability to return to the workforce may be limited.
3. Inflation risk: retirees face the risk that inflation will erode the purchasing power of their savings as they progress through retirement.
And to deal with these risks, there are three types of retirement products:
1. Annuities: This product provides a guaranteed income for life. It protects from longevity and sequence-of-returns risk, and it can protect from inflation risk if a real annuity is purchased. But annuities do not provide any growth potential or potential to leave an inheritance, and in general they are not liquid if more funds are needed for an emergency. [Social Security and employer defined-benefit pensions also fit into this category]
2. Systematic Withdrawals from Savings: Retirees can put together an investment portfolio of stocks, bonds, and other assets with the intention of regularly withdrawing funds to spend in retirement. This is what the “safe withdrawal rate” literature is about. This approach doesn’t protect from longevity risk or sequence-of-returns risk, and it only protects from inflation risk if asset returns can keep up with inflation. The benefits of this approach include that it provides potential to keep one’s nest egg growing and leave a large inheritance as well as providing liquidity.
3. Guaranteed Lifetime Withdrawal Benefits: These are a mix between annuities and systematic withdrawals. When markets are down, these provide a guaranteed return. When markets are up, these share some of the upside, but not the full amount due to the expenses of providing the downside guarantee.
With three risks and three products, the questions then become (1) how to choose the optimal allocation between these three products, and to the extent that it is permissible, (2) how to choose the optimal asset allocation within each product?
The book provides a framework for thinking about how to do this, and I will come back to this issue again some day with a “Part 2” for this review.