Balancing increased longevity and retired lifestyle

Retirees face a delicate trade-off between enjoying their desired post-retirement lifestyle and reducing longevity risk.

A retirement income portfolio that contains stocks and bonds is sensitive to sustainable withdrawal rate. This is the rate at which retirees can withdraw required amount from their portfolio every year and yet have enough assets to meet their desired post-retirement lifestyle. The question is: What is the maximum withdrawal rate that balances longevity risk and desired lifestyle?

This article discusses return sequencing and how it affects longevity risk. It shows how retirees can arrive at a maximum withdrawal rate to moderate longevity risk.

The objective of a retirement income portfolio is to enable a retiree draw cash flows from it to sustain her desired post-retirement lifestyle. Large withdrawal each year could deplete the portfolio, leading to longevity risk: The risk that a retiree may outlive her portfolio.

Longevity risk arises because cash flow generated from the retirement income portfolio through dividends and interest income is not enough to sustain a retiree's desired lifestyle. This forces retirees to generate cash by selling portfolio assets.

Consider two scenarios. In scenario 1, the portfolio generates 10 per cent loss in year 1 followed by 10 per cent gain in year 2. In scenario 2, the portfolio generates 10 per cent gain in year 1 followed by 10 per cent loss in year 2. A simple calculation shows that the portfolio value in scenario 1 will be lower than that in scenario 2; the difference in value amounts to one-fifth or 20 per cent of the yearly consumption.

This example conveys that sequencing of returns is important for a portfolio — 10 per cent loss followed by 10 per cent gain would require the portfolio to generate 11 per cent just to recover capital. Whereas 10 per cent gain followed by 10 per cent loss requires only a return of 9 per cent to recover the losses. And this difference could widen with time, increasing the retiree's longevity risk.

The question is: How can retirees moderate this risk through withdrawal rate?

Suppose the retiree cashes her retirement portfolio and buys an immediate annuity for life. This instrument removes longevity risk as the cash flows are sustainable — the annuity pays a certain sum till the retiree's death.

But most retirees do not prefer to have only annuities in their portfolio. We assume that a retiree allocates her money equally to stocks, bonds and annuities. Note that this portfolio has the same initial value as the purchase price of the annuity. A retiree's yearly withdrawals from this portfolio can be, hence, equal to the yearly payment on the annuity.

Consider an immediate-pay annuity purchased for Rs 30 lakh that pays Rs 25,000 a month, translating into a 10 per cent rate (3 lakh/30 lakh). This should be the maximum sustainable withdrawal rate on the stock-bond-annuity portfolio as well. Why? Both portfolios have same value today. And if annuity paying that amount can survive for life, so should the stock-bond-annuity portfolio having the same withdrawal rate.

Unlike annuity, the stock-bond-annuity portfolio is subject to downside risk. But it also contains upside potential. It would be optimal to set-up a side-pocket account to hold exposure to money market mutual funds.

In the years when the portfolio generates more returns than the maximum sustainable withdrawal rate, the retiree can transfer the money to the side-pocket account. This money can be used during later years when the portfolio's returns are lower than the maximum sustainable withdrawal rate.

Most retirees prefer to carry equity and bonds along with annuities in their retirement income portfolio. This forces them to adopt a sustainable withdrawal rate to balance their lifestyle expenses with longevity risk.

Benchmarking a stock-bond-annuity portfolio with a pure-annuity portfolio helps in “fixing” the sustainable withdrawal rate.

The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor learning solutions. He can be reached at >

Read the rest of this article by Signing up for Portfolio.It's completely free!

What You'll Get


This article is closed for comments.
Please Email the Editor