The Mortgage Professor: Another Desirable Feature Of A Retirement Plan: A Set-Aside

By Jack Guttentag
The Mortgage Professor

WWR Article Summary (tl;dr) As Jack Guttentag reports, “Retirement management is largely a seat-of-the-pants process. The only exception seems to be the 4 percent rule, which says that a retiree can draw 4 percent of her financial assets every year, plus an annual inflation adjustment, without ever running out.”


A recent column I wrote on retirement (“What should you look for in a retirement plan?”) indicated that in order to assure that a retiree will not run out of money at an advanced age, a primary retirement objective, most plans should contain an annuity.

In this column I will discuss a second major objective of retirement plans that is often ignored: not leaving more or less money in the estate than the retiree would have chosen if she knew in advance the day of her death.

To meet this objective, a retirement plan can include a set-aside, which is an amount targeted for the retiree’s estate.

Bequests Under the 4 Percent Rule
Retirement management is largely a seat-of-the-pants process. The only exception seems to be the 4 percent rule, which says that a retiree can draw 4 percent of her financial assets every year, plus an annual inflation adjustment, without ever running out. The rule in effect ignores objective two in order to meet objective one. The result will often be an estate substantially larger than the retiree would have chosen otherwise.

Consider a female retiree of 62 with a nest egg of $2 million, half in common stock and half in interest-bearing securities. If her portfolio earns a return of 8.1 percent, her estate will receive $4.9 million if she dies at 82, $8.7 million if she dies at 92, and $16.6 million if she dies at 102. The probability of a return of 8.1 percent or higher is about 50 percent, based on that being the median return over 745 25-year periods during 1926-2012.

Note that in a worst case where the rate of return falls to 3.6 percent, the 4 percent rule fails both objectives, running dry at age 95. The estimated probability of this occurring, based on the same historical data-base, is 2 percent.

Bequests in RIS: The Set-Aside
RIS stands for Retirement Income Stabilizer, which is the retirement planning model I have been developing with Allan Redstone. The retiree using RIS allocates a portion of her financial assets to the purchase of a deferred annuity and draws the remainder as spendable funds during the deferment period. At the end of that period, her assets are gone and her spendable funds thereafter come from the annuity. Her estate receives nothing from the plan, unless she includes a set-aside.

RIS thus forces the retiree to decide, at the time the plan is adopted, how much of her wealth will be set aside for her estate. The set-aside amount can accumulate interest, and the decision is not irrevocable, as we shall see.

If the female retiree of 62 in our example uses RIS to purchase a 10-year deferred annuity with an annual 2 percent inflation adjustment but without a set-aside, and if the rate of return on her financial assets is 8.1 percent, her monthly spendable funds will begin at $8,282 and rise by 2 percent a year until she dies. After 10 years, the source of the funds will change, from asset withdrawals to the annuity. If she dies after 10 years, her estate will receive nothing from the plan.

Assuming that the retiree elects to set aside $250,000 for her estate, her monthly draw amount will drop from $8,282 to $7,247, rising by 2 percent a year. The value of the set-aside will grow over time, at 8.1 percent it will reach $1 million when she hits 81 and $2 million at 89. She would be free, of course, to draw on some of that herself as it is her money!

The Set-Aside in a Worst Case
A retirement plan should always consider how the plan would work, or not work, in a worst case. The worst case used here is a return on assets of 3.6 percent. Only 2 percent of the 745 25-year periods during 1926-2012 had returns of 3.6 percent or less. I continue to assume a set-aside of $250,000.

The worst case generates a decline in monthly spendable funds during the 10-year deferment period from $7,247 to $5,506. In month 121, the annuity kicks in at with a starting payment of $8,834. The Set-Aside survives the worst case, though it does not grow as rapidly. At age 73, the set-aside is $359,000 and at 83 it is $509,000.

The retiree in a worst case has another option regarding the set-aside. She could use it to offset the decline in spendable funds during the deferment period. If she did that, the set-aside would no longer go to her estate. That is a personal decision to be made when and if the worst case happens, which it probably will not.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

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