Foolishness of the 4% rule

[Deleted User]

I intend to draw down much more than 2% - 3% as I don't intend being buried with a huge pension pot.... The excess you between what you draw and what you need could be placed in a SAS ISA, held in cash, put into rolling 5 year saving plans, 

This is a tax management strategy as opposed to safe withdrawal  strategy. An important topic but different from the topic of this thread. 

MK62

OldScientist said:

With a rate of 2.7% for a RPI annuity at 65 (with a 5 year guarantee that will not have a large effect at that age, see https://www.hl.co.uk/retirement/annuities/best-buy-rates) the actuaries appear to be expecting annualised inflation at about the 5% mark (if my rough calculations are correct) - so currently you are overpaying for inflation protection provided the BoE's target of 2% is met!

There's some safety margin built in, but don't forget the annuity providers slice of the action.......if that's equivalent to 2% pa, it's easier to hide that when rates are high......a lot more difficult when rates are lower, as they are today.

Nobody knows for sure of course......the next 30 years could turn out to be the worst ever period for retirees relying on drawdown, in which case, today's annuities could end up looking good........but if those years turn out to be "average", then I suspect today's annuity purchasers might feel that with hindsight it might have been better to go down the drawdown route.

No guarantees either way though.

Personally, at the rates currently on offer, I wouldn't go near an annuity at the moment.........but then I'm not as risk averse as some.

[Deleted User]

OldScientist said:

Deleted_User said:

MK62 said:

Deleted_User said:

MK62 said:

Deleted_User said:

Suspect that a lot of people who look at a constant level of expenditure from invested portfolio are extremely conservative and leave large unspent portfolios.  

For someone focused on ensuring a guaranteed minimal level of expenditure and not having enough DB income, use of a portion of the portfolio to buy annuities is the only way of ensuring this minimal level of expenditure.  The balance can then be both invested and used more aggressively.  In practice this strategy would translate in retiree’s ability to safely spend a lot more, even though annuities are unpopular. 

......though after buying the annuity to fund his/her minimal level of expenditure, this retiree may not have enough left to "safely spend a lot more".

Given that people seem to be brave enough to only withdraw 2 or 3% of their investments, an annuity would jack up their safe incomes by quite a bit. 

How so?

Given that 3% of eg £500k gives an income of £15k pa........how does buying an annuity "jack up" the safe income "by quite a bit"?

An RPI linked annuity, at 60, to supply a starting income of £10k pa, would currently cost a little under £500k.......there'd be very little left to cover the shortfall, let alone any increase.

RPI linked annuities are rare and non-competitive.  Should not be used.  Products worth buying are level annuities.  You use the remainder of portfolio which stays invested to deal with inflation.  Another option is escalating annuity with payments increasing by the same 1 or 2%. And keep in mind that statistically retirees spend less as they get older so inflation might not even be an issue in practical terms - but I wouldn’t want to rely on this statistics. 

Starting life annuity at 20, 30, 40, 50 or 60 is kinda silly.  Anything can be made look absurd using this approach.  You can however buy an annuity at 60 to start at 65 or 70 or 75.  Then you get extra mortality credits as well as investment growth over the period before payments start. 

With a rate of 2.7% for a RPI annuity at 65 (with a 5 year guarantee that will not have a large effect at that age, see https://www.hl.co.uk/retirement/annuities/best-buy-rates) the actuaries appear to be expecting annualised inflation at about the 5% mark (if my rough calculations are correct) - so currently you are overpaying for inflation protection provided the BoE's target of 2% is met! Under those conditions, an annuity with a 3% escalation with a rate of 3.3% at least looks more reasonable. A possible rule of thumb (as if we didn't have enough of those!) is that if the annuity rate is greater than your intended withdrawal rate, then purchase may be useful (since it will then reduce the amount required to be withdrawn from the portfolio). So, if your target withdrawal was 4%, then a level annuity might be OK from 60 (rate is 4.2%), while one with 3% escalation meets the rule of thumb from 70 (4.1%). If your spend target is 3%, then an annuity with 3% escalation meets the rule of thumb at 65 (since the rate is 3.3%).

Level annuities may be useful for covering relatively short periods (since inflation doesn't have too much time to operate) - the median annualised inflation rate over 30 year periods in the US is around 3% (sorry, I don't have the UK figures to hand), so a level annuity bought at 65 would be worth about 40% of its original value in real terms by the time the annuitant was 95 (this average might explain the popularity of 3% escalations).

Purchasing annuities over several years (e.g. at ages 65, 70, 75, etc.) can also make sense (e.g. see Milevsky and Young, Annuitization and asset allocation, 2007 who said  where “annuitization can take place in small portions and at anytime, we find that utility-maximizing investors should acquire a base amount of annuity income (i.e. Social Security or a DB pension) and then annuitize additional amounts if and when their wealth-to-income ratio exceeds a certain level”.

Annuities are certainly not the bargain they were even 30 years ago with increases in life expectancies of about 20% for 65 year old males and decreases in interest rates. For example, according to Cannon and Tonks, UK annuity price series, 1957–2002, 2004, a 65 year old male would have got a level annuity with 5 year guarantee at a rate of 13.8% in 1990 and 8.5% in 2000 compared to the 4.9% now available.

Lots of good points.  

I question 3% escalation - seems too high  to be a good deal. We are moving into investor - specific scenarios. Someone who only needs to spend a small portion of his portfolio on an annuity to cover outstanding minimum income needs wouldn’t need any escalation at all. Equities provide long term inflation protection. Then there is the whole question of spending actually declining with age (eg as people stop travelling) so arguably there is no need for any inflation protection. And one could get into more complex strategies like annuity ladders.

Saying “annuities are poor value compared to 1990s” requires context.  Annuities represent fixed income portion of the overall portfolio. In 1990s you could buy inflation protected government bond providing 5% real return for 30 years.  What are your options for fixed income today? I’d say in relative terms annuities are more attractive than in the past. 

[Deleted User]

There's some safety margin built in, but don't forget the annuity providers slice of the action.......

They make profit but their costs are much lower than if you were to try and do what they do.  They buy bonds at much lower cost because of their size.  They buy bonds with longer terms and better rates because their duration is much longer than yours.  And then you get mortality credits which yu don’t get with bonds. Last but not least, you don’t know your duration and therefore have to be conservative. They can shoot for averages and provide you with a guarantee. 

Thrugelmir

Deleted_User said:

There's some safety margin built in, but don't forget the annuity providers slice of the action.......

They buy bonds at much lower cost because of their size.  They buy bonds with longer terms and better rates because their duration is much longer than yours.  

Active fund managers benefit likewise. Passive fund managers are forced to buy expensive stocks when they enter an index. The investors then suffer the loss. 

Malthusian

For years the only purpose of RPI-linked annuities has been to enable people to calculate the value of a DB pension at "open market rates" so they can point out how valuable they are.

I have never encountered one in the wild (though plenty of level annuities). Due to how long it takes to make up the income forgone, combined with the fact that expenditure generally decreases as you get older, they don't make sense for anybody. Unless you are so terrified of running out of money that the only difference an annuity makes is how much money you have available to stuff into shoeboxes.

Thrugelmir

Malthusian said:

For years the only purpose of RPI-linked annuities has been to enable people to calculate the value of a DB pension at "open market rates" so they can point out how valuable they are.

I have never encountered one in the wild (though plenty of level annuities). Due to how long it takes to make up the income forgone, combined with the fact that expenditure generally decreases as you get older, they don't make sense for anybody. Unless you are so terrified of running out of money that the only difference an annuity makes is how much money you have available to stuff into shoeboxes.

Some people will prefer the security of a rising income rather than that of watching a diminishing pot. If you've no one to leave your estate too. Returns on investments are far from being inflation linked though many believe them to be. 

Thrugelmir

Here's a link to the MSCI PIMFA Private Investor Income Index.  Doubt many people weight their portfolio's anywhere close to this . 

https://www.msci.com/documents/1296102/16246671/MSCI+PIMFA+Private+Investor+Income+Index-Sept'19.pdf/4741d908-d614-8479-003c-3dae447437d5

[Deleted User]

Malthusian said:

For years the only purpose of RPI-linked annuities has been to enable people to calculate the value of a DB pension at "open market rates" so they can point out how valuable they are.

I have never encountered one in the wild (though plenty of level annuities). Due to how long it takes to make up the income forgone, combined with the fact that expenditure generally decreases as you get older, they don't make sense for anybody. Unless you are so terrified of running out of money that the only difference an annuity makes is how much money you have available to stuff into shoeboxes.

Hardly anyone sells RPI linked annuities so they are not competitively priced.  Seem to be used primarily to claim that “annuities are bad”. 

OldScientist

Deleted_User said:

OldScientist said:

Deleted_User said:

MK62 said:

Deleted_User said:

MK62 said:

Deleted_User said:

Suspect that a lot of people who look at a constant level of expenditure from invested portfolio are extremely conservative and leave large unspent portfolios.  

For someone focused on ensuring a guaranteed minimal level of expenditure and not having enough DB income, use of a portion of the portfolio to buy annuities is the only way of ensuring this minimal level of expenditure.  The balance can then be both invested and used more aggressively.  In practice this strategy would translate in retiree’s ability to safely spend a lot more, even though annuities are unpopular. 

......though after buying the annuity to fund his/her minimal level of expenditure, this retiree may not have enough left to "safely spend a lot more".

Given that people seem to be brave enough to only withdraw 2 or 3% of their investments, an annuity would jack up their safe incomes by quite a bit. 

How so?

Given that 3% of eg £500k gives an income of £15k pa........how does buying an annuity "jack up" the safe income "by quite a bit"?

An RPI linked annuity, at 60, to supply a starting income of £10k pa, would currently cost a little under £500k.......there'd be very little left to cover the shortfall, let alone any increase.

RPI linked annuities are rare and non-competitive.  Should not be used.  Products worth buying are level annuities.  You use the remainder of portfolio which stays invested to deal with inflation.  Another option is escalating annuity with payments increasing by the same 1 or 2%. And keep in mind that statistically retirees spend less as they get older so inflation might not even be an issue in practical terms - but I wouldn’t want to rely on this statistics. 

Starting life annuity at 20, 30, 40, 50 or 60 is kinda silly.  Anything can be made look absurd using this approach.  You can however buy an annuity at 60 to start at 65 or 70 or 75.  Then you get extra mortality credits as well as investment growth over the period before payments start. 

With a rate of 2.7% for a RPI annuity at 65 (with a 5 year guarantee that will not have a large effect at that age, see https://www.hl.co.uk/retirement/annuities/best-buy-rates) the actuaries appear to be expecting annualised inflation at about the 5% mark (if my rough calculations are correct) - so currently you are overpaying for inflation protection provided the BoE's target of 2% is met! Under those conditions, an annuity with a 3% escalation with a rate of 3.3% at least looks more reasonable. A possible rule of thumb (as if we didn't have enough of those!) is that if the annuity rate is greater than your intended withdrawal rate, then purchase may be useful (since it will then reduce the amount required to be withdrawn from the portfolio). So, if your target withdrawal was 4%, then a level annuity might be OK from 60 (rate is 4.2%), while one with 3% escalation meets the rule of thumb from 70 (4.1%). If your spend target is 3%, then an annuity with 3% escalation meets the rule of thumb at 65 (since the rate is 3.3%).

Level annuities may be useful for covering relatively short periods (since inflation doesn't have too much time to operate) - the median annualised inflation rate over 30 year periods in the US is around 3% (sorry, I don't have the UK figures to hand), so a level annuity bought at 65 would be worth about 40% of its original value in real terms by the time the annuitant was 95 (this average might explain the popularity of 3% escalations).

Purchasing annuities over several years (e.g. at ages 65, 70, 75, etc.) can also make sense (e.g. see Milevsky and Young, Annuitization and asset allocation, 2007 who said  where “annuitization can take place in small portions and at anytime, we find that utility-maximizing investors should acquire a base amount of annuity income (i.e. Social Security or a DB pension) and then annuitize additional amounts if and when their wealth-to-income ratio exceeds a certain level”.

Annuities are certainly not the bargain they were even 30 years ago with increases in life expectancies of about 20% for 65 year old males and decreases in interest rates. For example, according to Cannon and Tonks, UK annuity price series, 1957–2002, 2004, a 65 year old male would have got a level annuity with 5 year guarantee at a rate of 13.8% in 1990 and 8.5% in 2000 compared to the 4.9% now available.

Lots of good points.  

I question 3% escalation - seems too high  to be a good deal. We are moving into investor - specific scenarios. Someone who only needs to spend a small portion of his portfolio on an annuity to cover outstanding minimum income needs wouldn’t need any escalation at all. Equities provide long term inflation protection. Then there is the whole question of spending actually declining with age (eg as people stop travelling) so arguably there is no need for any inflation protection. And one could get into more complex strategies like annuity ladders.

Saying “annuities are poor value compared to 1990s” requires context.  Annuities represent fixed income portion of the overall portfolio. In 1990s you could buy inflation protected government bond providing 5% real return for 30 years.  What are your options for fixed income today? I’d say in relative terms annuities are more attractive than in the past. 

You're absolutely right about investor-specific scenarios - how important the failure of taking 4% of your portfolio (if you were to follow that approach) rather depends on how much of your essential spend is covered by other income (DB, SP, or annuities).

The decline in spend (that appears to be well documented in both the US, e.g. https://www.kitces.com/blog/safe-withdrawal-rates-with-decreasing-retirement-spending/, which would include both care and health care costs, and the UK, https://ilcuk.org.uk/wp-content/uploads/2018/10/Understanding-Retirement-Journeys.pdf, which would include care costs) is a tricky one - I've modelled this broadly reproducing the answers given in the Kitces blog - an extra 0.5% at the beginning of retirement, may be quite useful. What I have not yet seen is a similar approach with the variable withdrawal methods (e.g. VPW tells you how much you could withdraw, but if you don't need it all then some could stay in the portfolio). 

I was thinking that the difference between a typical annuity rate and the 4% withdrawal rate has got much smaller since the 90s and, I suspect, this is what puts people off from buying them (and transferring DB pensions).