Most literature devoted to defined contribution schemes deals with the accumulation phase. The drawdown phase — when funds pay outc— gets much less attention.
That’s too bad, because surveys suggest that the biggest fear of pensioners is outliving their income. In this column I’ll outline four ways in which a lump sum can generate income that’s reasonably sustainable over a saver’s lifetime.
1. Buy a lifetime annuity
Buying a lifetime annuity used to be more or less a requirement in the UK until recently. Its advantages are that the income lasts for life, regardless of how long that may be, and that there is no cheaper way to guarantee any level of income for life. Why, then, do most people shun it?
One reason is that people instinctively compare the lump sum with the annual income. Meir Statman, a finance professor at the Leavey School of Business, eloquently recounts the regret of an annuity-purchasing friend, quoting him as saying, “Yesterday, I was a millionaire. Today I’m living on $79,700 a year” – and that was in the good old days of high interest rates.
A second reason is loss of control. The lump sum is gone and the deal is irreversible. Your portfolio flexibility has gone with it.
A third reason is that an annuity is effectively a fixed income investment. The ability to take some growth risk vanishes. And a fourth is that it may feel like a gamble: early death causes a huge loss.
As with most financial issues, there are trade-offs to be considered and the cheapest and most certain way of creating income for life will appeal to some and not others.
2. Draw down an amount each year based on your future longevity
This is a straightforward concept. Suppose you have £200,000 in your pension pot, and your predicted future longevity is 16.2 years. Divide the £200,000 by 16.2, and you get £12,346. That’s how much you draw down in the coming year.
If you live as long as predicted and earn no investment return, the annual £12,346 will last exactly the right length of time. Problem solved.
In fact, you can invest the money any way you like, with whatever combination of safety and growth you feel comfortable with. Since your drawdown left a balance (£187,654 if you withdrew the amount on the first day of the year), there will be some pension pot (the balance adjusted by the investment return) remaining at the end of the year. Let’s say the new balance is £190,000.
At the start of the next year you are one year older. You still have a future life expectancy, though it’s a now little bit shorter than 16.2 years. Let’s say it’s 15.5 years. Divide the £190,000 by 15.5, and withdraw £12,258. And so on.
There is always some balance in the pension pot. It never declines to zero as there is always some future life expectancy as long as you’re alive. And so the process continues (it’s a standard approach in the US.)
The advantages of this option are that it guarantees some income for life, and it permits whatever asset allocation you are comfortable with.
The main disadvantage is that the amount of income is both variable and uncertain, because there is no certainty to the future investment return that the pension pot will earn.
A second disadvantage is that over time, as future life expectancy decreases, the proportion of the pension pot withdrawn each year becomes large, depleting the pot faster and resulting in drawdowns that become much smaller later in life.
A partial solution is to add some number each year (such as six years) to the future life expectancy. Of course the drawdowns are smaller, but the decline later is not nearly as rapid.
3. Buy longevity insurance (a deferred annuity), and draw down an amount each year from your remaining assets that is designed to last until your longevity insurance kicks in
I will explain the third approach for the sake of completeness — even though it isn’t yet available in the UK. You pay a lump sum to purchase longevity insurance, which is an income for the balance of your life, commencing at some future date (the deferred date) if you are still alive then. For example, you’re 65 and pay a lump sum that guarantees that, if you reach the age of 85, you’ll get an income for as long as you live after that.
The balance of your pension pot only has to last until that deferred date. The financial impact of your longevity uncertainty has gone, and you have the simpler task of drawing down some regular amount from the pot until the deferred date.
The main benefit of this approach is that you pay relatively little for longevity protection, while preserving the control, flexibility and liquidity of maintaining the rest of your pension pot for drawdowns.
A disadvantage relative to buying an immediate annuity is that you implicitly pay more for your longevity protection.
Also, as with any approach where you maintain control of your pension pot, your drawdown will be variable and depends on the extent to which you seek growth for your pot’s assets, since growth is inevitably uncertain and variable.
4. Assume death at some advanced age and draw down an amount each year
In the final approach you essentially self-insure your longevity risk by choosing some advanced age (such as 95 or 100) and arranging your drawdowns to last until the end of that distant horizon.
This approach has the benefit of preserving control, flexibility and liquidity in your pension pot. The main disadvantage is that it’s the most expensive way to deal with longevity uncertainty, since you don’t pool your longevity risk with that of others. It’s like arranging to have sufficient assets to replace your home and its contents in the event of a fire, rather than paying an insurance premium.
I’ve set out the pros and cons of each approach so that you can decide which of them suits you best psychologically, before you find a professional to make the actual drawdown calculation.
Of course, you may find you’re unable to decide between, let’s say, two of these ways. Or that you prefer one and your partner prefers another. In that case, though, you could use both ways, dividing your assets.
Don Ezra is the former co-chairman of global consulting for Russell Investments worldwide, and the author of “Happiness: The Best is Yet to Come”