In a recent essay (“Investment Advice for Ray Kurzweil”), I extolled the benefits of the “1% Ratchet Rule” under which a family would spend each year 1% of the high-water mark of family wealth. The rationale for this rule is simply that it works for someone who plans to live forever, like Ray, or for those who want to build family wealth over multiple generations. In contrast, if you spend 2% or more of your maximum wealth each year then there is a significant probability of eventually running wealth down to zero. I understand that most people will not find the recommended rule attractive. For one thing, most people simply do not have sufficient wealth to make the strategy feasible. Also, not everyone is interested in adopting a very long-term planning horizon. Indeed, many people are content to “die broke.”
If you are willing to die broke, you can spend a lot more than 1% of your wealth each year.
A recent article1 promotes the idea of people converting their Defined Contribution Plans (“DC” plans, like savings plans or 401Ks) into Defined Benefit Plans (“DB” plans, like traditional pension plans or Social Security). The reason is that DB plans do a better job of hedging longevity risk, or the risk of outliving your savings. This is because DB plans generally pay out until death of the participant, so it is impossible to outlive your pension.
Meanwhile, a DC plan does not guarantee future benefits. The mechanism proposed for converting a DC into a DB plan is pretty simple: at retirement you purchase a portfolio of Treasury Inflation Indexed Securities (TIPS) that support inflation indexed spending for the first fifteen or twenty years of retirement and deferred life annuities that begin paying out at age 80 or 85, after the TIPS bonds have matured.
The beauty of this strategy is that it will enable annual spending of a substantial percent of wealth, much greater than the 1% Ratchet Rule. The exact percent of wealth that is feasible depends on TIPS yields and longevity assumptions, but even in today’s very low interest environment would be at least 5%. To see how it would work, suppose that you reach your retirement age of 65 with $1 million in investable funds and want this to support spending $50,000 each year, adjusted for inflation, the rest of your life. Even if TIPS yields are zero (like today), you can purchase for $750,000 a series of 15 TIPS bonds each with current face value $50,000 with maturities one through 15 years. Those purchases assure $50,000 of real spending for fifteen years. Next, for about $200,000 you can purchase an inflation-indexed deferred life annuity that begins making an inflation-adjusted payment (assuming fifteen years of two percent annual inflation, the initial payment would be 50,000*1.02^15=$67,293) on your 80th birthday, and continues paying each year until your demise. Thus, for less than $1 million you have secured a real payment stream of $50,000 for life. The “yield” is greater than 5%.
Expand Social Security!
One downside to the strategy is that many people are not comfortable with making large purchases of deferred life annuities. One reason for this may be concern for the credit-worthiness of the insurance company selling the annuities.
Here’s a solution for that problem – in addition to selling Treasury bonds, authorize the U.S. Treasury to sell actuarially fairly priced deferred life annuities. Effectively, this would allow people to buy more Social Security, except that unlike the pay-as-you-go Social Security program, the deferred annuity program would stand on its own, not requiring any subsidy.
Such a federal program would provide serious competition for private annuity providers. Since the alternative to selling annuities is to issue Treasury bonds, the effective “investment yield” on the Treasury issued annuities would be the Treasury bond yield. Private companies could compete by taking on riskier portfolio strategies and offering greater annuity payouts, albeit at greater risk of insolvency.
Naturally, if you commit all your resources to the TIPS-plus-deferred-annuity strategy, in order to maximize lifetime consumption, then you will end up dying broke. This is a feature not a bug. After all, any legacy or remaining wealth at time of death represents foregone consumption.
1Stephen Sexauer and Laurence Siegel, A Pension Promise to Oneself, Financial Analysts Journal, 2013.