###### CERF Blog

A typical piece of financial advice is to reduce your equity allocation as you age. When you are young, there is plenty of time to recover from a market debacle. Not so much if the debacle occurs after you are already retired. One rule of thumb is that your equity allocation should be 100 minus your age. For example, if you are 70 years old this rule suggests a 30% equity allocation. For risk averse people, even 30% might be too high.

How much of your accumulated wealth can you comfortably spend each year in retirement? This depends on your likely longevity and market rates of return. If your primary allocation is in fixed income, then in today’s environment your prospective after-tax rate of return is probably no more than 1%. Given 1% rate of return, how much can you spend each year?

Well, that is a time value of money question that is easily handled. All you need to know is when you are going to die. Here are a few computations

Life Expectancy | 10 | 15 | 20 | 25 | 30 | 35 | 40 |

Annual Rate of Return | 1.0% | 1.0% | 1.0% | 1.0% | 1.0% | 1.0% | 1.0% |

Annual Spend % | 10.6% | 7.2% | 5.5% | 4.5% | 3.9% | 3.4% | 3.0% |

So, let’s suppose at age 65 you have accumulated a fortune of $1,000,000. The table says that at 1% rate of return you can spend $55,000 per year for 20 years, or $39,000 per year for 30 years, or $30,000 for 40 years.

If you are pretty comfortable you will die in 10 years, you can spend $106,000 each of those glorious years. If you are not certain of dying in 10 years, then spending $106,000 each year would be very risky.

A more conservative strategy would be to spend $30,000 per year; you will run out of money only if you live past 105. But you can do a lot better than this.

A nice way to eliminate the risk of living too long is to invest in life annuities. An attractive seller of life annuities is TIAA-CREF, the investment company that handles college educator pensions. TIAA-CREF is a very highly rated company (which is very important if you are buying a life annuity) that seems to favor transparency and simplicity. You can go to their website and easily determine the “yield” or spending rate that is offered by a life annuity. For readers not familiar with life annuities, the simplest version means that you receive a constant monthly or annual payment stream until you die. This is called a straight annuity. There are much more complex variants that offer protection against dying too early, or partial participation in equity market advances, but I’m focusing here on the basic product.

Naturally, the cost of a life annuity depends heavily on your age. According to the TIAA-CREF website, the upfront one-time cost of a $1 lifetime annual payment stream for an adult male is as follows:

Age 60 65 70 75 80

Cost of $1 Annuity $20.00 $18.20 $16.00 $12.50 $10.00

Today, a 65-year old male can purchase a $1 payment stream for life for an upfront cost of $18.20, or a “yield” of 5.5% (1/18.20).

Thus, assuming this fellow had $1 million, he could purchase a lifetime stream of $55,000 per year. If he is in good health his life expectancy is probably 25 years. Compared to the time value of money calculation above, this looks like a pretty good deal. Naturally, his heirs will get none of the $1 million, even if he dies very soon after purchasing the annuity. But if the chief concern is maximizing lifetime consumption and eliminating the risk of running out of money, the life annuity could be a winner.

What about the individual who aims to build family wealth? That individual would surely not be interested in allocating 100% to life annuities, but perhaps a partial allocation would be sensible, particularly in light of the current low level of bond yields. Consider an individual with a $5 million portfolio and desired annual spending of $100,000. This spending goal could be achieved by devoting a fairly small portion of the portfolio to a life annuity and then allocating the remainder largely to equities.

Given the annuity prices above, we can calculate what percentage of wealth is required to purchase an annuity that covers 100% of the spending goal. Since the cost of an annuity declines with age, the percentage of your portfolio required to produce a given income stream also declines with age.

Age Percent of wealth required to purchase a 2% of wealth annuity

60 40%

65 36%

70 32%

75 25%

80 20%

To see the logic of this table consider the 60-year old. The “yield” on a life annuity at age 60 is 5.0%. In order to achieve an annuity equal to 2% of wealth, the 60-year old would have to allocate 40% of wealth (.02 = .05*.40) to the annuity. Similarly for the other ages.

The “100-Age” Rule would suggest an equity allocation of 20% for an 80-year old. However, using annuities and assuming 2% of wealth is the spending goal, purchasing a life annuity would enable an 80% equity allocation. 80% at 80! Even at age 65 the annuity looks like a decent deal. You can lock in your $100,000 spending goal with just 36% of your wealth, leaving a large fraction of the portfolio available to be invested in equities, hopefully to appreciate greatly in future decades.