A life annuity is a convenient way to reliably run-down savings in retirement. The annuity provider assumes the mortality risk (the probability of surviving for longer than expected) and the investment risk (the probability of earning less than expected). The annuitant can therefore count on receiving the annuity until death.
The trouble is that, given a choice, not many retirees choose to buy an annuity.
“[In the US] The first cohort with substantial amounts of unannutized pension wealth is now entering retirement…But rates of voluntary annuitization remain extremely low. Although a substantial literature shows that annuitization can be welfare enhancing…it seems likely that the vast majority of households will retain their pension wealth in unannuitized form and gradually decumulate it over their lifetimes.”
Most usually, retirees will not get advice but will use ‘rules of thumb’.
“We show that two of the rules of thumb that households might plausibly adopt -- spending the interest and dividends while preserving the capital, and consuming a fixed 4 percent of initial wealth – can be highly sub-optimal.”
One definition of ‘sub-optimal’ in this context is leaving an unintended bequest (not spending enough); another is running out of money before death. In the absence of insurance (an annuity), it isn’t possible to eliminate these risks so the aim should be to reduce them.
The Inland Revenue has an interest in this as it imposes tax penalties if drawdown rates are too low. The considerable tax breaks conferred on formal saving schemes during the accumulation and decumulation phases are intended to help retirees support themselves in retirement. The rules are expressed in ‘Required Minimum Distribution’ (RMD) tables where the minimums increase with age, reflecting the shorter expected payment periods involved. They will also automatically fluctuate with changing asset values.
“The RMD strategy generally results in drawdown rates that are “too low” resulting in a consumption path that, on average, increases with age.” That runs against experience that suggests the need for income tends to decline with age.
“In contrast, our optimal strategy results in an age-related decline in consumption, reflecting our choice of a utility function in which the coefficient of risk aversion is related to the intertemporal elasticity of consumption.”
The report notes that no account is taken of household preferences; what savers actually want to do with their money. For example, some US retirees might expect that their medical costs will increase with age.
“The extent to which the RMD level of consumption is too low also depends on the assumed level of asset returns. At lower anticipated returns, the RMD strategy will be less sub-optimal.”
PensionReforms understands why the government makes the RMD rules but it does illustrate just how involved governments need to become when they suggest how savers should save and what subsidies they might give to promote ‘acceptable’ behaviour.
In the end, retirees will use rules of thumb and probably will not seek professional help. They will probably leave unintended bequests which is not what retirement saving should be about. (File size 754 KB; 26 pp) 695