SYSTEMATIC WITHDRAWALS, LIFE ANNUITIES AND INVESTMENTS MARK J. WARSHAWSKY, PH.D., PRESIDENT, RELIAS LLC AUTHOR, RETIREMENT INCOME: RISKS AND STRATEGIES JANUARY 10, 2014 Comparing and Designing Strategies for Lifetime Income and Asset Management for Retirees With 401(k) Accounts/IRAs

SECURITY AND FLEXIBILITY IN RETIREMENT Workers in baby boom generation increasingly rely on DC plans and IRAs as their primary source of retirement financing outside of Social Security Disciplined lifetime withdrawal is being lost with the decline of traditional DB plans A sound strategy is needed for DC plan participants  To generate a reliable lifetime flow of retirement income  To preserve some wealth for varied liquidity needs (e.g., family emergency) and bequest Focus of this presentation  Compare the performance of several existing and possible products and strategies in retirement, by evaluating the trade-offs between income security and wealth preservation, in inflation-adjusted terms  Put forward a good strategy that is efficient, low risk, robust and strikes a reasonable balance between income and wealth, while emphasizing the former  Use a methodology which is comprehensive and scientific, based on solid research, to determine the “best” or “optimal” strategy designed for each retired household Based directly on Chapters 5 and 7 of my book, Retirement Income: Risks and Strategies, 2012, MIT Press (also influenced by Chapters 4 (participant survey) and 6 (formal theoretical economic model)), and also based on our paper, “Retirement Income Strategies in Expected Utility and Loss Aversion Frameworks” 2

COMPARING SOME STRATEGIES FOR INCOME MANAGEMENT IN RETIREMENT Strategy 1. Systematic withdrawals from account balances invested in mutual funds (personal endowment)  Fixed percentage withdrawal from balances of a mix of mutual funds – does not exhaust wealth entirely, as “Bengen rule” fixed dollar approach commonly used by financial advisors might  Liquidity to investors and upside potential  Income fluctuates with investment performance (and, in real terms, with inflation) Strategy 2. Fixed payout income immediate life annuity (SPIA)  One-time purchase at retirement with all retirement account wealth  Fixed level of nominal income for life guaranteed  “Traditional” problems: extra cost owing to adverse selection of mortality risks, illiquidity, timing risk in the purchase price due to changing interest rates 3

COMPARING SOME STRATEGIES FOR INCOME MANAGEMENT IN RETIREMENT (CONT.) Strategy 3. Immediate variable life annuity (IVA)  One-time purchase at retirement with all wealth, but no pricing risk  Underlying mutual funds selected by investors, within menu offerings  Income for life, fixed in units, but variable with investment performance  Wealth and liquidity needs not serviced Strategy 4. Deferred variable annuity plus guaranteed minimum withdrawal benefit rider (VA+GMWB)  One-time purchase at retirement with entire account balance  Underlying mutual funds selected by investors, within offerings and limits  Variable income for life, but nominal level no lower than GMWB  GMWB is a certain fixed percentage of the guaranteed income base (GIB), which is non-decreasing; amount can step up on the GMWB rider anniversary if the investments perform well  Basic death benefit with remaining account value paid to beneficiaries or withdrawn by account holder 4

COMPARING SOME STRATEGIES FOR INCOME MANAGEMENT IN RETIREMENT (CONT.) Strategy 5. Mix of systematic withdrawals from account with mutual funds and fixed payout immediate life annuity, one-time wealth split at retirement  Mutual funds give liquidity, flexibility, and opportunities for realization of equity premium (higher return)  Fixed life annuity guarantees a (nominal) consumption floor  Actual real income fluctuates with investment performance and inflation Strategy 6. Mix of systematic withdrawals from account and fixed payout immediate life annuity, gradual annuitization at certain ages (ladder)  Start with all (or almost all) wealth in mutual funds, shift to life annuities with age, and complete annuitization (full or partial) by certain age  Help ease the impact of annuity rate fluctuations (dollar cost averaging)  Help circumvent the psychological obstacle to the (irreversible) purchase of life annuities  “Mortality credit” increases with age of life annuity purchases, overcoming “extra costs”  Provides an “option” to stop annuitization mid-stream if personal circumstances (e.g. health) change  Potentially greater wealth creation and certainly more account availability prior to complete annuitization  Even with nominal annuities, laddering gives some degree of inflation hedge 5

ASSUMPTIONS UNDERLYING FIRST-STAGE ANALYSIS OF STRATEGIES – ASSET AND ANNUITY ALLOCATION AND MORTALITY Investor’s risk preference represented for this initial stage of analysis: equal proportion (50-50) of account between high-risk assets (equity) and low-risk assets (bonds and/or life annuities) With account being annuitized, the equity share increases (up to 100%) to maintain same overall risk exposure (based on result from Chapter 6) One-time split of wealth in Strategy 5: 70% in mutual funds and 30% in fixed payout life annuity Gradual annuitization in Strategy 6: start with 100/0 fund/annuity split at age 65 and reach full annuitization at 75, for example Investors retire at 65 with initial wealth of $1m, die at 100 if not earlier, with mortality based on unisex mortality table for general population (unisex table is legal requirement for qualified retirement plans) 6

STOCHASTIC SIMULATIONS AND OTHER STRATEGY CONSIDERATIONS Model only qualified plan/IRA accounts – distributions and annuity payouts are taxable income Asset returns and inflation and annuity pricing modeled using an estimated stochastic system (VAR, Campbell specification), based on data Used 2008 retail price and product information in this stage of analysis, but results are maintained if fees/costs are changed proportionately, e.g. for institutional pricing Mutual fund management expense ratio: 1.20% Mortality, expense & admin. fees on VAs (M&E&A): 1.20% GMWB rider fee: 0.60% Immediate life annuity conservatively priced with load, Treasury yields, and annuitant mortality GMWB lifetime distribution guarantee is 5% GMWB features have tightened considerably since

INITIAL MEASURES OF SUCCESS AND RISK Measures A – probability distribution of income levels and also shortfall risk among those still alive  Income amount = 5% of mutual fund balance or of GIB, and/or annuity payout  Average, 50th percentile (median, most likely), 5th percentile (bad), and 95th percentile (good) outcomes  Income shortfall risk – likelihood of income falling below $45k (slightly below nominal guarantee by GMWB at initial age) Measure B – probability distribution of account balances among those still alive  Wealth balance = mutual fund balance or account value  Average, most likely, bad, and good outcomes All values are adjusted for stochastic realizations of inflation 8

RESULTS: STOCHASTIC OUTCOMES OF REAL INCOME ACROSS STRATEGIES 9

RESULTS: PROBABILITY OF REAL INCOME FALLING BELOW $45,000 10

RESULTS: STOCHASTIC OUTCOMES OF REAL ACCOUNT BALANCES ACROSS STRATEGIES 11

PRELIMINARY CONCLUSIONS Systematic withdrawals from mutual funds have opportunities for greater wealth at the risk of investment losses and income shortfalls Wealth needs aside, fixed and variable immediate life annuities distribute the highest lifelong incomes VA+GMWB somewhat addresses both income and wealth needs but is hampered by high fees Strategy of mutual fund withdrawals + laddered fixed life annuities works like VA+GMWB but provide more flexibility in the choice between income security and maximization and wealth preservation, and lower cost Contract terms, especially fees, are important More research next on advanced optimal strategies “Best” or “Optimal” in an analytical sense needs a formal framework for what is considered better (higher welfare) for the individual or household 12

OPTIMAL STRATEGIES FOR LIFETIME INCOME AND ASSET MANAGEMENT IN RETIREMENT 13

“LOSS AVERSION” METHODOLOGY AND ASSUMPTIONS Focus hereafter on strategies “5” and “6” – combination of systematic withdrawals and initial and gradual /laddered purchases of single-premium immediate life annuities In this second “middle” stage of our analysis, loss aversion framework minimizes the combined probability of real income falling below $45k, and real balances falling below $250k, based on $1M portfolio at age 65, for unisex individual, or couple, with emphasis on income Asset mix set is originally at 50/50, but as SPIAs are purchased, remaining investment portfolio is moved to equities For couples, J & 75% S annuities are purchased and income goal is cut when widowed Stochastic modeling is as before, but now updated to 2009 and possibility of economic collapses is added, lowering expected returns Search over rate of systematic withdrawals from account (0 to 10%), and annuitization schedule (from 5 to 35 years, with life annuity share at beginning and end in 5% increments). 14

RESULTS FOR LOSS AVERSION APPROACH 15 Real $00095 th percentile 50 th percentile 5 th percentileMeanStd. Dev. Shortfall Prob. (%) A. Life annuity ladder plus systematic withdrawal Balance Income B. No annuity, equity-bond mix Balance Income C. No annuity, equity-bond mix Balance Income Notes: Baseline assumptions: initially $1 million at age 65 with equity-bond mix, preference weight on income shortfall probability α=2/3, real consumption floor C0=$45,000, and real balance threshold W 0 =$250,000. A. weighted shortfall risk 36.2%, withdrawal 5%, annuity initial 10%, ending 100% by 20 years B. weighted shortfall risk 42.2%, withdrawal 7% C. weighted shortfall risk 42.8%, withdrawal 7% Source: Authors’ simulations. Range of balances and income from optimal strategy for individual in retirement

OPTIMAL LOSS AVERSION STRATEGY FOR SINGLES – SOURCES OF REAL INCOME 16 Strategy: Withdrawal 5%, annuity initial 10%, ending 100% by 20 years

OPTIMAL LOSS AVERSION STRATEGY FOR COUPLES – SOURCES OF REAL INCOME 17 Strategy: Withdrawal 5%, annuity initial 0%, ending 100% by 30 years

“EXPECTED UTILITY” METHODOLOGY AND ASSUMPTIONS: THIRD AND FINAL STAGE OF ANALYSIS “Expected utility” is a sophisticated model developed by mathematicians von Neumann and Morgenstern and has been used in Nobel Prize work by several economists. In our context, it is a mathematical function representing the preferences and goals of the retired household for higher income and greater wealth, but with due concern for risk. Our algorithm to maximize expected utility produces a strategy chosen to optimize outcomes for lifetime inflation-adjusted income and liquid net worth, in the face of the range of several contingencies and uncertainties, such as personal longevity, investment returns, interest rates, and inflation. Initial conditions, at the time of the analysis, are considered, including demographics (such as age, single or couple, health, and so on), retirement assets available, other sources of income, such as Social Security, employer pensions, and so on, and current insurance and investment product characteristics and conditions 18

“EXPECTED UTILITY” METHODOLOGY AND ASSUMPTIONS (CONTINUED) Information is gathered from the retired household to also determine key preference parameters for the algorithm including attitudes toward risk, and the desire for a bequest and liquid wealth; these parameters would be centered around population average values, as found in the professional literature The strategy employs the simple building blocks we identified in the last few slides: immediate straight life annuities (single or joint-and-full-to-survivor), and index mutual funds. The optimization tells us the rate and extent of life annuity purchases, of systematic withdrawals from the funds, and the asset allocations Our latest algorithm adds refinements such as inclusion of Social Security, different product fee levels, differential mortality rates, more refined withdrawal and annuitization approaches and details in annuity pricing, an updated VAR stochastic return and inflation model, a model of insurer failures, and maximum lifetime to 105. Default preference parameters are set as found in the professional economics literature. It is also possible to set the stochastic simulations “engine” to start with current financial conditions, especially with regard to interest rates 19

“EXPECTED UTILITY” METHODOLOGY AND ASSUMPTIONS (CONTINUED) The “expected utility” model, using average preference parameters, gives somewhat greater weight to younger ages, liquidity and bequests, especially when retirement resources are sizeable, and results in less annuitization overall and higher rate of SW than the “loss aversion” approach. The inclusion of Social Security also lowers somewhat the optimal amount of annuitization purchased on the market. Mass customization is now possible, with the inputs of different levels of risk aversion, desire for liquidity and bequests, amounts of retirement assets, asset initial allocations, Social Security and DB income, health status, and varied demographics for individuals and couples The “Average Certainty Equivalent” or ACE is the best summary statistic for the strategy; higher is better Illustrations and examples on next slides are based on same assumptions as earlier slides, except data extended to 2011, includes median Social Security retirement benefits, investment expense is lowered to 25 bps, and possibility of economic collapses is removed Simulated annual rates and returns (VAR process) 20

RESULTS FOR EXPECTED UTILITY APPROACH 21 Real $00095 th percentile 50 th percentile 5 th percentileMeanStd. Dev. A. Assets $1000 Balance Income Notes: Baseline assumptions: single, retired age 65 with equity-bond mix, median 2010 Social Security retirement income, preference parameters as found in professional literature A. ACE $56.42, withdrawal 6%, annuity initial 5%, ending 20% by 18 years Source: Authors’ simulations. Optimal strategy for real income and asset management in retirement

OPTIMAL EXPECTED UTILITY STRATEGY FOR CASE “A” – REAL INCOME AND WEALTH RANGE OF OUTCOMES 22

OPTIMAL EXPECTED UTILITY STRATEGY FOR CASE “A” – SOURCES OF REAL INCOME (MEAN) 23 Strategy: Withdrawal 6%, annuity initial 5%, ending 20% by 18 years

EXTENDED RESEARCH AND BUSINESS APPLICATION Longevity insurance, delayed annuitization and other strategies marketed by other organizations are not supported in subsequent analyses because of pricing inefficiencies, lower income and/or higher risk Household tax considerations for after-tax investments, as well as optimal Social Security claiming, are also natural, if complex, extensions to be added in the future New rules from the Departments of Treasury (minimum distribution requirements) and Labor (illustration of income flow disclosed annually (on a life annuity basis) for 401(k) accounts) are expected soon; create interest and give context Business case and plan and product description, along with further details on the “expected utility” technology, are available for further discussion if there is practical interest in implementation See 24