1. 1 Sustainable Withdrawal Rates and How Alternative Strategies Affect the Heirs Peter James Lingane, EA, CFP® Financial Security by Design Lafayette, CA peter@lingane.com July 25 and 26, 2007

2. 2 Required Investment Cash Flow Necessary spending and taxes less all income flows except investment flows Necessary spending and taxes less all income flows except investment flows Initial amount and escalation rate are customer specific Initial amount and escalation rate are customer specific Quoted as fraction of initial portfolio value Quoted as fraction of initial portfolio value May, or may not, be quoted net of tax May, or may not, be quoted net of tax

3. 3 Today’s Focus Customers of moderate means Customers of moderate means Life annuity Life annuity Bond portfolio followed by a life annuity Bond portfolio followed by a life annuity Diversified investment portfolio Diversified investment portfolio The Planner’s Role The Planner’s Role

4. 4 Understand Your Customer! Single female, normal life expectancy Single female, normal life expectancy $30,000 AT, inflation-adjusted until age 85 $30,000 AT, inflation-adjusted until age 85 25% federal ordinary tax, plus state 25% federal ordinary tax, plus state Home is reserved for LTC and the heirs Home is reserved for LTC and the heirs Estate and health documents are in order Estate and health documents are in order Health insurance; no life insurance Health insurance; no life insurance

5. 5 85 year old Single Woman Life annuity – lowest risk Life annuity – lowest risk $30,000 AT for life costs $230,000 Bond portfolio – low risk Bond portfolio – low risk $30,000 AT for 15 yr. costs $360,000 Inflation may be an issue at younger ages Inflation may be an issue at younger ages

6. 6 Inflation-Protected Bonds “TIPS” Secure, liquid Treasury bonds Secure, liquid Treasury bonds Inflation risk transferred to the Treasury Inflation risk transferred to the Treasury Quoted yields are net of inflation Quoted yields are net of inflation Nominal YTM ~ Real YTM + Inflation Rate

7. 7 65 year old Woman $30,000 after-tax, inflation adjusted for 20 years 1.Indexed life annuity $640,000 single life; $740,000 joint lives 2.$730,000 combination strategy: TIPS portfolio plus a life annuity from age 85 3.$750,000 investment portfolio

8. 8 Present Value of Risked Residual $30,000 after-tax, inflation-adjusted, 65WF Present Cost Residual Single Life, Indexed Annuity 640,000zero Combination730,000200,000 Investment Portfolio 750,000400,000

9. 9 Best for Everyone? Immediate life annuity plus Immediate life annuity plus Immediate gifts to the heirs Immediate gifts to the heirs

10. 10 Forecasts Must Be Probabilistic with respect to returns, inflation, life expectancy Draw time sequences from the historical record Draw time sequences from the historical record Randomize the historical record Randomize the historical record Describe historical record mathematically Describe historical record mathematically

11. 11 Incorporate Life Expectancy When Describing Risk of Exhausting Portfolio Failure within 35 years; or Failure within 35 years; or Failure before death Failure before death Which is the more meaningful? 27% risk of failure within 35 years; or 27% risk of failure within 35 years; or 5% risk of failure before death 5% risk of failure before death Which is the less frightening?

12. 12 Pay Attention to the Assumptions 5% risk of failure before death 4.5% initial cash flow, inflation-adjusted 4.5% initial cash flow, inflation-adjusted No tax on earnings, gains or withdrawals No tax on earnings, gains or withdrawals 0.3% expenses 0.3% expenses 60% large cap stocks, 40% bonds 60% large cap stocks, 40% bonds Historical simulations, 1926 – 2005 Historical simulations, 1926 – 2005 White female, aged 65, normal health White female, aged 65, normal health

13. 13 Effect of Income Tax 0.3% expenses, 60% large cap stocks, 65 WF After Tax Cash Flow 3.4%4.0%4.5% No tax (Roth IRA) 1%5% 25% Deferred Tax 5%17%27% 15% Current Tax 1%5%12%

14. July 9 14 Sustainable Cash Flow vs. Age 0.3% expenses, no tax, WF, 1926-2005

15. July 9 15 Impact of Portfolio Composition Risk of Exhausting Portfolio Before Death, 65WF

16. July 9 16 Impact of Portfolio Composition Present Value of Residual, 65WF

17. 17 Impact of Expenses Sustainable Cash Flow, 5% risk, 65WF, no tax

18. 18 Escalating Required Cash Flow Sustainable cash flow often increases when expenses are escalated realistically Sustainable cash flow often increases when expenses are escalated realistically Reports of high sustainable cash flows are often caused by low escalation rates Reports of high sustainable cash flows are often caused by low escalation rates Constant annuities stress the portfolio; inflation-linked annuities relax the portfolio Constant annuities stress the portfolio; inflation-linked annuities relax the portfolio

19. 19 Monte Carlo requires a mathematical model of financial markets and of inflation Current reality Current reality –Model descriptions are limited –Few validation and sensitivity studies –Wide variation in predicted failure rates Criticisms (practical impacts are not known) Criticisms (practical impacts are not known) –Serial correlations omitted –Binary correlations sometimes omitted –Constant distributions, variances, correlations

20. 20 Analytical “Monte Carlo” Solution Milevsky and Robinson, 2005 Allows planners to determine, using Excel, risk of failure before death as function of Allows planners to determine, using Excel, risk of failure before death as function of Real cash flow Portfolio return & standard deviation Life expectancy Assumptions Assumptions Constant mortality risk, an approximation Real portfolio returns are lognormal

21. 21 Real Portfolio Returns, 60% Equities 12-month rolling intervals 1926 - 2005

22. 22 Implications of Lognormal Real Portfolio Returns Partially validates analytical model Partially validates analytical model Eliminates the correlation matrix, which a llows d irect comparisons of historical and Monte Carlo simulations by imbedding a lognormal distribution of real portfolio returns in a historical simulator. Eliminates the correlation matrix, which a llows d irect comparisons of historical and Monte Carlo simulations by imbedding a lognormal distribution of real portfolio returns in a historical simulator.

23. July 9 23 Historical versus Analytical 5% risk of failure before death, 0.3% expenses, no income tax, cash flow escalated as inflation

24. 24 Midcourse Corrections Decision rules are “… a bumpy path that not all clients may be willing, or capable, of sustaining.” Decision rules are “… a bumpy path that not all clients may be willing, or capable, of sustaining.” Planning date versus retirement date Planning date versus retirement date Increase cash flow to age-adjusted value Increase cash flow to age-adjusted value Accelerate IRAs distributions Accelerate IRAs distributions

25. 25 Conclusions – For Planners Know Your Customer Know Your Customer Life Expectancy Rate of Cash Flow Escalation Bequest motivation and tolerance for volatility Consider life annuities plus immediate gifts Consider life annuities plus immediate gifts Construct diversified portfolios Construct diversified portfolios Control expenses and taxes Control expenses and taxes Analytical Monte Carlo model Analytical Monte Carlo model

26. 26 Conclusions – for Model Providers Risk of exhausting portfolio before death Risk of exhausting portfolio before death Descriptions of model, input parameters Descriptions of model, input parameters S Simulator performance specifications Certify simulators against these specifications Identify reasons for the differences between historical and Monte Carlo simulations ” to prior work Reconcile “breakthroughs” to prior work

27. 27 Caveats Regrettably, this analysis contains errors Regrettably, this analysis contains errors “Trust, but verify!” Interest rates, annuity payouts and tax rates are near historic lows. Interest rates, annuity payouts and tax rates are near historic lows. Uncertainty in forecasts Uncertainty in forecasts