Thursday, September 30, 2010

Annuity or Lump Sum Payment? (Part IV)

In the first post I asked you to consider the risk you should be trying to mitigate as you choose between a lump sum and an annuity. In the second post I discussed considerations if you choose the annuity. In the third post we discussed alternatives for investing a lump sum. In this post we’ll consider how much money you can safely withdraw each year.

Deciding how much you can withdraw leads right back to this question: how long are you going to live? The shorter your life span, the more you can “pay yourself” each year. With one year, all the money is yours to do as you wish. If you want to keep the inflation adjusted principal to give to your favorite charity (which may be your kids) you can only spend the real return each year. With long TIP real returns less than 1.75%, you need a huge pile of money to live off the income. For example, to pay yourself $50,000 a year that will increase with inflation, a 1.75% real rate of return means you need to have $2,857,000. Those are the extremes; what about the rest of us?

Okay, so no one has given you a look into their crystal ball to determine your date of death. You are going to have to guess. If you guess too many years, you didn’t use your money wisely—some will be left over. If you guess too few years, you are penniless when you live past the date you guessed.

Let’s say you have a nest egg of $1,000,000. With a real rate of return of 1.75%, if you only expected to live ten years, the first year you can take out $108,000. Planning to live twenty years? You can withdraw only $59,000. Thirty years? Only $42,000. Forty years? Then $34,000 for you in year one. The next year you get an increase to cover inflation during the year.

Taking on more risk (add equities, corporate bonds, etc. to your portfolio) in order to increase your expected real rate of return works well if you start when markets are low; poorly if markets are at their top. How do you know which is which? You don’t, except in retrospect. We all know trying to time the markets doesn’t work well for most of us.

Wait, you say, I Googled it and depending on my age websites tell me I’m safe to take out 4%, 5%, 6% a year. Do they guarantee you won’t run out of money? No, they don’t. The more sophisticated models give you a percentage chance that you’ll be okay. Which is great if your life is a Monte Carlo simulation where there are hundreds of thousands of you who live to various ages and get various results on their investments. But you are only one person.

Yeah, you say, but I like that 95% probability from the simulation.

And I say the only way you are going to do that is if a very large part of your portfolio is made up of annuities where you have no mortality risk and you’ve minimized the inflation risk as much as you can (see post 2).

I’m glad we have that settled!

~ Jim