Unfortunately, each one has a number of glaring weaknesses.

• What if you are significantly older or younger than these studies used?  In other words what if your planning horizon isn’t 30 or 35 years?
• What if you are not willing to invest in the aggressive stock allocation these studies all recommend?
• How do fees affect the withdrawal rate (e.g., mutual fund expense ratios, advisor fees, etc.)?
• How do market conditions affect the safe withdrawal rate (Kitces starts to address this).

I attempt to address these issues by taking the following approach

• Assume bad things will happen at the beginning of retirement (.e.g, dividends drop by 25% and PE drops to 9,  interest rates go slightly higher than their historical average)
• Assume we might live to age 100
• Perform an amortization calculation to determine safe withdrawal amount

If you want to see how this works you can play with the safe withdrawal spreadsheet I have set up for this purpose.  I’ll be releasing the full justification for this method in the future.   Have fun and feel free to leave me comments.

Let’s take a quick look at the Federal Employees Retirement System (FERS).

With 20 years of service the  full retirement age is 60.  The pension amount is %1/year of service X high 3 average pay.  So 20 years of service results in a pension worth 20% of the person’s high 3 salary.  This pension then increases with inflation (with 1% lag when inflation is over 3%).

So to duplicate this deal, how much would you need to save?

Assumptions:

• Salary increases 1% faster than inflation
• Bonds average 2% real return
• Equities average 7% real return (historical, the projected rate is closer to 5% real return)
• An inflation adjusted annuity at age 60 costs $20 for each $1 of income desired (source: AIG).

So in 20 years a $50K salary would grow to around $61K (in today’s dollars).  20% of that is $12,200.  We would need $244K in savings (in today’s dollars) to purchase an inflation ajusted annuity that pays $12,200/year.

If we only invest in bonds (to achieve the same level of confidence as a government pension) we would need to save a little over 18% of salary for 20 years.  If we assume a risker investment stance (e.g., 50% equities/ 50% bonds), the savings requirement drops to 14.5%.

If you run these kinds of calculations on state and corporate pensions you discover that most state pensions fall in the 15% to 20% equivalent savings while corporate pensions tend to fall into the 10% to 15% equivalent savings.  If you factor in lower equity premiums or lower risk (i.e,. few equities), the percentages go even higher.

With the national savings rate only recently recovering from 0% to almost 7%, it is clear that most Americans have not been savings anywhere near these rates.

The PBGC does not covered defined contribution pensions (i.e., 401(k), 403(b), etc) and it does not cover other benefits like retiree health insurance.  And lastly, there is a limit to how large a pension the PBGC will insure.  In 2009 PBGC had the following limits.

Source: Maximum monthly guarantee tables

Investment Choice

I am assuming that zero risk tolerance means only CD’s under FDIC limits, immediate/fixed annuities under state guarantee limits (typically $100K) and treasury bills, bonds and notes and savings bonds.  If you also want inflation protection then you are limited to inflation protected CDs under FDIC limits, inflation adjusted immediate annuities under $100K, Treasury Inflation Protected securities (TIPs) and I-Bonds.

Unfortunatley, inflation protected CD are virtually non existant and rarely offer yields significantly better than TIPs.  I-bonds limit purchases to 2x$5K/person/year and typically have much lower yields than TIPs.  And lastly there are only a few insurance companies that have inflation adjusted immediate annuities, so if you need to invest more than a few hundred thousand it means taking on insurance company risk.  If you have more than a few hundred thousand dollars that leaves us with TIPs as the best vehicle for providing safe inflation protected returns.

Emergency Fund

Before getting into how to strucutre your investment, make sure to put aside an emergency fund.  You are going to be creating a paycheck for yourself, and just like when you are working, it is important to have an emergency fund for the unexpected need.

How long does your money need to last? 

The typical retired couple has around a 10% chance that one of them will live to age 100.  So unless you have health issues or family history that suggests you are different than the norm, I would recommend planning on having your money last until age 100 (97 if unmarried).  This means a 65 year old couple should plan on having their money last 35 years.

Structuring your Invetments

If you can stay under the insurance guarantee amounts, using an inflation adjusted immediate annuity is by far the simplest way to go.  It has the further benefit of aggregating mortality risk so the insurance company can provide a higher standard of living than you could on your own without taking additoinal risk.

For larger sums of money where you are not willing to take on insurance company risk and here is how to create a TIPs ladder for your paycheck.  First, go to any site that provides an amotization schedule (e.g., http://www.bretwhissel.net/amortization/amortize.html) and put in the amount of money you have for creating your paycheck, the number of years and the real interest rate that TIPs are paying (currently around 3%).  The result is a year by year listing of how much interest will be paid each year and how much principal will suplimenting that payment.

For example, with an initial $1 million and 3% real return, the annual paycheck would be $46,539.  In the first year $30,000 of that would be interest and $16,539 would be principal.  So you would buy $16,539 worth of TIPs that mature in one year (this will end up being rounded because bonds are denominated in $1000 bundles).  Looking at the table you see that year two has $29,503 in interest, so you would buy $17,035 woth of TIPs that mature in two years.  You would continue buying TIPs for each year’s maturity until you had gone out 20 years (the longest term TIPs) and would put the remaining balance $584,584 in the 20 year TIPs.

For the next 20 years, this portfolio requires no maintenance.  Maturing treasuries and interest payments will supply you with an inflation adjusted living stipend.  After 20 years you will need to recreate the ladder.  If interest rates have gone down, your living standard will go down a little, but just like a mortgage which is mostly interest at the beginning and principal at the end, a lower interest rate 20 years down the line will have a much smaller affect than it would have if it changed today.  You also have the option to annuitize a portion of the remaining funds if you want to boost your living standard further.  Since there are fewer years of life left at this point, the insurance company risk also becomes significantly smaller.

• Their distributions are too high.  The 7% should be 5% and the 5% should be 4%.  Which means if you use them you should reinvest some of the distribution back into the fund.
• The high commodities allocation is problematic considering the bubble commodities is currently going through.
• They are a little too aggressive.  The most conservative fund only has 40% in bonds.

For the time being, unless you are extremely investment phobic, it is better to roll your own, but these should mature into very nice products.

These products are still new so I’m not confident that pricing has stabilized yet (i.e., enough competition to ensure you are getting your money’s worth).  The other issue is that they are not inflation indexed so you need to take that into account.  Otherwise, I think these products are a great addition to the array of immediate annuities that already exist.

You can skip over the math. The text has all kinds of fascinating statistics like whether peoples perception of their longevity affects their savings (no), or whether their desire to leave a bequest affects their savings (yes).

The abstract states:

“very little of this dispersion can be explained by chance differences in individual circumstances largely outside the control of individuals’….investment choice is not a major determinant of the dispersion in asset accumulation…conclude that the bulk of the dispersion must be attributed to differences to in the amount that households choose to save”

In other words, no matter your earning potential or investment acumen, the strongest predictor of retirement preparation (monetarily speaking) is a person’s propensity to save.  Left unexamined is how easily people can change their propensity to save.