Financial Analysts Journal Volume 71 · Number 1 ©2015 CFA Institute The Only Spending Rule Article You Will Ever Need M. Barton Waring and Laurence B. Siegel After examining an array of approaches to determining a spending rule for retirees, the authors propose the annually recalculated virtual annuity. Each year, one should spend (at most) the amount that a freshly pur- chased annuity—with a purchase price equal to the then-current portfolio value and priced at current interest rates and number of years of required cash flows remaining—would pay out in that year. Investors who behave in this way will experience consumption that fluctuates with asset values, but they can never run out of money. ow much of your capital Calculating a Spending can you afford to spend Rate: An Annuitization Heach year? A great deal of effort has been expended on Problem CFA INSTITUTE determining how to construct FINANCIAL ANALYSTS JOURNAL In this article, we tie back to long- an efficient investment portfolio, standing and widely accepted how much risk to take, and how GRAHAM research asserting that the pur- to accomplish many other valu- and pose of investment policy for the able tasks on the accumulation individual is to support consump- side of the investment equation. DODD tion by providing an annuity of AWARDS OF EXCELLENCE But a body of useful thinking on payments in some form for one’s the decumulation or spending remaining life. Our insight is that side, in language accessible to constructing a spending rule is the investor, is just beginning to Top Award itself an annuitization problem at emerge. Despite the best efforts heart but does not require purchas- of investment counselors, 401(k) providers, con- ing an actual annuity, and we discuss how to imple- sultants, and a few scholars to determine rules and ment this observation. An annuity converts a principal heuristics for spending one’s money in such a way sum into a set of payments of equivalent present value, that one does not run out of it too soon, the investor to be made periodically over time. When we think is still too often guided by vastly oversimplified of annuities in general, we usually think of an insur- rules of thumb. ance company life annuity, a set of car payments, or Spending rules are, of course, vitally important. a mortgage. Such annuities, consisting of payments You do not want to run out of money before you from one party to another, are conceptually no differ- die. You do not want to have to go back to work ent than converting one’s savings into an annuity of (“Thank you for shopping at Walmart! Did you find future consumption payments to oneself. everything you needed today?”). And since you can’t The idea that an annuity is the right structure take it with you, you do not want to be too miserly for converting current capital into future income either. Although living at a low standard for fear of has been around for a very long time. The classic penury is not quite as bad as running out of money, literature on asset allocation and investment strategy, it is no picnic. going back at least as far as Merton (1975, 1977) and Rubinstein (1976), is consistent with today’s con- sensus that a real (inflation-adjusted) life annuity or equivalent hedge position that begins payments M. Barton Waring is the retired chief investment officer upon retirement is, from the retiree’s point of view, for investment policy and strategy at Barclays Global the risk-free asset. Investors, San Francisco. Laurence B. Siegel is the Gary But to secure an income in old age, not every- P. Brinson Director of Research at the CFA Institute one wants to buy literal annuities—from insurance Research Foundation, Charlottesville, Virginia. companies—for various reasons, including concerns January/February 2015 www.cfapubs.org 91 Not for General Distribution Waring_&_Siegel.IPE.indd 91 3/27/2017 12:58:06 PM Financial Analysts Journal about insurance company counterparty risk and a all time in order to be a proper annuity with respect desire for the higher expected returns from risky to calculating the next payment. assets. These reasons alone have likely kept investors If a properly designed annuity or equivalent lad- from taking advantage of the annuity concept (nor dered bond hedge is ultimately the correct risk-free do they often set up a literal consumption hedge, a asset for protecting consumption, then the ARVA is closely related strategy). So, in light of the fact that the right vehicle for those who, for whatever reason, most people are going to hold mixed portfolios earn- do not choose a policy of risk-free investing. ing volatile returns, how can we think about spend- In other words, the problem is not to find the ing while staying true to the concept of annuitization? correct, single, constant spending rate for the entirety The answer: through periodic re-annuitization, a of one’s retirement, as many practitioners seem to principle introduced in Waring and Whitney (2009, assume. There is no such rate—unless the entire port- p. 123) and echoed in Sexauer and Siegel (2013) folio is engineered to perfectly hedge planned con- and which we present and elaborate in more detail sumption (and all spending goes as planned!). The here. We call a portfolio managed according to this problem is to recognize that with any other invest- principle an annually recalculated virtual annuity ment strategy—one that includes unhedged risky (ARVA)—“virtual” because the investor does not assets—spending must vary as total asset values and have to buy an actual annuity to reap many of the interest rates fluctuate; there is no other safe way benefits of annuity thinking, even if she continues to meter spending so that there is no danger of the to hold a portfolio of risky assets. money running out. Specifically, the first year’s payout of a level- Whether or not a given investor buys annuities, payment real (inflation-adjusted) annuity is what annuity thinking is required to arrive at a simple, the investor can afford to spend this year and still effective answer to the question of how much to be as well off at the end of the year as at the begin- spend each period. This article applies annuity think- ning,1 keeping in mind that the investor is one year ing to the practical problem of asset decumulation, older at the end of the year and thus has one year’s particularly in retirement. less consumption to pay for. (Later in the article, we discuss “shapes” of the payout plan, including such How Much Money You’ll Need: nonperiodic payments as bequests and periodic pay- What’s Your Number? ment shapes other than level payments.) Although we call this essay a spending rule article, If the investor pursues a riskless strategy or there is another, parallel discussion that attracts a as near to one as can be achieved with existing lot of attention: How large an asset pool does one securities—which, for a US dollar consumer, is a need to accumulate for retirement? This question laddered portfolio of Treasury Inflation-Protected is directly posed in a small book by Lee Eisenberg: Securities (TIPS), with cash flows matched to the The Number: What Do You Need for the Rest of Your investor’s planned consumption—then the recal- Life and What Will It Cost?, a New York Times best- culated annuity “payment” or spending amount seller in 2006. One of us has also written on this in each period will be the same as the originally topic (Sexauer and Siegel 2013), discussing a retire- calculated annuity payment; it has been locked in ment multiple—a number by which to multiply the safely. An ARVA from the hedged strategy is thus annual income requirement to arrive at the savings equivalent to an actual annuity. goal, or “the number.” The spending rate and the If, however, the investor pursues a strategy that retirement multiple are, of course, reciprocals of includes risky assets (equities, credit bonds, hedge each other and are thus different ways to have the funds, and any other assets that do not directly same discussion. hedge consumption), the portfolio’s value will change at the end of each year as a result of ordi- The Number, the Road to Monte nary market movements, good or bad. In this case, the recomputed ARVA will vary each period as the Carlo, and Other Approaches current spending amount is adjusted to reflect gains Many researchers have tried to determine a “safe” or losses on the risky investment portfolio (as well as spend-down rate. Perhaps the best known is Bengen changes in the real interest and inflation rates used (1994).2 He determined the highest spending rate to price the virtual annuity). So, we also get the right that did not deplete the portfolio over the range of spending answer if we recalculate in each period for historical experience in the United States since 1926 investors whose asset pool supporting the annuity (it is 4%). Soon after, the “Trinity study” of Cooley, is not perfectly hedged and thus contains unhedged Hubbard, and Walz (1998) used simulations to deter- risky assets and experiences volatile investment mine, for each spending rate, the chance that a port- returns. An annuity need not be calculated once for folio would be exhausted before the intended time.3 92 www.cfapubs.org ©2015 CFA Institute Not for General Distribution Waring_&_Siegel.IPE.indd 92 3/27/2017 12:58:06 PM The Only Spending Rule Article You Will Ever Need Current practice tends to follow the Trinity must and will pass directly through to the amount approach, choosing a spending rate that produces no that can be spent on consumption as the ARVA is more than an x% chance of ruin, where x is the risk of recalculated each period.