Approaches to decumulation

Yes, decumulation is a real word. With a car you accelerate and then decelerate. With a pension pot you accumulate and then decumulate: you draw money out of the pot to enable you to live the retirement lifestyle you desire.

Now that it’s no longer necessary to buy a lifetime income annuity, many questions arise. Should you buy an annuity, after all? If not, how should you invest your pot? And, most worrying of all: will you outlive your savings? Today I’ll outline three fundamental approaches to decumulation, plus two variations. If you’re talking to a financial adviser, it could be useful to discuss the issues I’ll mention.

In retirement all of us want some combination of three fundamental goals. Longevity insurance: we don’t want to outlive our savings. Safety: there’s no opportunity to add to the pot, so bad investment news is tough to overcome. Growth: for most of us, our desired lifestyles are richer than we are, so we would still like some opportunity for investment growth.

With that as background, here are the three fundamental approaches, and their pros and cons.

As before, the first approach is to buy an annuity, preferably inflation-linked; if not, the annuity starts off higher, but your purchasing power will decline by the amount of inflation each year. Many retirees accept the decline, with the implicit logic that their “propensity to consume” (as Keynes put it) declines as their age increases.

The big advantage of an annuity is that it provides longevity insurance: you won’t outlive your savings. And typically it provides the highest guaranteed income from any given size of pension pot.

But it has disadvantages. It’s a once-for-all contract, with no further flexibility. It’s essentially a 100 per cent fixed interest investment, with no growth potential. Early death makes it a gamble. (That’s what risk pooling is all about.) And of course, in principle the insurance company could go bust, though there would still probably be a high proportion of the payments made.

Future life expectancy

A second approach overcomes some of the disadvantages while retaining the longevity feature. This is the basis of the American “minimum drawdown” rule. It’s very simple, in concept. If this year your future life expectancy is ‘E’, and your pension pot is ‘P’, then withdraw P/E. Next year, see what P and E have changed to, and withdraw next year’s value of P/E. And so on. Since, if you’re still alive, you always have some future life expectancy, E is always a positive number, and doesn’t reach zero until the end of the mortality table (which is typically some age like 110 or 120 that you aren’t likely to have to worry about). And that, combined with the fact that you’re never withdrawing the entire balance of your pension pot, means that you won’t outlive the pot.

The third approach is sometimes called “self-insurance”. Never mind expectancy-related calculations. Pick some advanced age, which becomes the goal for your lifespan. (Typically this is something like age 100. It should certainly be much higher than 90, because a 65-year-old couple has roughly a two-thirds chance that at least one partner will survive beyond 90.) Invest the pot with the appropriate combination of growth and risk. Withdraw, each year, some systematic amount: for example, whatever amount your adviser calculates each year as likely to be sustainable until the advanced age.

For greater depth and insight, Look up two outstanding papers online: Nest’s A retirement income blueprint and the true-to-title The only spending rule article you will ever need by Siegel and Waring (for the record, I know the authors, but have no connection with any of them).

Don Ezra is the former co-chairman of global consulting for Russell Investments worldwide, and the author of “Happiness: The Best is Yet to Come”