Income Sustainability in Retirement: A Case Study of the Life-Cycle Account

Abstract

This article uses Monte Carlo analysis to simulate returns for a popular retirement portfolio strategy and the income derived from it in retirement in order to calculate the chance of it being depleted while the retiree is still alive. I analyze and contrast several withdrawal strategies from the account to illustrate the important trade-offs between income needs and account sustainability. Furthermore, the simulations are compared with payouts from an annuity to show the important differences between each vehicle’s ability to provide income. The primary findings are that portfolios have a higher chance of account instability with advanced age and income needs, whereas annuities may provide less income earlier in retirement, but the income is sustainable for life.

TOPICS: Wealth management, retirement, pension funds, analysis of individual factors/risk premia

Key Findings

• • The article simulates account balances and annual income withdrawals from a life-cycle investment fund held into retirement. The stochastic simulations generally showed relatively higher rates of account exhaustion past age 90.

• • The analyzed accounts were spent down in two ways: (1) at the Internal Revenue Service–mandated required minimum distribution (RMD) rule and (2) at a withdrawal rule equal to the maximum of either the RMD or a fixed amount to allow the investor to smooth income over the remainder of their life. This allows for a comprehensive analysis of differential income from a portfolio in retirement because of stochastic investment returns. The simulations show significant heterogeneity with respect to income in retirement when the drawdown follows the Internal Revenue Service’s rule for RMDs. The principal findings also show that when retirees follow a fixed annual withdrawal rule, they face nontrivial probabilities that they will either outlive their retirement savings or face the prospect of significantly diminished income at a time when additional work is not feasible.

• • When the spend-down simulations are compared with an annuity—low-fixed income withdrawals from the account—real annuity payouts typically offer higher income in retirement until advanced ages. As income needs rise, the life-cycle account may offer higher income early in retirement, but with an increasing probability of account depletion later in retirement, upon which the account becomes be exhausted while the annuity still provides income.