An Easy Way to Create a Lifetime Income Stream
In this article, I share the transcript of my recent discussion with Don Ezra about how individuals can create a lifetime income stream from their wealth as they reach retirement and how sponsors of defined contribution plans could use this method to help their retiring plan participants do the same.
Listen to the entire podcast episode here
Don Ezra is not only a former colleague of mine from our days at Russell Investments, but also a legend in the pension world.
His industry recognitions include being awarded the Lillywhite Award (from the Employee Benefits Research Institute, 2004) for extraordinary lifetime contributions to Americans' economic security, the Graham and Dodd Scroll Award (from the Financial Analysts Journal, 1985) recognizing excellence in financial writing, and the Roger Murray Prize (from the Q Group, 1983) for excellence in quantitative research in finance. (View Don’s entire background here.)
This podcast episode was special for me because reconnecting with Don takes me back to a time when he and I worked together at Russell Investments back in the early 2000s. That was a time when DC plans were overtaking DB plans in terms of participant count and assets.
Back then, it was becoming clear to all of us that the future pension for individuals in America would come in the form of essentially a 401(k) or some other defined contribution-type account. That was a scary prospect- still is today in many ways- because we were taking most of the risks inherent in creating a secure retirement and handing them to the individual and wishing them luck.
Funding risk, investment risk, longevity risk, and many others, we've been transferring these from institutions, namely employers who have the expertise or the resources to hire the necessary experts to manage these risks, and we were giving them to individuals to manage themselves.
The topic of our discussion, which is essentially how to make your retirement funds last as long as you do, is one of those challenges that DB plans used to handle for us but now has been transferred to individuals.
This trend from DB to DC caused many of us to start thinking about how to DB-ize DC plans. This is how Don and I came to work more closely together. He knew pensions as well as anyone in the world, and I had responsibility for Russell's DC business at the time in the US. So, we collaborated on projects and presentations. And he was always gracious and patient sharing his thoughts with me about DB-ization of defined contribution plans.
Join Don and me as we discuss his thoughts on an easy way to create a lifetime income stream.
Matt: Don, welcome. It's great to talk with you again. Thanks for being a guest on The Retirement Space Podcast.
Don: Matt, it's an absolute pleasure. It's a continuation of a pleasure I had working with you at Russell Investments, and even though we were in different departments, I knew every time I heard you speak, I always learned something. And so, the idea of being a co-author with you and with Bob Collie on a book about defined contribution plans, which were coming into vogue, was something I really wanted to do, and I really had a wonderful experience with both of you when we did that book. And it's a pleasure doing something with you again.
Matt: Well, that's kind of you to say, Don. Thank you.
Don, you have written books and spoken extensively about retirement issues. And a big part of your career was dedicated to the defined benefit world. However, in the last couple of decades, you've also journeyed over into the defined contribution space. Can you tell the listeners a little bit about how your professional journey took you from the defined benefit world to the defined contribution world?
Don: Sure, it started during my professional life at Russell Investments, and you were part of my transition from defined benefit to defined contribution. It seemed to me many of the governance angles were quite different, and it was actually a much more complicated world than plan sponsors thought. They thought that once we're out of DB, DC is very simple. And I thought, no, no, it's a much more complex world. And I think when we wrote our book, we demonstrated that.
What I've found since I actually retired, or I hate that word, I'll use George Russell's words, since I graduated from full-time work, I found that my focus has changed entirely away from defined benefits and the system to individuals and how they cope with financing their retirement. And that has become almost my sole focus now.
Everything I've learned about defined contribution, I learned from adapting defined benefit principles to a set where there's a couple or one person, and they are trying to apply defined benefit principles to their life. How do we do that? That's all I've ever done; change the thing I'm focusing on. But as I say, all I focus on now is individuals, not on the system as a whole.
Matt: I love that story because, you know, back in the day, early in my professional career in the early 1980s, defined benefit was king. There were more defined benefit plans. They held more assets, and they had more participants.
We all know what's happened in the decades since, but for a big part of my career, DB practitioners and DC practitioners, we didn't interact much. We existed almost like in two different worlds. But one of the outcomes of this trend towards DB-ization of DC plans is that pension experts like yourself have brought their knowledge and experience into the defined contribution space. So, it's great to have that DB expertise in the defined contribution space.
Don: Yeah, it actually translates reasonably well. My thought experiments are always, imagine my wife, and I are the last two survivors in a DB plan. What advice would I give the trustees, and what advice I'd give us as well? Except that if there isn't enough money, instead of someone having to put in more money to provide the defined benefit, we have to take out less money.
Matt: Yeah, that's a great way of looking at it. Don, when I had the idea to ask you to be a guest on this podcast, you made it easy for me, probably without even knowing it, because you still write, you still post a lot of content on your blog, and looking through your articles, it was like choosing from a menu of great ideas.
And one of them jumped out at me. It was a blog post you wrote last fall, fall of 2022, titled An Easy Way to Create a Lifetime Income Stream. And when I read it, I thought it would make a perfect outline for a podcast episode. So, can you tell us a little bit about the background of that piece? In the article, you describe how you were giving a presentation; well, I'll let you describe the setup for that article.
Don: Well, I realized that the really tough part about defined contribution is not the accumulation stage. I mean, that's absolutely essential. There is nothing without it. But once you get to the end of the accumulation stage, what do you do? Say to the individual, "Here's your money. Thank you, goodbye. You're on your own. I'll give you a life raft as you're on the ocean."
There was nothing to help individuals with how to take money out of that capital that they've accumulated and spend it. It seemed to me that what we really need as a start, it's not perfection but what you need is a start, is a default option that really works for most people. And it vastly improves the situation for most people, and I don't see default options being set up.
And so, I approached the guys at Pensions and Investment and said, "I have an idea here." I've worked with them for years and years and years. I've been on their advisory board. And I said, "I have an idea, and I would like to explain it." And they said, "Can we chat about that and do it as a sort of on-stage fireside chat?" So, we did that last fall in Carlsbad. And that's where I put these ideas together for expression.
Matt: Well, I'm glad you did. And then, you summarize the key points in a post on your blog. So, let's restate the issue that we're dealing with. I always like to use Seth Godin's framework of who's it for, what's it for? Who is the message for? This could be for a defined contribution plan sponsor that might want to consider how to create a default payout option for their participants. But it also is useful information for an individual who's thinking about how to make their wealth last as long as they do.
Don: Yes, it's for both. It was aimed at plan sponsors because a default option should be something simple that works for the retirees, but it's easy for the sponsor to implement and can be done for retirees who know absolutely nothing about how to do this.
So, make it easy for the employer. If an individual wants to do this, it actually turns out that it works pretty well for the individual regardless. There are academic papers that say this default option is actually superior to the other individual options that there are, so it's worth going through what the options are and how they work, and so on. But even for an individual who doesn't know how to do this, for a sponsor, it's very, very simple to implement this, and makes life an awful lot better for their retirees.
Matt: What you're solving for is a sound withdrawal method that can be used as a starting point, not necessarily the absolute optimal solution for a particular individual. And the reason I bring this up is that often experts like yourself are asked their opinion about this problem or that in search of the perfect solution. And sometimes, searching for the perfect solution gets in the way of seeing a practical one.
Don: That’s right. People, as you say, very often assume that nothing but the best is acceptable. And frankly, that makes life very difficult. I mean, you might be searching for it forever. What a waste of time. And even when you come across the best possible solution, you may not recognize that it's the best possible solution.
And this is a case of the perfect being the enemy of the good. Nobel Prize winner Herbert Simon had a word for what we should do in practice. It's the word satisfice. It's an odd word, but it means exactly what it sounds like; a combination of satisfy and suffice. The solution has to meet a high standard; otherwise, it doesn't satisfy, and when we find that sort of solution, it suffices. It's enough. We should just adopt it and move on. In other words, it's pretty good, and it's good enough. It doesn't have to be perfection.
Matt: We're looking for a solution that works for a broad range of people, it improves their current situation, and is easy to implement, right?
Don: Yes, it needs to have those characteristics.
Matt: Alright then, if we are trying to improve on what individuals are currently doing, then we should describe what they're currently doing, right? What is the current state that we're trying to improve upon?
Don: The current state essentially is that at retirement, people have access to the capital, and they're given it. And so there they are with the lump sum, and they have absolutely no idea what to do with it.
And they may go to an expert, but most people do not. Most people just deal with it themselves. And the thing that they do is essentially, when we retire and are given a lump sum of capital, we do not touch our capital. That's the evidence. It's not just anecdotal evidence.
There is well-documented evidence that comes from Australia. Why Australia? Because in Australia, their Social Security system is a capital accumulation system. It's like a 401(k). It's not like a pension benefit payout system. So, people tend to have much more retirement capital on hand in Australia than in other countries.
And in Australia, people are so scared of touching their capital that when they die, they leave, on average more than 90% of what their savings amounted to when they retired. Essentially, they spend interest and dividends and are scared stiff of touching their capital. Imagine how much better they could have lived if they hadn't been too scared to touch it.
So, I think people would benefit enormously from knowing how to draw down their capital at a pace that won't exhaust it.
Matt: I know from my experience talking with people here in the US I've found similar situations. They're scared to touch their principal. They think as soon as they start touching their original amount, it'll be a slippery slope, and they're going to run out of money.
And I understand that fear. It's not just a math calculation. There's a lot of emotion involved. And when you're older, there are fewer options to replenish your wealth. Yet it's wasteful because they don't have access to the principle that could fund a lifestyle that's higher than they would otherwise experience if they don't touch their original capital.
Don: That's exactly the thing. It's almost as if they're leaving a legacy rather than spending it themselves, and they grossly underspend. Whether they want to leave a legacy or not, it's just that they're scared.
Matt: And there’s nothing wrong with leaving a legacy. Certainly nothing wrong with that, but it should be on purpose, not accidental or the result of lack of planning.
I know you're prepared to talk about the various methods people could adopt to manage their lifetime income, so we can do a little compare and contrast. But before we get into that, can you talk a little bit about why this is such a tricky problem to solve?
Don: Yeah, and the guy who captured it best was Nobel Prize winner Bill Sharpe, who called it the nastiest, hardest problem in finance. And the reason for that is that there are two simultaneous very large unknowns; you don't know what returns you're going to earn on your retirement assets, and you don't know how long you'll live, so how long you'll need it for?
And you put them together, and it's awfully tough to know how much capital you need for a retirement income that will last for all your uncertain length of life.
I actually did some did some work comparing the two forms of uncertainty; the length of life uncertainty and the return uncertainty. And I realized that, confronted by two big simultaneous unknowns, a theoretical approach was beyond my ability to solve. So I did a thought experiment that divided the problem into two separate parts, each with one unknown.
Here's what I did. I said: imagine two highly unusual planets, planet A and planet B. On planet A, longevity is certain. Everybody knows exactly how long you're going to live. How much money do you need for your retirement? You know how long you're going to live, but you don't know how much investment return you're going to earn. So, you don't know how much capital you need.
On planet B, investment returns are certain. You tell me what you're going to invest in, and I'll tell you exactly what the returns are. But longevity is uncertain, so I don't know how long I'm going to need it for. So again, you don't know how much capital you need.
And then I asked myself, on which planet is there more uncertainty? And when I did the calculations for each planet, each with only one degree of uncertainty. And then, I compared the uncertainty across the two planets. It turned out that the answer is, well, it depends on your age.
For a male age 60, or a female age 65, longevity uncertainty has a smaller financial impact than being invested in fixed income or a balanced stock and bond portfolio. And we're used to that, and we can bear that. And so, longevity uncertainty is not a problem when you're 60 or 65.
But as age increases, the two curves cross over, and by male age 75 or female age 80, longevity uncertainty has a larger financial impact than being 100% in equities. Well, wow, that's way riskier than we can stand. So, if at that age, 75 or 80, you are uncomfortable being 100% in equities, and who isn't, you should hedge or reduce your exposure to longevity uncertainty. Because if you don't, you're effectively living with being more than 100% in equities.
Matt: That is interesting analysis. It wasn't intuitive, at least not to me, until we discussed this in detail that longevity risk grows the older you get and actually becomes greater than investment risk. Yeah, very interesting.
And I also like how you used planet analogies there, or metaphors, since this is The Retirement “Space” Podcast. (Pause for polite laughter.) So, thank you for that.
OK, Don, I'd like to get into the discussion about the various methods of creating income in retirement. And you say there are five of them. But one last thing before we do that, I want to reiterate that we're not giving financial advice here. We're not giving legal advice. We're merely discussing the attributes of the different methodologies. What's right for any individual, that's going to be up to their specific situation, which you and I don't know anything about.
Don: Oh, totally yeah, absolutely. Because it's not as if there is one obvious, best way and this is perfect.
There are really five different ways, and they all have pros and cons, and so you have to decide either as an individual or with a financial expert or, if you're a plan sponsor, which method is easy and effective to implement.
So let me let me quickly go through them. The first one is to buy a guaranteed lifetime income, it's also called an annuity, from an insurance company. And people tend not to like this because they lose access to their capital. It's all gone. Flexibility is gone, and they lose most of their capital if they die early. So, even though it generates a very high income, there are big psychological negatives to that one. So that's one.
Number 2 is a longevity pool where people put all their money in together and pay out to the survivors; no absolute guarantee now as to the size of the payments because they'll vary with the rate at which the members of the group pass away. So, your income varies with that experience, but an advantage of this approach is that you can invest in growth-seeking assets to try and increase the size of your income over time.
But this solution, by the way, is not available in the United States, even though you can find it in Australia and in Canada. By the way, with both of these solutions, the annuity, and the longevity pool, you can also get a return of unused capital if you die early. But if you want that death benefit, although it solves a psychological problem, the cost of it is something like a 30% reduction in your periodic payments. And in effect, you're sacrificing your own living standard in order to leave money to your heirs.
A third approach is to split your prospective future into two parts. Typically, what you would do is to say: from now until age 85, and then beyond age 85, whatever that may happen to be. And then you only buy the guaranteed lifetime income payments beyond age 85. That's called a deferred annuity. In the United States in a DC plan, it's often called a QLAC, qualified longevity annuity contract. In principle, this is a great solution for an individual. The thing is, because the insurance doesn't start until beyond your life expectancy, it may only cost 10% to 15% of what the full lifetime income annuity costs. And the remaining 85% to 90% can be invested anywhere you want. You own it.
You have a fixed period, up to age 85, to make withdrawals, so you can calculate how much capital you can withdraw each year because there's a fixed term up to age 85. I believe that the United States is the only country in which these deferred annuities are still available. So, it is a great solution for an individual to implement, and actually, I use this approach myself as part of my own situation. I have more than one approach, but it's tough for a DC plan to make as a default option because it's very much individualized.
Matt: OK, to restate, in this method, where there are two distinct periods, the individual or couple, they just have to make their wealth last until they reach the end of that first period; in your example, you use age 85. And then after that, the deferred annuity kicks in, which then eliminates for that second period all longevity risk.
Don: Exactly. So, the big risk at that point has gone, and now you've only got the investment uncertainty, and you can cope with that in various ways.
So, here's a fourth method. And the 4th method is essentially to self-insure. What you do is you approach your unknown longevity by estimating your own future lifetime horizon, what is your expected survival age, probably with the help of an expert.
And then when you get that, which may be your own, or your own and your partner's joint and survivor, life expectancy, you might build in a margin of safety, like add five more years to that just to have more than a 50 percent chance of success. In that way, you are self-insuring your longevity risk.
If you do this, you then have total investment freedom. You always own the assets, and you draw down capital at a rate that will last the rest of your planning horizon. Now, one thing you have to do with this approach is to recognize that your planning horizon, your expected survival age, gradually increases over time because the longer you survive, the more select a group of survivors you belong to, and your expected survival age increases.
So, this approach is actually a more expensive way than buying an annuity to generate lifetime income because this form of self-insurance requires you to provide for a longer lifespan than most people encounter. In essence, you're over-insuring, but it is all within your control.
Matt: OK. You've covered four of the methods so far. Let's talk about number five.
Don: The 5th way isn't really a planning approach. It was built by the IRS for income tax purposes, and it's commonly called RMD, which stands for required minimum distribution.
And what you do here is, each year, you withdraw an amount equal to whatever your remaining assets are, divided by your expected survival years. And by the way, those expected survival years automatically take into account your gradually increasing expected survival age, unlike that fourth approach.
You take your assets, divide by your future life expectancy, and that's how much you withdraw. You can invest the money any way you want. You always own the assets. And the formula as you adjust every year for your future expected survival, the formula ensures that you never withdraw all your capital. For most people, even though there is no guarantee of the amount of these periodic withdrawals- and remember, it's very expensive if you want to have a guarantee- the other advantages are huge, and it's very simple to administer.
That's why in my fireside chat last fall, I said I think it makes a great default option, not just in the United States but anywhere in the world. As I mentioned, there are academic papers that have explored this RMD approach and have concluded it's not just a simple approach; it's actually, in practice, superior to the other approaches.
Matt: So, in absence of any other method for managing your retirement savings, for the remainder of your life, this is a good foundational process for withdrawing your wealth and funding your lifetime income.
But then, an individual can customize it to suit their needs. For instance, you and I talked in preparation for this episode that if somebody were to start using the RMD method and then experience favorable or even average investment returns, the annual distribution amount might actually go up because your assets are still growing faster than your life expectancy goes down.
Well, there's nothing wrong with that. You don't have to spend all that money. You could take that excess and keep it in your portfolio, or you could set it aside as an emergency fund, a rainy-day fund, or whatever. But it's a beginning point for an individual who doesn't want to use these other methods.
Don: Yes, and I think it's a very good beginning point. I compare this with climbing Mount Everest. In round numbers, Mount Everest is 30,000 feet up. And the way in which you climb Mount Everest is you don't start at sea level and start walking up and up and up and up till you get to 30,000 feet. You actually go to about 20,000 feet and establish yourself there. You establish Base Camp there. And then very gradually from 20,000 feet up you can climb to Camp 1, Camp 2, Camp 3, Camp 4, until you reach the summit.
And I think of RMD as like climbing Mount Everest. It gets you to base camp. It gets you 20,000 feet up the mountain. It doesn't get you to the top, but it's far better than being abandoned at sea level, which is where most of us find ourselves at retirement.
And if you want to go even higher than 20,000 feet, then as you said, you need to personalize the approach; maybe something along these lines. So, let's say you divide your ideal lifestyle into two spending components, what you feel is absolutely essential, your needs, and what is desirable but not absolutely essential; so, your needs and your wants. And maybe you lock in the needs, the essential part, in some way. And then be willing to take some element of risk with the desirable part to make it more and more likely that you can do it. And make sure via one of those other approaches I mentioned that you won't ever run out of capital.
Now all of that personalization probably requires some financial expertise as well as a deep knowledge about your own willingness to tolerate lifestyle risk, how much lifestyle risk you're willing to tolerate. And by the way, in my view, lifestyle risk is the only risk that counts.
The risk that we geeks talk about; we talk about longevity risk, we talk about investment return risk. Those are not outputs of calculations; they are inputs into lifestyle risk because those risks create the risk that your lifestyle may or may not be what you want. Ultimately, money is a means to an end, not an end in itself. And I see lifestyle risk as the one that we as individuals understand much better than the experts do because it's ourselves we're talking about.
Matt: Yes, that's a great perspective. You and I think alike on this issue.
Well, Don, I think you've covered it. We could go deeper on so many aspects of this topic, plenty of interesting tangents to follow and discuss, but for the purpose of this episode, I think you nailed it.
And before we sign off, I want to say that it's been great to collaborate with you again on a content project. This has been a fantastic conversation and I'm sure the listeners will find it interesting and useful. Thanks again.
Don: My absolute pleasure. Thank you, Matt.
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