Betting on Death and Capital Markets in Retirement: A Shortfall Risk Analysis of Life Annuities versus Phased Withdrawal Plans

Transcription

1 Being on Deah and Capial Markes in Reiremen: A Shorfall Risk Analysis of Life Annuiies versus Phased Wihdrawal Plans Ivica Dus, Raimond Maurer, and Olivia S. Michell March 2004 Ivica Dus Johann Wolfgang Goehe-Universiy of Frankfur Deparmen of Finance Keenhofweg 139 (Uni-PF 58), Frankfur Germany T: F: dus@wiwi.uni-frankfur.de Raimond Maurer (corresponding auhor) Johann Wolfgang Goehe-Universiy of Frankfur Deparmen of Finance Keenhofweg 139 (Uni-PF 58), Frankfur Germany T: F: RMaurer@wiwi.uni-frankfur.de Olivia S. Michell The Wharon School, Universiy of Pennsylvania 3641 Locus Walk, 307 CPC Philadelphia PA T: 215/ F: 215/ michelo@wharon.upenn.edu JEL Codes: G22 Insurance; G23 Pensions; J26 Reiremen and Reiremen Policies; J32 Pensions; H55 Social Securiy and Public Pensions This research was conduced wih suppor from he Social Securiy Adminisraion via he Michigan Reiremen Research Cener a he Universiy of Michigan, under subconrac o he Universiy of Pennsylvania. Addiional suppor was provided by he Cener for Financial Sudies of he Universiy of Frankfur and he Pension Research Council of he Wharon School a he Universiy of Pennsylvania. Daa collecion was faciliaed by he German Invesmen and Asse Managemen Associaion (BVI). Research for he paper was underaken while he second auhor was a Mezler Visiing Professor a he Deparmen of Insurance and Risk Managemen a he Wharon School. We are graeful for commens provided by Jeffrey Brown, Neil Dohery, Amy Finkelsein, Alex Muermann, Sephen Shore, and Ken Smeers. Opinions and errors are solely hose of he auhors and no of he insiuions wih whom he auhors are affiliaed. This is par of he NBER Program on he Economics of Aging Dus, Maurer, and Michell. All Righs Reserved.

2 2 Being on Deah and Capial Markes in Reiremen: A Shorfall Risk Analysis of Life Annuiies versus Phased Wihdrawal Plans Absrac How migh reirees consider deploying he reiremen asses accumulaed in a defined conribuion pension plan? One possibiliy would be o purchase an immediae annuiy. Anoher approach, called he phased wihdrawal sraegy in he lieraure, would have he reiree inves his funds and hen wihdraw some porion of he accoun annually. Using his second acic, he wihdrawal rae migh be deermined according o a fixed benefi level payable unil he reiree dies or he funds run ou, or i could be se using a variable formula, where he reiree wihdraws funds according o a rule linked o life expecancy. Using a range of daa consisen wih he German experience, we evaluae several alernaive designs for phased wihdrawal sraegies, allowing for endogenous asse allocaion paerns, and also allowing he worker o make decisions boh abou when o reire and when o swich o an annuiy. We show ha one paricular phased wihdrawal rule is appealing since i offers relaively low expeced shorfall risk, good expeced payous for he reiree during his life, and some beques poenial for he heirs. We also find ha unisex moraliy ables if used for annuiy pricing can make women s expeced shorfalls higher, expeced benefis higher, and bequess lower under a phased wihdrawal program. Finally, we show ha delayed annuiizaion can be appealing since i provides higher expeced benefis wih lower expeced shorfalls, a he cos of somewha lower anicipaed bequess.

3 Being on Deah and Capial Markes in Reiremen: A Shorfall Risk Analysis of Life Annuiies versus Phased Wihdrawal Plans 1. Inroducion Many reirees face he quesion of how o draw down he pension asses ha hey have accumulaed over heir worklives. Economiss ofen sugges ha a sensible approach is o purchase a life annuiy. An annuiy is a financial conrac beween an insured person and an insurance company ha pays ou a periodic amoun for as long as he annuian is alive, in exchange for an iniial premium (Brown e al., 2001: p. 1). The paymens may be fixed in nominal erms (fixed annuiy), or hey migh rise a a pre-specified fixed nominal escalaion rae (graded annuiy), or hey could be indexed o inflaion (real annuiy) keeping he reiree s sandard of living consan. Alernaively, hey migh reflec he reurn of a specific asse porfolio which backs he (variable) annuiy, or hey can depend on he insurance company s experience wih moraliy, invesmen reurns, and expenses (paricipaing annuiy). As Michell e al. (1999) noe, he essenial aracion of a life annuiy is ha he individual is proeced agains he risk of ouliving his own asses, given uncerainy abou his remaining lifeime, by pooling longeviy risk across a group of annuiy purchasers. Yaari (1965) shows ha risk-averse reirees wihou a beques moive facing annuiy markes ha charge acuarially fair premiums, should annuiize 100 percen of heir wealh. Though life annuiies provide invaluable longeviy insurance ha canno be replicaed by pure invesmen vehicles, hey also have some disadvanages. Firs, he purchaser faces loss of liquidiy and conrol over his asses, because he lump sum premium canno be recovered afer purchase of he annuiy, irrespecive of special needs (e.g. o cover unexpeced expendiures for uninsured medical coss). 1 Second, in is simples form, where income paymens are coningen on he individual s survival, here is no chance of leaving money for heirs, even in he case of he annuian s early deah. Oher explanaions for why individuals will be relucan o buy annuiies are he high adminisraive coss levied by insurance companies (Michell e al., 1999), he abiliy o pool longeviy risk wihin families (Brown and Poerba, 2000; Kolikoff and Spivak, 1981), and he presence of oher annuiized resources from Social Securiy or employer-sponsored defined benefis plans (Munnell e al., 2002). Recen developmens in European pension sysems have focused aenion on alernaive income wihdrawal paerns for asse pools dedicaed o old-age consumpion. In Germany, so-called Rieser plans offer ax inducemens for volunary saving in individual pension accouns (IPA) during he worklife, underscoring he governmen s ineres in boosing asse accumulaion in an aging populaion (Börsch-Supan e al., 2003a, b). When he age of reiremen is reached, weny percen of he accumulaed asses in he IPA can be aken as a lump-sum disribuion. The res mus be drawn down in he form of a lifelong annuiy (offered by a commercial insurance company) or a phased wihdrawal plan (ypically offered by muual fund and/or bank providers) which mus parly rever ino an annuiy a he age of 85. In he UK, personal pensions have also grown in populariy (Blake e al., 2003). As in Germany, a porion of he accumulaed asse can be aken as a lump sum, while wih he res, one is legally obliged o buy an annuiy by he age of 75. In Canada, a age 69 reirees mus eiher buy an annuiy wih heir ax-shelered savings or creae a discreionary man- 1 See Brugiavini (1993) for a heoreical model in which he healh saus of he reiree is sochasic.

4 2 aged wihdrawal plan (Milevsky and Robinson, 2000). In he US, no compulsory annuiizaion is required for 401(k) plans a reiremen; insead, many workers roll over heir funds as a lump sum ino an Individual Reiremen Accoun and manage he funds hroughou reiremen. Research ineres is increasing regarding he decumulaion phase for hese accouns. A key aspec of he reiree s decumulaion process is he decision of how o inves hese reiremen plan asses and how o srucure payous during he reiremen period, so as o bes balance consumpion flows versus beques inenions wihou running ou of money. An alernaive sraegy o buying a life annuiy is associaed wih wha has been called self-annuiizaion or phased wihdrawal approach (c.f. Milevsky and Robinson, 2000). A reiremen, he wealh endowmen is allocaed across various asse caegories (e.g. equiy, bonds, cash) ypically included in a family of muual funds where he asses will earn uncerain raes of reurn. A cerain amoun of he invesed funds can hen be wihdrawn periodically for consumpion purposes. The paricular advanage of such a phased wihdrawal sraegy, as compared o he life annuiy, is ha i offers greaer liquidiy, he possibiliy of greaer consumpion while alive as well as he possibiliy of bequeahing some of he asses in he even of early deah. On he oher hand, relying on income flows wihdrawn direcly from an IRA wihou any insurance provides no pooling of longeviy risk. Consequenly, if he reiree consanly consumes an equal amoun from his accoun, he could oulive his asses before his uncerain dae of deah, paricularly in he even of long-run low invesmen reurns. An alernaive wihdrawal rule is o no ake ou some fixed amoun per period, bu raher o consume a specified fracion of he remaining fund wealh each period. This second sraegy, in conras o he fixed wihdrawal echnique, avoids he risk of ouliving one s oal asses, as long as he benefi-o-wealh raio is lower han one. Neverheless, due o sochasic invesmen reurns, he value of he pension accouns asses change over ime implying ha he periodically wihdrawn amoun mus vary in andem and i could be subsanially lower or higher han he benefi payable under a life annuiy. To be able o evaluae he differen decumulaion opions on a quaniaive basis, i is necessary o inroduce a formal risk/reurn framework for decision-making under uncerainy. The sandard approach in financial economics is o maximize he expeced discouned value of a (ime separable) uiliy funcion for uncerain fuure benefis and (if necessary) for a beques. For example, Blake e al. (2003) use a uiliy funcion of he consan relaive risk class (CRRA), o evaluae differen wihdrawals plans assuming mandaory annuiizaion is required a age 75. Milevsky and Young (2003) use a similar objecive funcion o deermine he value of he opion o defer annuiizaion. A shorcoming of such an approach, especially in he pracical world, is ha he decision-maker may lack explici measures of risk preferences (Pye 2000). As a resul, risk-value (or risk-reurn) models of choice have he advanage of developing an explici measure of risk, an explici measure of value, and a funcion reflecing he rade-offs beween value and risk. Clearly, individuals prefer more reurn o less and less risk o more, oher hings equal. This propery allows a parial-ordering of opporuniies wihin a risk-reurn dominance conex, even if he exac preference weighs for he risk and reurn radeoff are unknown. Depending on which risk meric is seleced and how he radeoff beween risk and reurn is formulaed, a risk-value model can bu need no be consisen wih he expeced uiliy approach of choice (Sarin and Weber 1993). 2 2 Perhaps he mos widely used risk-reurn model in he area of finance is he classic mean-variance porfolio analysis elaboraed by Markowiz (1952), which is, iner alia, consisen wih a quadraic uiliy funcion (see Campbell and Viceira, 2002, p. 24). A general analysis of condiions regarding he compaibiliy of muliparameer rade-off models of choice wih he expeced uiliy model is given in Schneeweiß (1967).

5 3 In his paper, we ake a risk-value approach, whereby he reurn is he expeced level of benefis as well as he expeced possibiliy of beques, and he risk is he possibiliy of no reaching a benchmark or desired level of consumpion. Previous sudies aking his ack focus on he probabiliy of consumpion shorfall as he operaive risk measure. 3 Assuming ha he reiree consumes a fixed real amoun a specific poins in ime from a self-managed pension accoun, hese auhors calculae he probabiliy of running ou of money before he uncerain dae of deah using alernaive assumpion abou he asse allocaion, he iniial consumpion-o-wealh raio, and he opimal waiing ime before swiching he reiremen wealh ino an annuiy. Our work exends his lieraure in several direcions. Firs, we examine he risk and reurn profiles of several variable selfannuiizaion sraegies ha provide paymens according o predeermined benefi-o-wealh raio. Second, we address a major shorcoming of he shorfall-probabiliy risk measure, namely ha i ignores he size of he possible loss ha may be experienced. In pracice, of course, boh heoreical and empirical argumens sugges ha invesors ake boh he probabiliy and he amoun of a possible shorfall ino consideraion. Our conribuion is o go beyond prior work by looking no only a he probabiliy of a consumpion shorfall, bu also consider he size of he shorfall when i occurs. Third, we examine how he resuls change if a mandaory annuiizaion rule were imposed akin o hose in he recen German and UK pension regulaion. Fourh, we evaluae he impac of allowing he annuiizaion dae o be endogenous, along wih he asse allocaion decision. We illusrae how he risk of a consumpion shorfall and reurn profiles of fixed and variable phased wihdrawal sraegies compare o he life annuiy, and indicae wha dominan sraegies migh be. The remainder of his paper is divided ino four secions. The nex secion describes several differen wihdrawal sraegies. To illusrae heir implicaions, we assume condiions wih respec o capial and insurance markes producs and pricing found in he German annuiy and capial markeplace. We adop hese so as o be informaive abou alernaive payou opions ha migh be conemplaed under he German Rieser plans when hey reach mauriy. Mos resuls focus on an age- 65 male reiree, bu we also provide findings for oher ages and for women. Secion hree repors resuls using a fixed asse allocaion paern, and Secion four permis asses o be allocaed opimally. A final secion summarizes and concludes. 2. The Case of Phased Wihdrawal 2.1 Wihdrawal Plans wih Fixed Benefis We assume ha he reiree is endowed wih an iniial wealh of V 0 ha he can use o buy a singlepremium immediae life annuiy paying consan annual real benefis B a he beginning of each year, for life wih no beques. We denoe his as he benchmark annuiy and refer he reader o Appendix A regarding he pricing of such an insurance produc using assumpion abou moraliy, loadings and ineres raes o discoun fuure annuiy paymens. If he reiree does no annuiize his wealh, he invess he reiremen asses in various financial asses (e.g. equiies, bonds, cash) ypically represened by a family of muual funds, and hen he wihdraws a cerain amoun a he beginning of he year for consumpion purposes. Throughou he paper, we assume ha benefis are axed 3 See for insance Milevsky e al. (1997), Milevsky and Robinson (2000), Milevsky (1998, 2001), Ameriks e al. (2001), Pye (2000, 2001) and Albrech and Maurer (2002).

6 4 as ordinary income; herefore axes will no change he desirabiliy of volunary annuiizaion or sysemaic wihdrawal from a self-managed reiremen accoun. 4 Under he fixed benefi rule, he reiree will sell a he beginning of each year as many fund unis as required o reach he same yearly benefis paid by he life annuiy, unil eiher he dies, or he reiremen asses are exhaused. Formally, he benefis B a he beginning of each year are given by: B = min( B, V ), (1) where V is he value of he reiremen accouns asses wealh a he beginning of year ( = 0, 1, ) jus before he wihdrawal B for ha year is made. The reiree faces an ineremporal budge consrain ha wealh nex period V +1 equals wealh oday V, less wha is subraced for benefi paymens B, imes he (inflaion adjused) porfolio reurn R +1 over he period, or zero if he fund is exhaused: ( V B)(1 + R+ 1) V > B V + 1 = ( V B ) (1 + R+ 1) =. (2) 0 V B. Noe ha he benefi paid B depends on he value V of he reiremen asses used o finance wihdrawals. If hese asses are risky, he benefi payous are exposed o uncerain capial marke reurns. The idea of he fixed benefi rule is o replicae he income from a life annuiy as long as he funds permi, while a he same ime offering some beques poenial in he even of an early deah. Neverheless, he risk of he fixed benefi rule is ha adverse capial markes linked o longeviy oucomes migh produce a siuaion where V his zero and herefore B = B +1 = = 0, while he reiree is sill alive Phased Wihdrawal Rules wih Variable Benefis Under a variable phased wihdrawal plan, he reiree receives no a fixed benefi amoun per period, bu raher (as in Meron, 1971) an ex ane fixed fracion of he reiremen asses remaining each period. This benefi-wealh raio can be consan, increasing, or decreasing over ime. Due o he sochasic naure of capial markes, he value of he reiree s fund is exposed o posiive as well as negaive flucuaions. Consequenly, he level of benefi paymens under a variable wihdrawal plan also flucuaes in andem wih he accouns value. Depending on he wihdrawal fracion and he realized reurns of he reiremen accouns asses, benefi paymens could be subsanially lower or higher han paymens from a life annuiy a some poin during he pos reiremen phase. A variable phased wihdrawal plan and a variable annuiy have in common he fac ha hey pay pension benefis ha vary wih uncerain invesmen reurns. Neverheless, he former offers he possibiliy of bequeahing he remaining value of he reiremen accoun in he case of he reiree s deah, while he laer does no. The pah of benefis payable using a variable phased wihdrawal rule can be formalized as follows. Le V be he value of he reiremen asses a he beginning of period ( = 0, 1, ) before he wihdrawal B for ha year is made. A he beginning of every period, an ex ane specified fracion ω (0 < ω 1) is wihdrawn from curren wealh; hence he reiree receives a paymen according o: B = ω V (3) 4 This is accurae for he German conex; for more on annuiy ax reamen in he US see Brown e al. (2001).

7 5 Furher le R +1 denoe he reurn of he funds over he period. Then, he ineremporal budge consrain of he reiremen accoun is given by: V V B ) (1 + R ) = (1 ω ) V (1 R ). (4) + 1 = ( If he reiree dies a he beginning of period +1, V +1 represens he beques poenial for his heirs. Noe ha if he asses of he pension accoun are invesed in risky asses (e.g. socks and/or bonds), he reurns are also uncerain, and herefore boh he pension benefis B as well as he beques poenial V are random variables. In wha follows, we focus aenion on hree specific wihdrawal rules ha generae variable benefis: he fixed percenage rule, he 1/T rule, and he 1/E(T) rule. Each is discussed in urn. Fixed Percenage Wihdrawal Rule: Here a consan fracion is wihdrawn each period from he remaining fund wealh, i.e. he benefi-wealh raio is fixed over ime: B V ω = ω. = This wihdrawal rule has he advanage of simpliciy, requiring no informaion regarding he maximum possible duraion of he payou phase or he reiree s characerisics (i.e. age, sex). "1/T Rule" Wihdrawal Rule: The idea behind his rule is o se he wihdrawal fracion according o he maximum possible duraion of he plan, denoed by T. One way is o se T equal o he oldes age assumed in a moraliy able; anoher is o fix i a he reiree s life expecancy as of his reiremen dae (Brown e al., 1999). In he firs case, he maximum number of paymens T is given by he limiing age l of he moraliy able minus he curren age of he reiree x plus one: T = l x +1. (6) The reiree ges a fracion of 1/T of his iniial pension accoun as he firs paymen, he second paymen is worh 1/(T 1) of he remaining asses, and so forh unil he reiree eiher passes away or reaches he plan s limiing age l. Formally, he benefi-wealh raio a he beginning of year ( = 0, 1, T-1) of his reiremen plan is given according o: B 1 = ω =. (7) V T In conras o he fixed percenage rule discussed above, he wihdrawal fracion is no consan bu raher increases wih age. Wha his means is ha he longer he reiree survives, he higher he wihdrawal fracion will be. For example, if l = 110 and x = 65 he firs wihdrawal fracion a age 65 is ω 0 = 1/46 = 2.17%, he second a age 66 is ω 1 = 1/45 = 2.22%, and a age 101 he benefi o wealh raio is ω 101 = 10%. The rule pay ou all of he remaining wealh of he reiremen accoun (i.e. ω 110 = 100%) by he age of 110 no beques poenial is lef in conras o he fixed percenage rule. 1/E[T(x)]" Wihdrawal Rule: This rule, which we will call he 1/E(T) rule for shor, akes ino consideraion he reiree s remaining life expecancy in a dynamic way. Now he wihdrawal fracion is no longer deermined by he maximum lengh of he plan, bu insead by he reiree s life expecancy remaining. Le p x represens he condiional probabiliy ha an x-year old man will aain age x +, he complee expecaion of life is calculaed as: (5)

8 6 [ ] T ( x + ) = = l x E (8) p x 0 where l is he maximum age according o a moraliy able. Then, for an a reiremen x-year old man, he benefi-o-wealh raio in period afer reiremen, condiional on he fac ha he is sill alive, is given as: B V 1 = ω =. (9) E[ T ( x + )] The shorer his expeced remaining lifeime, he higher he fracion he will wihdrawal from his pension accoun. Therefore, he wihdrawal fracion rises wih he age of he reiree. Since he reiree s life expecancy is less han he maximum age of he moraliy ables, he benefi-o-wealh raio of he 1/E(T) rule exceeds ha of he 1/T rule, in general. The 1/E(T) wihdrawal rule is used in he US during he decumulaion phase of 401(k) plans, where he ax auhoriy seeks o ensure ha reirees consume heir ax-qualified pension accouns insead of leaving hem as bequess for heir heirs (see Munnell e al., 2002). 3. Risk and Reward Analysis of Phased Wihdrawal Plans Condiional on Survival 3.1 Research Design To compare he risk and value characerisics of he four phased wihdrawal rules, i is useful o begin wih an assessmen of expeced payous condiional on reiree survival (Secion 4 generalizes resuls wih moraliy-weighed risk and reward compuaions). For he momen, herefore, we focus only on he risk resuling from capial markes and suppress moraliy. To do so, we assume a 65- year old male reiree who seeks o compare benefis under he four phased wihdrawal plans given an iniial asse balance. The plan asses are rebalanced annually o mainain an asse pool spli evenly beween socks and bonds, consisen wih recommendaions by financial advisors (asse allocaion is opimized in he nex secion). 5 The analysis o follow uses assumpions drawn from he German capial and annuiy marke environmen (we also offer some comparisons using US assumpions). Accordingly, we employ an annuian moraliy able provided by he German Sociey of Acuaries o calculae survival probabiliies and expeced lifeime (in he 1/E(T) case). Since his able ends a age 110, we se l = 110 for he 1/T rule. For he fixed percenage wihdrawal rule, we selec ω = 5.82%, since his benefi-owealh raio produces an iniial payou equal o he life annuiy in he firs year of he plan. In he case of he fixed benefi rule, we assume ha he iniial wihdrawal coninues unil he reiree dies or he accoun is exhaused. We nex assess he risk and reurn paerns ha emerge under hese alernaive phased wihdrawal paerns (before axes), compared o a fixed real annuiy providing lifelong consan payous. When focusing on risks and benefis, he compuaions eiher assume ha he reiree is alive, or conversely 5 Feldsein e al. (2001) and Ibboson (2003) assume ha reirees hold heir non-annuiized asses in a 60% sock, 40% bond porfolio. Here, for illusraive purposes, we use a more conservaive spli, consisen wih he posiion recommended by he Presiden s Commission o Srenghen Social Securiy (see Cogan and Michell (2003)). Some financial advisers propose ha invesors hold equiies equal o 100 minus heir age; see Canner e al. (1997) or Vora and McGinnes (2000). The number 100 could (probably) be jusified wih he maximum age used in mos populaion moraliy ables bu we noe ha annuian moraliy ables generally have a maximum age of years higher.

9 7 we evaluae he beques poenial if he reiree is assumed o pass away a a specific age. To do so, we specify an exogenous srucure on he ex-ane probabiliy disribuion governing he financial uncerainy of fuure reurns and esimae he parameers of such a model from independen (e.g. yearly) hisorical observaions of real reurns. Wih such a model in place, i is possible o look ino he fuure and compue he expeced benefi paymens and differen shorfall-risk measures of he four wihdrawal plans in which we are ineresed. Implemening i relies on he assumpion ha he sochasic specificaion of he asse values in he reiremen accoun follows Geomeric Brownian moion, a sandard assumpion in financial economics. This implies ha he yearly log-reurns are i.i.d. and normally disribued. We also use German hisorical ime series over he period for he German Equiy Index (DAX) and he German Bond Index (REXP) as proxies for sock and bond invesmens. The DAX represens an index porfolio of German blue-chip socks, and he REXP represens a porfolio of German governmen bonds. Each of hese indices is adjused for capial gains as well as dividends and coupon paymens (on a pre-ax basis). To accoun for poenial adminisraive coss, we subrac he equivalen of 0.5% p.a. from he yearly porfolio reurn. 6 Subsequenly, asse reurns are adjused for inflaion by using he German Consumer Price Index. These yearly daa produce esimaes (before axes) for he real log average rae of reurn, he volailiy and he correlaion-coefficiens of socks and bonds as repored in Appendix B. Since we assume normally disribued log reurns, i.e. I = ln(1 + R ) ~ N(µ, σ ), hese parameers imply a real log average rae of reurn on he fify-fify sock-bond porfolio of µ = 5.52 percen wih a sandard deviaion of σ = %. Noe ha his produces an expeced gross rae of reurn of E(1 + R ) = E[exp(I )] = exp[ *0.1378²] = Assuming ha he normaliy propery also holds for he log porfolio reurns, 7 i is sraighforward o develop an analyical closed form soluion for he probabiliy disribuion of fuure benefis of he differen variable phased wihdrawal rules since he ineremporal budge consrain given in equaion (4) is (log)linear (see Appendix C for deails). However, because he value of he reiremen accouns value migh hi zero, he ineremporal budge consrain in equaion (2) for he fixed benefi rule is no (log)linear, and fuure benefis are pah-dependen. Hence, even under he assumpion of independen and idenically disribued log porfolio reurns, for he fixed benefis wihdrawal plan he probabiliy disribuion of fuure benefis is unknown. Therefore, o obain esimaes for he differen risk and reurn measure we use Mone-Carlo simulaion o generae a large number (i.e. 100,000) of pahs for he evoluion of he wihdrawal plan Analysis of Expeced Benefis Figure 1 depics he Expeced Benefis profiles condiional on survival, for he four phased wihdrawal rules, as compared o he annuiy profile. Focusing on he fixed benefi rule shows ha in he firs year, mean benefis are (by consrucion) equal o he annuiy benefi. However, in he following years, he expeced paymens from he plan are decreasing, reflecing he risk of running ou of money. The fixed fracion rule also sars wih a benefi equal o he life annuiy payou, and afer 6 Feldsein e al. (2001) p. 60 use a similar procedure o accoun for adminisraion coss. 7 This assumpion is widely used in sraegic asse allocaion (e.g. Feldsein e al. (2001) or Campbell and Viceira (2002)) and can be jusified by a Taylor approximaion of he nonlinear funcion relaing log-individual-asse reurns o log porfolio reurns. For full deails see Campbell and Viceira (2002), p and Campbell e al. (2001). 8 Milevsky and Robinson (2000) have developed an analyical approximaion mehod based on momen-maching echniques and he reciprocal gamma disribuion and herefore can avoid Mone Carlo-simulaion.

10 8 ha, mean benefis slighly rise as he reiree ages. This is due o he fac ha he pension accoun s expeced gross rae of reurn is 6.66% p.a., which exceeds he consan benefi-o-wealh-raio of 5.82% p.a. (i.e *( ) = > 1). Figure 1 here By conras, he 1/T rule pays a much lower expeced benefi up o he age of 80, bu hereafer, he expeced benefi rises exremely quickly and o very high levels, reaching almos 700% of he annuiy paymen lae in life. This can be explained by he low wihdrawal fracions of his rule during he firs par of he reiremen plan. Up o age 95, he benefi-o-wealh raio is lower han he expeced rae of reurn (i.e. 6.66%); consequenly, he expeced value of he pension asses grows over ime. Reserves buil up in earlier ages can be used o increase he expeced benefis in laer years. The 1/E(T) rule sars a a level of abou 85% of he annuiy paymen and increases o 100% if he reiree reaches age 70. This payou approach reaches is maximum expeced paymen of abou 150% a age of 83. Afer his age, he expeced paymens are monoonously decreasing, reaching he level of he life annuiy a age 91. A ages older han 100, following he 1/E(T) rule would leave he reiree very exposed o quie low benefis, asympoically approaching 0. Noe ha he wihdrawal fracion under he 1/E(T) rule is higher han under he 1/T rule. Only for he firs six years of he reiremen plan will he benefi-o-wealh raio be lower han he expeced reurn earned on pension asses. If he reiree survives unil age 71, his expeced lifeime is abou 15 years, resuling in a wihdrawal fracion of 6.66% which is abou he same as he expeced rae of reurn. Beyond ha age, he wihdrawal fracion grows ever larger han he expeced asse reurns backing benefi paymens. For some ime (i.e. up o age 83), he increasing wihdrawal fracions produce increasing expeced benefis. Bu because less and less wealh is lef in he fund, a some poin (here age 83) he expeced benefi amouns decrease alhough he wihdrawal fracion increases Shorfall Risk Analysis Shorfall Probabiliy In accordance wih oher fields of research, as well as wih convenional wisdom, shorfall risk is associaed wih he possibiliy of somehing bad happening, in oher words, falling below a required arge reurn. Reurns below he arge (losses) are considered o be undesirable or risky, while reurns above he arge (gains) are desirable or non-risky. In his sense, shorfall-riskmeasures are called relaive or pure measures of risk. 9 To analyze his risk in he case of our phased wihdrawal sraegies, we employ several differen shorfall risk measures. We begin wih he shorfall probabiliy, defined as: SP(B ) = P(B < z). (10) This measures he probabiliy ha he periodic wihdrawal B is smaller han a chosen benchmark z, which is here he paymen provided by he life annuiy. 9 The concep of shorfall risk was inroduced in he area of finance by Roy (1952) and Kaaoka (1963), and i was expanded and heoreically jusified by Bawa (1975) and Fishburn (1977, 1982, 1984). I was widely applied o invesmen asse allocaion by Leibowiz e al. (1996) and used by Leibowiz and Krasker (1988) and Maurer and Schlag (2003) among ohers o judge he long erm risk of socks and bonds. In addiion Libby and Fishburn (1977); Kahneman and Tversky (1979); Laughhuun e al. (1980) and March and Shapira (1987) show ha in empirical business decisionmaking, many individuals judge he risk of an alernaive relaive o a reference poin.

11 9 Figure 2 depics he Shorfall Probabiliy for he fixed benefi rule, he fixed fracion rule (5.82%), he 1/T approach and he 1/E(T) rule, as compared o he annuiy benefi. In he firs year, all he sraegies excep he fixed benefi program face a high probabiliy of shorfall, and he only reason he fixed benefi approach does no is ha i is se by consrucion o pay he iniial annuiy value as long as he funds have no been exhaused. The fixed benefi program offers a Shorfall Probabiliy close o zero a he beginning of he reiremen period, bu his risk meric begins o rise over ime, reaching abou 20% around age 85. By conras, boh he 1/T and 1/E(T) rules have very high shorfall probabiliies early in he reiremen period. This is because a reiree invesing his asses in a muual fund hoping o generae he same paymen offered by he life annuiy mus wihdraw abou 6.50% of he fund annually. Bu he wihdrawal fracions under he 1/T and he 1/E(T) rules are smaller early in reiremen, meaning ha he wealh remaining grows quickly. Consequenly he shorfall probabiliy declines over ime, hough he wihdrawal fracion is growing. The reiree ha wihdraws a fixed fracion each year faces a risk profile ha is remarkably high for all ages. In early years, he probabiliy of receiving a benefi below he benchmark life annuiy is abou 50%, gradually increasing o abou 60% a he end of he period. 10 Figure 2 here Anoher ineresing finding has o do wih he gradien of he Shorfall Probabiliy under he 1/E(T) rule. Early in he reiremen period here is a very fas decline in his risk, bu if he reiree is sill alive a age 83, he SP begins o rise very quickly due o he special consrucion of his spending rule. In conras o he 1/T rule, expeced paymens a he beginning of he plan are already higher, meaning ha few reserves are buil up in he beginning of he plan. Also, he 65-year-old reiree has an expeced remaining lifeime of 19 years, and his expeced remaining lifeime decreases over ime, especially afer he age of 80. The shorer is he remaining expeced lifeime, he more wealh will be wihdrawn in he 1/E(T) case. As he wihdrawal fracions increase, less and less wealh is lef in he fund; a some poin, wealh remaining is insufficien o provide high enough paymens, so he shorfall probabiliy again increases Shorfall Measures Tha Incorporae Severiy As Bodie (2001: 308) noes, a major shorcoming of he popular SP risk meric is ha i compleely ignores how large he poenial shorfall migh be. The shorfall probabiliy answers he quesion how ofen consumpion falls shor, bu no how bad he loss is if i occurs, under each of he differen wihdrawal rules. To provide informaion abou he poenial exen of a shorfall, we nex calculae he Mean Excess Loss (MEL) as an addiional risk measure. Formally his risk meric is given by: MEL(B )=E[ z B B < z ]. (11) I indicaes he expeced loss wih respec o he benchmark, under he condiion ha a shorfall occurs. Therefore, given a loss, he MEL answers he quesion how badly on average does he sra- 10 This resuls from he lognormal disribuion of fuure benefis which become increasingly skewed o he righ, he longer he reiree remains alive. Noe ha he expeced level reurn (i.e. exp( *0.1378²) - 1 = 6.66%) of he reiremen accoun asses is greaer han he wihdrawal fracion (i.e. 5.82%), bu he median level reurn (i.e. exp(0.0552) - 1 = 5.68%) is slighly below he wihdrawal fracion, so he shorfall probabiliy rises wih age.

12 10 egy perform; i MEL can be characerized as a wors case risk measure, which is highly sensiive wih respec o realizaions a he ail of he disribuion (i.e. large-scale shorfalls). 11 An addiional shorfall risk measure ha links boh he probabiliy and he exen of he condiional shorfall in an inuiive way is he Shorfall Expecaion (SE): SE(B ) = E[max(z - B,0)] = MEL(B ) SP(B ). (12) The shorfall expecaion is he sum of losses weighed by heir probabiliies, and hence i is a measure of he uncondiional average loss. As equaion (12) shows, he SE is simply he produc of he shorfall probabiliy and he mean level of shorfall given he occurrence of a shorfall. 12 In Figure 3 we plo he Mean Excess Loss resuls for he various wihdrawal sraegies of ineres, namely he fixed benefi rule, he fixed fracion rule (5.82%), he 1/T approach and he 1/E(T) rule. Here we compare he MEL for each acic versus he annuiy benefi. Resuls are similar in form: ha is, in he firs year, all sraegies bu he fixed benefi program have a posiive MEL, since he fixed benefi approach pays for as long as possible an amoun equal o he iniial annuiy. The 1/T rule has a paricularly high iniial MEL, a 60% of he value of he annuiy paymen, and his falls only o 30% some 15 years ino he reiremen period. Boh he 1/E(T) and he fixed fracion rules have 30% MEL profiles hrough abou age 90, bu hen he 1/E(T) rule confrons he reiree wih a rapidly rising mean excess loss aaining close o 100% lae in life. By conras, he 1/T plan faces he reiree wih a gradually declining expeced loss afer age 90, falling o abou 30%. The resuls make clear ha from a wors-case risk perspecive, he fixed fracion rule, and he 1/E(T) rule, are no proper financial insrumens for insurance agains longeviy. Figure 3 here The profiles for he Shorfall Expecaion appear in Figure 4, and i will be recalled ha hese combine he Shorfall Probabiliy and he Mean Excess Loss, all condiional on survival. This graph underscores he paerns revealed by he wo previously analyzed risk measures. Now he fixed benefi rule has a very low Shorfall Expecaion hrough abou age 83, whereas he 1/T rule is iniially he riskies wih a 60% SE. I akes a very long ime unil he SE of he 1/T rule declines o a negligible level older han age 90 for he hypoheical individual under sudy. The fixed fracion and he 1/E(T) rules have a SE of less han 20% hrough a leas age 80, bu he 1/E(T) rule again races ou wha is perhaps unexpeced behavior afer falling o low levels hrough abou age 84, he risk begins o rise subsanially 20 years afer reiremen, and i has he highes expeced shorfall for he long-lived individual. Figure 4 here 11 The MEL is closely conneced wih he Tail Condiional Expecaion (TCE), which is given by TCE = E(R R < z) = z MEL. The TCE has some favourable feaures, e.g. i is (in conras o he shorfall probabiliy) a coheren risk measure wih respec o he axioms developed by Arzner e al. (1999). 12 In addiion, he SE is relaed o he price of a (derivaive) financial conrac which allows he annuian o ransfer he downside risk of a phased wihdrawal plan ino he capial marke. For example, if he reiree buys a pu opion paying P = max(z B, 0) a ime, hen he is compleely hedged agains he risk ha he benefi from he wihdrawal plan is lower han he paymen from he benchmark annuiy z. Noe ha he fuure benefis are direcly relaed o he marke value of he reiremen accouns asses V. Using sandard argumens from opion pricing heory, he price of such a (European) pu opion is given by p 0 = E Q [max(z B, 0)]/exp(R f ), where E Q denoes he expecaion operaor wih respec o he risk adjused ( maringale ) probabiliies and R f is he risk free ineres rae.

13 Analysis of Expeced Bequess The oher side of he sory behind hese rules is ha he reiree mus in effec compare his own consumpion wih he poenial value of he beques ha would go o he heirs if he should die. Figure 5 illusraes he expeced beques under he various formulaions, condiional on deah. The paern exhibiing mos sabiliy is he fixed fracion rule, bu he oher hree are highly divergen. For example, he 1/T rule shows an ineresing pah, firs rising in he early reiremen period when wihdrawals are small. Abou 35 years afer reiremen, however, he expeced beques begins o decline very quickly a fac ha is direcly aribuable o he consrucion of his plan. The older a reiree ges, he more he or she wihdraws from his accoun: hus five years before he plan ends, he reiree wihdraws 1/5=20% of he remaining wealh. If he reiree should by chance live beyond age 110, his approach offers no coninued paymen or beques poenial. The 1/E(T) rule also offers only a very low beques poenial afer reaching a limiing age. In conras wih he 1/T rule, however, he 1/E(T) plan offers lower expeced inheriance a every age. Paricularly if he reiree does no die unil 20 years ino reiremen, he inheriance will decline dramaically. Figure 5 here 4. Risk-Minimizing Phased Wihdrawal Sraegies 4.1. Opimized Wihdrawal Rules in a Risk-Reurn Conex Thus far, our analysis has assumed ha he reiree holds his pension plan asses in a fixed-weigh porfolio comprised of 50% socks and 50% bonds over a fixed invesmen horizon. Thus he payous during reiremen ake ino accoun only capial marke uncerainy, and here was no possibiliy of opimizaion around risk/reward radeoffs. In his secion, we exend he analysis by including a consideraion of moraliy risk, and furher we discuss wo addiional phased wihdrawal rules ha permi he reiree o opimize he design of he wihdrawal paerns. In he nex subsecion, our analysis varies he invesmen weighs of he associaed wih sock, bonds, and cash invesmens, o aain a risk-minimizing saic asse allocaion. The porfolio weighs are herefore deermined endogenously (excluding shor-selling), following Albrech and Maurer (2002). In he following subsecion, we go on o examine he impac of mandaory shifing o annuiizaion a a specific age. This is currenly required in ax qualified German Rieser plans a he age of 85 and for UK income drawdown plans a he age 75. In boh counries, he resricion of mandaory swiching has already considerable criicism in he public debae (c.f. Blake e al. 2003; Börsch-Supan and Wilke, 2003b). To evaluae how he relaive ranking of he alernaive wihdrawal rules migh change wih an endogenous asse mix in he reiree s invesmen fund and oher plan design parameers, i is useful o define he expeced presen value of he shorfall, called here EPVShorfall : l = x p xse(b ) EPVShorfall = (1 + R ) 0 Here, SE(B ) = E[max(z B, 0)] denoes he expeced shorfall wih respec o he arge z, which is equal o he benefi provided by he benchmark life annuiy. The possible expeced shorfall in year are weighed by he condiional probabiliy p x ha a man aged x a he beginning of he reiremen phase is sill alive, in he case when a shorfall occurs. All possible expeced shorfalls are dis- f (13)

14 12 couned back o he beginning of he reiremen period using he risk-free ineres rae R f (i.e. assuming a fla erm srucure of real ineres raes) and summed over he maximum lengh of he moraliy able used. This useful summary measure of he risk associaed wih a phased wihdrawal sraegy may be inerpreed as he lump sum premium ha would be required for he reiree o ransfer his shorfall risk o an insurer, assuming acuarially fair pricing and no addiional loading. 13 Given his funcion, we minimize i wih regard o asse allocaion and oher plan design parameers, o derive he asse allocaion paerns mos amenable o alernaive wihdrawal rules. Previous sudies, mos noably Milevsky (1998), Milevsky and Robinson (2000) and Albrech and Maurer (2002), approach he issue of opimal fixed benefis wihdrawal rules by adoping he crierion of conrolling he probabiliy of a consumpion shorfall in reiremen. On he oher hand, as we have argued, his perspecive does no accoun for he size of he loss when i happens, which our risk measure does. 14 To exend he approach, we adop wo addiional reward measures associaed wih each opimized phased wihdrawal sraegy, namely, he expeced presen value of benefis received during life (EPVBenefis) and he expeced presen value of bequess a deah (EPVBeques). These are defined, respecively, as: l = x p x E(B ) EPVBenefis, and (14) = (1 + R ) 0 f EPVBeques = l x = 1 1 p x q x+ (1 + R E(V ) f ) (15) Here, he EPVBenefis is similar defined as he money worh concep used by Michell e al. (1999) and reflecs he expeced presen value of benefi paymens condiional on survival. Finally, EB- VBeques measures he expeced presen value of he inheriance ha he reiree would pass on o heirs, in he even of deah. We implemen hese merics insead of adoping a specific uiliy funcion for several reasons. Firs, hese risk measures are consisen wih expeced uiliy analysis, since hey are he primiives ha ener ino uiliy maximizers objecive funcions. 15 Any paricular funcional form mus embody specific radeoffs beween risk and reurn componens, whereas our approach can remain agnosic 13 Noe, if SE(B )/(1+R f ) is calculaed wih respec o he corresponding risk adjused ( maringale ) probabiliies (consisen wih an arbirage free capial marke) of he underlying asse process, i is consisen wih he price of an European pu opion which pays he difference if a shorfall happens in year afer reiremen. Then he EPVShorfall is he value of a porfolio consising of (European) pu opions weighed by survival probabiliies p x. 14 For insance, having a shorfall a he age of 75 implies a greaer expeced consumpion loss, han he same shorfall a he age of 85. Therefore, he opimizaion procedure used in Albrech/Maurer (2002) does no ake ino accoun he iming and magniude of he loss when i occurs. 15 For example, assume ha he individual rades off expeced benefi paymens versus he expeced shorfall vis a vis he benchmark annuiy z, i.e. Φ(B )=E(B ) ke[max(z B, 0)] wih risk aversion parameer k>0 (and ignoring bequess). This risk value model is consisen wih a uiliy funcion suggesed by Fishburn (1977) of he form u(x)=x if x z resp. u(x)=x k(z-x) if x<z. As Bawa (1975, 1978) has shown, he mean/se-opimizaion model sudied here corresponds wih he concep of second order sochasic dominance. To allow radeoffs beween EPVBenefi and EPVShorfall, we make he usual assumpion ha he individual s objecive funcion is given by a ime separable uiliy funcion of he Fishburn ype, and ha he individual s ime preference is equal o he risk-free real ineres rae. See also Brachinger and Weber (1997) for risk as a primiive.

15 13 abou he specific weighs aached o each (Sarin and Weber 1993). Second, risk minimizaion is consisen wih many sudies in he lieraure (c.f. Albrech and Maurer, 2002; Chen and Milevsky, 2003; Milevsky and Robinson, 1994), and i is also consisen wih convenional wisdom offered by money managers and financial planners when providing advice regarding reiremen income payous (c.f. Ameriks, forhcoming; Ameriks e al., 2001; Ibboson Associaes, 2003). The specific opimized rules we propose are wo: a Fixed Percen Opimized rule, and a 1/T Opimized rule. The firs (Fixed Percen Opimized) rule minimizes he expeced presen value of he shorfall by selecing joinly he opimal consan wihdrawal fracion and he reiree s asse allocaion. This conrass from our earlier consan wihdrawal rule, by endogenizing he wihdrawal fracion. Compared o he non-opimized Fixed Percen rule, we expec ha allowing wo parameers, he fracion consumed as well as he asse allocaion, will be more successful in conrolling boh moraliy and capial marke risk. The second rule, denoed as 1/T Opimized minimizes he EP- VShorfall by selecing joinly he maximum duraion of he plan condiional on survival, along wih he asse allocaion. We expec ha he 1/T Opimized rule will permi more consumpion when he probabiliy is high ha he reiree remains alive, as compared o he non-opimized 1/T rule, bu i will also offer lower expeced bequess Comparaive Resuls: Annuiy versus Phased Wihdrawal Plans Table 1 repors resuls for he various wihdrawal rules of ineres here allowing opimized asse allocaion. These may be compared o resuls for he benchmark case of a life annuiy benefi which appear in Row 1: a 65-year old male who pays 100 for an immediae real annuiy will receive annual benefis of 5.82 for life (a he beginning of each year). By consrucion, boh he EPVShorfall and EPVBeques are zero for he annuiy purchase; he EPVBenefis measure is slighly below 100 due o he annuiy load assumed. In Row 2 we repor resuls for a phased wihdrawal program where he Fixed Benefi is equal o he annuiy a 5.82 as before; of course, he reiree may run shor of funds since he is no acually annuiizing. The opimized asse allocaion associaed wih minimizing he EPVShorfall for his Fixed Benefi wihdrawal plan consiss of 20% socks and 80% bonds, and associaed wih his plan is an expeced shorfall worh 3.58 per 100 of iniial asses. As long as he reiree lives, he can expec benefis oaling (in presen value), or abou 4.3% below he real annuiy. Of course, on oher hand, he beques his heirs can expec is quie large, a 53.2 (or more han half he iniial invesmen). Clearly, unless a reiree had an enormous ase for bequess, annuiizaion would be judged far superior o aking a fixed benefi a 5.82 per annum unil he fund is probably exhaused. Rows 3 and 4 of Table 1 displays resuls for wo Fixed Percenage sraegies. The firs is deermined by selecing a Fixed Percenage rule ha pays ou a firs-year benefi equivalen o he 5.82 real lifelong annuiy purchased by he 65-year old male paying 100. Given his consan benefi-wealh-raion (i.e. ω = 5.82%) we solve for he opimal asse mix minimizing he EPVShorfall. Table 1 here The second sraegy selecs a fixed fracion ha is now also opimized wih regard o EPVShorfall. Wha is differen here is ha boh he asse allocaion and he wihdrawal fracion is simulaneously opimized a he beginning of he reiremen phase. These wo rows indicae is ha, in boh cases, he risk measured by he EPVShorfall is almos four imes as large as under he Fixed Benefi approach. Offseing his could be he higher benefi sream condiional on survival and higher beques

16 14 value o he heirs. Boh Fixed Percenage sraegies have slighly higher equiy exposures (30%) han he Fixed Benefi approach (20%). This is in conras o he high equiy exposures recommended by Albrech and Maurer (2002) and Vora and McGinnes (2000) using a fixed benefi wihdrawal approach. Of course he opimized sraegy ha permis a fixed percenage payou of 7% of he accoun annually has a lower expeced shorfall and higher expeced benefis han he nonopimized sraegy. Nex we urn o he wo 1/T rules, where again he firs simply ses T o he maximum plan duraion (he oldes age in he moraliy able), and opimizing asse allocaion wih minimizing EPVshorfall. The second endogenously evaluaes boh, he asse allocaion and he plan duraion ha minimizes EPVShorfall. I is ineresing ha he simple 1/T rule (Row 5) resuls in he highes equiy exposure, and i is also unlikely o be preferred by many: he size of he expeced shorfall is he larges of hose considered ( 35 of he iniial 100 asse), and he expeced benefis are he lowes of hose examined. The only clear gainers are likely o be he heirs. We conras his wih he paern ha would resul from opimizing he maximum plan duraion, which he reiree could do if he had Social Securiy or welfare o live on in he even ha his asse is exinguished and he is sill alive. This would occur around age 87, according o he program compued. Row 6 indicaes using he 1/T rule opimized for asse allocaion and he dae of running ou of asses offers lower risk, higher expeced han he annuiy, a reasonable beques, and he asse allocaion is no oo risky (15% equiy, 75% bonds, and 10% cash). Finally we examine Row 7 which refers o he 1/E(T) rule, which is consisen wih he phased wihdrawal scheme allowed by he US ax auhoriy for 401(k) pension plans. This is an ineresing sraegy, because i offers quie low expeced shorfalls, and 6% higher expeced benefis as compared o he life annuiy, while sill affording a decen beques poenial. The asse allocaion implied is raher conservaive, wih 20% in equiy and 80% in bonds. Overall, looking across he phased wihdrawal plans, here is no clearly dominan sraegy, since all involve radeoffs beween risk, benefi, and beques measures, and individual preferences may vary. Neverheless, he 1/E(T) rule seems relaively appealing as compared o he ohers, as long as he reiree has only a moderae appeie for bequess. The second panel of Table 1 repors resuls for a female age-65 reiree considering he same phased wihdrawal paerns. To summarize resuls, we find ha women confron lower expeced shorfall risks in all cases and can anicipae higher EPVBenefis. This occurs because he lower female moraliy ranslaes ino a lower iniial annuiy paymen; i.e. her acuarially fair benefi is 5.02 per year for a 100 purchase (versus he male payou of 5.82). Consequenly, variable wihdrawal plans have he woman wihdraw less early in life, leaving more asses in he fund o earn fuure capial marke reurns. Since he woman also is expeced o live longer, she will more likely be alive o reap he fruis of he invesmen. We would herefore predic, and he resuls confirm, ha he 1/E(T) rule is more aracive o women han men, since i offers raher low expeced shorfalls, and 15% higher expeced benefis as compared o he annuiy, while sill affording a decen beques poenial. I is also ineresing ha he asse allocaion sraegies for women are similar o hose for men bu do have slighly lower equiy exposure overall. Thus far, he analysis has assumed he reiree begins he payou phase a age 65, bu i may be of ineres o explore how he phased wihdrawal paerns behave wih alernaive reiremen ages. Table 2 displays he findings for a male reiring a age 60 or age 70, which can be direcly compared wih he op panel of Table 1. Wha he resuls show is ha he phased wihdrawal paerns are un-

17 15 ambiguously more aracive for an age 60 reiree, as compared o he 65 year old. In oher words, all expeced shorfall risk measures are lower, expeced benefi payous o he living reirees are higher, and expeced bequess are similar; he porfolios seleced are slighly ligher in equiies. This is because he moraliy drag for he life annuiy purchased by a Younger person, and herefore he benchmark, is subsanially lower. By conras, he higher moraliy faced by a 70-year old reiree produces a higher benchmark annuiy which ranslaes ino greaer EPVShorfalls, lower expeced benefis, and also lower expeced bequess. This is despie having 10-15% higher equiy exposure. This would lead one o conclude ha annuiizaion would be relaively more appealing o older reirees, as compared o phased wihdrawal paerns. 16 Table 2 here Thus far we have assumed ha he annuiy benchmark is compued in each case using he sexspecific moraliy ables relevan o he individual making he purchase. Neverheless, in some conexs, insurers are required o use a unisex able when selling annuiies: for example, his is he case in he Unied Saes if an annuiy is purchased using accruals in an employer-based defined conribuion plan (McGill e al., 1996). Likewise in he UK, unisex ables are used o price annuiies in he Personal Pension arrangemens. A unisex moraliy able is generaed by averaging moraliy probabiliies for men and women a each age. Naurally, using a unisex able slighly booss he annuiy paid o a female reiree and slighly reduces he male s benefi, as compared o using sexspecific ables. Thus when German moraliy ables are used o value unisex payous (as in Appendix A), he payou for a female from a 100 annuiy purchase would rise by 7% from 5.02 o 5.37, whereas for he male i would decline by 7.7% from Using a unisex able for annuiizaion would obviously change he benchmark for comparisons wih phased wihdrawal plans. Ye he phased wihdrawal plans would sill embody he sex-specific moraliy paerns relevan o he individual decisionmaker. Resuls using he unisex able for he annuiy benchmark appear in Table 3. The annuiy benefi is now equal by consrucion for men and women, a 5.37 annually for a 100 purchase. As a resul, he female annuian would clearly do beer han she would under he sex-specific able, and he male would do worse. One surprise is ha he resuls are less clearcu under he phased wihdrawal paerns. For men, expeced shorfalls under all wihdrawal paerns are lower, expeced benefis are lower, and bequess are higher. The paern is he opposie for women: expeced shorfalls are higher, expeced benefis are higher, and bequess lower. Hence when a governmen mandaes unisex ables for annuiy pricing, women who eleced a phased wihdrawal plan would be exposed o greaer risk. I is ineresing ha his migh be an unexpeced and undesired resul for hose advocaing unisex ables in pension plans. 17 Table 3 here 16 Similar conclusions apply o women, hough he differences by reiremen age are less pronounced (resuls available on reques). 17 Thus far we have assumed ha he buyer and seller of he annuiy have symmeric informaion regarding annuian moraliy, ha is, he annuiy is priced using he same survival probabiliy assumed o calculae he risk and reurn measures. Such annuian moraliy ables recognize he fac ha, due o adverse selecion, annuians oulive he populaion as a whole. On he oher hand, if a reiree believes he is no more likely han average o live a long ime, he migh use populaion survival raes insead of annuian raes. Implemening his belief in our framework enhances he relaive risk/reurn characerisics of a phased wihdrawal plan (resuls available on reques).

18 Phased Wihdrawal Plans wih Mandaory Deferred Annuiies The resuls above sugges ha some reirees migh prefer o engage in a mixed sraegy: ha is, o underake phased wihdrawals during he early porion of he reiremen period, and hen o swich o an annuiy hereafer. Furhermore, some researchers have suggesed ha such a mixed sraegy would be aracive: i enhances he payou early on, in exchange for relaively low risk, and i also adds he insurance feaure laer in life (Blake e al., 2003; Milevsky, 1998). In addiion, some governmens have recenly required ha he elderly annuiize afer a phased income drawdown period. For example, in he UK, compulsory annuiizaion is required a age 75, and German Rieser Plans require annuiizaion a age 85. To examine he risks and rewards associaed wih phased wihdrawal followed by annuiizaion a some laer age, we revisi our calculaions under each wihdrawal rule, assuming annuiizaion is required if he individual is sill alive a eiher age 75 or 85. Two approaches are considered. In he firs case, which we call he swiching sraegy, a reiree would follow he relevan phased wihdrawal rule unil reaching a mandaory swiching age. In all cases, for he benchmark, we use he real annuiy ha he reiree could have purchased a age 65, o compare our new resuls wih prior findings. If, a he swiching poin, he fund is inadequae o purchase his real annuiy, he gap represens a shorfall; conversely, if he accoun holds more han is needed o buy he benchmark annuiy, his excess can be allocaed o increase he beques or used for higher consumpion. In he following, we assume ha an excess (if any) is used o increase he level of he annuiy saring a age 75 or 85, enhancing he EPVBenefis raher han EPVBeques measure. For he second case, we examine an immediae purchase deferral sraegy. In his case, he reiree purchases an annuiy on reiremen, wih deferred payous beginning a age 75 (or 85). The deferred annuiy benefi is se equal o he benchmark ha he reiree could have received if he iniiaed annuiy paymens a age 65. I is worh noing ha i is unclear wha one migh expec from hese swiching sraegies, in erms of risks and rewards. Some analyss sugges ha swiching may be a preferred sraegy, relying on he fac ha he moraliy drag rises wih age, so annuiies pay ou more for a given premium, he older one is when purchasing hem (Milevsky, 2001). On he oher hand, his work focuses only on he probabiliy of a shorfall bu does no weigh he size of he loss, condiional on he shorfall occurring. By delaying annuiizaion, he reiree can benefi from capial marke reurns if hey are favorable, so benefi paymens can be higher while he lives, or bequess higher if he dies. Ye delaying annuiizaion also exposes him o shorfall risk. In Table 4 we indicae findings for a male reiring a age 65, making he decision o swich from a phased wihdrawal o an annuiy a eiher age 75 (or 85). 18 Comparing resuls in Panel A of Tables 1 and 4, we see ha if delayed annuiizaion is available, his generally increases he EPVBenefis and shrinks he EPVShorfall, boh of which are beneficial. The EPVBeques falls, indicaing ha he deferred annuiizaion sraegy is likely o be mos aracive o hose seeking o secure consumpion while alive, wihou compleely sripping he heirs of some promised funds. In oher words, he risk/reurn profile of he phased wihdrawal plan ha includes a delayed annuiy is enhanced, as compared o no annuiy, a he cos of a smaller beques poenial. Also ineresing is he fac ha swiching o an annuiy laer in life (i.e. a age 85; compare panels A and B in Table 4) raises he 18 Resuls for women are available on reques.

19 17 equiy share of he porfolio slighly, bu grealy enhances he bond exposure. Also, buying he annuiy laer obviously promise more beques poenial, a he cos of higher shorfall. Table 4 here Table 5 displays resuls for a 65-year old male purchasing a deferred annuiy a he beginning of he reiremen period, wih annuiy payous beginning a age 75 (or 85) assuming he is alive. In conras o he mandaory annuiizaion sraegy, we see ha he risk and reurn profile depends heavily on he chosen wihdrawal rule. In he case of he 1/T rule combined wih a deferred annuiy payable from age 75, he logical sraegy is o consume all remaining wealh using he phased wihdrawal acic by age 74, secure in he knowledge ha one is proeced agains longeviy risk hereafer. This paern provides a benefi sream worh slighly more han he real annuiy, and i offers low shorfall risk and low expeced bequess. This is an imporan resul since i indicaes he advanage of allowing flexibiliy unil age 75, paired wih proeced consumpion afer ha age. Similar resuls hold if he deferred annuiy were o begin a age 85, wih slighly higher benefi and beques levels a he expense of somewha higher shorfalls. By conras, he 1/E(T) rule combined wih a deferred annuiy a age 75 provides he reiree wih relaively low payous up o age 75, producing a high EPVShorfall, bu afer ha age, benefis flow from boh he annuiy and he phased wihdrawal plan which raises EPVBenefis (and higher poenial bequess). Delaying he annuiy payou dae o age 85 insead of 75 exposes he reiree o much higher shorfall risk, along wih higher possible wealh for he heirs. Table 5 here 4.4. Comparaive Resuls In addiional analyses (available on reques), we have also explored he sensiiviy of our resuls o a range of alernaive capial and annuiy marke scenarios. An ineresing experimen consrucs an environmen ha migh be relevan o he US reiree, where life expecancy is longer han in Germany, loadings are lower, and he capial marke has differen risk/reurn characerisics. For moraliy, we use he US Annuian 2000 Basic Male able; for porfolio consrucion, we derive means and sandard deviaions for socks, bonds, and cash using Ibboson Associaes daa over he period (he same period over which we esimaed he German capial marke parameers). While annuiy payous are quie similar in he wo counries, he capial markes have very differen characerisics. The mean reurns on socks and bonds are slighly lower in he US han Germany, bu volailiy on socks is much lower in he US (17.2% insead of 25.4% in Germany), and i is much higher on bonds (11.8% versus 5.2% in Germany). Under hese assumpions we re-opimize he wihdrawal rules and find for all wihdrawal plans ha he US reiree would hold a much higher level of equiy exposure in he risk-minimizing porfolio. Neverheless, he wihdrawal fracions are no much affeced for he 1/T and he Fixed Percenage rules. This is accompanied by a higher shorfall risk, higher expeced benefis, and comparable expeced bequess, driven by he fac ha bonds are riskier in he US han in Germany. 5. Discussion and Conclusions Though sandard economic models imply ha mos people would highly value he proecion agains longeviy risk ha annuiizaion offers, many reirees do no purchase annuiies wih heir disposable wealh. Cerainly if older people have no desire o leave a beques, annuiies would seem

20 18 o be srongly preferred. Ye here is evidence ha many older people do anicipae leaving a beques: for insance, Hurd and Smih (1999) find ha more han half of he elderly expec o leave a beques worh more han $10,000. As a resul, here would seem o be grea need for models o guide reirees as hey examine radeoffs beween consumpion versus he possibiliy of leaving a beques. Of course such radeoffs generally require he reired worker o exchange some risk for some reurn, in which case here is a naural role for phased wihdrawal programs during he reiremen period. Taking risk and value as primiives is appealing for several reasons (Brachinger and Weber, 1997). Firs, from a descripive perspecive, a risk-value model such as ours is likely o be useful in explaining reiree preferences by undersanding how hey rade off expeced benefis, bequess, and he risk of consumpion shorfalls. Second, policymakers and regulaors may benefi from evidence on he risk-reurn paerns of differen wihdrawal opions in ax-favored individual reiremen plans. Of course financial inermediaries offering reiremen producs such as banks, insurance companies, and muual funds, can use his informaion o design and marke producs ha have ypical benefi, beques, and risk feaures. Finally, professional financial planers may offer beer informaion o heir cliens when hey make reiremen invesmen choices. Our approach uses he concep of shorfall-risk, whereby he benefis of a life annuiy serves as he benchmark, building on research by Milevsky (1998, 2001), Milevsky and Robinson (1994, 2000), Milevsky e al. (1997) and Albrech and Maurer (2002). We exend his research in wo direcions. Firs, we use a risk meric which considers boh he probabiliy of a consumpion shorfall as well as he size of he shorfall when i occurs. Second, we focus no only on phased wihdrawal plans wih fixed benefis, bu also on variable benefi paerns in conjuncion wih a predeermined benefi-owealh raio. We evaluae several alernaive designs for phased wihdrawal sraegies, invesigaing wihdrawal rules while allowing for endogenous asse allocaion paerns, and allowing he worker o make decisions boh abou when o reire and when o swich o an annuiy. Of course, selecing a specific wihdrawal paern requires furher informaion on uiliy weighs o rade consumpion agains bequess, bu many reirees and heir financial counselors may find i difficul o ariculae heir uiliy funcions in advance. For his reason we find ha i is useful o explore various explici risk and reurn measures for alernaive wihdrawal plans in a sochasic environmen, allowing for randomness in boh he ime of deah and invesmen reurns. We conclude he following: Discreionary managemen of accumulaed asses wih sysemaic phased wihdrawals for consumpion purposes offers many advanages: flexibiliy, bequess, and possibly higher raes of consumpion han can be paid by sandard life annuiies. Bu following phased wihdrawal plans also requires he reiree o devoe aenion o asse allocaion and wihdrawal rules. Reirees using a phased wihdrawal plan who seek o minimize he risk of consuming less han he real annuiy benchmark will allocae heir reiremen asses more in fixed income han in equiies. Noneheless, which specific mix is eleced mus depend on plan design, age, moraliy risk, and oher facors. A phased wihdrawal sraegy paying he same benefi as he annuiy exposes one o he risk of ouliving one s asses while sill alive. A phased wihdrawal plan using a fixed benefi-owealh raio avoids he risk of running ou of money, since benefis flucuae in andem wih he pension fund s value. Bu a fixed benefi wihdrawal rule affords lower risk han variable wihdrawal rules, if one uses a moraliy-weighed shorfall-risk measure (which includes boh shorfall probabiliy and magniude of loss).