Should Households Base Asset Decumulation Strategies On Required Minimum Distribution Tables?
Over the last 30 years, 401(k) and other defined contribution retirement plans have displaced defined benefit pension plans in the private sector (US). Defined benefit plans traditionally provided benefits in the form of a lifetime annuity. In contrast, in 401(k) plans, annuitization is voluntary, rare, and often not even a plan option. Participants face the challenge of decumulating their wealth over their remaining lifetimes, trading off the risk of outliving that wealth against the cost of unnecessarily restricting their consumption.
Devising an optimal plan requires the application of numerical optimization techniques that are beyond the abilities of households and their financial advisers. Households, to the extent that they plan decumulation at all, must rely on rules-of-thumb that are clearly sub-optimal. For example, a widely advocated rule is to consume 4 percent of initial wealth.
This paper explores an alternative approach, namely for households to base their decumulation strategies on Required Minimum Distribution (RMD) tables. These specify the minimum amounts that must be drawn out of IRA and 401(k) accounts to avoid tax penalties. Although the IRS makes no claim that the withdrawals are optimal, a strategy based on these tables does satisfy two important requirements of an optimal decumulation strategy. First, assuming no bequest motive, the percentage of remaining wealth that is consumed each year will increase with age, reflecting decreasing remaining life expectancy. Second, the dollar amount consumed will respond to fluctuations in the market values of financial assets. Although Bengen (1994) shows that a household following this strategy is at relatively low risk of outliving its wealth, the 4 percent rule fails the test of optimality because the amount consumed does not respond to realized investment returns.
Assuming plausible preference parameters, and using numerical optimization techniques, we compare a strategy based on the RMD tables with three alternative rules of thumb: 1) the 4 percent rule described above; 2) spending the interest and dividends while preserving the capital; and 3) spending down over one’s life expectancy. We also calculate an optimal strategy and evaluate the RMD and alternative strategies in terms of “strategy equivalent wealth,” the percentage by which the initial financial assets of a household following the optimal strategy would have to increase so that it would be indifferent between adopting that strategy and following the RMD or other rule of thumb. We test the sensitivity of our findings to alternative assumptions regarding rates of return, household wealth, risk preferences,annual mortality risk, and marital status.