Retirement Spending on Planet Vulcan: Longevity Risk and Withdrawal Rates
by Moshe A. Milevsky and Huaxiong Huang
Recommendations from the media and financial planners regarding retirement spending rates deviate considerably from utility maximization models (models that assume consumers optimize how they spend money).
We argue that wealth managers should advocate dynamic spending in proportion to survival probabilities, adjusted up for exogenous pension income and down for longevity risk aversion.
In this article
- Literature on Retirement Spending Rates
- Numerical Examples and Cases
- Conclusion: Back to Planet Earth
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We conducted a study to attempt to derive, analyze, and explain the optimal retirement spending policy for a utility-maximizing consumer facing) an indeterminate lifetime. We deliberately ignored financial market risk by assuming that all investment assets are allocated to risk-free bonds (e.g., Treasury Inflation-Protected Securities [TIPS]). We made this simplifying assumption in order to focus attention on the role of longevity risk aversion in determining optimal consumption and spending rates during a retirement period of indeterminate length.
By longevity risk aversion, we mean that different people might have different attitudes toward the “fear” of living longer than anticipated and possibly depleting their financial resources. Some might respond to this economic risk by spending less early on in retirement, whereas others might be willing to take their chances and enjoy a higher standard of living while they are still able to do so.
In particular, we focused exclusively on the impact of life span uncertainty—longevity risk—on the optimal consumption and retirement spending policy. To isolate the impact of longevity risk on optimal portfolio retirement withdrawal rates, we placed our deliberations on Planet Vulcan, where investment returns are known and unvarying, the inhabitants are rational and utility-maximizing consumption smoothers, and only life spans are random.
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Huaxiong Huang is a professor of mathematics at York University in Toronto.