Annually Recalculated Virtual Annuity

A very low risk way to handle your portfolio in retirement is to invest the whole thing in inflation-protected government bonds and choose a spending level that will have your money last for a very long life.  A related idea is the Annually Recalculated Virtual Annuity (ARVA) where you invest as you see fit and choose your retirement spending level as though your portfolio were invested in inflation-protected government bonds.  Then each year you recalculate your spending level based on your new portfolio size, your new age, and prevailing bond interest rates.

The ARVA idea was introduced by Waring and Siegel in their well written and accessible paper The Only Spending Rule Article You Will Ever Need.  Investors who use the ARVA idea will have annual retirement spending “that fluctuates with asset values, but they can never run out of money.”

The ARVA idea is broadly similar to my own retirement spending plan that is designed to adapt my retirement spending as my portfolio fluctuates.  The similarities between mine and ARVA are that they take into account the planned number of years of retirement left, and they use an assumed rate of return to calculate the amount to spend each year that will ultimately deplete the portfolio.  The differences are in the assumed lifespan and how we arrive at the assumed rate of return.

Very low retirement spending

The downside of ARVA is that it is very conservative and will have you spending very little.  One reason for this is low government bond yields.  In Canada, inflation-protected government bonds are called Real-Return Bonds (RRBs), and as I write this their annual yield is 0.21% above inflation.  A second reason is the authors’ retirement duration advice: “Whatever one’s view on the likelihood of living to extreme old age, it seems prudent to provide for oneself to at least age 105 if male or 110 if female.”

Consider the case of a 60-year old woman.  To provide for a 50-year retirement (until she’s 110 years old) making an investment return of only 0.21% above inflation, we can use the PMT spreadsheet function to find that she can only spend 2.1% of her portfolio in her first year of retirement.  This is a far cry from the widely-quoted 4% rule, particularly when we consider that the ARVA strategy adapts to portfolio fluctuations and can lead to future declines in spending.  Usually, when retirees are prepared to accept future reductions in spending (when portfolio returns disappoint), it increases their current safe spending amount.

To arrive at a rate of return assumption, I use 4% above inflation less costs for stocks, and 0% above inflation less costs for bonds.  I adjust my assumed stock returns downward when the blended Cyclically Adjusted Price-Earnings (CAPE) ratio of my stocks exceeds 20.  Unless the CAPE rises crazily, this gives me an assumed return that is higher than current Real Return Bond rates.  For the length of my retirement, I assume my wife and I will live to 100, rather than 110 and 105.

When I apply ARVA to my own portfolio, I find that it reduces my spending level by 34%.  This is a large reduction considering that most experts already find my approach too conservative.  However, many of these experts are financial advisors who feel the pressure from their clients to say that higher spending rates are safe and reasonable.  So, I’m comfortable that I’m not being unreasonably conservative.

Conflicting Desires

The authors observe that “most people are short on retirement savings to begin with and are anxious to convince themselves that their need for more assets to support desired spending is less than it really is.  Even otherwise thoughtful investors seem springloaded to reject out of hand the need to provide for one’s entire life—and yet they do nonetheless worry about the risk of running out of money.”  The ARVA approach appeals to the “worry” side of this contradiction.

Other spending profiles

So far, we’ve been discussing flat retirement spending over time (with inflation adjustments).  However, it is possible “to modify the shape of the payout, the relative amounts spent over time. There is nothing special about equal payments.”  However, it’s possible to take this too far.  If we decide we’ll spend twice as much in our 60s as in our 80s, we’re using the ARVA approach in name only.  When we get to our 80s and find we can’t cut our spending in half, the ARVA promise that we’ll never run out of money falls flat.

Insurance products

In theory, insurance companies should be able to make a profit for themselves and help retirees by pooling longevity risk.  Academics see the poor uptake of annuities as the “annuity puzzle.”  Unfortunately, there is a big gap between academic theory and the practical reality of the products that insurance companies offer.

“In its seemingly boundless desire to offer something—anything—to appeal to longevity risk hedgers without providing safe (properly hedged), simple, transparent, and fairly priced life annuities, the insurance industry has designed a number of strategies that guarantee a lifetime income (subject to the insurer’s continued solvency).”  As an insurance company customer, “it is hard to figure out whether you are getting a fairly priced deal, so you are probably not.”

Conclusion

The ARVA strategy for deciding how much to spend annually from a portfolio will appeal to the most conservative retirees who want to be certain they’ll never run out of money.  However, most retirees will find the ARVA spending level to be far lower than they were hoping for.  My own fairly conservative strategy calls for more than 1.5 times the spending that ARVA permits.