A better way to fund your retirement: ARVA explained

The usual rule of thumb that people use to plan how to fund their retirement is to withdraw 4% a year from their pool of savings.

Research on the 4% rule indicates that it will probably allow you to avoid running out of money before you die—a possibility that people fear more than death.

But the rule comes with no guarantee that you won’t outlast your money, or, conversely, that you won’t unintentionally leave a large pot of money unspent when you die.

If the markets perform poorly in the early years of your retirement, stubbornly sticking to a 4% withdrawal can deplete your retirement nest egg relatively quickly. On the other hand, if markets are good, the rule may lead you to live too frugally and leave a big bequest.

To most people, it makes more intuitive sense to adjust their spending up and down in response to how markets perform and the varying size of their pool of savings in any given year.

But how can you know how much to reduce or increase your withdrawals? The answer is to use a strategy I’ve written about before that goes by the ungainly name of annually recalculated virtual annuity or ARVA.

To understand how the ARVA strategy works, let’s look at each of the component words in its name, starting with annuity.

Most people are familiar with annuities sold by life insurance companies. In exchange for a lump sum payment, the company pays you a regular stream of income until your death.

For a variety of reasons, many people resist buying annuities, preferring to hold a portfolio of stocks and bonds. Nevertheless, your goal in funding your retirement is to get what an annuity gives you—a steady stream of income to finance your consumption.

So, how can you do it while still holding a volatile mix of assets? That’s where the word virtual in the ARVA strategy comes in.

You don’t actually buy an annuity. Instead, you create a virtual annuity by using the same calculations an insurance company does in deciding how much to pay out on an annuity for the remainder of your life.

The trick in ARVA is you make those calculations each year, based how much money is left in your pool of retirement savings. In other words, you use annuity math to do an annual recalculation and decide how much to spend in the coming year.

While these calculations are relatively simple—we do them all the time for our clients—the advantages of the ARVA strategy over the 4% withdrawal rule are quite remarkable.

Most importantly, by varying your withdrawals, ARVA allows you to avoid the risk of running out of money, on one hand, or dying with a large unintended surplus, on the other.

But it does more than that. Adjusting your withdrawals according to ARVA can enhance your income during retirement.

In my latest whitepaper, titled Getting More Without Saving More, I look at the impact of using ARVA on a fictional retired couple. For Alice and Bob, allowing year-to-year variations in spending of 5% using ARVA means an additional 25% withdrawal over the retirement period.

For this couple, the combined impact was to boost withdrawals throughout the 30-year retirement period by an amount equivalent to an additional 1.25% investment return.

Why does ARVA generate more income? In all scenarios, ARVA converts all the assets into income whereas to protect against a small risk of running out of money, the 4% rule leaves a significant surplus, on average.

The benefits of ARVA add up to a lot of peace of mind for people facing the complex task of drawing down their retirement savings.

To learn more about ARVA, you can read this paper. And I encourage you to download my whitepaper to read more about my research into how ARVA and two other strategies can enhance your income in retirement.