Swedroe: Annuities & Problems Of Longevity

April 11, 2016

Developing A Retirement Plan

Equity investors must also consider that market volatility calls into question the use of risky assets to generate stable periodic cash flows throughout a long-term horizon. The reason is that, although long-term expected returns from stocks may be attractive, a sequence of negative returns can deplete a retirement income portfolio to the point where it lacks sufficient dollars to recover. In other words, the sequence of returns matters.

Consider the following example: From 1973 through 1999, the S&P 500 returned 13.9% per year and inflation rose 5.2% a year. Thus, the real return for an investor in the S&P 500 Index was 8.7%. Knowing this, in hindsight, one might think you could retire in 1972 and still safely withdraw an inflation-adjusted 7% every year (almost 2% per year below the annualized realized return) from your original principal and not worry about running out of assets.

However, because the S&P 500 declined by approximately 40% in the 1973-1974 bear market, the portfolio would have been depleted by the end of 1982—in just 10 years! In the decumulation phase, certainly the order of returns matters a great deal.

The bottom line is that success in retirement planning requires the careful consideration of your ability, willingness and need to take risk; appropriate and forward-looking assumptions about expected returns; an understanding of the consequences of changes in wealth; spending requirements; assessment of alternative strategies; and once the plan is implemented, ongoing monitoring not only of the financial condition of your portfolio but the spending assumptions made in building the plan as well.

When developing a retirement plan, your first objective should be to ensure the sustainability of adequate income over a lifetime. Risk modeling tools, such as a Monte Carlo simulator, play an important role in helping to determine the likelihood of ending with positive wealth, and if there is a shortfall, what its magnitude and duration may be. And risk models demonstrate that payout annuities can play an important role in retirement planning, helping to reduce the risk of running out of assets.

The Annuity Puzzle

Numerous academic studies advocate partial to full annuitization of financial assets. Despite the evidence, the majority of investors remain reluctant to annuitize both for behavioral and financial reasons.

Why or Why Not Annuitize?

An annuity is not an investment vehicle. Instead, it’s an insurance product designed to protect an individual from a catastrophic risk, specifically the risk of running out of money in retirement. It allows an individual to convert a lump-sum payment into a stream of income that continues for life.

The future payments from the annuity protect an individual from both financial market risk and, more importantly, longevity risk. Because the risk of outliving one’s assets is reduced, and annuities have built-in mortality credits, the academic literature has found structured annuity payouts allow a retiree either to increase the amount of dollars they can expect to withdraw from a portfolio without increasing the odds of failure (depleting assets) or to maintain the same withdrawal rate while increasing the odds of success.

Mortality Credits

The concept of a mortality credit is illustrated by the following example. On Jan. 1, we have 50 85-year-old males who each agree to contribute $100 to a pool of investments earning 5%. They further agree to split the total pool equally among those who are still alive at the end of the year.

Also, suppose that we (but not they) know for certain that five of the 50 will pass away by Dec. 31. This means the full pool, now $5,250 ($5,000 principal plus $250 interest), will be split among just 45 people. Each will receive $116.67, or a return on investment of 16.67%. If, instead, each person had invested independently of the pool, the total amount of money earned would have been $105, or a return on investment of 5%. The difference in returns is the mortality credit.

Despite the mortality credits, most individuals still hesitate when it comes to annuities. One reason is behavioral. A lot of investors exhibit what is called “loss aversion.” They feel that converting to an annuity “gambles away” their assets should they die earlier than expected. Thus, their heirs would inherit a smaller estate. Another reason is that some investors dislike giving up control of their assets, believing they might do better if the money remained and grew in their own investment accounts.

In addition, investors can be deterred by financial restrictions. Since most annuities are illiquid and irreversible, assets cannot be accessed should unexpected needs, such as health-related costs, arise. As a result, they may impose an unacceptable constraint on future consumption.

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