The Retirement Researcher’s Guide Series

Safety-First Retirement Planning

An Integrated Approach for a Worry-Free Retirement

Wade D. Pfau, PhD, CFA, RICP

Copyright © 2019 by Wade
Donald Pfau. All rights reserved.

Published by Retirement
Researcher Media, Vienna, Virginia.

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Library of Congress
Cataloging-in-Publication Data:

Pfau, Wade D., 1977–

Safety-First Retirement
Planning: An Integrated Approach to Securely Reaching Lifetime Financial Goals /
Wade D. Pfau.

pages cm

Includes index.

ISBN [978-1-945640-06-3]
(paperback) - ISBN [978-1-945640-07-0] (e-book)

Library of Congress Control
Number:2019912666

Retirement Researcher, Vienna,
VIRGINIA

1. Retirement Planning. 2.
Financial, Personal. I. Title.

Cover Design: Trevor Alexander
and Mineral Interactive

Graphics and Layout: Watermark
Design Services

Printed in the United States
of America

To those hard workers seeking
to someday

enjoy their retirement.

Table of Contents

Preface. viii

Acknowledgments. xi

Chapter 1: Overview of
Retirement Income Planning. 1

The Retirement Researcher Manifesto. 5

The Retirement Income Challenge. 9

Two Philosophies for Retirement Income
Planning. 16

The Road Ahead. 21

Chapter 2: Fixed-Income
Assets. 25

Understanding How Bonds Work. 26

Bond Pricing 101. 27

Bond Duration. 30

Treasury Inflation-Protected
Securities (TIPS) 33

The Yield Curve and Break-Even
Inflation. 35

Laddering with Individual Bonds. 38

Chapter 3: Stocks and
Diversified Investment Portfolios. 43

Overview of Stocks and the Stock
Market 44

Historical Market Returns. 46

Modern Portfolio Theory. 49

The Case for Stocks. 54

Caveats about a Primary Reliance on
the Stock Market 59

Determining Sustainable Spending from
Investments. 76

Chapter 4: Income
Annuities (Risk Pooling) 89

Menu of Income Annuity Features and
Options. 90

Annuity Pricing 101. 95

Payout Rates and Rates of Return for
Income Annuities. 104

Money’s Worth Measures for Income
Annuities. 110

The Annuity Puzzle: Other Issues
Impacting the Annuity Decision. 121

Chapter 5: Variable
Annuities. 126

Overview of Annuity Types. 128

Deferred Variable Annuities. 132

Chapter 6: Fixed Index
Annuities. 156

Crediting Interest with an Annual
Reset One-Year Term Point-to-Point Crediting Method. 158

Factors Affecting the Parameter Values
for Fixed Index Annuities. 167

The Choice of Crediting Method. 171

Lifetime Income Benefits. 173

Other Fixed Index Annuity Details. 175

Chapter 7: Life
Insurance. 181

Term Life Insurance. 183

Whole Life Insurance. 188

Whole Life Insurance in a Lifetime
Financial Plan. 191

Additional Considerations for Whole
Life Insurance. 217

Variable and Universal Life Insurance. 225

Concluding Thoughts. 232

Chapter 8: Fitting
Income Annuities into a Financial Plan. 234

The Fundamental Logic of an Income
Annuity. 234

Income Annuities and Legacy. 240

Income Annuities and True Liquidity. 245

Allocation to an Annuity. 246

Partial Annuitization and Asset
Allocation for Remaining Investments. 248

Inflation Risk Management and Income
Annuities. 254

When to Purchase and When to Start
Income. 260

Risk Pooling vs. Risk Premium: A Monte
Carlo Investigation. 269

Chapter 9: Product
Allocation for Retirement 275

The Efficient Frontier for Retirement
Income. 276

Upside Exposure, Downside Protection,
and Liquidity Provisions. 278

Tax Treatment 280

Credit Risk for Annuities. 286

Final Thoughts and Best Practices. 291

Further Resources. 300

Glossary of Acronyms. 301

About the Author 302

Preface

The challenge in building an effective
retirement income plan is to use available income tools and tactics in a
strategic manner to meet the financial goals of retirement while also managing
the risks confronting those goals. The financial goals of retirement include
sustainably meeting a lifestyle spending goal for as long as one lives,
providing a legacy for the family or community, and maintaining liquidity to
cover unexpected expenses and contingencies in retirement.

Meanwhile, the three major categories of risk
for a retirement income plan include longevity, market volatility, and spending
shocks. Longevity risk is the possibility of living longer than planned, which
could mean not having resources to maintain the retiree’s standard of living. Market
volatility is the risk that poor market returns are realized, leading to a
reduced portfolio value and a reduced ability to maintain the retirement
standard of living. Taking distributions from investments in retirement further
amplifies market risk by increasing the importance of the ordering of
investment returns. This is called sequence-of-returns risk. Finally, spending
shocks are the risk that expensive bills materialize, such as for long-term
care or health care, which require large expenditures that deplete assets and
reduce the ability to maintain lifestyle at later ages.

Retirement income planning is the field of
financial planning which addresses this challenge. It is still a relative
newcomer within financial services, and it continues to experience growing
pains and disagreements about the best way to help retirees succeed. In
reviewing existing approaches, I have identified two very distinct schools of
thought for managing the finances of retirement.

First, probability-based advocates generally
support using an aggressive investment portfolio with a large allocation to
stocks to meet retirement goals. My earlier book How Much Can I Spend in
Retirement? A Guide to Investment-Based Retirement Strategies provides an
extensive investigation of probability-based approaches. With
these investment solutions, a higher lifestyle may be supported if one is
willing to spend and invest aggressively in the hope of subsequently earning
higher market returns. Should decent market returns materialize, investment
solutions can be sustained indefinitely while also helping to support legacy
and liquidity. Probability-based advocates are generally comfortable with the
expectation that decent returns will materialize such that these approaches
will probably work just fine.

However, an investments-only mind-set is not the optimal way
to build a retirement income plan. There are pitfalls in retirement that we are
less familiar with during the accumulation years. Traditional wealth management
is not equipped to handle longevity and sequence risk in a fulfilling way. Retirees must self-manage longevity and market risk, which means more
assets are required to cover spending goals over an assumed long time horizon combined
with the possibility that poor market returns chip away at the portfolio. Nonetheless, longevity protection is not guaranteed with investments
and assets may not be available to support a long life or legacy. For retirees who are worried about outliving their assets and not
successfully meeting their lifetime financial goals, probability-based strategies
can become excessively conservative and stressful.

This book is primarily about the other school
of thought: the safety-first approach to retirement income. Safety-first
advocates support a more bifurcated approach to building retirement income
plans that integrates investments with insurance, providing lifetime income
protections. Probability-based advocates generally view annuities and life
insurance as unnecessary in retirement. They see the stock market as a
straightforward way to obtain superior retirement outcomes. Safety-first
advocates disagree.

Risk pooling with insurance provides an
alternative means for potentially earmarking fewer assets to cover lifetime
spending goals, effectively reducing the potential overall cost of retirement.
With risk pooling, one does not need to plan for the very expensive case of an
extremely long life combined with poor market returns. Instead, the retiree
pays an insurance premium that will provide a benefit to support spending if
those risks materialize and retirement becomes more expensive. An unprotected
investment portfolio may otherwise deplete. Insurance
companies can pool sequence and longevity risks across a large base of
retirees, allowing for retirement spending that is greater than the sustainable
withdrawal rate from investments for someone self-managing these risks. When
bonds are replaced with insurance-based risk pooling assets, retirees can
improve the odds of meeting their spending goals while also supporting more
legacy at the end of life, especially in the event of a
longer-than-average retirement.

Lifetime income through insurance, whether
that be annuities or life insurance, can help to manage market volatility and
investment risks, to protect from longevity risk, to more efficiently earmark
assets to cover retirement spending, to reduce the fear and worry that many
have about outliving their assets in retirement, and to simplify the financial
plan.

We walk through this thought process and logic
in steps, investigating three basic ways to fund a retirement spending goal:
with a bond ladder, with a diversified investment portfolio, and with annuities
and life insurance. We consider the potential role for different types of
annuities including simple income annuities and their various flavors, variable
annuities, and fixed index annuities. When we properly consider the range of
risks introduced after retirement, I conclude that the integrated strategies
preferred by safety-first advocates, which combine investments and insurance,
support more efficient retirement outcomes that better support spending and
legacy.

I welcome your feedback and questions. You can reach me at:

wade@retirementresearcher.com

As a final note, I have avoided including footnotes to make the
book more readable and give it a less academic feel. Each chapter ends with a Further
Reading list that includes the bibliographic information for resources mentioned.

Wade Pfau

King of Prussia, PA

Acknowledgments

Writing a book is a major endeavor, and I have been helped
along the way by countless individuals. First and foremost, I would like to
thank my colleagues at Retirement Researcher and McLean Asset Management for
providing the vision and resources to make this book possible. I’m grateful for
the leadership and willingness of Alex Murguia and Dean Umemoto to build a firm
that can turn my research on retirement income planning into practical
solutions for real-world retirees. I would also like to thank Trevor Alexander,
Briana Corbin, Rob Cordeau, Bob French, Paula Friedman, Christian Litscher, Morgan
Menzies, Kyle Meyer, and Jessica Wunder.

I am also deeply indebted to Don and Lynne Komai and the
Watermark Design Office for their assistance in developing the layout and
design for this book.

A special thanks to David Meyers, Jen Dunbar, Steven
Hoagland, and other members of the Retirement Researcher Basecamp, as well, for
helping to develop the book title.

Furthermore, I am grateful to the American College of
Financial Services for their leadership and focus on retirement income planning,
particularly David Blanchett, Michael Finke, David Littell, George Nichols,
Kirk Okumura, and Steve Parrish.

When it comes to retirement income planning, I also wish to
thank countless other practitioners and researchers who have helped me along
the way. A partial list must include Bill Bengen, Bill Bernstein, Jason
Branning, Jason Brown, J. Brent Burns, Ian Cahill, Bill Cason, Curtis Cloke,
Jeremy Cooper, Dirk Cotton, Wade Dokken, Harold Evensky, Francois Gadenne,
Jonathan Guyton, David Jacobs, Dean Harder, Rick Hayes, Jamie Hopkins, Robert
Huebscher, Stephen Huxley, Michael Kitces, David Lau, Manish Malhotra, Ed
McGill, Moshe Milevsky, Aaron Minney, Dan Moisand, Brent Mondoskin, Emilio
Pardo, Kerry Pechter, Robert Powell, John M. Prizer, Jr., Art Prunier, Dick
Purcell, Jason and Art Sanger, Bill Sharpe, Jeff Smith, Larry Swedroe, Joe
Tomlinson, Bob Veres, Steve Vernon, and Mark Wutt.

I also wish to thank my family for their support and the
sacrifices made to help me get this book written.

Finally, I wish to thank everyone who has read and
participated at RetirementResearcher.com since 2010.

Chapter 1: Overview
of Retirement Income Planning

Strong disagreements exist about how to position a retiree’s
assets to best meet retirement goals. Two fundamentally different philosophies
for retirement income planning—which I call probability-based and safety-first—diverge
on the critical issue of where a retirement plan is best served: in the
risk/reward trade-offs of a diversified and aggressive investment portfolio, or
in the contractual protections of insurance products.

On the one side are investments-centric
approaches of the probability-based philosophy that rely on the risk premium
from the stock market. This is the idea that stocks will outperform bonds over
sufficiently long periods, and this investment outperformance will provide
retirees with the opportunity to fund a higher lifestyle. Those favoring
investments (the probability-based approach) rely on the notion that while the
stock market is volatile, it will eventually provide favorable returns for most
retirees and will outperform bonds. The upside potential from an investment
portfolio is viewed as so significant that insurance products are not needed. Investment approaches are probability-based in the sense that they will
probably work. My book How Much Can I Spend in Retirement? A Guide to
Investment-Based Retirement Strategies provided a detailed analysis for
these probability-based investment approaches for retirement.

An alternative school of thought for
retirement income is the safety-first approach. It is my focus in this book. Safety-first
advocates are generally more willing to accept a role for insurance as a source
of income protection to help manage various retirement risks. For
investments-only strategies, retirement risks are generally managed by spending
less in retirement, as longevity risk is managed by assuming a long life, and
market risk is managed by assuming poor market returns. But insurance
companies pool these market and longevity risks across a large base of
retirees—much like a traditional defined-benefit pension—allowing for
retirement spending that is more closely aligned with average, long-term,
fixed-income returns and average longevity. This could support a higher
lifestyle than what is feasible for someone self-managing these risks by
assuming low returns and a longer time horizon.

Safety-first advocates recognize that risk
pooling can be a more effective way to manage retirement risk because it allows
retirees to spend as though they will experience average outcomes; those with
average lengths of life and average market returns will have paid an insurance
premium that is transferred to those who experience a more costly combination
of a longer retirement and poor market returns. This can allow everyone in the
risk pool to spend more than they may otherwise feel comfortable spending
without this protection in place, or to otherwise earmark a smaller asset base
to fund their lifestyle in retirement.

The income protections provide a license to
spend assets because the retiree knows that subsidies (or insurance benefits)
will be received from the risk pool if risks manifest that otherwise threaten
the sustainability of an unprotected investment portfolio. Income protections
manage longevity risk and calibrate the planning horizon to something much
closer to life expectancy. Those who fall short of life expectancy subsidize
the income payments for those who outlive it. Those subsidies are known as mortality
credits. While receipt of those subsidies clearly benefits the long-lived,
arguably both groups can benefit by enjoying higher spending while alive
because they have pooled the longevity risk. Their spending can be based on
averages, and they do not have to self-manage the risk by planning for an
overly long retirement.

Income protections through insurance can also provide peace
of mind for retirement lifestyle that leads to a less stressful and more
enjoyable retirement experience. Overly conservative retirees become so
concerned with running out of money that they spend significantly less than
they could. A dependable monthly check from an annuity can provide the explicit
permission to spend and enjoy retirement and can simplify life for those with
reduced cognitive skills or for surviving spouses who may be less experienced
with financial matters.

As for legacy, a death benefit can be created with life
insurance to provide a specific legacy amount. Additionally, an annuity supporting
lifetime income dedicates assets specifically toward the provision of income,
allowing other assets to be earmarked specifically for growth. This can allow
for a larger legacy, especially when the retiree enjoys a long life and more of
his or her income is supported through the annuity’s mortality credits.

With investment solutions, a more comfortable lifestyle may
be maintained for those willing to invest aggressively in the hope of
subsequently earning higher market returns to support a higher income rate.
Should decent market returns materialize and sufficiently outpace inflation,
investment solutions can be sustained indefinitely. Upside growth could also
support a larger legacy and provide liquidity for unexpected expenses.

However, the dual impact of market and longevity risk leaves
an investment portfolio vulnerable to the possibility of being unable to
support the desired lifestyle over the full retirement period. These are risks
a retiree cannot offset easily or cheaply in an investment portfolio.
Investment approaches seek to reduce market and longevity risk by having the
retiree spend conservatively. Retirees spend less to avoid depleting their
portfolio through a bad sequence of market returns in early retirement and
because they must be prepared to live well beyond their life expectancy. The
implication is clear: should the market perform reasonably well in retirement,
the retiree will significantly underspend relative to their potential and leave
an unintentionally large legacy.

At the same time, longevity protection (the risk of
outliving savings) is not guaranteed with investments, and assets may not be
available to support a long life or legacy. A reverse legacy could
result if the portfolio is so depleted that the retiree must rely on others
(often adult children) for support. This is particularly important in light of
the ongoing improvements in mortality. Today’s retirees will live longer and
have to support longer retirements than their predecessors. For healthy
individuals in their sixties, we are approaching the point where forty years
must replace thirty years as a conservative planning horizon.

Retirees experience reduced risk capacity as they enter
retirement. Their reduced flexibility to earn income leaves them more
vulnerable to forced lifestyle reductions resulting from the whims of the
market. A probability-based strategy could backfire.

For preretirement wealth accumulation, there
has been less focus on appreciating the joint impact that longevity risk and market
risk could play on a financial plan after retirement. Investment managers have
tended to view risk pooling as unnecessary because the stock market can be
expected to perform well over time. However, once distributions begin, any
downward volatility in the early years of retirement can disproportionately
hurt the sustainability of a retirement spending plan. With longevity risk,
retirees do not know just how long their assets will need to last. Investment
managers either remained ignorant of these risks or were otherwise comfortable
allocating assets while treating these risks as distant and low-priority
concerns.

Meanwhile, those favoring insurance (safety-first) believe
that contractual protections are reliable and that staking your retirement
income on the assumption that favorable market returns will eventually arrive
is emotionally overwhelming and dangerous. The insurance side is clearly more
concerned with the implications of market risk than those favoring investments,
believing that even with a low probability of portfolio depletion, a retiree gets
only one opportunity for a successful retirement. At the very least, they say,
essential income needs should not be subject to the whims of the market. The
safety-first school views investment-only solutions as undesirable because the
retiree retains all the longevity and market risks, which an insurance company
is in a better position to manage.

Today, the value provided by risk pooling is
becoming better understood by investment managers as retirement income planning
has emerged as a distinct field within financial services. This is happening as
traditional sources of risk pooling, such as company pensions and Social
Security, play a reduced role and retirees look for ways to transform their
401(k) savings into sustainable lifetime spending. Employers now tend to
contribute to various defined-contribution pensions like 401(k)s, where the
employee accepts longevity and investment risk and must make investment
decisions. 401(k) plans are not pensions in the traditional sense, as they
shift the risks and responsibility to employees rather than employers. In the
transition from defined benefit to defined contribution, people are not getting
as much access to risk pooling as they used to.

Without the relative stability provided by earnings from employment,
retirees must find a way to convert their financial resources into a stream of income
that will last the remainder of their lives. Wealth management has traditionally
focused on accumulating assets without applying further thought to the differences
that happen after retirement. To put it succinctly, retirees experience reduced
capacity to bear financial market risk once they have retired. The standard of living
for a retiree becomes more vulnerable to enduring permanent harm as a result of
financial market downturns. It is now clear that the financial circumstances facing
retirees are not the same as for preretirees, calling for different approaches from
traditional investment advice for wealth accumulation.

A mountain-climbing analogy is useful for clarifying the distinction
between accumulation and distribution, as the goal ultimately of climbing a mountain
is not just to make it to the top; it is also necessary to get back down. The skillset
required to get down a mountain is not the same as that needed to reach the summit.
In fact, an experienced mountain climber knows that it is more treacherous and dangerous
to climb down a mountain. On the way down, climbers must deal with greater fatigue,
they risk falling farther and with greater acceleration when facing a downslope
compared to an upslope, and the way our bodies are designed makes going up easier
than coming down.

Exhibit 1.1

The Mountain-Climbing Analogy for Retirement

The retirement phase, when you are pulling
money from your accounts rather than accumulating wealth, is much like descending
a mountain. The objective of a retirement saver is not just to make it to the top
of the mountain, which we could view as achieving a wealth accumulation target.
The real objective is to safely and smoothly make it down the mountain, spending
assets in a sustainable manner.

Seeking efficiencies and protections to better support
sustainable spending is a primary focus for this book. When we
properly consider the range of risks introduced after retirement, it is
difficult to overcome the conclusion that the integrated strategies preferred
by safety-first advocates, which combine investments and insurance, support
more efficient retirement outcomes that better support spending and legacy and
help retirees to make it more safely down the mountain.

The Retirement Researcher
Manifesto

As I have attempted to summarize the key messages and themes
that have underscored my writing and research going into this book, I find that
the following eight guidelines serve as a manifesto for my approach to retirement
income planning. It is helpful to start with these guidelines because this book
is ultimately about how to implement these guidelines in practice.

Play the long game

A retirement income plan should be based on planning to live,
not planning to die. A long life will be expensive to support, and it should take
precedence over assuming one will not live long. Fight the impatience that could
lead you to choose short-term expediencies carrying greater long-term cost. This
does not mean, however, that you sacrifice short-term satisfactions to plan for
the long term. Many efficiencies can be gained from a long-term focus that can support
a higher sustained standard of living.

Retirees must still plan for a long life, even when rejecting
strategies that only help in the event of a long life. Remember, planning for average
life expectancy is quite risky—half of the population outlives their expectancy.
Planning to live longer means spending less than you otherwise would. Developing
a plan that incorporates efficiencies that will not be realized until later can
allow more spending today in anticipation of those efficiencies. Not taking such
long-term, efficiency-improving actions will lead to a permanently reduced standard
of living.

Do not leave money on the table

The holy grail of retirement income planning is finding strategies
that enhance retirement efficiency. I define efficiency as follows: if one strategy
allows for more lifetime spending and a greater legacy value for assets relative
than another strategy, then it is more efficient. Efficiency must be defined from
the perspective of how long you live. Related to the previous point, a number of
strategies can enhance efficiency over the long term (but not necessarily over the
short term) with more spending and more legacy.

Use reasonable expectations for portfolio returns

A key lesson for long-term financial planning is that you should
not expect to earn the average historical market returns for your portfolio. Half
of the time, realized returns will be less. As well, we have been experiencing a
period of low interest rates, which unfortunately provides a clear mathematical
reality that at least bond returns are going to be lower in the future. This has
important implications for those who have retired. (These implications are relevant
for those far from retirement as well, but the harm of ignoring them is less than
for retirees.) At the very least, dismiss any retirement projection based on fixed
8 or 12 percent returns, as the reality is likely much less when we account for
portfolio volatility, inflation, and a desire to develop a plan that will work more
than half the time.

Be careful about plans that only work with high
market returns

A natural mathematical formula that applies to retirement planning
is that higher assumed future market returns imply higher sustainable spending rates.
Bonds provide a fixed rate of return when held to maturity, and stocks potentially
offer a higher return than bonds as a reward for their additional risk. But a risk
premium is not guaranteed and may not materialize. Probability-based retirees
who spend more today because they are planning for higher market returns than available
for bonds are essentially “amortizing their upside.” They are spending more today
than justified by bond investments, based on an assumption that higher returns in
the future will make up the difference and justify the higher spending rate.

For retirees, the fundamental nature of risk is the threat that
poor market returns will trigger a permanently lower standard of living. Retirees
must decide how much risk to their lifestyle they are willing to accept. Assuming
that, a risk premium on stocks will be earned and spending more today is risky behavior.
It may be reasonable behavior for the more risk tolerant among us, but it is not
a behavior that will be appropriate for everyone. It is important to think through
the consequences in advance.

Build an integrated strategy to manage various retirement
risks

Building a retirement income strategy is a process that requires
determining how to best combine available retirement income tools in order to meet
retirement goals and to effectively protect against the risks standing in the way
of those goals. Retirement risks include longevity and an unknown planning horizon,
market volatility and macroeconomic risks, inflation, and spending shocks that can
derail a budget. Each of these risks must be managed by combining different income
tools with different relative strengths and weaknesses for addressing each of the
risks. There is no single solution that can cover every risk.

Approach retirement income tools with an agnostic
view

The financial services profession is generally divided between
two camps: those focusing on investment solutions and those focusing on insurance
solutions. Both sides have their adherents who see little use for the other side.
But the most efficient retirement strategies require an integration of both investments
and insurance. It is potentially harmful to dismiss subsets of retirement income
tools without a thorough investigation of their purported role. In this regard,
it is wrong to describe the stock market as a casino or to dismiss annuities or
permanent life insurance as expensive and unnecessary.

For the two camps in the financial services profession, it is
natural to accuse the opposite camp of having conflicts of interest that bias their
advice, but each side must reflect on whether their own conflicts color their advice.
On the insurance side, the natural conflict is that insurance agents receive commissions
for selling insurance products and may only need to meet a requirement that their
suggestions be suitable for their clients. On the investments side, those charging
for a percentage of assets they manage naturally wish to make the investment portfolio
as large as possible, which is not necessarily in the best interests of their clients
who are seeking sustainable lifetime income and proper retirement risk management.
Meanwhile, those charging hourly fees for planning advice naturally do not wish
to make their recommendations so simple that they forego the need for an ongoing
planning relationship. It is important to overcome these hurdles and to rely carefully
on what the math and research show. This requires starting from a fundamentally
agnostic position.

Start by assessing all retirement assets and liabilities

A retirement plan involves more than just financial assets. The
retirement balance sheet is the starting point for building a retirement income
strategy. At the core is a desire to treat the household retirement problem in the
same way that pension funds treat their obligations. Assets should be matched to
liabilities with comparable levels of risk. This matching can either be done on
a balance sheet level, using the present values of asset and liability streams,
or it can be accomplished on a period-by-period basis to match assets to ongoing
spending needs. Structuring the retirement income problem in this way makes it easier
to keep track of the different aspects of the plan and to make sure that each liability
has a funding source. This also allows retirees to more easily determine whether
they have sufficient assets to meet their retirement needs or if they may be underfunded
with respect to their goals. This organizational framework also serves as a foundation
for choosing an appropriate asset allocation and for seeing clearly how different
retirement income tools fit into an overall plan.

Exhibit 1.2 provides a basic overview of potential assets and
liabilities to consider.

Exhibit 1.2

Basic Retirement Assets and Liabilities

Retirement Balance Sheet

Assets

Liabilities

Human capital

Fixed expenses (Longevity)

Continuing career

Essential living needs

Part-time work

Taxes

Debt repayment

Home equity

Discretionary expenses (Lifestyle)

Financial assets

Travel & leisure

Checking accounts

Lifestyle improvements

Brokerage accounts

Retirement plans

Contingencies (Liquidity)

Long-term care

Annuities & life insurance

Health care

Other spending shocks

Social capital

Social Security

Legacy goals (Legacy)

Medicare

Family

Company pensions

Community & society

Family & community

Distinguish between technical liquidity and true
liquidity

An important implication from the retirement balance sheet view
is that the nature of liquidity in a retirement income plan must be carefully considered.
In a sense, an investment portfolio is a liquid asset, but some of its liquidity
may be only an illusion. Assets must be matched to liabilities. Some, or even all,
of the investment portfolio may be earmarked to meet future lifestyle spending goals.
Curtis Cloke describes this in his Thrive University program for financial advisors
as allocation liquidity. Retirees are free to reallocate their assets in any way
they wish, but the assets are not truly liquid because they must be preserved to
meet the spending goal. Assets cannot be double counted, and while a retiree could
decide to use these assets for another purpose, doing so would jeopardize the ability
to meet future spending. In this sense, assets are not as liquid as they appear.

This is different from free-spending liquidity, in which assets
could be spent in any desired way because they are not earmarked to meet existing
liabilities. True liquidity emerges when there are excess assets remaining after
specifically setting aside what is needed to meet the household liabilities. This
distinction is important because there are cases when tying up a portion of assets
in something illiquid, such as an income annuity, may allow for the household liabilities
to be covered more cheaply than could be done when all assets are positioned to
provide technical liquidity.

In very simple terms, an income annuity that pools longevity
risk may allow lifetime spending to be met at a cost of twenty years of the spending
objective, while self-funding for longevity may require setting aside enough from
an investment portfolio to cover thirty to forty years of expenses. Because risk
pooling and mortality credits allow for less to be set aside to cover the spending
goal, there is now greater true liquidity and therefore more to cover other unexpected
contingencies without jeopardizing core spending needs. Liquidity, as it is traditionally
defined in securities markets, is of little value as a distinct goal in a long-term
retirement income plan. It must be true liquidity to count.

The Retirement Income Challenge

The process of building a retirement income strategy involves
determining how to best combine retirement income tools to optimize the balance
between meeting various retirement goals and effectively protecting those goals
from retirement risks. Building an optimal strategy is a process, and there is no
single right answer. No one approach or retirement income product works best for
everyone. Different people will approach the problem in different ways, as some
will feel affinity for solutions connected with managing withdrawals from an investment
portfolio, while others will begin from a desire to build income guarantees. The
objective becomes to flesh out the details for how each income tool could contribute,
quantify the advantages and disadvantages of different strategies, and determine
how to best combine the income tools into an overall plan that can best meet
goals and manage risks.

Financial Goals for Retirement

It is important to clarify the goals for a retirement income
plan, as different income tools are better suited for different goals.
Retirement plans should be customized to each person’s specific circumstances.
Each retiree should seek to meet specific financial goals in a way that best
manages the wide variety of risks that threatens those goals. The primary
financial goal for most retirees relates to their spending: maximize spending
power (lifestyle) in such a way that spending can remain consistent and
sustainable without any drastic reductions, no matter how long the retirement
lasts (longevity). Other important goals may include leaving assets for
subsequent generations (legacy) and maintaining sufficient reserves for
unexpected contingencies that have not been earmarked for other purposes
(liquidity). Lifestyle, longevity, legacy, and liquidity are the four Ls of
retirement income.

Changing Risks in Retirement

It is important to understand from the very outset how changing
risks are primarily what separate retirement income planning from traditional wealth
management. Retirees have less capacity for risk, as they become more vulnerable
to a reduced standard of living when risks manifest. Those entering retirement are
crossing the threshold into an entirely foreign way of living. These risks can be
summarized in seven general categories, listed in Exhibit 1.3.

Exhibit 1.3

Retirement Risks

Reduced earnings capacity

Retirees face reduced flexibility to earn income in the labor
markets as a way to cushion their standard of living from the impact of poor market
returns. One important distinction in retirement is that people often experience
large reductions in their risk capacity as the value of their human capital declines.
As a result, they are left with fewer options for responding to poor portfolio returns.

Risk capacity is the ability to endure a decline in portfolio
value without experiencing a substantial decline to the standard of living. Prior
to retirement, poor market returns might be counteracted with a small increase in
the savings rate, a brief retirement delay, or even a slight increase in risk taking.
Once retired, however, people can find it hard to return to the labor force and
are more likely to live on fixed budgets.

Visible spending constraint

At one time, investments were a place for saving and accumulation,
but retirees must try to create an income stream from their existing assets—an important
constraint on their investment decisions. Taking distributions amplifies investment
risks by increasing the importance of the order of investment returns in retirement.

It can be difficult to reduce spending in response to a poor
market environment. Portfolio losses could have a more significant impact on the
standard of living after retirement, necessitating greater care and vigilance in
response to portfolio volatility. Even a person with high risk tolerance (the ability
to stomach market volatility comfortably) would be constrained by his or her risk
capacity.

The traditional goal of wealth accumulation is generally to seek
the highest returns possible in order to maximize wealth, subject to risk tolerance.
Taking on more risk before retirement can be justified because many people have
greater risk capacity at that time and can focus more on their risk tolerance. However,
the investing problem fundamentally changes in retirement.

Investing during retirement is a rather different matter from
investing for retirement, as retirees worry less about maximizing risk-adjusted
returns and worry more about ensuring that their assets can support their spending
goals for the remainder of their lives. After retiring, the fundamental objective
for investing is to sustain a living standard while spending down assets over a
finite but unknown length of time. The spending needs that will eventually be financed
by the portfolio no longer reside in the distant future. In this new retirement
calculus, views about how to balance the trade-offs between upside potential and
downside protection can change. Retirees might find that the risks associated with
seeking return premiums on risky assets loom larger than before, and they might
be prepared to sacrifice more potential upside growth to protect against the downside
risks of being unable to meet spending objectives.

The requirement to sustain an income from a portfolio is a new
constraint on investing that is not considered by basic wealth maximization approaches
such as portfolio diversification and modern portfolio theory (MPT). In MPT, cash
flows are ignored, and the investment horizon is limited to a single time period
such as a year. This simplification guides investing theory for wealth accumulation.
When spending from a portfolio, the concept of sequence-of-returns risk (the
order that market returns arrive) becomes more relevant, as portfolio losses early
in retirement will increase the percentage of remaining assets withdrawn to sustain
an income. This can dig a hole from which it becomes increasingly difficult to escape,
as portfolio returns must exceed the growing withdrawal percentage to prevent further
portfolio depletion. Even if markets subsequently recover, the retirement portfolio
cannot enjoy a full recovery. The sustainable withdrawal rate from a retirement
portfolio can fall below the average return earned by the portfolio during retirement.

Heightened investment risk

As we just discussed, retirees experience heightened vulnerability
to sequence-of-returns risk when they begin spending from their investment portfolio.
Poor returns early in retirement can push the sustainable withdrawal rate well below
that which is implied by long-term average market returns.

The financial market returns experienced near the retirement
date matter a great deal more than retirees may realize. Retiring at the beginning
of a bear market is incredibly dangerous. The average market return over a thirty-year
period could be quite generous, but if one experiences negative returns in the early
stages when spending begins, withdrawals can deplete wealth rapidly, leaving a much
smaller remainder to benefit from any subsequent market recovery, even with the
same average returns over a long period of time. What happens in the markets during
the fragile decade around the retirement date matters a lot.

The dynamics of sequence risk suggest that a prolonged recessionary
environment early in retirement without an accompanying economic catastrophe could
jeopardize the retirement prospects for particular groups of retirees. Some could
experience much worse retirement outcomes than those retiring a few years earlier
or later. It is nearly impossible to see such an instance coming, as devastation
for a group of retirees is not necessarily preceded or accompanied by devastation
for the overall economy.

Unknown longevity

The fundamental risk for retirement is unknown longevity, which
is summarized in the question, How long will your retirement plan need to generate
income? It is the risk of running out of assets before running out of time. The
length of retirement could be much shorter or longer than the statistical life expectancy.
A long life is wonderful, but it is also costlier and a bigger drain on resources.
Half of the population will outlive their statistical life expectancy, and that
number is only increasing as scientific progress increases the number of years we
can expect to live. For some retirees, the fear of outliving resources may exceed
the fear of death. This can create a paralyzing effect on retirement spending.

When determining longevity, it may seem natural to base
calculations on the aggregate US population, but clear socioeconomic
differences have been identified in mortality rates. Higher income and wealth levels
and more education each correlate with longer lifespans. This may not be a
matter of causation (i.e., more income and education cause people to live
longer), but perhaps an underlying characteristic leads some people to have a
more long-term focus, and that, in turn, may lead them to seek more education
and practice better health habits. The very fact that you are reading this
somewhat technical tome on retirement income suggests you probably have a
longer-term focus and can expect to live longer than the average person. In
this case, mortality data based on population-wide averages will underestimate
your longevity.

Not everyone will live longer, as unfortunate accidents and
illnesses will inevitably befall some along the way. But in a statistical
sense, my average reader will live longer than the average person.

The American Academy of Actuaries and the Society of
Actuaries created the Longevity Illustrator (www.longevityillustrator.org) to
help users develop personalized estimates for their longevity based on a few
questions about age, gender, smoking status, and an overall assessment of health.
It is a free and simple-to-use resource. Exhibit 1.4 provides its output for
sixty-five-year-old males and females based on their health assessment and
smoking status.

Exhibit 1.4

Planning Ages for Sixty-Five-Year-Olds from the
Longevity Illustrator

Males

Nonsmoker

Smoker

Health Classification

Excellent

Average

Poor

Excellent

Average

Poor

Chance of Survival

90%

72

71

70

68

68

67

75%

80

78

76

73

72

71

50%

87

85

83

81

78

76

25%

94

92

90

88

85

83

10%

98

97

95

94

91

89

Females

Nonsmoker

Smoker

Health Classification

Excellent

Average

Poor

Excellent

Average

Poor

Chance of Survival

90%

75

74

72

70

69

68

75%

83

81

79

76

75

73

50%

90

88

86

84

82

80

25%

96

94

93

92

89

87

10%

101

99

97

97

95

93

Source: The Longevity Illustrator, www.longevityillustrator.org.

In a probability-based world, the available means for an
individual to manage longevity risk is to choose a conservative planning
horizon for which there is a sufficiently low probability to outlive. This will
require spending less so that available assets can be drawn out for a longer
period of time. The probability of surviving to advanced ages is low.
Individuals must determine how low a level of spending they are willing to
accept today in their effort to plan for a longer life and better ensure that
they will not deplete their assets before death.

For example, a nonsmoking sixty-five-year-old female in
average health who is willing to accept a 10 percent chance for outliving her
financial plan would want her plan to work to age ninety-nine. For a male with
the same characteristics, age ninety-seven corresponds to accepting the same
amount of longevity risk.

In 1994, William Bengen chose thirty years as a conservative
planning horizon for a sixty-five-year-old couple when he discussed sustainable
retirement spending. But as mortality improves over time, this planning horizon
is becoming less conservative, especially for nonsmokers in reasonable health.

The Society of Actuaries (SOA) also produced the 2012
Individual Annuity Mortality tables that I think will appropriately reflect the
situation for my readers. Compared to the Longevity Illustrator numbers shown
in Exhibit 1.4, the individual annuity mortality table corresponds with data
for nonsmokers in average to good health. And this data set provides mortality
rates at all ages, making it useful for supporting the annuity calculations in
this book. This mortality data is specifically for annuity purchasers who tend
to live longer than average. For instance, those with significant illnesses
tend to avoid buying annuities. The data also reflects estimates for future
mortality improvements and is not based only on the situation in one year.

Exhibit 1.5 uses this data with mortality improvements
projected for a starting year of 2019 to illustrate longevity risk by showing
the probability of survival to different ages beyond sixty-five. It also shows
outcomes for a couple’s joint longevity. With retirement planning, the trouble
is knowing what age to plan for, as this distribution of potential retirement
lengths is quite wide. With this data, the probability of a sixty-five-year-old
reaching age ninety-five is 23 percent for males, 30 percent for females, and 46
percent for at least one member of an opposite-gender couple. For a couple,
thirty years is getting close to being the life expectancy for its longest
living member. The probability of outliving a thirty-year time horizon is not
insignificant. Longevity risk is the risk of living longer than anticipated and
not having the resources to sustain spending for a longer lifetime. It is
reflected in the exhibit as if one builds a plan to work through age
ninety-five but then lives past this age.

Exhibit 1.5

The Probability of Survival from Age Sixty-Five and
the Longevity Risk for a Planning Age of Ninety-Five

Source: Own calculations for Society of Actuaries
2012 Individual Annuitant Tables with improvements through 2019.

Spending shocks

Unexpected expenses in retirement come in many forms, including:

·
unforeseen need to help family members

·
divorce

·
changes in tax laws or other public policy

·
changing housing needs

·
home repairs

·
rising health care and prescription costs

·
long-term care

Retirees must preserve flexibility and liquidity to manage unplanned
expenses. When attempting to budget over a long retirement period, it is important
to include allowances for such contingencies.

Compounding inflation

Retirees face the risk that inflation will erode the purchasing
power of their savings as they progress through retirement. Low inflation may not
be noticeable in the short term, but it can have a big impact over a lengthy retirement,
leaving retirees vulnerable. Even with just 3 percent average annual inflation,
the purchasing power of a dollar will fall by more than half after twenty-five years,
doubling the cost of living.

Sequence-of-returns risk is amplified by greater portfolio volatility,
yet many retirees cannot afford to play it too safe. Short-term fixed-income securities
might struggle to provide returns that exceed inflation, causing these assets to
be quite risky in a different sense: they may not be able to support a retiree’s
long-term spending goals. Low-volatility assets are generally viewed as less risky, but this may not be the case
when the objective is to sustain spending over a long time horizon. Retirees must
keep an eye on the long-term cumulative impacts of even low inflation and position
their assets accordingly.

Declining cognitive abilities

Finally, a retirement income plan must incorporate the unfortunate
reality that many retirees will experience declining cognitive abilities, which
will hamper portfolio management and other financial decision-making skills. For
the afflicted, it will become increasingly difficult to make sound portfolio investments
and withdrawal decisions at advanced ages.

In addition, many households do not equally share the management
of personal finances. When the spouse who manages the finances dies first, the surviving
spouse can run into serious problems without a clear plan in place. The surviving
spouse can be left vulnerable to financial predators and other financial mistakes.
Survivors often become more exposed to fraud and theft.

While liquidity and flexibility are important, retirees should
also prepare for the reality that cognitive decline will hamper the portfolio management
skills of many as they age, increasing the desirability of advanced planning and
automation for late-in-life financial goals.

Two Philosophies for Retirement
Income Planning

Within the world of retirement income
planning, the siloed nature of financial services between investments and insurance
leads to two opposing philosophies about how to build a retirement plan. There is
an old saying that if the only tool you have is a hammer, then everything starts
to look like a nail. This tendency is alive as those on the investments side tend
to view an investment portfolio as a solution for any problem, while those on the
insurance side tend to view insurance products as the answer for any financial question.

As a basic introduction to these schools, a simple litmus test
can be applied. Monte Carlo simulations are often used in financial planning contexts
to gain a better understanding of the viability of a financial plan in the face
of market and longevity risks. Monte Carlo simulations create randomized series
of market returns to test financial plans and their sustainability through
various market environments. Suppose a Monte Carlo simulation identifies a retirement
plan’s chance of success as 90 percent. Both sides of the debate might accept this
as the correct calculation from the software, but they will have dramatically different
interpretations of what to do with this number.

For probability-based thinkers, a 90 percent chance is a more
than reasonable starting point, and the retiree can proceed with the plan. It has
a high likelihood of success, and that’s enough for them. If future updates determine
that the plan might be on course toward failure, a few changes, such as a small
reduction in spending, should be adequate to get the plan back on track.

Those identifying with the safety-first school, however, will
not be comfortable with this level of risk, focusing instead on the 10 percent chance
of failure. They make a distinction between essential expenses and discretionary
expenses and seek a solution that practically eliminates the possibility of failure
for meeting essential expenses. Jeopardizing success, they say, is only reasonable
for discretionary expenses.

Financial service professionals and retirees should understand
which school they most identify with and to what extent their own thinking might
incorporate views from each school. Consumers of the financial services profession
must understand whether they and their advisor are speaking the same language. Advisors
able to communicate effectively from both sides will be more likely to deliver successful
retirement income outcomes by being able to tailor comfortable plans for their
clients.

The Probability-Based School of Thought

How much can retirees withdraw from their savings, which are
invested in a diversified investment portfolio, while still maintaining sufficient
confidence that they can safely continue spending without running out of wealth
for the length of retirement?

In the early 1990s, William Bengen read misguided claims in the
popular press that average portfolio returns could guide the calculation of sustainable
retirement withdrawal rates. If stocks average 7 percent after inflation, then plugging
a 7 percent return into a spreadsheet suggests that retirees could withdraw 7 percent
each year without ever dipping into their principal. Bengen recognized the naïveté
of ignoring the real-world volatility experienced around that 7 percent return,
and he sought to determine what would have worked historically for hypothetical
retirees at different points. He used data extending back to 1926 for US financial
markets for his research, which introduced the concept of sequence-of-returns
risk to the financial planning profession.

The problem he set up is simple: a new retiree makes plans for
withdrawing some inflation-adjusted amount from his or her savings at the end of
each year for a thirty-year retirement period. For a sixty-five-year-old, this leads
to a maximum planning age of ninety-five, which Bengen felt was reasonably conservative.
What is the highest withdrawal amount as a percentage of retirement date assets
that, with inflation adjustments, will be sustainable for the full thirty years?
He looked at rolling thirty-year periods from history (1926 to 1955, 1927 to 1956,
etc.). He found that with a 50/50 asset allocation to stocks and bonds (the S&P
500 and intermediate-term government bonds), the worst-case scenario experienced
in US history was for a hypothetical 1966 retiree who could have withdrawn 4.15
percent at most. That is if distributions are taken at the end of each year.
More realistically, if distributions are taken at the start of each year, this
sustainable withdrawal rate falls to 4.03 percent. Thus was born what is known as
the 4 percent rule.

Bengen’s work pointed out that sequence-of-returns risk will
reduce safe, sustainable withdrawal rates below what is implied by the average portfolio
return over retirement. Its popularity has coalesced into what we are calling the
probability-based approach.

The probability-based approach is based closely on the concepts
of maximizing risk-adjusted returns from the perspective of the total portfolio.
Asset allocation during retirement is generally defined in the same way as during
the accumulation phase—using modern portfolio theory (MPT) to identify a portfolio
on the efficient frontier in terms of single-period trade-offs between risk and
return. Different volatile asset classes that are not perfectly correlated are combined
to create portfolios with lower volatility. The efficient frontier identifies the
asset allocation combinations with the highest probability-weighted arithmetic average
return (often called expected return in finance literature) for an acceptable
level of year-by-year volatility (often called risk). Investors aim to maximize
wealth by seeking the highest possible return given their capacity and tolerance
for volatility over a specific time horizon.

For retirement planning, spending and asset allocation recommendations
from the efficient frontier are based on historical or Monte Carlo simulations of
failure rates in order to mitigate the risk of wealth depletion inherent in drawing
down a portfolio of volatile assets. The failure rate is the probability that wealth
is depleted before death or before the end of the fixed time horizon which stands
in for a maximum feasible lifespan. Asset allocation decisions are generally guided
by what can minimize the failure rate in retirement. Advocates of the probability-based
approach take this as license to use more aggressive asset allocations in
retirement.

Advice from Bengen and subsequent studies is to have a stock
allocation between 50 and 75 percent, but as close as possible to the higher end.
Probability-based advocates are generally more optimistic about the long-run potential
of stocks to outperform bonds and provide positive real returns, so investors are
generally advised to take on as much risk as they can tolerate in order to minimize
the probability of plan failure. This school of thought was the focus of my
book How Much Can I Spend in Retirement? A Guide to
Investment-Based Retirement Strategies.

The Safety-First School of Thought

The safety-first school of thought was originally derived from
academic models of how people allocate their resources over a lifetime to maximize
lifetime satisfaction. Academics have studied these models since the 1920s to figure
out how rational people make optimal decisions. In the retirement context, the question
to be answered is how to get the most lifetime satisfaction from limited financial
resources. It is the basic question of economics: how to optimize in the face of
scarcity? More recently, Nobel Prize winners such as Paul Samuelson, Robert Merton,
Franco Modigliani, and William Sharpe have explored these models.

Safety-first arrives from a more academic foundation, so it is
often described with mathematical equations in academic journals. As a result, it
has been slow to enter the public consciousness. The safety-first approach is probably
best associated with Professor Zvi Bodie from Boston University, whose popular books
such as Worry-Free Investing and
Risk Less and Prosper have
brought these ideas alive to the public. Michael Zwecher’s Retirement Portfolios is also
an excellent resource written for financial professionals about this school of thought.

Advocates of the safety-first approach view prioritization of
retirement goals as an essential component of developing a good retirement income
strategy. The investment strategy aims to match the risk characteristics of assets
and goals, so prioritization is a must.

Prioritizing goals has its academic origins in the idea of utility
maximization. As people spend more, they experience diminishing marginal value with
each additional dollar spent. The spending required to satisfy basic needs provides
much more value and satisfaction to someone than the additional spending on luxuries
after basic needs are met. Retirees should plan to smooth spending over time to
avoid overspending on luxuries at the present and then being unable to afford essentials
later.

In developing Modern Retirement Theory, financial planner Jason
Branning and academic M. Ray Grubbs created a funding priority for retiree liabilities.
Essential needs are the top priority, then a contingency fund, funds for discretionary
expenses, and a legacy fund. They illustrate these funding priorities with a pyramid.
Building a retirement strategy requires working from the bottom to properly fund
each goal before moving up to the next. There is no consideration of discretionary
expenses or providing a legacy until a secure funding source for essentials and
contingencies is in place.

The purpose of saving and investing is to fund spending and
other goals during retirement. Safety-first advocates move away from asset
allocation for the investment portfolio to broader asset-liability matching, which
focuses more holistically at the household level and emphasizes hedging and insurance
along with investing for upside. In simple terms, hedging means holding individual
bonds to maturity, and insurance means using annuities and life insurance as
solutions for longevity and market risk.

With asset-liability matching, investors are not trying to maximize
their year-to-year returns on a risk-adjusted basis, nor are they trying to beat
an investing benchmark. The goal is to have cash flows available to meet spending
needs as required, and investments are chosen in a way that meets those needs. Assets
are matched to goals so that the risk and cash-flow characteristics are comparable.
For essential spending, Branning and Grubb’s Modern Retirement Theory argues that
funding must be with assets meeting the criteria of being secure, stable, and sustainable.
In this regard, another important aspect of the investment approach for the safety-first
school is that investing decisions are made in the context of the entire retirement
balance sheet. This moves beyond looking only at the financial portfolio to consider
also the role of human and social capital. Examples of human and social capital
include the ability to work part-time, pensions, the social safety net, and so on.

An important point is that volatile assets are seen as inappropriate
for basic needs and the contingency fund. Stated again, the objective of investing
in retirement is not to maximize risk-adjusted returns, but first to ensure that
basics will be covered in any market environment and then to invest for additional
upside. Volatile (and hopefully, but not necessarily, higher returning) assets are
suitable for discretionary expenses and legacy, in which there is some flexibility
about whether the spending can be achieved.

Asset allocation, therefore, is an output of the analysis, as
the entire retirement balance sheet is used, and assets are allocated to match appropriately
with the household’s liabilities. Asset-liability matching removes the probability-based
concept of safe withdrawal rates from the analysis, since it rejects relying on
a diversified portfolio for the entire lifestyle goal.

In fact, the general view of safety-first advocates is that
there is no such thing as a safe withdrawal rate, such as the 4 percent rule,
from a volatile portfolio. A truly safe withdrawal rate is unknown and
unknowable. Retirees only receive one opportunity to obtain sustainable cash
flows from their savings and must develop a strategy that will meet basic needs,
no matter the length of life or the sequence of postretirement market returns
and inflation. Retirees have little leeway for error, as returning to the labor
force might not be a realistic option. Volatile assets like stocks are not
appropriate when seeking to meet basic retirement living expenses. Just because
a strategy did not fail over a historical period does not ensure it will always
succeed in the future.

The idea is to first build a floor of low-risk, contractually
protected income sources to serve basic spending needs in retirement. The floor
is built with Social Security and any other defined-benefit pensions, and by using
financial assets to do things such as building a ladder of TIPS or purchasing an
annuity with lifetime income protection. Not all of these income sources are inflation
adjusted, and you need to make sure the floor will be sufficiently protected from
inflation, but this is the basic idea.

The objective for retirement is first to build a safe and
secure income floor for the entire retirement planning horizon, and only after
that does one include more volatile assets that provide greater upside
potential and accompanying risk. Once there is enough flooring in place, retirees
can focus on upside potential with remaining assets. Since this extra spending (such
as for nice restaurants, extra vacations, etc.) is discretionary, it will not be
the end of the world if it must be reduced at some point. The protected income floor
is still in place to meet basic needs no matter what happens in the financial
markets. With this sort of approach, withdrawal rates hardly matter.

The Road Ahead

Retirement plans can be built to manage varying risks by
strategically combining different retirement income tools. Our discussion of
tools will focus on meeting spending and legacy goals with the intention of
preserving some true liquidity to serve as reserves for spending shocks. The
book navigates through the tools for building a retirement income plan with the
basic ordering in mind: bonds, stocks, insurance. The first option is to use
individual bonds to build a retirement income bond ladder that locks in desired
spending at targeted dates. The bond yield curve determines how much can be
spent in this way. To spend more than bonds can support, the second option is
to rely on a diversified investment portfolio to provide higher returns by
earning a risk premium above bonds. The third option is to pool longevity and
market risks by using annuities and life insurance.

Fixed-Income and Individual Bonds

A starting point for retirement income is to hold
fixed-income assets to their maturity to protect assets for upcoming retirement
expenses. Holding bonds to their maturity can keep the retiree from selling
them at a loss, which may help alleviate sequence-of-returns risk. Individual
bonds do not provide longevity protection, however. And while they may provide technical
liquidity, selling them early to use for other contingencies could result in
capital losses as well as the loss of assets that had been earmarked to cover
future spending. Traditional bonds will be exposed to inflation risk, but
Treasury Inflation-Protected Securities (TIPS) can be used to lock in the
purchasing power of money in real terms. We investigate bonds further in
Chapter 2.

Total-Return Investment Portfolios (Risk
Premium)

Making systematic withdrawals from a well-diversified
investment portfolio is a common way to obtain retirement income. Systematic
withdrawals do not protect a retiree from longevity risk or sequence-of-returns
risk and may only protect from inflation risk when asset returns can keep up
with inflation. This approach has its benefits, such as the potential to keep the
nest egg growing to leave a large inheritance, as well as provide a sense of
technical liquidity that could become true liquidity if markets perform well. A
total-return approach is particularly vulnerable to declining cognitive
abilities, as it requires complex financial decision-making to manage
distributions and investments. It is the foundation of the probability-based
approach. We review the process of determining sustainable spending with a
volatile investment portfolio in Chapter 3.

Annuities (Risk Pooling)

Annuities with lifetime income protections can provide an
effective way to build an income floor for retirement. Annuities, as opposed to
individual bonds, provide longevity protection by hedging the risks associated
with an unknown retirement length. Annuities can be real or nominal, fixed or
variable, and income payments can begin within one year or be deferred to a
later age. Social Security and the traditional defined-benefit pensions still offered
by some employers may also be treated as annuities providing lifetime income
protection as well.

The simplest type of annuity is an income annuity. We
introduce these in greater detail in Chapter 4. There are also countless types
of annuities can be used for many different purposes, including reasons
unrelated to providing lifetime income.

With our focus in this book on retirement income, though,
there are two additional annuity types we consider in detail. These include
deferred variable annuities with lifetime income provisions, which are the
subject of Chapter 5, and fixed index annuities (a newer name for equity index
annuities) with lifetime income provisions, which are the subject of Chapter 6.
Unlike income annuities that solely focus on protecting lifetime income, these
other annuity types provide various combinations of lifetime income, liquidity,
and upside growth potential.

Life Insurance (Risk Pooling)

Permanent life insurance is another tool that can play a
role in a retirement income plan. In Chapter 7, we focus on whole life
insurance and discuss briefly about variable and index life insurance as well. Whole
life insurance provides a death benefit and a guaranteed cash value, both of
which can be used in different ways to help support a lifetime financial plan.
We focus on four potential roles for life insurance, including meeting a legacy
goal with less assets, providing the comfort and support to also use an annuity
with lifetime income protections, using the cash value of the life insurance as
a volatility buffer asset to help manage sequence risk, and treating the cash
value as a fixed-income alternative that may provide competitive returns on an post
tax basis, especially if life insurance is desired in the preretirement period.

Product Allocation

Retirement income planning is not an either/or proposition. In
the final two chapters, we step away from the notion that either investments or
insurance alone will best serve retirees. Each tool has its own advantages and
disadvantages. An entire literature on product allocation has arisen, showing
how a more efficient set of retirement outcomes can be obtained by combining
investments with insurance in the form of partial annuity strategies.

Deciding whether to annuitize, when to annuitize, how much
to annuitize, and whether to build a ladder of annuities over time are all
important questions. Annuities protect from longevity and sequence-of-returns
risk, and they can protect from inflation risk if a real annuity is purchased.
Because income continues automatically, they also provide protection for
cognitive decline. David Laibson, a professor at Harvard University, refers to
income annuities as “dementia insurance.”

Chapter 8 focuses on issues about including income annuities
into an overall retirement income plan. Chapter 9 provides a deeper comparison
of different types of annuities in terms of their tax treatment, credit risk,
and additional provisions for upside and liquidity. We also provide tips on
distinguishing good and bad annuities, as well as criteria for choosing an
annuity type.

Further Reading

Bengen, William P. 1994. “Determining Withdrawal Rates
Using Historical Data.” Journal of Financial Planning 7 (4): 171–180.

Bodie, Zvi, and Michael J. Clowes. 2003. Worry-Free Investing:
A Safe Approach to Achieving Your Lifetime Financial Goals. Upper Saddle River,
NJ: Financial Times Prentice Hall. [http://amzn.to/2mWqdUG]

Bodie, Zvi, and Rachelle Taqqu. 2012. Risk Less and Prosper:
Your Guide to Safer Investing.
Hoboken, NJ: John Wiley. [http://amzn.to/2sjgBFT]

Branning, Jason K., and M. Ray Grubbs. 2010. “Using a Hierarchy
of Funds to Reach Client Goals.”
Journal of Financial Planning 23 (12): 31–33.

Zwecher, Michael J. 2010. Retirement Portfolios: Theory,
Construction, and Management. Hoboken, NJ: John Wiley. [http://amzn.to/2u0cbRA]

Chapter 2: Fixed-Income
Assets

For standard investment approaches, bonds are generally
treated as a diversifying asset class that can help to reduce portfolio
volatility. The standard investing philosophy for accumulation does not really
consider how the nature of risk changes upon retiring. In short, it uses modern
portfolio theory to choose an asset allocation strategy that includes bonds as
part of a total-returns investment portfolio. Bonds, with their lower expected
returns and volatility, provide a way to reduce the portfolio’s overall
volatility to an acceptable level while still maintaining a sufficient overall
portfolio return.

Asset allocation in this framework is generally determined in
terms of assets-only considerations to build a diversified portfolio with the
highest expected return for the accepted level of risk. To the extent that
retirement income needs are considered, it is generally to find an asset
allocation that will minimize the probability of failure for the financial
plan. Looking back to William Bengen’s original work in the 1990s about
sustainable spending rates, the best worst-case historical spending rates could
be achieved with an overall bond allocation of 20 to 65 percent. He also found
that intermediate-term US government bonds provided a sweet spot in terms of
return and volatility trade-offs, keeping worst-case historical spending rates
at the highest possible level.

As a pure building block for retirement income, though, we
may think of holding individual bonds to maturity to provide the desired cash
flows to fund annual expenses on an ongoing basis throughout retirement. In
this method, maturing bonds and bond coupon payments provide a steady and known
stream of contractually protected income to meet planned expenditures. There
will not be capital losses if bonds are not sold prior to maturity.

A retirement income bond ladder is the natural starting
point for building a retirement income strategy. It can neutralize
market-related risks for the retirement income plan, though it still exposes
the retiree to longevity risk, as it is possible to outlive the end-date chosen
for the bond ladder. If one seeks to spend more than the bond yield curve can
support for a given ladder length, the two options are to seek a risk premium
through stock market investments, or to pool longevity risk through insurance
products. In this chapter, we lay the foundation for understanding how the
retirement income bond ladder works as a baseline for a retirement income
strategy.

Understanding How Bonds
Work

Before we can discuss bonds in depth, it is important that
we establish a common understanding of what bonds are and how they work. As a
starting point, a bond is a contractual obligation to make a series of specific
payments on specific dates. Typically, this includes interest payments made on
a semiannual basis until the maturity date and the return of the bond’s face
value. Bonds are issued by both governments and private corporations to raise
funds, and they are purchased by investors seeking an investment return on
their capital.

Treasuries are issued by the US government. Technically, treasuries
with maturities of a year or less are called bills, while those with
maturities of more than a year up to ten years are called notes. Bonds
typically refers to treasuries with maturities of more than ten years. In my
discussion, I will use the term bond generically to represent these
cases. Bank CDs also function as a type of bond in terms of providing specified
cash flows at specified dates, though they are not traded on secondary markets.

Bond interest rates—both coupon rates and the yields subsequently
provided to investors—are determined by the interaction of supply and demand
for the bonds as they continue to be traded. An increase in demand—such as that
triggered by a “flight to quality” when investors are panicked by the falling
prices of risky assets—will push up the price of these bonds. Conversely, a
stretched government seeking to raise funds through an increasing supply of new
bond issues will reduce the price of bonds.

Newly issued bonds are sold on the primary market, but many
go on to be traded on secondary markets. A bond that sells at par value can be
purchased for the same price as its face value. Bonds may also sell at a
premium (higher than face value) or discount (lower than face value). Bond
prices are quoted in terms of bid and ask prices. Bid is the price the
bond can be sold for, and ask is the price at which it can be purchased.
The difference in prices is the spread made by the party helping conduct the
exchanges between buyers and sellers. Household investors will experience lower
bid and higher ask prices than reported in newspapers because the newspapers
report the wholesale prices for institutions placing trades in excess of $1
million.

Rising interest rates will lower prices for existing bonds,
so the subsequent return to the new purchaser can match the higher returns
available on new bonds with higher interest rates. Conversely, lower interest
rates will increase the price existing bonds can sell for. If sold at their
face value, these older bonds offer higher returns than newly issued bonds, and
their owners will want to hold them. An agreeable selling price can only be
found if the bond sells at a premium, and then the new purchaser receives a
subsequent return on their purchase price that is in line with newly issued
bonds. The price of a bond on the secondary market will fluctuate in the
opposite direction of interest rates.

In the universe of bonds, there is not one single interest
rate. Differences in interest rates among bonds reflect several factors:

·
the time to maturity for the bond (longer-term bonds will
experience more price volatility as interest rates change)

·
the credit risk of the bond (bonds that are more likely to
default on their promised payments are riskier and will have to reward
investors with higher yields)

·
liquidity (bonds that are more actively traded may offer lower
yields as investors will demand an additional return premium for sacrificing
liquidity)

·
the tax status of the bond (municipal bonds from state and local
government agencies are free from federal income taxes and thus offer lower
interest rates)

Bonds may also feature other options that affect the price
an investor is willing to pay. For instance, if the bond is callable (meaning
the issuer retains the right to repay it early if interest rates decline), the
potential capital gains are reduced, which in turn lowers the price investors
are willing to pay.

US government treasuries are generally seen as having the
lowest credit risk, and they will generally offer lower yields than corporate
bonds with the same maturity date. They are less likely to default and create
problems for borrowers to receive what is owed. They are backed by the full
faith and credit of the US government. Treasuries are also free from state and
local taxes.

In recent years, financial innovation has led to the
creation of many new types of fixed-income instruments with varying risk and
return potential, but the retirement income planning discussion here is about
using traditional government or noncallable (face value cannot be repaid early)
high-quality corporate bonds to support a retirement income strategy.

Bond Pricing 101

As a bond provides a contractual right to a series of future
payments received at specified points of time, the price for a bond is simply
the present discounted value of the future cash flows. The face value of a bond
will be repaid at maturity.

A zero-coupon bond provides only a bond’s face value,
and it will be sold at a discount to the face value in order to provide a
return and compensate for the risks related to holding it. A coupon bond
provides the face value at maturity in addition to a series of coupon payments
(often on a semiannual basis) until the maturity date. The coupon rate
is contractually defined as a percentage of the face value.

The yield to maturity is the internal rate of return
an investor will earn by holding a bond to maturity and receiving its cash
flows. The yield to maturity for a new investor differs from the coupon rate
whenever the bond sells for a different price than its face value.

Exhibit 2.1 provides a simple example to understand the
pricing process for bonds. The bond being considered is a ten-year coupon bond
with a face value of $1,000 and a coupon rate of 3 percent. In this simple
example, one coupon payment of $30 (3 percent of $1,000) is made at the end of
each year for ten years to the bond’s owner(s) on those dates, and the face
value is paid in full at the end of the tenth year. These can be seen in the
exhibit’s Cash Flows column. The next three columns provide the discounted
value of these cash flows for different interest rates: 3 percent, 3.5 percent,
and 4 percent. When the discount rate is 3 percent, we see that the total
discounted cash flows add to $1,000, which is the same as the face value. This
is an important point: When the interest rate is the same as the bond coupon
rate, the price of a coupon bond will match its face value.

Let’s be clear about what the discounted value of the payments
means. In year ten, for instance, the discounted value of the payment with a 3 percent
interest rate is $766.42. Imagine placing this amount in a bank account that
earns an annually compounded 3 percent return each year. After ten years, it
will grow to be $1,030, which is the amount of the cash payment provided in
year ten. In other words, an investor would need to set aside $766.42 today in
order to have $1,030 in ten years if the funds grew at a 3 percent annually
compounded return.

If interest rates in the economy are 3.5 percent, then an
investor would not be willing to pay $1,000 for this bond that provides only 3 percent
coupon payments. The investor would prefer a new bond that presumably is now
offering a 3.5 percent coupon. To entice an investor to purchase the bond in
this exhibit, the bond would have to be sold for a lower price. In a
competitive and active market, bonds with the same maturity and risk
characteristics must offer the same potential return for both parties to agree
to a trade. In this case, the future cash flows are discounted at 3.5 percent,
and the sum of these discounted cash flows (and potential selling price) is $958.42.

Whoever owns the bond is entitled to the predefined cash
flows of $30 per year plus $1,000 more in the final year. These cash flows do
not change with interest rates. What changes is the selling price of the bond.
For an investor who pays $958.42 for the bond, the yield to maturity received
by the investor on this smaller investment is 3.5 percent. Note that a 0.5
percent increase in interest rates reduced the selling price of the bond by 4.2
percent. If the investor sold the bond, the return received by the previous
owner is defined in terms of any coupon payments received less the capital loss
associated with the interest rate rise. Increasing interest rates lower the
prices for existing bonds. The same phenomenon is also shown for an interest rate
of 4 percent. In this case, the bond’s price would have to be set at $918.89 to
adequately entice an investor. The 8.1 percent price reduction provides a yield
to maturity of 4 percent to the new purchaser that then matches the overall
higher interest rate in the economy.

Exhibit 2.1

Basic Pricing for a Ten-Year Coupon Bond

Coupon Rate:

3%

Face Value:

$1,000

Interest Rates:

3%

3.5%

4%

Year

Cash Flows

Discounted Cash Flows

1

$30.00

$29.13

$28.99

$28.85

2

$30.00

$28.28

$28.01

$27.74

3

$30.00

$27.45

$27.06

$26.67

4

$30.00

$26.65

$26.14

$25.64

5

$30.00

$25.88

$25.26

$24.66

6

$30.00

$25.12

$24.41

$23.71

7

$30.00

$24.39

$23.58

$22.80

8

$30.00

$23.68

$22.78

$21.92

9

$30.00

$22.99

$22.01

$21.08

10

$1,030.00

$766.42

$730.19

$695.83

Bond Price:

$1,000.00

$958.42

$918.89

Price Change:

0.0%

-4.2%

-8.1%

The yield to maturity can differ from the coupon rate as
bonds are bought and sold at prices other than face value, exposing the
investor to interest rate risk—the risk that a bond price will fall due
to rising interest rates.

Coupon rates are one of the most confusing aspects of bonds
for people to understand. When the bond is issued, it pays a set coupon rate.
For a regular Treasury bond, if the coupon rate is 3 percent and face value is
$1,000, then the bond pays coupons of $30 per year. Usually these are paid
semiannually—two coupon payments of $15 in this case. Note that the coupon rate
never changes. Interest rates can change, but that will affect the
yield, not the coupon rate. If interest rates rise, then the price the bond can
be sold at will decrease, raising the underlying yield to maturity to match the
increasing interest rate. But if I buy a $1,000 face value bond on the
secondary market for only $700 and it has a 3 percent coupon, it is important
to understand that my coupon income will be based on 3 percent of $1,000, not 3
percent of $700. Though this may seem basic and simple as I explain it, it has
proved to be a major source of confusion.

The yield is the yield to maturity based on the ask
price paid by the investor—the return the investor would get for buying the
bond today and holding it to maturity. If the ask price matches the face value,
then the yield will be the same as the coupon. If the ask price is higher, then
the yield will be less than the coupon, and if the ask price is lower, then the
yield will be higher than the coupon. Why? This gets back to the point I was
stressing before about how the coupon rate never changes. The bond provides a
promise for a fixed set of payments. It pays all the fixed coupon amounts and
repays the face value at the maturity date. These payments do not change. But
bonds can be sold and resold on secondary markets prior to the maturity date.
If I pay $900 for a bond providing a fixed set of promised payments, then I’m
going to get a higher return on my $900 investment than if I paid $1,100 for
the same set of promised payments. Lower ask prices imply higher yields, and
vice versa.

Exhibit 2.2

The Seesaw for Bond Prices and Interest Rates

Bond Duration

Bond prices are sensitive to interest rate changes, and bond
duration is a measure of just how sensitive. For instance, in Exhibit 2.1, an
increase in interest rates for the simple bond from 3 percent
to 4 percent caused the bond’s price to fall by 8.1 percent. This bond has
a duration of 8.1, meaning that a 1 percent rise in interest rates leads to an
8.1 percent drop in price. The bond duration is measured in years, and the
weighted-dollar average for the time when the cash flows are received in this example
is 8.1 years.

Exhibit 2.3

Bond Prices and Interest Rates

Current
Bond Value:

$1,000

Coupon Rate:

3%

(annual)

Current Interest Rate:

3%

New Interest Rate: New
Bond Price

Years to Maturity

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

1

$1,020

$1,015

$1,010

$1,005

$1,000

$995

$990

$986

$981

5

$1,097

$1,072

$1,047

$1,023

$1,000

$977

$955

$934

$913

10

$1,189

$1,138

$1,090

$1,044

$1,000

$958

$919

$881

$846

20

$1,361

$1,258

$1,164

$1,078

$1,000

$929

$864

$805

$751

30

$1,516

$1,360

$1,224

$1,105

$1,000

$908

$827

$756

$693

New Interest Rate:
Percent Change for Bond Price

Years to Maturity

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

1

2.0%

1.5%

1.0%

0.5%

0.0%

-0.5%

-1.0%

-1.4%

-1.9%

5

9.7%

7.2%

4.7%

2.3%

0.0%

-2.3%

-4.5%

-6.6%

-8.7%

10

18.9%

13.8%

9.0%

4.4%

0.0%

-4.2%

-8.1%

-11.9%

-15.4%

20

36.1%

25.8%

16.4%

7.8%

0.0%

-7.1%

-13.6%

-19.5%

-24.9%

30

51.6%

36.0%

22.4%

10.5%

0.0%

-9.2%

-17.3%

-24.4%

-30.7%

Exhibit 2.3 uses the same basic setup as Exhibit 2.1 to
provide more insight about how bond prices relate to interest rates and time to
maturity. Again, the basic scenario is that we have purchased a bond with a
$1,000 face value and 3 percent annual coupon payments. The current interest
rate for a comparable bond is also 3 percent. Sometime shortly after purchase,
interest rates change, with the exhibit showing new potential interest rates
from 1 to 5 percent. The exhibit shows the new price that bonds with different
maturities could sell for after the rate change. The bottom section of the
exhibit shows the percentage change in price resulting from the rate change.
Here we can clearly see how bond prices move counter to interest rates, and how
price fluctuations are more dramatic for longer-term bonds, demonstrating their
higher duration. At the extreme, the thirty-year bond would experience a
capital gain of 22.4 percent if interest rates fell by 1 percent,
and a 17.3 percent capital loss if interest rates rose by 1 percent.
Price risk increases with time to maturity. If interest rates rose to 5 percent,
the capital loss for a thirty-year bond would be 30.7 percent—comparable to a significant
stock market drop. Despite their reputation as reliable and predictable, bonds
can be risky.

While more complex bonds can have some unusual duration
properties, the basic noncallable coupon and discount bonds we consider for a
retirement income plan define duration in a straightforward way. A bond’s duration
is essentially the effective maturity of a bond—an average of when the bond’s
payments are received, weighted by the discounted size of those cash flows.

A zero-coupon bond provides one payment at the maturity
date, so its duration is the same as the time to maturity. The further away the
maturity date, the higher the bond’s duration, making it more sensitive to
interest rate changes. A coupon bond will have a shorter duration than the time
to the maturity date because coupon payments are received before the maturity
date. Higher coupon rates push relatively more cash flows sooner, which
otherwise lowers the duration for a bond with the same maturity date. Also,
lower interest rates mean the future cash flows from a bond are discounted less
relative to nearer-term cash flows, and so bond duration increases when
interest rates are low. An implication for this point is that our low-interest-rate
environment increases the interest rate risk for holding bonds, as a rate
increase can result in a bigger capital loss.

An observant reader of Exhibit 2.3 might note that duration
is not symmetric. For a thirty-year bond, a 1 percent increase in interest
rates to 4 percent results in a capital loss of 17.3 percent, while a 1 percent
decrease in interest rates to 1 percent results in a capital gain of 22.4
percent. The duration measure works best for small interest rate changes
because it is a linear approximation to a shape that is curved. The term convexity
describes price sensitivity to interest changes more precisely. Bond prices are
more sensitive to rate decreases (prices rise more) than to equivalent rate
increases (prices fall by less). These differences are accounted for by the
fact that changing interest rates also impact duration. The duration for a
given bond rises as interest rates fall and future cash flows are discounted by
less. But for a household retiree, duration provides a close enough
approximation to this relationship, and only those with a greater interest in
the mathematics of bond pricing should worry about further adding bond convexity
to their discussion.

Though somewhat technical, this discussion of bond duration
is important because the concept also applies to retirement spending
liabilities and, therefore, the ability to meet retirement goals. Retirement
spending has a duration that can be defined in the same way as an effective
maturity for those cash flows. It is an average of when expenses must be paid,
weighted by the size of the discounted values of those expenses.

Individual bonds have a duration. A bond fund, which is a
collection of bonds, also has a duration equal to the average duration of each
holding weighted by its proportion in the fund. Retirement liabilities have a
duration, too. If the duration of the bonds and the spending liabilities can be
matched to the same value, then the retiree has immunized his or her interest
rate risk. Rising interest rates would lower the value of bond holdings, but
rising rates also lower the present value of the future spending obligations.
When durations are the same, both the asset and liability values are reduced by
the same amount, and the retiree remains equally well-off in terms of the
ability to meet liabilities. This is the meaning of immunizing interest rate
risk. If the durations do not match, then the retiree is exposed to interest
rate risk.

Treasury
Inflation-Protected Securities (TIPS)

In discussing retirement liabilities, it is also important
to address the issue of inflation and how to think about bonds when they are
meant to fund a liability that grows with the consumer price index.
Fortunately, this is now practical as the United States began issuing Treasury
Inflation-Protected Securities (TIPS) in 1997. Backed by the full faith and
credit of the US government and assurances that inflation cannot eat away at
their value, TIPS provide a risk-free asset for US-based investors.

The face value and coupon payments for TIPS are both indexed
to keep pace with inflation and preserve purchasing power, and their yields are
quoted in real inflation-adjusted terms. Whenever positive inflation (as
opposed to deflation) is expected, real yields will be less than the nominal
yields quoted on traditional (i.e., not inflation adjusted) bonds. As an
approximation:

real interest rate = nominal interest rate − expected
inflation rate

Nominal interest rates are determined by compensation
expected to keep pace with inflation plus a real rate of return for the
investor. Supply and demand affect bond prices and interest rates. Real
interest rates can be negative.

Investors may expect a positive nominal return on their
investment (otherwise, there is no reason to invest), but that return may not
be able to keep pace with inflation. Unlike traditional bonds, TIPS yields are
quoted as real interest rates.

Their nominal yields are not known in advance because they
depend on the subsequently realized inflation experience. Conversely, we know
nominal yields for traditional bonds, but their real yields can only be known
after observing the realized path of inflation up to the maturity date.

Inflation adjustments for TIPS are linked to the Consumer
Price Index for All Urban Consumers (CPI-U). These adjustments are tracked in
terms of the accrued principal, which is a unique term for TIPS. Accrued
principal is the inflation-adjusted value of the initial face value since the
TIPS was issued. For TIPS, inflation adjustments are realized by having the
coupon rate be paid on the value of the accrued principal, not the nominal
initial face value.

As well, at the maturity date, the investor receives the
accrued principal back, not the nominal face value. A real coupon rate is paid
on an inflation-adjusted amount, and an inflation-adjusted amount is returned
at the maturity date.

If there is deflation, the accrued principal can decrease,
but it is protected from falling below its initial par value. This means that
TIPS on the secondary markets with lower accrued principal will be able to
provide better protection from a deflationary episode, other factors being the
same.

Otherwise, deflation that is not significant enough to cause
the accrued principal to fall below its initial par value will hurt TIPS
relative to traditional bonds. Generally, the purpose of TIPS is to provide
protection from unexpectedly high inflation, and buying TIPS with a lower relative
accrued principal is a secondary consideration when choosing specific TIPS to
purchase.

It is important to note that TIPS are purchased in nominal
dollars. On the secondary market, the ask price for TIPS is quoted in real
terms, represented as a percentage of the inflation-adjusted accrued principal.
The price paid is the ask price times the accrued principal divided by 100.

TIPS notes and bonds have been issued since January 1997.
Until mid-2002, each auction for TIPS of the various maturities provided an
initial real yield above 3 percent. Lucky investors in 1998 and 1999 could have
purchased thirty-year TIPS yielding close to 4 percent and yields on ten- and
twenty-year TIPS exceeded 4 percent in 1999 and 2000. Since this time, TIPS
yields have fallen.

An auction for a five-year note held in October 2010 made
headlines as the real yield dipped below zero (to -0.55 percent) for the first
time. Purchasers of those issues locked in yields that will not keep pace with
inflation. Though surprising at the time, negative yields for TIPS have become
the norm in recent years until the flattening of the yield curve in 2018
brought shorter-term TIPS yields above 0 percent again.

In 2003, Zvi Bodie and Michael J. Clowes published the book Worry-Free
Investing: A Safe Approach to Achieving Your Lifetime Financial Goals, in
which they argued that typical retirement-oriented investors should rely
primarily on TIPS for their retirement savings. Of course, other financial
assets should be included in retirement portfolios, but, they said, only once
you have enough savings (after accounting for any income expected from Social
Security and other defined-benefit pensions) to cover your planned retirement
expenditures without these riskier assets. In an interview in the February 2010
issue of Journal of Financial Planning, Bodie confirmed his continued
endorsement of this strategy. He also indicated that his personal retirement
portfolio is 100 percent in TIPS.

TIPS tend to be the preferred choice in academic approaches
to retirement income, assuming that spending needs grow with inflation. But not
everyone agrees. First, there are issues to consider related to how TIPS
provide adjustments for the Consumer Price Index for All Urban Consumers
(CPI-U). The CPI-U does not match the actual inflation experience of any
individual household purchasing a different basket of goods. The Bureau of
Labor Statistics has also created an experimental CPI for the elderly that
suggests their consumption basket cost may grow at a faster overall rate. It is
also safe to assume that the spending of many households will not keep pace
with inflation in retirement as their consumption basket changes over time.
TIPS are presented by some as the perfect hedge for the retirement spending
liability, but that is only true if a retiree’s spending grows at the same rate
as the CPI-U.

Another reason TIPS are not universally adored is that while
they are exempt from state and local taxes (like all treasuries), the inflation
adjustments provided for their coupon payments and principal are taxable at the
federal level. This tax will need to be paid on an ongoing basis for the
inflation adjustments on the accrued principal, even though you won’t see a
penny of it until the maturity date. Calculating taxes for this “phantom
income” can be especially complex, so many retirees prefer to hold their TIPS
in qualified retirement accounts.

Another negative is that TIPS tend to have a higher duration
than traditional treasuries because of their lower real coupon rates and
because the cash flows received from TIPS will weigh more heavily toward
payments with bigger inflation adjustments made closer to the maturity date.

Michael Zwecher suggests in his 2010 book Retirement
Portfolios that he is not dogmatic about seeking inflation protection. He
views the higher yield on traditional bonds as a premium for writing a call
option on inflation. As indicated, traditional bonds lose out when inflation is
unexpectedly high. Some retirees may be willing to accept this risk in return
for the higher yield that traditional bonds provide otherwise. This could be
especially true of households who are not as exposed to this inflation risk
either because their spending will not keep pace with inflation or because they
have inflation protection from other assets like Social Security.

Overall, there is no single answer to the choice of TIPS
versus traditional treasuries. I tend to lean toward TIPS as a default choice,
but individual circumstances could certainly warrant a more mixed approach.
Individuals who can live comfortably on their inflation-adjusted Social
Security benefit, for instance, may have little need for TIPS.

The Yield Curve and
Break-Even Inflation

Understanding the relationship between bond risk and time to
maturity and duration of a bond provides the basis for understanding the bond
yield curve. The yield curve shows the yields to maturity for a series of
bonds—typically US Treasury bonds—with the same credit quality but different
maturity dates, along with the term structure for interest rates.

Exhibit 2.4 provides an example of the yield curve for
Treasury Bonds and for TIPS on May 1, 2019.

Exhibit 2.4

US Government Yield Curve for Constant Maturity
Bonds and TIPS, May 1, 2019

Source: US Department of the Treasury.

Bonds with more distant maturity dates typically offer
higher interest rates than bonds with earlier maturity dates. This is not
always the case, but in the exhibit, we do see this effect, even though it is
more muted than usual. For treasuries, a thirty-year treasury was yielding 2.92
percent while a five-year treasury was yielding 2.31 percent, for instance.
Likewise, with TIPS the real yield for a thirty-year maturity was 0.95 percent,
compared with 0.48 percent for a TIPS with a five-year maturity.

Longer-term bonds experience bigger price fluctuations as
interest rates change. When interest rates increase, the price of existing
bonds on the secondary market falls in order to calibrate the yield investors
will receive from owning existing bonds with the yields being offered by newly
issued bonds at the higher interest rates. Bonds that mature sooner are less
exposed to this price risk. Thus, shorter-term US Treasury securities are
generally considered to be among the lowest-risk investment assets when
annualized volatility represents the measure of risk, which means they tend to
be offered at a lower yield. Higher yields accompany longer-term bonds, as
investors need an added incentive to accept the higher price risks.

The shape of the yield curve is molded by two theories.
First, expectations theory suggests that the shape of the yield curve should be
reflected by beliefs about future short-term interest rates. For example, investing
in bonds over ten years can be done in two ways:

1.      Buy
a ten-year bond, or

2.      Buy
a one-year bond and then reinvest in a new one-year bond after one year,
continuing with a succession of ten one-year bonds.

For markets to be in balance, these two strategies should
offer the same expected return to an investor, meaning that the combined impact
of one-year rates over ten years should match the rate for a ten-year bond. An
inverted yield curve where short-term rates exceed long-term rates can be
understood as a clear expectation that short-term interest rates will fall in
the future. Since interest rate fluctuations are extremely difficult to
predict, the expectations theory alone would probably leave the average yield
curve relatively flat.

The other theory to determine yield curve shape is the
liquidity preference theory, which suggests a need for a risk premium to
be offered for longer-term bonds to account for their increased interest rate
risk and price volatility, as discussed. Longer-term bonds are less liquid, as
well, since this price risk could force them to be sold at a loss if an
unexpected expense arose. With this risk premium added to the expectations
theory, the typical or neutral shape for the yield curve becomes upward
sloping.

With TIPS, we now have a better idea of market expectations
for future inflation, though I would not call it perfect. TIPS offer a
break-even inflation rate, defined as the difference in yields on the same
maturity of traditional treasuries and TIPS. TIPS yields may not reflect the
true underlying real interest rate because they have a few other components
built into their pricing, such as a premium for their relative illiquidity as
they represent a smaller market than treasuries, and a potential additional
premium for the protection they provide against unexpected high inflation.

Despite the other factors of TIPS pricing, the difference
between Treasury and TIPS rates for the same maturity represents a reasonable
market estimate of future inflation expectations. Exhibit 2.5 uses the same
data as in Exhibit 2.4 to find this difference.

Exhibit 2.5

US Government Yield Curve and Implied Break-Even
Inflation, May 1, 2019

Maturity

Treasury Yield

TIPS

Yield

Implied Break-Even
Inflation Rate

1 Year

2.39%

n/a

n/a

5 Years

2.31%

0.48%

1.83%

10 Years

2.52%

0.59%

1.93%

20 Years

2.74%

0.79%

1.95%

30 Years

2.92%

0.95%

1.97%

Source: US Department of the Treasury.

Again, we see with the thirty-year maturity that treasuries
yield a nominal 2.92 percent. Its real yield is unknown and depends on realized
future inflation. Meanwhile, a thirty-year TIPS offers a real yield of 0.95
percent. Its nominal yield is unknown, as it also depends on realized future
inflation. The difference between these yields is the implied break-even
inflation rate: 1.97 percent, or approximately 2 percent. Without a liquidity
or inflation-protection premium, this represents the market’s equilibrium
estimate of future inflation. Over the next thirty years, the markets have
priced in expectations for inflation of about 2 percent.

If realized annual inflation exceeds 2 percent over the next
thirty years, then TIPS will outperform treasuries. But if inflation falls
short, TIPS will underperform. If enough traders thought inflation would be
higher than this, they would buy TIPS and sell treasuries,
raising the price of TIPS today, and giving us lower TIPS yields, higher treasury
yields, and a larger break-even inflation rate. Such trading would continue
until the market reaches the equilibrium we observe.

Traditional bonds are priced around the objective of getting
a return that exceeds expected inflation. If inflation is unexpectedly high,
then the real return on nominal bonds is less. TIPS, on the other hand, keep
pace with higher inflation because it triggers a higher nominal return above
their underlying real interest rate. Essentially, TIPS provide protection from
unexpected inflation. They outperform treasuries when inflation exceeds the
implied break-even inflation rate.

This is a valuable attribute when spending is expected to
grow with inflation. Traditional bonds outperform if inflation is unexpectedly
low. Low inflation also makes it easier to meet retirement spending goals, so
this outcome is less in need of protection. Retirees generally get more use
from insurance that protects from high inflation, making TIPS a more
natural candidate for retirement portfolios. In short, TIPS provide retirees
with reliable, inflation-adjusted income that will maintain its real purchasing
power.

Laddering with
Individual Bonds

Duration matching is not straightforward for bond funds when
shares of the bond fund must be sold to meet ongoing retirement expenses. If
rates have risen, shares of the bond fund may need to be sold at a loss, with
more shares sold to meet a given spending objective. This triggers sequence
risk and locks in losses. Immunization only works if interest payments can be
reinvested at a new higher interest rate to compensate for capital losses. But
not all the funds are fully reinvested when a spending goal is met, so
reinvestment risk and interest rate risk do not get neutralized. The return on
remaining assets would need to be even higher to keep the retirement liability
funded. Immunization is harder when there is also a spending goal to support.

A more practical approach is to use individual bonds in a
retirement income plan. A retirement income bond ladder can be structured so
the cash flows provided through coupons and maturing face values will provide a
steady and known stream of contractually protected cash flows for the ongoing
expenditure needs in retirement. Cash flows from the bonds are matched to fund
desired expenses at desired dates. Interest rate risk can be ignored for the
retirement expenses that have been matched with these dedicated assets.
Sequence risk is reduced because there is less risk of assets being sold at a
loss. Rebalancing may be required in terms of extending the length of the bond
ladder as time passes to cover future expenses, but the complexities involved
in an ongoing effort to match durations can be better avoided.

Retirement income bond ladders generally take the form of
Treasury bonds to minimize the possibility of default risk. For a household
retiree, maximizing investment returns is not the goal; the goal is to meet
expenses. Paper losses on individual bonds do not have to be realized if the
bond is held to maturity. While the retiree misses out on the opportunity to
buy the bond at a lower price later, this cannot be known in advance. It is
always unfortunate to buy bonds and then see the price drop due to rising
rates. But if the initial purchase allows the retiree to meet his or her
retirement objective, then it is a successful purchase, no matter what interest
rates subsequently do.

Retirees who realize that it is nearly impossible to predict
interest rate fluctuations can take comfort in knowing that individual bonds
allow them to enjoy retirement and ignore subsequent interest rate
fluctuations. Ignoring interest rate fluctuations is not possible with a bond
fund strategy that has to make frequent adjustments to the portfolio’s duration
in order to immunize against interest rate risk.

The difference between a traditional bond ladder as an
accumulation tool and a retirement income bond ladder is that with a
traditional ladder, the cash flows received as coupons and face value are reinvested
to purchase new replacement bonds at prevailing prices that extend the ladder
and keep its length relatively constant over time. With a retirement income
bond ladder, the cash flows received are spent on planned retirement
expenses. A retirement income ladder will naturally wind down if other assets
from outside the ladder are not used to extend it further as time passes.

As we have discussed, changing interest rates lead, in turn,
to capital gains or losses for investors. For professional bond traders, rising
interest rates would be a serious problem for someone who had just purchased a
long-term bond. Most traders have no intention of holding bonds to maturity and
will realize capital losses on the subsequent sale. Interest rate increases might
also force retirees owning bond funds into a position of selling shares at a
loss in order to meet retirement expenses. For a bond portfolio that is not
fully immunized, this triggering of sequence-of-returns risk can create
irreparable harm for retirees.

I would argue that it is much easier for a retiree to ignore
unrealized capital losses on an individual bond than for a professional trader
or retiree needing to sell bond shares to meet expenses because the individual
bond is bought with the purpose of being held to maturity to provide a desired
amount of spending at that date.

Exhibit 2.6 quantifies this point. If interest rates are at 3
percent when a thirty-year bond is purchased, but then subsequently rise
permanently from 3 percent to 4 percent during the first year the bond is held,
the retiree is sitting on an unrealized capital loss for the next twenty-nine
years. After one year, the bond price falls to $838, representing a 16.2
percent loss. Nevertheless, the bond continues to pay its 3 percent coupon
payments and at maturity will repay the $1,000 face value. As the maturity date
slowly approaches, the unrealized losses slowly dissipate. The bond price
gradually returns to match its face value. The full recovery will happen at the
maturity date when the final cash flows are received as expected. In this way,
a household investor can be justified in ignoring those unrealized capital losses
on the bond, as they will not be realized if the bond is held to maturity.

It is important to provide a caveat that this analysis is
easier to think about with TIPS because with traditional bonds interest rate
increases could result from increases in inflation that would reduce the
purchasing power of the bond at maturity.

Exhibit 2.6

Thirty-Year Maturity Bond with 3 Percent Coupons
and $1,000 Face Value

Ongoing Price of Bond if Interest Rates Stay at 3
Percent and if Interest Rates Rise to and Stay at 4 Percent

A full thirty-year bond ladder could be created with the
idea of generating lifetime income. One might seek more than thirty years, but
Treasury bonds with maturities past that are not available. A thirty-year bond
ladder does not truly provide lifetime income. The bond ladder would be
spent down entirely by year thirty, creating a problem for someone still alive
in year thirty-one. For this reason, not all assets should be used to construct
such a ladder. It is important to set something aside for unplanned
contingencies and the prospect of living longer than thirty years. For
unplanned expenses, while the bond ladder is liquid, selling portions of it to
meet unexpected expenses directly means sacrificing some of the assets
earmarked for later retirement spending. Also, retirees selling individual
bonds prior to their maturity dates face interest rate risk, as a rise in
interest rates would force capital losses to be realized in these cases. For
someone considering a thirty-year retirement income bond ladder, it is
important to also take a serious look at income annuities as a cheaper and more
secure way to generate lifetime income.

As for the mechanics of selecting bonds and building a bond
ladder, I discuss this in greater detail in my book How Much Can I Spend in
Retirement? For the present book, the focus is on comparing other
strategies that seek higher returns than bonds, and so simplifying the bond
piece can be justified. The level of sustainable spending calculated using a
full bond yield curve ends up being quite close to the level of spending
determined assuming a flat yield curve at the level of a long-term average
interest rate. With the bond yield curves shown in Exhibit 2.4, sustainable
spending with a flat 3 percent yield curve for treasuries or a flat 1 percent
yield curve for TIPS are reasonably good approximations for the sustainable
spending available from the full yield curve.

Exhibit 2.7 provides reasonable approximations for
sustainable spending in retirement as it relates to a bond interest rate (or,
as we develop in Chapter 3, a fixed return for an investment portfolio) and a
retirement longevity assumption. For a sixty-five-year-old with $1 million, the
exhibit shows sustainable spending levels given both returns and longevity. The
returns can express either nominal or real returns. If nominal returns, then
the spending numbers would also be nominal and would not adjust for inflation.
If the returns are real, however, then spending numbers are also real and would
grow with inflation.

If the retiree sought to buy a retirement income bond ladder
through age ninety-five using Treasury bonds, the 3 percent yield curve
assumptions suggests that the sustainable spending amount is $49,533. Again,
because this is an assumption about nominal bond yields, this spending amount
would not growth with inflation. As inflation is generally a positive number,
real returns are less than nominal returns. With real returns the initial
spending level would be less but would grow with inflation. With the 1 percent
TIPS yield curve assumption, sustainable spending through age ninety-five is
$38,364 plus inflation.

Exhibit 2.7

Sustainable Spending for a Sixty-Five-Year-Old with
$1 Million of Assets as Based on Fixed Portfolio Returns and Longevity

Fixed Return

0%

1.0%

2.0%

3.0%

4.0%

5.0%

Planning Horizon (Age)

70

$200,000

$204,000

$207,998

$211,995

$215,988

$219,976

75

$100,000

$104,537

$109,144

$113,816

$118,549

$123,338

80

$66,667

$71,410

$76,299

$81,327

$86,482

$91,755

85

$50,000

$54,867

$59,958

$65,258

$70,752

$76,422

90

$40,000

$44,957

$50,216

$55,755

$61,550

$67,574

95

$33,333

$38,364

$43,774

$49,533

$55,606

$61,954

100

$28,571

$33,667

$39,218

$45,184

$51,517

$58,164

105

$25,000

$30,154

$35,839

$42,002

$48,580

$55,503

110

$22,222

$27,431

$33,245

$39,597

$46,406

$53,583

The fixed return assumptions could be treated as bond
yields, in which retirement income is based on building a ladder of individual
bonds. In this case, the yield would reflect the average yield from the bond
ladder if the yield curve was not otherwise flat. These returns could also
reflect the return assumptions for a diversified investment portfolio. In this
case, these returns would reflect the net return assumption after working
through the series of factors described in the next chapter.

A thirty-year TIPS ladder is as close as we can get to a
real-world safe withdrawal rate for thirty years of inflation-adjusted
spending. The exhibit shows that at current interest rates, this number is less
than 4 percent of the initial retirement date assets. Spending more from an
investment portfolio is based on a hope that a higher return arrives to sustain
a higher spending rate. This is risky. It is important to note that with this
bond ladder, nothing will be left at the end of the thirtieth year. The
calculation is risk free for thirty years, but the possibility of living beyond
thirty years must be considered. A TIPS ladder does not hedge longevity risk.
Longevity risk can only be managed by assuming a more conservative planning age
with a lower probability to outlive, and then spending less to stretch the
asset base out over a longer retirement horizon.

Further Reading

Bodie, Zvi, and Michael J. Clowes. 2003. Worry-Free Investing: A Safe
Approach to Achieving Your Lifetime Financial Goals. Upper Saddle River,
NJ: Financial Times Prentice Hall. [http://amzn.to/2mWqdUG]

Pfau, Wade. 2017. How Much Can I Spend in Retirement:
A Guide to Investment-Based Retirement Income Strategies. McLean, VA:
Retirement Researcher Media. [http://amzn.to/2xLgXGC]

Zwecher,
Michael J. 2010. Retirement Portfolios: Theory, Construction, and Management. Hoboken, NJ: John Wiley. [http://amzn.to/2u0cbRA]

Chapter 3:
Stocks and Diversified Investment Portfolios

When the objective for an asset base is to
fund a specific stream of spending on a year-by-year basis for a known length
of time, the least risky way to do this is to build a bond ladder. As long as
the securities do not default, bond ladders provide the intended cash flows to
match spending liabilities at the appropriate dates. If spending grows with
inflation, TIPS will provide protection from a higher than expected inflation
experience. Conversely, traditional bonds will work for spending that does not
grow with inflation, or that otherwise grows at a fixed rate that is known in
advance.

As a quick reminder, the problem with trying to determine a
sustainable spending rate from an investment portfolio is that retirees must
manage a differing set of risks when deciding how much to spend.

The three basic risks for retirees are longevity risk,
market risk, and spending shocks. Longevity risk relates to not knowing how
long one will live and, therefore, how long wealth must last. Market risk
relates to the possibility that poor market returns deplete available wealth
and reduce the sustainable standard of living. Spending shocks are surprise
expenses from outside the planned budget, such as for long-term care and major
health expenses, which require a pool of contingency assets beyond what are being
used to support the expected portion of living expenses. Retirement will be
cheaper with some combination of a shorter life, strong market returns, and few
spending shocks. But retirement could become quite expensive when a long life
is combined with poor market returns and significant spending shocks.

Retirees face longevity risk and spending
shocks. They do not know how long they will live, and they must manage
unanticipated retirement expenses. With each additional year the cost of
retirement grows. If they misestimate their longevity, a bond ladder will be
depleted before the end of retirement. A bond ladder is an inefficient way to
manage longevity risk, as the only option is to assume an exceptionally long
retirement and to spend less to stretch out the asset base. As well, spending
shocks create the risk that assets meant for future lifestyle must be sold and
spent early, and this reintroduces interest rate risk and the potential for
capital losses on the bonds sales.

This book is about comparing two methods that
aim to generate higher returns than bonds in order to reduce the overall cost
of retirement. We compare two other ways to manage these longevity and spending
shock risks: risk pooling and the risk premium. This chapter focuses on the
risk premium, or the idea that stocks will outperform bonds over reasonable
lengths of time, and the additional growth potential of stocks can more easily
support a lifetime spending goal than bonds alone. While the risk premium
brings market risk back into the mix, the idea is that this risk is
sufficiently low, and the diversified portfolio will work better for managing
the overall combination of retirement risks.

Investors facing a situation of wishing to
fund specific spending amounts will often seek to create a diversified
portfolio including riskier components such as stocks. The intention is to seek
additional growth for assets to support a greater spending amount than bonds
can provide, and to otherwise lay a foundation to support spending for longer
periods than planned. Investment growth could also provide contingency funds to
help cover unanticipated spending shocks. This chapter explains the basis and
pitfalls of the probability-based approach that relies on the stock market as a
key tool for funding retirement.

Overview of Stocks and
the Stock Market

Stocks provide an ownership stake in a
company. They provide access to company earnings based on its future
performance. Companies can pay dividends to their stockholders to return
profits to the owners, or they could reinvest profits into the firm to lay the
foundation for better performance and even larger dividends to owners in the
future.

The stock price can be driven up when
investors anticipate stronger future performance than previously anticipated,
and this can serve as a source of capital gains for stocks owners who sell
shares. However, there are no contractual protections to receive either capital
gains or dividends. In the ownership structure, stockholders are residual
claimants, meaning that their rights to receive firm earnings or assets fall
behind most other claimants like bond holders or lenders. Companies could
underperform relative to expectations, and the stock price could decrease in
anticipation of a reduced ability for the company to pay dividends in the
future. The returns from a stock over a specified holding period are the
dividend payments it makes plus any capital gains or capital losses. For owners
having to sell shares after a price decline, stocks could underperform relative
to bonds.

The value of a stock can be estimated as the
present value of its anticipated future dividend payments. This relates to our
bond pricing discussion, as bonds can be priced as the present value of their
future cash flows. Except that, again, there are no promises supporting anticipated
dividends. Projections of company performance can change over time, leading to
fluctuations in stock prices. With this price volatility, funding retirement expenses
by selling stocks can be risky as stock prices may be in decline at the time
they need to be sold, requiring more shares to be sold to meet an expense.

Mutual funds and exchange-traded funds (ETFs)
provide a simple way for household investors to diversify across a broad range
of company stocks. These same investment vehicles exist for bonds as well. With
stocks, these investment vehicles provide a collection of stocks that help to
reduce the individual risks of companies by diversifying across a broader range
of companies. By limiting exposure to individual companies, this also limits
exposure to that company’s specific risks. If company specific risks are
independent from one another, then this diversification leaves investors
exposed to the overall systematic market risk for the collection of stock holdings,
while diversifying away from the company-specific risks so that overall
volatility is less.

Our analysis treats stock and bond investments
in terms of overall index returns, which implies that the funds in question are
index funds. Index funds are passively managed holdings of the components in a
market index, and they are generally offered with lower expenses than mutual
funds driven by active management decisions about which companies to hold. Actively
managed funds attempt to outperform the overall market either by identifying and
selecting mispriced securities or by forecasting broad market trends.

Actively managed funds may charge higher fees in
part to pay investment managers and researchers to select securities they believe
will outperform the overall market index. Whether such active management can
provide increased returns net of the investment management fees and taxes, after
accounting for the fund’s risk relative to the overall market, is a subject of
continued debate. Generally, though, the conclusion of academic research is
that there is no reason to believe than an actively managed fund will
outperform an index fund when considered net of investment fees, taxes, and
risk. Investment fees tend to be higher for active funds to compensate a larger
team of individuals working to select stocks, and active funds tend to generate
high taxes through their turnover of investments that passes capital gains to
the fund owners on an ongoing basis even if shares are not sold.

In a market equilibrium, higher return
investments must be viewed as riskier in terms of there being greater
volatility in the returns. If higher returning investments were not viewed as
riskier, demand would increase and the price would be pushed up immediately,
reducing the potential returns for subsequent owners.

This is the basis for the efficient market
theory, which says that stock prices incorporate all of the known information
regarding market performance. New information about a stock is processed
quickly through price adjustments. Good news, reflecting better future
performance prospects, will lead those with the information to purchase the
stock immediately, driving its price up, and vice versa. Current prices reflect
the aggregate expectations of all market participants. An implication of this
is that stock price movements should follow a random walk as new information,
either good or bad, will arrive in a random and unpredictable manner. An
implication of stock prices quickly incorporating information from all market
participants into their prices is that it is not feasible to systematically
beat the market through active decision-making. A lower cost passive strategy
based on index funds capturing the broad-based returns for different asset
classes can capture the overall market returns in the least costly and most tax
efficient manner when market prices behave efficiently.

Passive strategies can be supported with less
fees because they are not paying analysts, and the reduced turnover of holdings
helps to manage transaction costs and creates greater tax efficiency by
avoiding the realization of capital gains. Regarding taxes, index funds can be
more efficient because they have less turnover for the assets held, which in
turn can help reduce the creation of short-term capital gains that are taxed at
income tax rates. At the very least, actively managed funds introduce another
type of risk called tracking risk, which relates to how the returns might vary
from the index returns over time. Because our analyses are based on assumptions
for market indices, it is easier to think about our investments as index funds
rather than actively managed funds.

Historical Market
Returns

The primary subject of this book is comparing the risk
premium with risk pooling as a source of funding for retirement goals. An
important step is to first make clear what the risk premium is and how it relates
to an investment portfolio. Fundamentally, investors prefer certainty to uncertainty.
A bond provides a known yield with contractual protections helping to ensure
that its return is realized if held to maturity. Stock returns are more uncertain,
as they depend on the future performance of the company as well as on changing investor
perceptions about the company.

If a stock offered the same average return as bonds, but
with greater volatility around that average, the typical risk averse investor
would not be willing to purchase it. Risk averse individuals are willing to pay
more to receive certainty, so less-volatile assets should have lower expected
returns. To accept risk, investors will seek a higher expected return over time
than they could receive from more reliable bonds. That higher expected return represents
the risk premium. Stocks can generally be expected to outperform bonds over
time, but such outperformance is not predictable and there can be reasonably
long stretches in which stock returns lag bonds.

A good starting point for understanding the historical
returns for different asset classes is with Morningstar and Ibbotson Associates
data. They have compiled US financial market returns since 1926 in their SBBI
(Stocks, Bonds, Bills, and Inflation) Yearbook. This data is usually
the source for calculating average historical market performance and creating
assumptions for future portfolio returns. We can use this data as a starting
point for understanding about historical stock performance.

Exhibit 3.1 provides historical averages and volatility for
different market indices in this dataset for both nominal and real terms. With
this dataset, small-capitalization stocks have offered the most return
potential along with the most volatility. Their simple average arithmetic
return was 16.2 percent during this time period in nominal terms, with a
standard deviation of 31.6 percent.

Arithmetic mean returns are calculated by adding up all the
annual returns from the historical data and then dividing by the number of
years in the data set. The standard deviation is a measure of volatility in
terms of the degree of fluctuations experienced around the average outcome. Approximately,
two-thirds of the historical returns fell within the range of 31.6 percent more
or less than the average of 16.2 percent. That range is -15.4 percent to 47.8
percent. The remaining one-third of historical returns were even more extreme
in either direction. Volatility reduces the predictability for realized
returns. When thinking of risk as volatility, we generally care most about the
risk for losses, but if market returns are symmetric around an average, then
using standard deviation will work just as well.

While the arithmetic mean represents the average historical growth
rate over a single year, it does not reflect the growth rate over a longer
period. The average compounded return represents the growth rate over multiple
years, and it is always less than the arithmetic mean for any volatile asset. Increased
asset volatility causes the compounded return to fall by even more relative to
the arithmetic return. For long-term investors, it is the compounded return
that matters.

To understand this volatility effect on compounded returns, realize
that positive and negative returns do not create a symmetric impact on wealth.
Negative returns must be followed by even larger positive returns to get back
to the initial point. For instance, a 50 percent drop requires a 100 percent
gain to get back to the starting point. For this reason, wealth will grow at a
lower compounded rate than the arithmetic average. Compounded returns take a
larger haircut as the volatility of returns increases. With the high volatility
of small-capitalization stocks, the compounded return was 11.8 percent, a full
4.2 percent less than the arithmetic average. The 11.8 percent return reflects
the fixed growth rate for the asset class that supported its cumulative return
over the entire historical period.

Next in the chart are large-capitalization US stocks, as
represented by the S&P 500 index since its creation in the 1950s, and a
more general index of large companies in the years before that. The arithmetic
average for large-capitalization stocks was 11.9 percent (roughly 12 percent,
which is why that number is used on occasion as an estimate for stocks returns)
with a standard deviation of 19.8 percent (roughly 20 percent). The volatility
impact was such that these stocks grew over time at an average compounded rate
of 10 percent.

Exhibit 3.1

Summary Statistics for US Financial Market Annual
Returns and Inflation, 1926–2018

Nominal Returns

Arithmetic Average Return

Average Compounded Return

Standard Deviation

Small-Cap Stocks

16.2%

11.8%

31.6%

Large-Cap Stocks

11.9%

10.0%

19.8%

Long-Term Corporate Bonds

6.3%

5.9%

8.4%

Long-Term Government Bonds

5.9%

5.5%

9.8%

Intermediate-Term Government
Bonds

5.2%

5.1%

5.6%

30-Day Treasury Bills

3.4%

3.3%

3.1%

Consumer Price Inflation

3.0%

2.9%

4.0%

Real (Inflation-Adjusted)
Returns

Small-Cap Stocks

13.0%

8.7%

31.0%

Large-Cap Stocks

8.8%

6.9%

19.8%

Long-Term Corporate Bonds

3.4%

3.0%

9.4%

Long-Term Government Bonds

3.1%

2.5%

10.8%

Intermediate-Term Government
Bonds

2.3%

2.1%

6.6%

30-Day Treasury Bills

0.5%

0.4%

3.8%

Source: Own calculations from SBBI Yearbook data
available from Morningstar and Ibbotson Associates.

Moving to bonds, Morningstar data shows that
since 1926, the average return from intermediate-term government bonds was 5.2
percent with a standard deviation of 5.6 percent. With the lower volatility,
the compounded return is only slightly less at 5.1 percent. For long-term
government bonds, annual returns averaged 5.9 percent with volatility of 9.8
percent, and long-term corporate bonds averaged 6.3 percent with volatility of
8.4 percent. The observation that corporate bonds enjoyed higher returns than
long-term government bonds with less volatility is an anomaly about the usual
link between risk and reward. But these are after-the-fact numbers and may not
reflect investor attitudes about risk. Corporate bonds are usually considered
to be riskier than government bonds due to their credit risk regarding potential
defaults. Meanwhile, thirty-day Treasury bills averaged 3.4 percent with
volatility of 3.1 percent. These different bond asset classes have varying
return and volatility characteristics.

Among the universe of bond fund choices,
retirement income studies generally show the most favorable results with intermediate-term
government bonds. They provide an appropriate balance between seeking higher
yields while also maintaining lower volatility to avoid jeopardizing the
spending goals for the portfolio. Including more types of bonds, such as
corporate bonds, long-term bonds, or short-term bills, can be justifiable for
reasons other than maximizing the sustainable spending rate from a portfolio.

The chart also shows that inflation historically averaged 3 percent
with a 4 percent standard deviation. With the low volatility, the compounded
inflation rate was only slightly less at 2.9 percent. This leads us into the
second part of Exhibit 3.1, providing the real historical returns after
removing inflation. Real returns put the analysis on a consistent basis over time
so that the long-run spending plans may be discussed in terms of today's
purchasing power. Focusing on two of the asset classes in the table that are
most relevant to our subsequent discussion, if we remove the effects of
inflation from the compounded returns, historically the S&P 500 provided an
inflation-adjusted compounded return of 6.9 percent, and it was 2.1 percent for
intermediate-term government bonds. The respective arithmetic real returns were
8.8 percent and 2.3 percent.

Modern Portfolio Theory

Before shifting into further discussion about whether these
historical numbers provide the most appropriate assumptions for future market
performance, it is worth understanding how to choose an asset allocation and
put together an investment portfolio while assuming that these historical
numbers are the right ones to use. The more basic point is that any assumptions
can be used. Once a set of assumptions are agreed upon, how is an investment
portfolio asset allocation determined as based on those assumptions? With
efficient markets, this asset allocation decision among the available asset
classes becomes the most important driver of overall portfolio returns and
volatility, rather than trying to select individual securities or predict
overall market movements.

In the 1950s, Harry Markowitz created Modern Portfolio
Theory (MPT), which has served as the foundation for how wealth managers build
investment portfolios for their clients. Harry Markowitz won the Nobel Prize in
Economics in 1990 for this work. It provides a framework for choosing an asset
allocation under a specific set of assumptions that wealth managers have
traditionally accepted as being a reasonable starting point for households.

His fundamental insight was to show why investments should
not be treated in isolation, but rather in terms of how they contribute to the
risk and return of the overall portfolio. A very volatile individual investment
might help to reduce overall portfolio volatility if its price movements tend
to be in the opposite direction of the rest of the portfolio. This is
diversification. Prior to Markowitz, portfolio managers seemingly did not
realize this on a widespread basis, as they viewed their job was to choose what
they felt are the very best individual securities, with each considered on a
standalone basis. In their view, diversification would only reduce the
potential for outsized returns.

Modern Portfolio Theory is a single-period model. It does
not reflect how households are making decisions over multiple periods of time.
It also does not include any spending constraint. It is an assets-only model
about how to achieve efficient diversification, or to find the best tradeoff
between portfolio returns and volatility. For the inputs, a user decides on the
universe of asset classes to consider, and then decides on an average arithmetic
return and standard deviation for each asset class, as well as the cross
correlations for returns between each of the asset classes.

While we have discussed arithmetic average returns and
standard deviations, correlations have not yet come up. The correlation
coefficient between two asset classes measures their degree of co-movements. It
ranges from -1 (move precisely in opposite directions) to one (move precisely
in the same direction). If the correlation coefficient is zero, this means that
the two asset classes move independently from one another. The lower the
correlation coefficient, the greater the reduction in the portfolio volatility
when the two asset classes are combined. With low correlations, the volatility
of the portfolio can be less than the volatility of any of its component asset
classes. Exhibit 3.2 provides an example of these inputs as based on the
historical returns from the Morningstar data.

Exhibit 3.2

Inputs for Calculating Modern Portfolio Theory’s
Efficient Frontier as Based on US Financial Market Nominal Annual Returns, 1926–2018

Correlation Coefficients

Arithmetic
Average Return

Standard
Deviation

Small-Cap
Stocks

Large-Cap
Stocks

Long-Term
Corporate Bonds

Long-Term
Government Bonds

Intermediate-Term
Government Bonds

30-Day
Treasury Bills

Small-Cap
Stocks

16.2%

31.7%

1

0.79

0.06

-0.10

-0.11

-0.08

Large-Cap
Stocks

11.9%

19.8%

0.79

1

0.16

0.00

-0.03

-0.02

Long-Term
Corporate Bonds

6.3%

8.4%

0.06

0.16

1

0.89

0.85

0.16

Long-Term
Government Bonds

5.9%

9.8%

-0.10

0.00

0.89

1

0.86

0.18

Intermediate-Term
Government Bonds

5.2%

5.6%

-0.11

-0.03

0.85

0.86

1

0.48

30-Day
Treasury Bills

3.4%

3.1%

-0.08

-0.02

0.16

0.18

0.48

1

Source: Own calculations from SBBI Yearbook
data available from Morningstar and Ibbotson Associates.

With these historical numbers we can see that movements in
small-cap and large-cap stocks are closely related, as are the movements
between the different types of bonds. But stocks and bonds did not experience
close movements with one another, and Treasury bill movements are mostly
unrelated to the other asset classes except intermediate-term government bonds.

As a next step, Exhibit 3.3 plots the portfolio returns and
volatilities for different combinations of the six asset classes as based on
their return characteristics shown in Exhibit 3.2. The exhibit shows the
portfolio return on the vertical axis and the portfolio volatility on the horizontal
axis. Investors would like to move toward portfolios in the upper left-hand
corner, all else being the same, as that direction represents portfolios with
higher returns and less volatility. The dots reflect the different combinations
for these asset classes. The curve that envelops them on the upper-left side is
the efficient frontier. It is the asset class combinations offering the highest
returns for a given volatility, or the least volatility for a given return. It
only makes sense for investors to consider asset allocation combinations from
the many combinations reflecting different risk-return characteristics on the
efficient frontier.

Exhibit 3.3

Modern Portfolio Theory’s Efficient Frontier as
Based on US Financial Market Nominal Annual Returns, 1926–2018

Source: Own calculations from SBBI Yearbook data provided
by Morningstar and Ibbotson Associates.

Efficient frontier diagrams do not actually show the asset
allocations of portfolios on the efficient frontier, but this information is
also available. Exhibit 3.4 provides an example of ten portfolios on the
efficient frontier shown in Exhibit 3.3. These range from the lowest return and
volatility combinations to the highest return and volatility combinations. For
example, portfolio one is listed with a 3.8 percent return and 3 percent
volatility. This portfolio consists of a 91.3 percent allocation to Treasury
bills along with small allocations to corporate bonds (7 percent), small-cap
stocks (1.3 percent), and large-cap stocks (0.4 percent). Despite small-cap
stocks being the most volatile asset class choice, the low correlation of characteristics
it shares with other asset classes helps it to play a small role in a low
volatility portfolio. The overall portfolio volatility of 3 percent is slightly
less than the 3.1 percent volatility of Treasury bills on their own. Then, as
we move down the list, we find portfolios with increasing returns and
volatilities that contain increasing allocations to stocks and a gradual phase
out for Treasury bills and other bonds. The fifth portfolio is the most
diversified with an allocation to five of the six asset classes. It provides
overall returns of 9.3 percent with a volatility of 11.2 percent.

Exhibit 3.4

A Selection of Outcomes from the Efficient Frontier
as Based on US Financial Market Nominal Annual Returns, 1926–2018

Asset Allocation

Portfolio Return

Portfolio Volatility

Small-Cap
Stocks

Large-Cap
Stocks

Long-Term
Corporate Bonds

Long-Term
Government Bonds

Intermediate-Term
Government Bonds

30-Day
Treasury Bills

1

3.8%

3.0%

1.3%

0.4%

7.0%

0.0%

0.0%

91.3%

2

5.2%

3.9%

4.2%

6.3%

0.7%

0.0%

38.0%

50.8%

3

6.6%

5.7%

7.2%

11.3%

0.0%

0.0%

71.0%

10.6%

4

7.9%

8.2%

13.1%

17.3%

12.4%

0.0%

57.3%

0.0%

5

9.3%

11.2%

19.8%

22.4%

31.2%

15.0%

11.5%

0.0%

6

10.7%

14.7%

29.5%

28.4%

15.1%

27.0%

0.0%

0.0%

7

12.1%

18.5%

40.3%

33.8%

0.0%

26.0%

0.0%

0.0%

8

13.5%

22.6%

51.2%

38.0%

0.0%

10.8%

0.0%

0.0%

9

14.8%

26.8%

68.1%

31.9%

0.0%

0.0%

0.0%

0.0%

10

16.2%

31.7%

100.0%

0.0%

0.0%

0.0%

0.0%

0.0%

Source: Own calculations from SBBI Yearbook data provided by
Morningstar and Ibbotson Associates.

We now understand that there are serious issues with using
MPT to determine investment portfolios for household investors, especially
after retirement begins. Harry Markowitz recognized this. After winning the
Nobel Prize in 1990, he was asked to write an article in 1991 for the first
issue of Financial Services Review about how MPT applies to household
investors. This article was named, “Individual versus Institutional Investing.”
In the article, he writes about how he had never thought about the household’s
investing problem before, and after reflecting on it for an evening, he
realized that households face a very different investing problem from the large
institutional investors, such as mutual funds, he had in mind when developing
MPT. MPT does not teach how individual households should build investment
strategies to meet their lifetime financial planning goals.

Namely, and this is really the key for understanding how the
retirement income problem differs from the MPT approach, households must meet
spending goals over an unknown length of time in retirement. MPT just seeks how
to grow wealth over a single time period, such as a year, when there is no need
to take distributions from the portfolio. It is an assets-only model. The
preretirement wealth accumulation notion that households seek to grow wealth is
more closely aligned with MPT, but the retirement income problem is vastly
different. There may surely be a relationship between the idea that having more
wealth will support more spending, and the idea that building diversified
portfolios is still valid, but that relationship is more complicated when it is
unknown how long the spending must last and when taking distributions from
assets works to amplify the impacts of investment volatility on the retirement
income plan.

With sequence risk for portfolio distributions, the extra
shares sold to meet a spending goal when markets are down are no longer
available to experience the growth of any subsequent market recovery. The point
chosen on the efficient frontier can be different when viewed in the context of
the household’s problem, and there can be a role for annuities or other risk
management tools that are not included as asset classes in traditional MPT. Simply,
MPT does not account for cash flows or longevity risk. It equates risk with
short-term asset volatility rather than with the ability to meet financial
goals.

Risk in the context of the household’s investing problem is
only tangentially related to the volatility or standard deviation of returns.
Volatility is important in that it relates to risk tolerance and whether
individuals can handle the short-term volatility of their portfolio. If greater
volatility leads them to not stick with their financial plan, then this must be
incorporated into the asset allocation decision. But more generally, risk for
the household relates to the ability to meet financial goals over a long-term
planning horizon.

A low-volatility portfolio offering insufficient return
potential can ensure failure for the financial plan. This is riskier from the
household’s perspective than a more volatile portfolio that supports a higher
probability of success for the financial plan. A key difference between
probability-based and safety-first approaches is that the probability-based
approach is more comfortable with accepting greater volatility for higher
return potential and an improved chance for success, while the safety-first
approach looks for alternatives that do not expose core retirement spending
goals to market volatility. The question is ultimately about which is the best
way to be able to spend more than a bond ladder can support: to rely on the
excess returns expected to be provided by the stock market, or to rely on the
power of risk pooling to bring additional spending power to those facing a
higher cost retirement.

The Case for Stocks

The case for using an aggressive investment portfolio with a
high stock allocation to fund retirement expenses rests on the idea that it
will probably work. Stocks are expected to outperform bonds, and if and when
that happens, a retiree will be able to spend more from their asset base in
retirement.

For example, in a February 2016 New York Times column
on retiring, David Levine suggested that people treat an all-stock allocation
very seriously, saying, “And, so, what I actually say to people who ask my
advice is this: Put as much money into the stock market as you can stand. One
hundred percent is best, but even if you are very risk-averse, allocate at least
75 percent to stocks.”

Exhibit 3.5 shows similar details as Exhibit 3.1 about
returns and volatilities for historical US data. But it also highlights more
about the differences in returns as one moves up the exhibit to better
highlight the idea of a risk premium. These are the historical excess returns
that more volatile asset classes provided. Starting from the bottom, historical
inflation averaged 3 percent. Short-term Treasury bills provided a historical
average return of 3.4 percent, which is 0.4 percent higher than inflation. That
represents the short-term real rate of return.

By investing in intermediate-term government bonds,
historically one could earn an average 5.2 percent return, which is 1.8 percent
more than Treasury bills and 2.2 percent more than inflation. Long-term US
government bonds offered another 0.7 percent higher historical return, and
long-term corporate bonds offered an additional 0.4 percent on top of the
government bonds for a 6.3 percent total return. Moving into stocks, large-capitalization
stocks averaged 11.9 percent returns. This was 5.6 percent more than long-term
corporate bonds, 6 percent more than long-term Treasury bonds, and 6.7 percent
more than intermediate-term treasuries. These are the types of numbers that are
often identified as the risk premium, or the expected additional return of
stocks over bonds, at least as based on the historical data. As expected, that
risk premium is even higher with small-capitalization stocks, which averaged an
additional 4.3 percent more than large-capitalization stocks, or, for instance,
11 percent more than intermediate-term government bonds. These risk premia have
been identified in terms of their arithmetic averages.

It is also the case that the compounded equity premium would
be less than its arithmetic value. For instance, though not shown in the
exhibit, large-capitalization stocks outperformed long-term government bonds by
4.5 percent in terms of compounded growth, as compared to the 6 percent
difference in arithmetic terms.

Exhibit 3.5

The Components of US Financial Market Annual
Returns

Stocks, Bonds, Bills, and Inflation Data, 1926–2018

Component Returns

Total Arithmetic Returns

Standard Deviation

Equity Premium

small-cap stocks

4.3%

16.2%

31.6%

large-cap stocks

5.6%

11.9%

19.8%

Real Bond Return

long-term corporate bonds

0.4%

6.3%

8.4%

long-term government bonds

0.7%

5.9%

9.8%

intermediate-term

government bonds

1.8%

5.2%

5.6%

short-term government bills

0.4%

3.4%

3.1%

Inflation

Inflation

3.0%

3.0%

4.0%

Source: Own
calculations from SBBI Yearbook data provided by Morningstar and Ibbotson
Associates.

These types of comparisons can be made between any of the
asset classes in the exhibit, and what these comparisons make clear is that
over the entire historical period, stocks have outperformed bonds by a dramatic
degree. Those seeking to grow assets in retirement by investing in stocks are relying
on these historical relationships to continue in the future.

Advocates for using aggressive investment portfolios as the
primary way to fund a retirement plan often will allude to the concept of
“stocks for the long run.” There is a degree of comfort that an aggressive
portfolio will provide sufficient returns in time to maintain retirement
sustainability. According to advocates, the long-run
growth potential for stocks can be expected to materialize so that the aggressive
portfolio can support a higher spending level than bonds alone.

To better understand this probability-based point of view,
Exhibit 3.6 plots the historical worst-case annualized nominal returns for
large-capitalization US stocks and intermediate-term US government bonds since
1926.

Over shorter holding periods, bonds were less exposed to
downside risks. Over one year, for instance, the worst case for bonds was a 5.1
percent drop, while stocks fell by 43.3 percent in their worst year. Over any historical
three-year period, bonds provided a positive annualized return. It took fifteen
years before stocks historically were always able to provide a positive return.
But for holding periods of at least seventeen years, the historical worst-case
annualized performance for stocks exceeds that for bonds. Over twenty-year
periods, for instance, stocks experienced a worst-case 3.1 percent annualized
return, compared to 1.6 percent for bonds. For thirty-year periods, the worst
case for stocks was 8.5 percent, compared to 2.2 percent for bonds. And for
forty-year periods, stocks’ worst performance was an 8.9 percent annualized
return, compared to 2.8 percent as the worst for bonds. For historical
forty-year periods, even the best case for bonds (8.1 percent) could not beat
the worst case for stocks.

Because probability-based advocates have confidence that the
historical record provides precedence for what can be expected in the future,
this is the basic logic for understanding the view that stocks should be the
primary asset to support retirement expenses.

Exhibit 3.6

Worst-Case Annualized Nominal Returns for
Different Holding Periods

S&P 500 and Intermediate-Term Government
Bonds, 1926–2018

Source: Own calculations from SBBI Yearbook data provided
by Morningstar and Ibbotson Associates.

As well, Bill Bengen’s work that led to the 4 percent rule-of-thumb
for retirement spending is also a historical exploration which shows that
higher stock allocations have tended to support more spending with little in
the way of additional downside risk. Though not framed this way, Bill Bengen’s
research is a type of efficient frontier analysis that includes a spending
constraint seeking to maximize the amount that could be spent in the worst-case
thirty-year period from the historical data. He found that the highest
worst-case spending level could be found for any stock allocation between 35
and 80 percent, and he argued that retirees should attempt to stick with stock
allocations in the higher end of the range because this would support
additional upside when not in a worst-case retirement scenario.

For historical data, I have confirmed this point in
international data as well, showing in my book How Much Can I Spend in
Retirement? that across the twenty countries in the Global Returns dataset,
the highest worst-case spending rate occurred with at least 50 percent stocks
in eighteen of the twenty countries. Only in Sweden and Switzerland did the
peak worst-case spending level occur with a lower stock allocation.

Noted financial advisor and historian William
Bernstein also makes a compelling case for stocks in his e-book Deep Risk:
How History Informs Portfolio Design. In the introduction, Bernstein begins
by offering an operational definition of risk. Risk is the size of real capital
loss times the duration of real capital loss. This gets at the idea that it is
a permanent, rather than a temporary, loss of capital that that is most
damaging to investors. Magnitude and duration of loss are both relevant
factors. Mistiming the markets, by buying high and selling low, is the most
common method whereby an investor sees this risk manifested, as this is the clearest
way to experience a permanent loss of capital. A more disciplined approach to
investing is needed to avoid this risk.

This definition allows Bernstein to identify
two flavors of risk: shallow risk and deep risk. Shallow risk is the loss of
real capital which recovers within several years, while deep risk reflects the
permanent loss of real capital. It could be defined, for instance, as a
negative real return over a thirty-year period.

It becomes apparent that stocks are risker
than bonds with respect to shallow risk, but that the opposite is true with
respect to deep risk. Throughout the world in the twentieth century, fixed-income
investors have suffered permanent losses in inflationary storms which equity
investors were better able to avoid. As Bernstein says, absence of leverage and
with sufficient liquidity, retirement savings are not wiped out by too high of
standard deviation, but rather by real-world events.

With deep risk, once one has become properly
insured to personal vagaries and carefully disciplined with respect to strategy
and approach, the four big threats over long horizons are:

1.      Severe
and prolonged high inflation

2.      Prolonged
deflation

3.      Confiscation

4.      Devastation

The remainder of his book focuses on these
four risks in terms of what damage they do, how likely they are to happen, and
what strategies provide the best chance to mitigate the threat. Relevant here
are the probabilities, the consequences of the hardship created, and the costs
of protection.

First in terms of the probabilities that each
threat will manifest, inflation is high, confiscation is medium, and deflation
and devastation are low. Inflation, though high in probability, has a lower
cost for protection. It is the most relevant for retirees to worry about, but it
is also the least catastrophic for a globally diversified investor. It is the
easiest to protect against with international diversification, TIPS held to
maturity to match spending needs, delaying Social Security, and an
inflation-adjusted annuity. A globally diversified stock portfolio is most
effectively protected from the deep risk of inflation, though stocks do
exacerbate shallow risk. Meanwhile, unexpected inflation devastates traditional
bonds.

Deflation, on the other hand, is the least
likely to happen. It is good for bonds and bad for stocks. Solutions include
cash, bonds, and international diversification, as well as gold. But using
bonds and bills carries a high cost if we experience inflation rather than
deflation.

As for confiscation and devastation, the best
defenses are holding foreign assets and having a means for escape. He argues
that confiscation is a likely deep risk as taxes will likely increase in the
future.

Bernstein’s conclusion is that the best
long-term defense against deep risk is a globally diversified equity portfolio
with tilting toward value and precious metals and natural resource companies,
TIPS, and potentially some gold and foreign real estate. Because of inflation,
bonds become riskier than stocks over long horizons, while shallow risk makes
investors with shorter time horizons more vulnerable with stocks. For lifetime
financial planning, determining how to transition between deep risk and shallow
risk at different points in the lifecycle is one of the greatest challenges
facing wealth managers.

Stocks have historically provided a return premium above
what is available from holding bonds. This has historically allowed stocks to
provide a higher return than bonds. Though this premium is risky and may fail
to materialize, many investment analysts are comfortable with the idea that
over long time horizons, stocks can reasonably be expected to continue their
outperformance.

This does certainly speak to the idea of
including a healthy dose of stocks within an overall retirement income
strategy, but the question remains about how reliant one should be on the stock
market to cover the day-to-day expenses of retirement.

Caveats about a Primary Reliance
on the Stock Market

Simple analyses, which look to historical returns as
estimates for what retirees should expect in the future, tend to provide an
incomplete picture that may overstate the potential for stocks relative to
other strategies. We will investigate some of the adjustments that should be
made to historical returns to obtain a better idea about the net returns from
an investment portfolio on a forward-looking basis. These include accounting
for the impacts of volatility on compounded returns, inflation, investment
fees, investor behavior, asset allocation, and taxes.

We can also identify stock returns as the sum of inflation,
real bond yields, and an equity premium, and we can look to what are reasonable
values at the present for these building blocks. Another important matter is to
incorporate the idea that most financial planning involves seeking a high
probability of success, which requires assuming below average returns, and the necessary
reduction to return assumptions is greater when distributions are taken.

While a risk premium must be expected in order to induce
investors to position their assets into more volatile investments, there is no
reason to necessarily believe that historical excess returns provide the best
predictors about the future risk premium. Also, it may take longer than
anticipated for returns on stocks to outpace bonds, and retirees who are taking
distributions become more vulnerable to this waiting game.

All too often, it seems that examples about retirement
planning are based on assumptions that investments will grow at a fixed 8 percent
or even 12 percent. While not impossible, the reality is that such return
assumptions are overly optimistic, especially for those approaching retirement.

For a lifetime financial plan, the most intuitive way to express
a portfolio return assumption is as an inflation-adjusted compounding return. Unfortunately,
this is not the most common way returns are expressed. It is more typical to
see returns expressed in nominal terms and even as arithmetic numbers that
incorrectly reflect long-term growth rates. As well, to understand potential
purchasing power, we should make further adjustments for taxes, fees, investor
behavior, and asset allocation. A quick review is in order for the steps needed
to arrive at a net real compounded return for a portfolio, as well as other adjustments
that may be needed to create a properly conservative portfolio return assumption.

Exhibit 3.7

Return Characteristics by Asset Allocation as Based
on US Financial Market Nominal Annual Returns, 1926–2018

Nominal Values

Real (Inflation-Adjusted)
Values

Arithmetic Average Return

Average Compounded Return

Standard Deviation

Arithmetic Average Return

Average Compounded Return

Standard Deviation

100% Stocks

11.90%

10.00%

19.80%

8.80%

6.90%

19.80%

90% Stocks

11.20%

9.70%

17.80%

8.20%

6.60%

17.80%

80% Stocks

10.50%

9.30%

15.80%

7.50%

6.30%

16.00%

70% Stocks

9.90%

9.00%

13.90%

6.90%

5.90%

14.10%

60% Stocks

9.20%

8.50%

12.00%

6.20%

5.50%

12.30%

50% Stocks

8.50%

8.10%

10.20%

5.60%

5.00%

10.60%

40% Stocks

7.90%

7.50%

8.50%

4.90%

4.50%

9.10%

30% Stocks

7.20%

7.00%

7.00%

4.30%

4.00%

7.80%

20% Stocks

6.50%

6.40%

5.90%

3.60%

3.40%

6.80%

10% Stocks

5.90%

5.70%

5.40%

3.00%

2.80%

6.40%

0% Stocks

5.20%

5.10%

5.60%

2.30%

2.10%

6.60%

Source: Own calculations from SBBI Yearbook data provided
by Morningstar and Ibbotson Associates. Stocks are represented by the
large-capitalization US stocks and bonds by intermediate term US government
bonds.

Exhibit 3.7 shows the historical returns for different asset
allocations for portfolios consisting of different combinations of the S&P
500 and intermediate term US government bonds (ITGB). As described with the
earlier discussion of Exhibit 3.1, for the period since 1926, Morningstar data
reveals that the S&P 500 enjoyed an average (arithmetic) return of 11.9
percent, while intermediate-term government bonds earned 5.2 percent.

Volatility

When simulating long-term financial plans, we also have to
account for volatility and the lack of symmetry in outcomes for positive and
negative returns, as discussed. We calculate the compounded returns over time
to account for this volatility. The S&P 500 compounded return fell to 10 percent,
while the compounded return for the less volatile bonds fell only slightly to
5.1 percent. These compounded returns express the growth rate for a portfolio
over longer periods, while the larger arithmetic average returns represent the average
return only for a single year.

At least one popular radio host likes to imply that his
listeners’ stock portfolios will grow at 12 percent, but this is a
misunderstanding on his part. It is the compounded return, not the arithmetic
return, that matters for the long-run growth of a portfolio.

Inflation

Next, we must remove inflation so the numbers allow for a
better understanding of purchasing power growth. Real returns will be less
because they preserve the purchasing power of wealth over time. Providing the
discussion in terms of real returns allows us to plan for the assumption that
future spending will grow with inflation. Even low inflation can compound over
time into a big impact on purchasing power. Not removing inflation from the
calculations can lead to confusion about the purchasing power of future
dollars. The real compounded returns fell to 6.9 percent for stocks and 2.1 percent
for bonds.

When it comes to inflation, it is important to be consistent
about assumptions. If spending is projected to increase with inflation in
retirement, then it makes sense to discuss assumptions in real terms. Real
returns are lower, but they account for inflation and support a spending need
that grows with inflation. Meanwhile, if spending needs are not anticipated to
grow with inflation, then discussing the return assumptions in nominal terms is
fine. Nominal returns are higher, supporting higher initial spending. That
higher initial spending then stays fixed instead of growing with inflation.
This means that purchasing power will decline over time, but it can be an
appropriate assumption if it matches the actual behavior of retirement spending.

Asset Allocation

The next step is to consider asset allocation. Though many articles
about long-term investing will assume 8 or 12 percent returns, this implicitly suggests
that the investor holds 100 percent stocks. That will rarely be the case, especially
for retirees. Consider, instead, a retiree with a 50/50 portfolio rebalanced annually.
For the historical data, Exhibit 3.7 shows that the arithmetic real return was 5.6
percent, and the standard deviation for returns was 10.6 percent. The compounded
real return was 5 percent for a 50/50 portfolio.

Exhibit 3.7 provides more details about these adjustments
for other asset allocations as well. These numbers make clear about how as the
asset allocation shifts from stocks to bonds, the portfolio returns and
standard deviations both decrease. Because these numbers also account for
correlations between assets, we do also see that the lowest standard deviation
occurs with 10 percent stocks instead of 0 percent stocks, despite stocks being
more volatile. This is an example about how diversification can reduce
portfolio volatility by including different asset classes that do not move
entirely in tandem. As retirees often seek to reduce their stock allocation in
retirement, it becomes important to base return assumptions on a more
bond-heavy portfolio that will have a lower expected return than a high-stock
portfolio.

Adjustments for Fees and Performance Relative
to Underlying Indices

For some, the 5 percent real return for the 50/50 asset
allocation choice might be a properly adjusted starting point for a portfolio return
assumption to project retirement outcomes, if this matched the retiree’s
desired asset allocation. We are getting closer. However, there are further
adjustments we could make to this 5 percent number to create a more realistic
and useful number for planning purposes. The number could potentially be a bit
larger with a more diversified portfolio including international assets,
alternative investments, real estate and small-cap stocks. This diversification
would primarily serve to reduce portfolio volatility, which can provide a lift
for the compounded return. Though it would entail risk, one might also wish to
assign a premium to the return assumption to account for a belief that the
investment manager can beat the returns on the underlying indices.

On the other hand, the 5 percent return may need to be
reduced further to account for any fee drag associated with the management of
the underlying investments. The index returns do not account for real-world investment
expenses. It is possible to find index funds with low expense ratios, but the
expenses for some actively managed funds can exceed 1 percent or even 1.5
percent per year. These are the operating expenses for mutual funds. As well,
there can be an additional 12b-1 fee on some mutual funds to help cover
marketing and distribution costs for the investment company. These expenses are
listed separately from the operating expense ratio and must not be forgotten.

Some mutual funds will also charge a front-end or back-end
load as a percentage of the assets when mutual funds are bought or sold. Beyond
these explicit expenses, mutual funds may underperform market indices on
account of the transaction costs for trading inside the fund and for tax inefficiencies
created by fund turnover. In a 2014 article for the Financial Analysts
Journal, John Bogle estimated that the all-in expenses for actively managed
mutual funds could add up to as much as 2.27 percent before adding the tax
impact. He estimated the tax impact as an additional 0.75 percent reduction in
annual returns.

When these fees are present, they reduce the net returns,
approximately, on a one-to-one basis. For instance, if a portfolio was
projected to have a 5 percent return before expenses, and investment expenses
add up to 2 percent, the investor could expect a net return of about 3 percent.
The precise impact is even a bit larger because the expenses apply not just to
the principal but also to the growth of the investment.

Adjustments for Taxes

Another issue besetting retirees is that returns will also
be affected by tax drag, as ongoing taxes for interest, dividends, and realized
capital gains must be paid with the passage of time. The tax efficiency for
various types of funds varies, and actively managed funds generally have less
tax efficiency than index funds. Morningstar has estimated that taxes for a
large-capitalization portfolio like the S&P 500 can reduce annual returns
by 0.68 percent. As for bonds, taxes must be paid on the ongoing interest
earned by the funds, which could easily reduce returns net of tax by 1 percent
or more.

In the John Bogle article just discussed, he estimated the
additional tax impact of actively managed funds as reducing returns by 0.75
percent. Indeed, returns net of taxes will be less for households using taxable
investment accounts. This aspect must also not be ignored when projecting
investment returns for a retirement portfolio.

Adjustments for Investor Behavior

Another concern is whether investors are disciplined enough
to stay the course with the investment strategy in order to earn the underlying
index market returns. Studies on retirement spending from investment portfolios
typically assume that retirees are rational investors who rebalance right on schedule
each year to their rather aggressive stock allocations. They never panic and
sell their stocks after a market downturn. For many retirees, this may not
describe their reality. The behavior gap refers to the concept that investor
behavior may cause real individuals to underperform relative to index market
returns.

The behavior gap has been estimated, and there is somewhat
of a consensus, that individual investors do underperform the overall markets
by a couple percentage points per year. For instance, Vanguard’s study of
Advisor’s Alpha identifies the most important factor explaining investor
underperformance as a lack of behavioral coaching to help investors stay the
course and stick with their plans. They estimate that having the wherewithal to
stay the course in times of market stress could add 1.5 percent of additional
annualized returns to the portfolios of typical investors. In other words,
without behavioral coaching, the typical investor could expect to underperform the
markets by 1.5 percent per year due to poor decision-making.

Evolution has designed us not to be effective long-term
investors, but rather to seek to avoid short-term dangers. The fields of
behavioral finance and behavioral economics have uncovered various biases
humans have that are helpful for day-to-day survival, but somewhat maladaptive
for long-term investing. A significant body of research is dedicated to
detailing these investor behaviors. These are some of the most common behaviors
that lead to poor financial outcomes.

Availability Bias/Recency Effect:
Using recent or current market behavior to predict future market behavior

The most recent events are always freshest in our minds, and
we tend to extrapolate recent events into the future, expecting more of the
same. We tend to make long-term decisions based on short-term performance.
Large recent market gains lead us to be optimistic about our chances, while
market losses have the opposite effect. It takes discipline to overcome these
natural tendencies to simplify matters into what can most easily be recalled.

Loss Aversion: Fearing a loss more
than you want to make gains

As human beings, we tend to feel that the pain of
experiencing a loss is greater than the joy felt by an equivalent gain. This
leads to emotional decision-making for financial decisions, as we feel worse
about losing relative to a starting point than a symmetric gain from the same
starting point. With evolution, this was probably a useful survival tool, but
it does not help with investing. It can lead to the avoidance of stocks that
require accepting greater short-term volatility (and paper losses) in the
effort to achieve upside growth potential and long-term gains. Not recognizing
this predisposition can cause people to misjudge their tolerance for risk,
making them more likely to bail on their financial plan.

Overconfidence: Believing you know more than other investors

While investment research increasingly points to the
difficulty of beating the market—especially after fees, trading costs, and
taxes are taken into account—it is natural to believe we know more than
everyone else. This is the “Lake Wobegon effect” in practice. As Garrison
Keillor relates in A Prairie Home Companion, Lake Wobegon is a place
“where all the children are above average.” It is all too easy for investors to
fall into this kind of thinking. We tend to be too confident in our decision-making
around random and uncertain events. This may lead to too much trading and less-than-prudent
amounts of diversification.

Hindsight Bias: Thinking you can predict market behavior because you
believe you know why past market behavior occurred

In hindsight, market losses may seem to have an obvious or
intuitive explanation. We seek to construct a narrative with cause and coherence,
such that memories about past events suddenly become straightforward and
predictable. This bias can feed into our overconfidence and cause us to believe
we will be able to anticipate such market changes the next time around.

Survivorship Bias: Underestimating the risk by ignoring the failed
companies

We may underestimate the degree of market risk if we look
only at companies still operating today. This misses out on the lessons of many
failed companies no longer on the investment radar. It is like thinking a
marathon would be easy to run because you watched a bunch of people cross the
finish line. You’re ignoring all the people who gave up before reaching the
end. This can also feed overconfidence.

Herd Mentality: Judging your own success or failure based on that of others

Sometimes the herd mentality can be rationalized. You don’t
want to miss out on being rich when everyone else is rich, and perhaps being
poor is not so bad when everyone else is also poor. But for a long-term
investor, following the herd rarely makes sense. It leads to joining the same
greed and fear cycle that drives the average investor to buy after markets have
already gained and to sell after markets have already dropped.

Ambiguity Aversion: Disliking uncertainty leads to betting on what is known

This behavior drives investors to bet more on what they know
than on what they do not know. It has been offered as an explanation for the
equity premium puzzle. Stocks have outperformed bonds consistently and by
relatively wide margins over time, more so than can be explained by their risks
for long-term investors. It may be because investors prefer the short-term
safety of bonds, not recognizing the greater long-term growth potential of
stocks.

Framing: Reacting differently based on whether the same outcome is
presented as a loss or a gain

People’s decisions can also be based on how a problem is
framed, even if the underlying problem is the same. For instance, asking
someone the probability they will live to eighty-five should lead to an answer
that is 100 percent less than the probability that they will die by age eighty-five.
But framing the problem in terms of dying by eighty-five leads to much less
optimism than framing the problem as surviving to eighty-five.

Home Bias and Company Stock: Preferring what is most familiar

Our brains are more comfortable with the familiar. At the
extreme, this can lead to disproportionate ownership in one’s own company
stock, or more simply a bias toward domestic assets over international assets.
Both actions lead to a less diversified portfolio and greater exposure to risks
that could have been diversified away.

Behavioral Cycle of Investing: Buying high and selling low

Falling markets can be stress-inducing events as we witness
our wealth evaporating at a quick pace. This stress can trigger short-term
fight-or-flight mechanisms in our behavior that may have helped to avoid
day-to-day dangers on an evolutionary basis, but which are not adapted toward
sustaining long-term investment success. Market volatility can lead to bad
decision-making and to jettisoning well-considered plans. Short-term stress
reactions will often involve deviating from the financial plan and selling
stocks out of fears for further portfolio losses when historical evidence
overwhelmingly suggests it to be wise to stay the course with the plan to build
greater long-term wealth. Once a well thought out investment plan is in place,
it is frequently better to do nothing in the face of stressful market
situations. But this counters human evolution about the way to respond to such
situations.

In times of market stress, it is important for retirees to
stick with their financial plans and the asset allocation that matches their
tolerance for market volatility. Most research about retirement spending from an
investment portfolio assumes that investors behave in this rational way. Unfortunately,
investors in financial markets tend to do the opposite of what happens in most
other markets: they buy more when prices are high and sell when prices are low.
This causes returns to drag behind what a “buy, hold, and rebalance” investor
could have earned. To the extent that households fall victim to bad behaviors,
the net returns and sustainable spending rates from their investments will be
less than otherwise possible.

Adjustments for Current Bond Yields

Another important consideration is that current interest
rates are lower than the historical averages. The historical average return is
not relevant for someone seeking to estimate future market returns from today’s
starting point. The general problem with attempting to gain insights from the
historical outcomes is that future market returns are connected to the current
values for the sources of market returns, rather than to their historical performance.

Returns on bonds depend on the initial bond yield and on
subsequent yield changes. Low bond yields will tend to translate into lower
returns due to less income and the heightened interest rate risk associated
with capital losses when interest rates rise. Decreasing interest rates provide
the only mechanism for bond returns to outpace bond yields, but this can only
go so far when bond yields already start low.

Exhibit 3.8 demonstrates that, historically, the
relationship between interest rates and subsequent bond returns has been tight.
The exhibit shows the relationship between bond yields and the subsequent
average annualized returns on bonds over the next five years using the
Morningstar and Ibbotson Associates Intermediate-Term Government Bond (ITGB)
index data since 1926 as a proxy for bonds. Much of the variation in
intermediate-term government bond returns over the subsequent five years can be
explained by their current yield. The year 2019 began with five-year Treasury
yields at 2.5 percent. This is 2.7 percent less than the historical average
ITGB return of 5.2 percent. This type of analysis suggests that the most
reasonable return assumption for retirements beginning at the start of 2019 is that
these bonds will average 2.5 percent returns rather than 5.2 percent returns.

Exhibit 3.8

The Relationship Between Bond Yields and
Subsequent Bond Returns

Source: Own calculations from SBBI Yearbook data provided
by Morningstar and Ibbotson Associates. Bonds are represented by intermediate
term US government bonds.

In order to maintain the same risk premium for stocks over
bonds, it would be necessary to reduce the return assumption for stocks by the
same amount. Even if interest rates were to increase later in retirement,
sequence-of-returns risk describes how it is the upcoming returns that matter
most, making this adjustment for returns necessary to obtain a more realistic
picture about retirement sustainability.

Adjustments for Market Valuations

A common way to estimate stock returns is to add an equity
premium to a bond yield. This technique for estimating returns is known as the
capital asset pricing model. This model was developed by William Sharpe in the
1960s, and he was awarded a Nobel Prize in economics for his work in 1990
alongside Harry Markowitz.

The model posits that the expected return on a financial
asset is equal to a risk-free rate of return plus a risk premium multiplied by
a factor showing the relationship between the asset and the overall market
portfolio. For an overall market index like the S&P 500, this suggests that
its return should be equal to the return provided by low-risk assets like
Treasury bonds plus a risk premium to account for the volatility of stocks.

We have discussed how bond yields are the best predictors
for subsequent bond returns. Historically, the S&P 500 outperformed intermediate-term
government bonds by 6.7 percent in arithmetic terms. Lower bond yields suggest
one reason why stock returns could be less. Adding 6.7 percent to the 2.5
percent bond yield at the start of 2019 would lead to an estimate for stock
returns of 9.2 percent, compared to the historical 11.9 percent arithmetic
average return. With low bond yields we should also expect lower stock returns
as well. Otherwise, stocks would end up providing a higher return premium over
bonds than they have historically, and there is little reason to expect a
higher risk premium today.

It is also worth addressing estimates of the equity premium.
Are the historical excess returns really the best predictors for the future
equity premium? An important matter to address is the relationship between the
equity premium and the cyclically adjusted price-earnings ratio. When
price-earnings multiples are high, markets have historically tended to exhibit
mean reversion as relatively lower future returns were realized, and vice
versa.

In the mid-1990s, Yale professor and Nobel laureate Robert
Shiller popularized the concept of the cyclically adjusted price-earnings ratio
(commonly abbreviated either as CAPE or PE10) as being a useful predictor of
subsequent stock market returns. The PE10 measure is the stock price divided by
the average real earnings on a monthly basis over the previous ten years. A
research article published by John Campbell and Robert Shiller in 1998
justifies this measure to remove cyclical factors from earnings, though there
is no particular reason to pick precisely ten years other than as an
approximation for the length of a business cycle. Today, Robert Shiller
provides updated data on the key variables used to calculate PE10 at his
website.

Though Robert Shiller focused on the relationship between
the PE10 measure and subsequent stock returns, the approach can just as easily
be applied to the relationship with the equity premium. The idea with both is
that when the PE10 measure is higher, subsequent expected stock returns or their
excess returns over bonds should be less.

The historical risk premium can vary based on the historical
period under consideration as well as on the choice of stock and bond indices.
Robert Shiller provides freely on his website data for US large-capitalization
stock returns, dividends, and earnings, as well as ten-year Treasury bond
yields. This data is available since 1871, making it the longest available data
series commonly used for retirement income research.

In this dataset, large-capitalization stocks provided an
average 5.8 percent higher arithmetic return than ten-year bond yields. This is
one way to estimate the equity premium. Exhibit 3.9 parses this historical data
in another way, however. It plots the values of PE10 at each historical point
against the arithmetic average of the risk premium over the subsequent ten
years. The line fitting best through this data shows a negative historical
relationship as higher values of PE10 are associated with lower subsequent
excess returns for stocks over bonds. To the extent that we view this model as
having credible predictive power, it suggests that the best guess for the risk
premium over the next ten years from January 2019 is only 1.4 percent, rather
than the historical average 5.8 percent. This lower risk premium results from
the higher market valuations facing retirees at the present, as PE10 was 28.64
in January 2019, compared to its historical average of 17.0. This projection is
well below the historical average because PE10 is well above its historical
average.

Exhibit 3.9

The Relationship Between the Cyclically Adjusted Price-Earnings
Ratio and the Risk Premium

Source: Own calculations with data from Robert
Shiller’s website (http://www.econ.yale.edu/~shiller/data.htm).

There is more controversy about the predictive powers of
PE10 for stock returns, or their excess returns over bonds, than there is for
bond yields to predict bond returns. There are compelling behavioral
explanations for why these relationships could remain in the future, but there
are also many arguments specifically about the problems with using PE10. For
instance, changing accounting standards with regard to how earnings are
calculated may be an explanation for why today’s PE10 does not properly align
with its historical values.

William Bernstein has also written about the paradox of
wealth, which is that returns on capital tend to decrease as societies become
wealthier. He tracks this trend back to the middles ages. This could explain
why we should expect PE10 to center around a higher level than in the past as
the returns on capital fall. A related argument along these lines is that low
interest rates could also justify a higher value of PE10 than otherwise. Nevertheless,
this issue of market valuations exemplifies why it may not always be wise to
use historical averages for excess returns to create estimates for the future
risk premium.

Sustainable spending rates for retirees are intricately
related to the returns provided by the underlying investment portfolio. And
with sequence-of-returns risk, the returns experienced early on will weigh disproportionately
on outcomes. In other words, for those already spending, the assumption that
returns will one day normalize to their historical averages is much less
relevant than it is for accumulators who will rely on more distant market
returns. Current market conditions are much more relevant, making it a mistake
to blindly apply a historical average return without further thought.

The Stock Market’s Greatest Hits

We must remember that the stock market is risky and can
experience extended downturns for long periods of time.

To get a sense of this, I’ve tallied up all the cases of
stock market drops greater than 50 percent in inflation-adjusted terms for
the twenty-one developed-market countries included in the Dimson, Marsh, and Staunton
Global Returns Dataset, 1900–2017. This dataset provides total returns for
stocks, long-term government bonds, short-term government bills, and
inflation on an annual basis since 1900. These calculations are based on
annual data, and the drawdowns from peak to trough may be even bigger with
monthly data, had that data been available. The data provides total market
returns, which includes reinvested dividends. Though World War I and II
account for some of these significant market drops, there are still plenty of
other examples from more peaceful times.

Exhibit 3A.1 shows the country name, years (beginning of
the first listed year to end of the second listed year), and the percentage
drop in real terms for the stock market over that period. I also provide the
year that the real stock market value would again exceed the level prior to
the market drop, as well as the number of years it took for this to happen. The
United States experienced two significant drops of this nature, with
recoveries happening in seven and ten years. The implication of the chart is
that stock market drops can be steeper than what the United States has
experienced, and the subsequent recoveries can take longer as well.

Exhibit 3A.1

The Stock Market’s Greatest Hits

Country

Time Period

Market Drawdown

Year Market Returned to
Predrawdown Level

Wait Time (Years)

Australia

1970–74

–66%

1985

(15)

Austria

1914–25

–96%

2003

(89)

1947–50

–83%

1960

(13)

1962–68

–61%

1989

(27)

2007–08

–61%

Still Waiting

Belgium

1914–18

–80%

1927

(13)

1929–34

–69%

1972

(43)

2007–08

–51%

2015

(8)

Canada

1929–32

–55%

1935

(6)

Finland

1917–21

–85%

1935

(18)

1943–48

–73%

1959

(16)

1974–77

–62%

1983

(9)

1989–91

–60%

1996

(7)

2000–02

–61%

Still Waiting

2008

–53%

2016

(8)

France

1943–50

–88%

1985

(42)

1962–1980

–50%

1985

(23)

Germany

1914–31

–84%

1958

(44)

1948

–91%

1955

(7)

2000–02

–58%

2007

(7)

Ireland

1973–74

–63%

1985

(12)

2007–08

–75%

Still Waiting

Italy

1913–21

–68%

1924

(11)

1944–45

–85%

1959

(15)

1974–77

–74%

1985

(11)

Japan

1943–47

–98%

1969

(26)

1990–02

–70%

Still Waiting

Netherlands

2000–02

–52%

2017

(17)

New Zealand

1987–90

–73%

2003

(16)

Norway

1917–21

–74%

1935

(18)

1974–78

–73%

1985

(11)

2008

–54%

2016

(8)

Portugal

1920–1924

–71%

1936

(16)

1974–1978

–94%

1987

(13)

1988–1992

–64%

1997

(9)

2008–2011

–51%

Still Waiting

South Africa

1919

–52%

1923

(4)

Spain

1936–50

–55%

1955

(19)

1974–82

–84%

1996

(22)

Sweden

1917–20

–68%

1936

(19)

2000–02

–54%

2006

(6)

Switzerland

1915–20

–73%

1927

(12)

1973–74

–56%

1985

(12)

United Kingdom

1973–74

–71%

1983

(10)

United States

1929–31

–61%

1936

(7)

1973–74

–52%

1983

(10)

Source: Own calculations from Dimson, Marsh, and
Staunton Global Returns Dataset (1900–2017). Of the twenty-one countries in
the dataset, only Denmark avoided having an entry in the exhibit.

Adjustments for a Conservative Return
Assumption

A simple approach for building a financial plan is to decide
on a rate of return for the investment portfolio and to plug that value into a
spreadsheet to represent assumed asset growth. Historical data may be used to calculate
historical average returns for different asset classes, which are then combined
to create the overall portfolio return. This approach is also known as
deterministic modeling, as there is no randomness in the future outcome. The
same return is obtained each year without variability.

Deterministic approaches are overly simplified because they
do not account for volatility and therefore miss the impact of
sequence-of-returns risk. The basic approach of assuming a fixed return
reflecting the best guess about future market returns leads to a retirement
plan with only a 50 percent chance to work. The outcomes are too optimistic and
could lead a retiree down an unsustainable path.

Monte Carlo simulations provide an alternative that is now
widely used in financial planning software. Simulations are used to develop
sequences of random market returns fitting predetermined characteristics, in
order to test how financial plans will perform in a wider variety of good and
bad market environments. The use of Monte Carlo tools has increased
considerably over the past decade, which can likely be attributed to lower
computing costs, increased recognition that returns are random, and desires to provide
more robust financial plans. A thousand or more simulations could be created to
test the robustness of a retirement plan in many market environments.

Monte Carlo simulations can be created for different asset
classes or for an overall portfolio. With the asset class approach, one defines
the arithmetic average return, the standard deviation for that return, and the
correlations with other asset classes. Random draws are then taken from statistical
distributions sharing these characteristics. By combining the arithmetic mean
with volatility, the resulting simulated returns will display the appropriate
compounded return over time. Historical data is commonly used to set these
input characteristics. Most financial planning software works in this way.

With Monte Carlo based financial planning software, retirees
generally focus on building a plan that achieves a high probability of success,
such as 80 or 90 percent. This implicitly means the underlying assumed return
is below average. But when thinking in terms of a fixed return assumption, we
usually consider what we view as the best guess for future returns. Again, the best
guess only implies a 50 percent chance for success. Half of the time, the
realized return will be higher and half the time it will be less. In order to
have a conservative fixed return assumption, we must further scale down from
our best guess estimate. This is a point which many investment management
professionals have not internalized into their thinking, as they are
conditioned to using their idea about average returns as the input.

Implied fixed investment returns are usually not shown with
Monte Carlo simulation output in financial planning software, but they do exist
underneath the hood. We can reverse engineer their values. So which implied
portfolio fixed return supports a 90 percent chance for success? The implied
return will be lower than the average return input for the simulation, and I
find support for appropriate portfolio return assumptions in the postretirement
period to be more conservative than in the preretirement period.

Consider three scenarios:

1.      An
individual investing a lump-sum amount for thirty years

2.      An
individual saving a fixed percentage of a constant inflation-adjusted salary at
the end of each year over a thirty-year accumulation period

3.      An
individual withdrawing the maximum sustainable constant inflation-adjusted
amount from a portfolio at the start of each year over a thirty-year retirement
period

Exhibit 3.10 provides the distribution of results for these
simulations. These simulations are based on a standard 50/50 portfolio using
historical Morningstar data for the S&P 500 and intermediate-term
government bonds. For the portfolio, Exhibit 3.7 revealed that the real
arithmetic average return was 5.6 percent, with a 10.6 percent standard
deviation. This leads to a real compounded return of 5 percent.

For the lump-sum investment, the numbers represent the
distribution of average compounded returns over 100,000 thirty-year periods.
For the accumulation phase, the distribution of outcomes is for the internal
rate of return for the final wealth accumulation when making thirty annual
contributions. For the retirement phase, the distribution of results is for the
internal rates of return on the portfolio when withdrawing the maximum
sustainable amount over a thirty-year period with distributions taken at the start
of each year.

The accumulation and distribution phases are dollar-weighted
returns, instead of simple time-weighted returns for the lump-sum investment,
because they account for cash inflows or outflows over time. Whenever there are
cash flows, the ordering of returns matters because returns at different times
will impact different amounts of net asset flows. This is the source of
sequence risk.

In all three cases, the median return was close to 5 percent,
with slight variations for accumulation and retirement based on the timing of
the cash flows. This matches the observation that with an expected growth rate
of 5 percent, the portfolio achieves at least a 5 percent growth rate only half
of the time, as the probability the median return can be achieved is only 50 percent.
When choosing a number to plug into a spreadsheet, a conservative retiree might
be more comfortable using something like the return in the 25th percentile—or
even the 10th—of the distribution. These lower return numbers would correspond
to 75 or 90 percent probabilities of success, respectively, for a financial
plan created with planning software.

Exhibit 3.10

Distribution of Compounded Real Returns over 30
Years

Monte Carlo Simulations for a 50/50 Asset
Allocation

Based on SBBI Data, 1926–2018, S&P 500 and
Intermediate-Term Government Bonds

Lump Sum

Accumulation

Retirement

1st Percentile

0.7%

0.2%

-0.1%

5th Percentile

1.9%

1.6%

1.3%

10th Percentile

2.6%

2.4%

2.0%

25th Percentile

3.7%

3.7%

3.3%

Median

5.0%

5.1%

4.9%

75th Percentile

6.3%

6.5%

6.6%

90th Percentile

7.5%

7.8%

8.2%

95th Percentile

8.2%

8.6%

9.2%

99th Percentile

9.6%

10.1%

11.2%

Mean

5.0%

5.1%

5.0%

Std. Deviation

1.9%

2.1%

2.4%

Source: Own calculations with 100,000 Monte Carlo
simulations for thirty-year periods. Portfolio returns are lognormally
distributed with a 5.6 percent arithmetic real return and 10.6 percent standard
deviation.

Exhibit 3.10 provides the implied fixed returns at other
percentiles of the distribution as created through this reverse-engineering
process. With the lump-sum investment, the compounded real return at the 25th
percentile is 3.7 percent. For an accumulator, the 25th percentile return is also
3.7 percent, while it is 3.3 percent for the retiree. Higher success rates are
connected with lower portfolio returns, since the return hurdle must be
exceeded by the portfolio for the financial plan to be successful. At the 10th percentile,
realized compounded real returns were 2.6 percent for the lump-sum investment,
2.4 percent for the accumulator, and 2 percent for the retiree.

These numbers are naturally lower to provide a greater
chance of success, and sequence-of-returns risk pushes these numbers even lower
for accumulators and retirees. The volatility of outcomes increases as we
transition from a lump sum (standard deviation of 1.9 percent) to accumulation
(2.1 percent) to retirement (2.4 percent). This trend represents growing sequence
risk.

Individuals accumulating or spending assets will have
different experiences than someone using a lump-sum investment. Accumulation
effectively places greater importance on the returns earned late in the career
when a given return impacts more years of contributions. This is
sequence-of-returns risk as it applies in the accumulation phase. With greater
importance placed on a shorter sequence of returns, we should expect a wider
distribution of outcomes.

As for retirement, the impacts are even bigger as sequence
risk further amplifies the impact of investment volatility. Retirees experience
heightened sequence-of-returns risk when funding a constant spending stream
from a volatile portfolio. A portfolio decline causes withdrawals to become a
larger percentage of remaining assets. This digs a hole for the portfolio that
can be difficult to escape. The distribution of internal rates of return during
retirement will be even wider because of the heightened importance placed on
the shorter sequence of postretirement returns. A conservative retiree seeking
a return assumption for retirement should use a lower value than for
preretirement.

In this discussion, I am tackling Monte Carlo from a
different direction—using Monte Carlo simulations to calculate a fixed average
growth rate for the portfolio. Those fixed returns could then be used in a
deterministic planning analysis to determine outcomes with a greater chance to
succeed. Conservative investors will want to work with lower assumed returns,
implying a need to save more today. The exhibit provides insight about
appropriately conservative adjustments for return assumptions.

Not only does sequence risk widen the distribution of
outcomes in retirement, but retirees also experience less risk capacity. With
less time and flexibility to make adjustments to their financial plans,
retirees who experience portfolio losses after leaving the workforce can
experience a devastating impact on remaining lifetime living standards.

This is another reason why individuals may want to use
different return assumptions pre- and postretirement. For example, a
conservative individual might be willing to use the 25th percentile return
during accumulation (calibrated to a 75 percent chance for success) but only
the 10th percentile during retirement (90 percent chance). If the individual
were comfortable with the arithmetic real return and volatility of 5.6 percent
and 10.6 percent, this would suggest using a 3.7 percent compounded real return
assumption in the spreadsheet for accumulation and a 2 percent compounded real
return assumption in the spreadsheet for retirement.

Because of sequence-of-returns risk, conservative investors
will want to use lower fixed-return assumptions than just the compounded return
assumed for a lump-sum investment. Sequence-of-returns risk is relevant for
both the accumulation and retirement phases. Assumed returns should be lower in
both cases. The impact is even greater for retirement. Conservative individuals
will not want to use the expected return for their portfolios when developing
lifetime financial plans. This is a really important point to remember and
internalize when working in environments that require a fixed-return assumption
without an accompanying volatility.

Determining Sustainable
Spending from Investments

Determining the sustainable spending rate from a diversified
investment portfolio in retirement requires making decisions about longevity
and market returns. The final section in this chapter provides an opportunity
to integrate this discussion in order to obtain a better sense about sustainable
distributions from an investment portfolio in retirement.

Rather than blindly applying something like the 4 percent
rule-of-thumb for portfolio distributions, we can create a more realistic
analysis using the process described in this section. This process provides
sustainable portfolio distributions that are calibrated to the retiree’s longevity
risk aversion (see callout box) and accepted risk for outliving the investment
portfolio.

Looking ahead, we also seek to develop market return
assumptions that can be applied to the pricing of annuities, with regard to the
bond yield curve, fees, and other related assumptions, so that we are able to compare
investments and annuities on an equal footing.

Longevity Risk Aversion and Choosing a
Planning Age

With the probability-based approach, what planning age
should a retiree choose when building a retirement income plan?

This is a personal decision to be based partly on
objective characteristics: gender, smoking status, health status and history,
family health history, and other socioeconomic characteristics that correlate
with mortality. It is also based on an individual’s answers to more
subjective questions: how do you feel about outliving your investment
portfolio, and what would be the impact on your standard of living if you
outlived your portfolio?

Moshe Milevsky coined the term longevity risk aversion
to describe the emotions related to how one feels about the possibility of
outliving one’s investment portfolio in late retirement. Beyond the objective
information available about mortality, longevity risk aversion is what will
drive a retiree’s decision about an appropriate planning age. Those with
greater fear of outliving their wealth will seek to build a financial plan
that can be sustained to a higher age for which there is a sufficiently low
probability to outlive.

To understand longevity risk aversion, consider which of
these statements resonates more with you.

1.      To get the most enjoyment out of retirement, it is
optimal to frontload spending and to enjoy a higher standard of living while
one is still able to do so.

2.      The thought of needing to significantly reduce my living
standard or burdening my children at an advanced age is sufficiently alarming
that I would rather maintain a more conservative lifestyle today to better
protect against this possibility.

Answering #1 implies lower longevity risk aversion, while
answering #2 implies high longevity risk aversion. With low longevity risk
aversion, the focus is on maximizing today’s lifestyle. With higher longevity
risk aversion, the focus shifts to protecting lifestyle in the future.

Exhibit 3A.2

Longevity Risk Aversion

An individual’s longevity risk aversion determines how he
or she will evaluate the trade-off between how a higher planning age improves
the chances that a plan will work and how it reduces the sustainable spending
amount in retirement. For example, a sixty-five-year-old female who is
willing to accept a 10 percent chance for outliving her financial plan may
decide to base her planning on surviving to age 100.

For retirees who are self-managing their longevity risk,
the idea is to choose a sufficiently long time horizon that one is unlikely
to outlive, then ensure that one’s plan can work for this long. Those with
greater longevity risk aversion, which is the fear of outliving their
resources, will seek a higher planning age with a lower probability to
outlive. Individuals pick planning ages that are sufficiently conservative to
reflect their personalized concerns about outliving their wealth. These
factors will feed into the decision about which planning age to use in
Exhibits 3.12 to 3.14.

Exhibit 3.11 brings together the factors that determine
portfolio return assumptions as outlined in this chapter. To derive generalized
stock and bond returns, we start with the components of portfolio returns:
inflation, real bond yield, and a risk premium for stocks relative to bonds.
First, the inflation assumption is 2 percent, which is based on the current
break-even inflation rates between traditional Treasury bond and TIPS as was
shown in Exhibit 2.5.

Next, the assumed real bond yield and return is 1 percent.
This is based on the current TIPS yield curve also seen in Exhibit 2.5. When
building a bond ladder for retiree income, the average yield for the ladder
matches closely to the long-term TIPS rates, which are approximately 1 percent.
Sustainable spending is approximated quite well by assuming a flat yield curve
at the long-term interest rate as compared to pricing a bond ladder based on
the entire yield curve. As our focus is on comparing the risk premium to risk
pooling, we simplify the analysis for bonds by assuming a flat yield curve with
a 1 percent real yield. When inflation is included, the yield curve is flat
with a 3 percent nominal yield. These two values become the assumed gross
arithmetic returns for bonds.

As for stocks, I assume a risk premium of 6 percent. This
matches the historical risk premium for the S&P 500 over long-term US
government bonds (as our yield curve, again, is based on a long-term bond to
reflect the average yield from a retirement income bond ladder) as shown in
Exhibit 3.5. Implicitly, then, stocks are represented by the S&P 500. Adding
the historical equity premium to the bond returns, we obtain an assumed 9 percent
nominal arithmetic return and a 7 percent real arithmetic return for stocks. Interest
rates are lower today, and the financial markets expect inflation to fall below
its historical averages, which is why our return assumptions end up lower than
their historical values.

The next step in Exhibit 3.11 is to adjust these gross
returns to account for all of the various factors we discussed. While the
portfolio diversification and alpha factor could increase returns, the other
factors listed (fees, investor behavior, taxes, and above average market
valuations) would generally lead to lower net returns. For the baseline
assumptions to be used for investments in this book, we will give the benefit
of the doubt to investments and assume no adjustments for these various
factors. This also justifies the assumption of fair annuity pricing at the
beginning of the next chapter. As will be seen in later chapters, the case for
using risk pooling to support retirement income is quite strong even when we do
not reduce net portfolio returns for investments. As such, in Exhibit 3.11 we
assume that the net returns for stocks and bonds match their gross returns.

The next steps in Exhibit 3.11 are to decide the standard
deviation assumptions for the asset classes as well as the asset allocation for
the portfolio, and to then combined these details to create overall net return
and volatility assumptions for the portfolio. In this example, I assume a
standard deviation of 20 percent for stocks. This closely matches the
historical volatility for the S&P 500, which Exhibit 3.1 shows was 19.8 percent
for both nominal and real returns.

As for bonds, I assume a 0 percent standard deviation. This
simplifies the fixed-income yield curve and inflation to be
unchanging over time. It also means that bond yields and bond returns are the
same. Since total returns for a bond portfolio are volatile, this assumption
requires explanation. I am eliminating interest rate risk from
the analysis, as there is no possibility for fluctuating interest rates to
create capital gains or losses for the underlying bond portfolio. If interest
rates rise, the value of a fixed-income portfolio declines, but the
present-value cost of funding a future spending goal also decreases. If the
duration of the bond portfolio matches the duration of the spending liability,
then interest rate fluctuations have offsetting effects on the asset and
liability sides of the retirement balance sheet and interest rate risk is
hedged.

Alternatively, we could think of our retiree
as holding individual bonds to maturity, which means that any capital gains or
losses from interest rate fluctuations would not be realized as the bonds reach
maturity and provide their face value as a source of retirement spending for
that year.

This simplification about fixed income does
not meaningfully impact the decision between investments and insurance; it
simply lets us focus more directly on the equity risk premium and insurance
risk pooling without also having to further worry about fluctuating interest
rates. Bond holdings may be riskier for households not using asset-liability
matching than implied by our analysis, which would disadvantage an investment
strategy using bonds relative to an annuity. Insurance companies do use
asset-liability matching so as to not be forced to sell assets at a loss.

Exhibit 3.11

The Building Blocks of Portfolio Returns

Stocks

Bonds

Components of Arithmetic
Returns

Inflation

2.0%

2.0%

Real Bond Return

1.0%

1.0%

Risk Premium

6.0%

---

Gross Nominal Arithmetic
Return

9.0%

3.0%

Gross Real Arithmetic Return

7.0%

1.0%

Further Adjustments:

Investment Management Fees

0.0%

0.0%

Portfolio Diversification /
Alpha

0.0%

0.0%

Investor Behavior

0.0%

0.0%

Taxes

0.0%

0.0%

Market Valuations

0.0%

0.0%

Net Nominal Arithmetic Return

9.0%

3.0%

Net Real Arithmetic Return

7.0%

1.0%

Standard Deviation of Returns

20.0%

0.0%

Asset Allocation

50.0%

50.0%

Portfolio Characteristics

Portfolio Nominal Arithmetic
Return

6.00%

Portfolio Nominal Compounded
Return

5.5%

Portfolio Real Arithmetic
Return

4.00%

Portfolio Real Compounded
Return

3.5%

Portfolio Standard Deviation

10.0%

Source: Own calculations and assumptions as described
in the text.

Using the portfolio return and volatility assumptions
determined in Exhibit 3.11, we then reverse engineer fixed return assumptions
and sustainable spending levels for a desired retirement time horizon and
targeted probability of success. The investment portfolio is
modeled using 100,000 Monte Carlo simulations for these portfolio returns, assuming
a lognormal distribution.

Exhibit 3.12 presents the implied compounded
real returns for different planning horizons and probabilities of success. As
these are real return factors, they would support inflation adjusted spending.
The arithmetic average portfolio return is 4 percent real with a standard
deviation of 10 percent. However, for deciding on a fixed return assumption,
one must account for the likelihood of success they seek for the spending plan
in terms of both a planning horizon and probability of success. For instance,
if the retiree sought a 90 percent chance that portfolio distributions could be
sustained through age ninety, this would imply an assumed fixed real growth
rate for the portfolio from the 10th percentile of outcomes at 0.5 percent.

Exhibit 3.12

Fixed Rates of Return Assumptions for a Sixty-Five-Year-Old

Reverse Engineered Inflation-Adjusted Compounded
Returns for Retirement

Planning Horizon (Age)

85

90

95

100

105

Worst Case

-5.9%

-5.0%

-4.2%

-3.7%

-3.3%

5th Percentile

-0.6%

-0.2%

0.1%

0.3%

0.5%

10th Percentile

0.2%

0.5%

0.8%

1.0%

1.1%

25th Percentile

1.7%

1.9%

2.0%

2.1%

2.2%

Median

3.4%

3.4%

3.4%

3.4%

3.4%

75th Percentile

5.3%

5.1%

4.9%

4.8%

4.8%

90th Percentile

7.0%

6.7%

6.4%

6.2%

6.1%

95th Percentile

8.1%

7.7%

7.3%

7.1%

6.9%

Best Case

19.2%

18.7%

18.3%

17.9%

17.5%

Std. Deviation

2.7%

2.4%

2.2%

2.1%

2.0%

Source: Own calculations with 100,000 Monte Carlo
Simulations for a 50/50 portfolio of stocks and bonds. These calculations are
based on the net portfolio returns shown in Exhibit 3.11. The portfolio's real
arithmetic return is 4% and standard deviation is 10%.

We should make a few observations about this 0.5
percent return value. First, it is less than the assumed 1 percent real return from
holding bonds. In other words, to achieve the desired success rate from the
diversified portfolio, one ends up assuming a lower return, and therefore a
lower spending amount, than bonds could ensure. The flip side of this, though,
is that 90 percent of the time the retiree could expect to earn a higher
effective return than this number and may even be able to grow their wealth throughout
retirement as they otherwise are spending less than would have been feasible.
Conversely, the bond ladder would lock-in the 1 percent real return throughout
retirement without a chance for upside.

The other interesting aspect is to note that
the fixed return assumption increases for longer retirement horizons, as it is
0.8 percent for planning through age ninety-five and 1 percent (matching the
bond yield) for planning through age 100. The reason that returns increase with
the time horizon is because to sustain spending for longer, the spending amount
must decrease, which reduces the impact of sequence-of-returns risk.

This concept is seen more clearly in Exhibit 3.13, which
provides the corresponding spending numbers for the returns in the previous
exhibit. Returning to the same example, if the retiree seeks a 90 percent
chance that spending lasts to age ninety, they would choose from the 10th percentile
of spending outcomes. That is $42,633 of annual inflation-adjusted spending. To
sustain spending through age ninety-five with the same success rate, spending
would need to reduce to $37,194. This is a 3.72 percent withdrawal rate from
retirement date assets, and it would be the number that corresponds to the 4 percent
rule-of-thumb with these market expectations for a thirty-year retirement. If
sustainability with 90 percent success was instead sought for thirty-five years
through age 100, then the annual spending number falls further to $33,418.
Again, it is because the spending amount decreases that the return assumption can
increase; the lower spending rate reduces the exposure to sequence-of-returns
risk and reduces the impact of investment volatility in the retirement plan.

Exhibit 3.13

Sustainable Spending for a Sixty-Five-Year-Old
with $1 Million of Assets

Reverse Engineered Inflation-Adjusted Sustainable
Spending Amounts for Retirement

Planning Horizon (Age)

85

90

95

100

105

Worst Case

$26,488

$20,318

$16,590

$14,033

$12,146

5th Percentile

$46,965

$38,870

$33,642

$30,051

$27,468

10th Percentile

$50,985

$42,633

$37,194

$33,418

$30,660

25th Percentile

$58,305

$49,440

$43,700

$39,692

$36,781

Median

$67,445

$58,079

$51,954

$47,702

$44,601

75th Percentile

$77,865

$67,998

$61,527

$57,027

$53,797

90th Percentile

$88,291

$77,965

$71,249

$66,603

$63,186

95th Percentile

$95,088

$84,616

$77,649

$72,783

$69,338

Best Case

$166,254

$159,535

$155,514

$152,157

$148,989

Std. Deviation

$14,717

$13,979

$13,480

$13,123

$12,863

Source: Own calculations with 100,000 Monte Carlo
Simulations for a 50/50 portfolio of stocks and bonds. These calculations are
based on the net portfolio returns shown in Exhibit 3.11. The portfolio's real
arithmetic return is 4% and standard deviation is 10%.

Retirement spending goals are often expressed in terms of
inflation-adjusted spending numbers. This is what the 4 percent rule-of-thumb
assumes. But as we move the discussion toward annuities, many annuities will protect
a fixed amount of spending without inflation adjustments. It is not appropriate
to compare the payout rate for a fixed annuity payment to the sustainable
distribution rate from an investment portfolio that assumes inflation-adjusted
spending. As such, Exhibit 3.14 repeats this analysis using the nominal
portfolio return assumptions from Exhibit 3.11, which include a 6 percent
return and a ten percent standard deviation.

When the returns are nominal rather than real, it means that
the spending numbers are nominal instead of real. They will start at higher
values but will not grow for inflation. Returning to the same example, seeking 90
percent success through age ninety-five allows fixed spending of $47,746, which
is 28.4 percent more than the corresponding $37,194 inflation-adjusted spending
number from the previous exhibit. Again, this spending starts at a higher value
but stays fixed rather than growing over time. If we compare to the pricing for
an annuity providing fixed payments, then it is the numbers in Exhibit 3.14
that provide the most directly comparable values.

Exhibit 3.14

Sustainable Spending for a Sixty-Five-Year-Old
with $1 Million of Assets

Reverse Engineered Fixed Sustainable Spending
Amounts for Retirement

Planning Horizon (Age)

85

90

95

100

105

Worst Case

$30,136

$26,347

$22,923

$19,862

$18,473

5th Percentile

$56,420

$48,687

$43,727

$40,394

$38,082

10th Percentile

$60,794

$52,781

$47,746

$44,369

$41,996

25th Percentile

$68,756

$60,421

$55,167

$51,635

$49,163

Median

$78,707

$70,049

$64,580

$60,900

$58,353

75th Percentile

$89,821

$80,818

$75,142

$71,335

$68,691

90th Percentile

$100,899

$91,636

$85,810

$81,861

$79,140

95th Percentile

$108,001

$98,510

$92,538

$88,571

$85,823

Best Case

$184,786

$175,766

$169,443

$166,628

$164,791

Std. Deviation

$15,818

$15,308

$14,988

$14,785

$14,654

Source: Own
calculations with 100,000 Monte Carlo Simulations for a 50/50 portfolio of
stocks and bonds. These calculations are based on the net portfolio returns
shown in Exhibit 3.11. The portfolio's nominal arithmetic
return is 6% and standard deviation is 10%.

To plant the seed for where this analysis is heading, in
Exhibit 4.1 from the next chapter, I calculate that the lifetime fixed payout
for a $1 million premium to a life-only income annuity for a sixty-five-year-old female is $57,800 per year. That
number can be directly compared to those shown in Exhibit 3.14, since in both
cases we are discussing nominal spending that does not grow with inflation.
Suppose this individual is considering an investments solution for retirement
and will use a 50/50 asset allocation to stocks and bonds and agrees with the
net return assumptions for which this example is based.

Suppose further that she seeks a 90 percent chance that her
portfolio will last to age ninety-five. In this case, she would use the 10th percentile
assumption for age ninety-five, which allows spending of $47,746 per year.
Because this amount is less than the annuity provides, it means she would need
more assets to support the same amount of spending as the annuity while
preserving the degree of comfort she desires for meeting her retirement income
goal. In this case, she would require 21 percent more assets, or $1.21 million
devoted to spending from the investment portfolio to comfortably match the
amount of spending that the annuity could provide with $1 million.

These discrepancies would become even larger if she were
even more longevity risk averse. For instance, if she sought a 95 percent
chance that her portfolio would last to age 100, she could only spend $40,394
annually. In this case, her nest-egg would need to be 43 percent larger, or
$1.43 million, in order to match the protected lifetime spending level afforded
by $1 million in the annuity.

On the other hand, if she were less longevity risk averse,
it is possible that investments would let her spend more than the annuity with
the caveat that the chances of outliving the investment portfolio would
increase accordingly. For instance, if she sought a 75 percent chance that her
assets would last to age ninety, then she could spend $60,421 from the
portfolio, which is larger than the $57,800 that the annuity could support from
the same underlying asset base.

These comparisons will become important later in the book
when we discuss how to integrate the retirement asset base to build retirement
income strategies that can more efficiently meet the various financial goals of
retirement. But before that, we must introduce risk pooling and how annuities and
life insurance can also serve as potential tools in a retirement income plan. We
will now shift from the risk premium to risk pooling.

Further Reading

Bengen, William P. 1994. “Determining Withdrawal Rates
Using Historical Data.” Journal of Financial Planning 7 (4): 171–180.

Bernstein, William J. 2012. The Ages of the Investor:
A Critical Look at Life-Cycle Investing (Investing for Adults). Efficient Frontier
Publications. [http://amzn.to/2s495L2]

Bernstein, William J. 2013. Deep Risk: How History
Informs Portfolio Design. Efficient Frontier Publications. [https://amzn.to/2XCsX7E]

Bogle, John C. 2014. “The Arithmetic of ‘All-In’ Investment
Expenses.” Financial Analysts Journal 70 (January/February).

Campbell, John Y., and Robert J. Shiller. 1998.
“Valuation Ratios and the Long-Run Stock Market Outlook.” Journal of
Portfolio Management 24 (2): 11–26.

Kinniry, Jr., Francis M., Colleen M. Jaconetti, Michael
A. DiJoseph, and Yan Zilbering. 2014. “Putting a Value on Your Value:
Quantifying Vanguard Advisor’s Alpha.” Vanguard Research Paper. https://www.vanguard.com/pdf/ISGQVAA.pdf

Levine, David A. 2016. “How Much of Your Nest Egg to Put
Into Stocks? All of it.” New York Times (February 13): p. B4.

Markowitz, Harry M. 1991. “Individual versus
Institutional Investing.” Financial Services Review 1 (1).

Milevsky, Moshe A., and Huaxiong Huang. 2011. “Spending Retirement on Planet Vulcan: The Impact of
Longevity Risk Aversion on Optimal Withdrawal Rates.” Financial Analysts
Journal 67 (2): 45–58.

Pfau, Wade. 2017. How
Much Can I Spend in Retirement: A Guide to Investment-Based Retirement Income
Strategies. McLean, VA: Retirement Researcher Media. [http://amzn.to/2xLgXGC]

Chapter 4:
Income Annuities (Risk Pooling)

For those seeking to spend more in retirement than the bond
yield curve can support, the alternative to seeking risk premium through an
aggressive asset allocation is to pool risk through insurance. Income annuities
are the simplest type of insurance products which trade a lump-sum payment for protected
lifetime income. The ability to convert a portion of assets (as it is not an
all-or-nothing decision) into a guaranteed income stream is a fundamental
retirement income tool which contrasts with an investment portfolio in terms of
the advantages and disadvantages for managing retirement risks.

We start our discussion of annuities with the income annuity
because it is the most straightforward and easy-to-understand way to convert a
pot of money into a guaranteed stream of spending for life. This chapter
focuses specifically on income annuities, also known as immediate annuities,
single-premium immediate annuities (SPIAs), deferred income annuities (DIAs),
or longevity insurance. The next chapters will expand the discussion to include
other types of more complex annuities that are also able to offer lifetime
income protections.

Risk pooling and mortality credits are the driver of value
from an income annuity. The annuitant accepts the risk of dying early and
receiving fewer payments from the annuity in exchange for the ability to
continue receiving payments for a very long time in the event of a long life. By
pooling longevity risks with a collection of individuals, an income annuity
allows its owners to spend assets as though they will earn fixed-income returns
and live to their life expectancy. Those who end up living beyond their life
expectancy will have their continuing benefits subsidized by those who die
before life expectancy.

With an income annuity, one is essentially offering to leave
part of the premium on the table for others in the risk pool in the event of an
early death, in order to receive the protection of maintaining an ongoing
income stream through subsidies from others in the event of a long life. While
this clearly benefits the long-lived, we can also conclude that it benefits the
short-lived as well by allowing them to enjoy a higher standard of living than
they might have otherwise been comfortable supporting from an unguaranteed
investment portfolio. This can allow for more spending and a more satisfying
retirement experience compared to those self-managing longevity risk by
spending less and then leaving too much behind at death.

This risk pooling capability can be an attractive
proposition when longevity is unforeseeable. With investing approaches that
exclude risk pooling and the mortality credits it can provide, greater spending
conservatism is otherwise needed to stretch assets out over a potentially long
retirement and in the face of a potentially poor sequence of market returns.
Risk pooling can provide a cheaper (in terms of being able to earmark fewer assets
for the purpose) and more efficient method for supporting a retirement income
goal. This can also leave the remaining assets to be more focused on growth,
which can even help to support a greater net legacy over time.

Income annuities also provide peace of mind and other
psychological benefits for retirees. Retirement income is no longer dependent
upon the vagaries of the stock market and its daily fluctuations. Annuity
owners could possibly even live longer because of the reduced stress they face
with funding their retirement, and also perhaps because they want to make sure
they get their money’s worth from the annuity by drawing from rather than
contributing to that risk pool.

Menu of Income Annuity
Features and Options

As a first step to understanding annuities, we consider
basic questions about how income annuities work, as well as what options are
available.

Who is covered by an annuity?

There are a few terms relevant to know about how annuities
are structured. The contract owner is the one who buys and makes decisions
about an annuity contract. The annuitant is the person or persons on whose age
and survival is used to determine annuity payments. The contract owner is often
also the annuitant, but this does not necessarily have to be the case. The
beneficiary is the one who will receive any death proceeds, such as a cash
refund, after the annuitant passes away.

When do income payments start?

Income annuities can be either immediate or deferred. An
immediate annuity begins income payments within one year of the purchase date,
while a deferred income annuity does not begin payments until at least one year
after the purchase date. A deferred income annuity purchased at retirement with
income beginning at age eighty or eighty-five is also referred to as longevity
insurance.

After the Treasury Department updated regulations in 2014 to
facilitate the use of longevity insurance inside retirement plans, longevity
insurance is now also known as a qualified longevity annuity contract (QLAC).
In practice, deferred income annuities are used less as a form of longevity
insurance and more for prepaying retirement and removing market risk in the
pivotal preretirement years. In such a case, one might purchase a deferred
income annuity at age fifty-five, for instance, for income to begin at sixty-five.

Do income annuities cover one life or two?

True to their name, single life income annuities only cover
one person’s life. With such an annuity, income payments continue until the
annuitant’s death. A joint life annuity, on the other hand, continues payments
for as long as at least one of two annuitants survives.

Often joint annuities are set up for two spouses, but
marriage is not a requirement for two annuitants to be included on a joint life
contract. Since payments are expected to last longer when two lives are covered,
the joint protection comes at the cost of a lower initial payout rate. A joint life
and 100 percent survivor annuity provides the same payment as long as one annuitant
is alive. With a joint life and 67 percent survivor annuity, the payment would
reduce by 33 percent upon the first annuitant’s death, allowing for a higher
initial payment level.

What are the different flavors of payouts?

A life-only income annuity is the Platonic ideal, offering the
highest payout and the most mortality credits. Payouts are highest because the
purchaser is taking the most “hit by a bus risk”—the common fear of signing an
annuity contract and then being hit by a bus and killed on the way out of the
office. Life-only annuities are popular with academics because acceptance of
this risk makes more funds available to the longer-surviving members of the
risk pool, allowing one to buy protected lifetime income at the lowest possible
cost. In practice, many annuity buyers will be uncomfortable with a life-only
annuity.

A variety of other flavors will lower the payout rate but
may otherwise make the income annuity a more palatable choice. By offering less
mortality credits to the risk pool because you want some protection for your beneficiary
in the event of an early death, you should, in turn, expect to receive less
mortality credits back from the risk pool in the event of a long life. This is
the nature of the trade-off that results in a lower payout rate for added
protections. Other flavors of annuities that lower the payout rate in exchange for
protections to the beneficiary in the event of an early death include:

·
Lifetime with ten-year period certain annuity: Pays for life. If the
annuitant dies before ten years is up, the beneficiary continues receiving
payments for the full ten years. These period-certain guarantees can also be
arranged for any number of years, such as five, fifteen, or twenty.

·
Cash refund provision: Provides a cash refund of the difference to
the beneficiary if an annuitant dies before the owner receives cumulative payments
from the annuity that sum to the initial premium.

·
Installment refund: Works very similarly to the cash refund,
except beneficiaries receive the difference as continued annuity payments in
installments until the full premium has been returned, rather than receiving a
onetime refund.

·
Period certain: An income annuity does not require a lifetime
provision. It may just make payments for a set period of time. This works the
same way as building a bond ladder and can be an alternative to individual
bonds when considering retirement income bond ladder strategies.

Are payments fixed or do they grow over time?

There are generally three options regarding income annuity
payments.

·
Fixed or level income annuity: These annuities will pay the same
amount on an ongoing basis for as long as the contract requires. The purchasing
power of the income payments will decrease over time as there is no adjustment
made for inflation.

·
COLA: A cost-of-living adjustment (COLA) provision allows payments
grow at a fixed compounding rate each year. For instance, if I decide that 3 percent
is a reasonable assumption for future inflation, I might choose a COLA of 3 percent
with the intention of preserving the purchasing power for my annuity income. If
realized inflation ends up being higher, I will lose purchasing power over
time, but purchasing power would increase if realized inflation ends up being
lower. COLAs can only approximate the inflation experience in retirement.

·
CPI: One could add a provision that the income growth rate of the
annuity payments precisely matches the Consumer Price Index (CPI). When
inflation is low, income grows more slowly, as do living costs for the retiree.
When inflation is high, income grows more quickly to better support the
increasing cost of living. CPI-adjusted income annuities hedge inflation risk
in the same manner as TIPS. Not many companies are currently offer CPI-adjusted
income annuities, and so the pricing may not be competitive.

The CPI option could still be attractive for someone who is
particularly worried that inflation will be higher than the markets expect. A
CPI-adjusted income annuity really is the closest thing we have to a risk-free
asset for retirement income. With these annuities, it is also important to
check the contract carefully about whether there is a cap on the inflation
adjustment. For instance, with a cap of 6 percent, even if inflation is 9 percent
in any given year, income payment will only grow by at most 6 percent. This
limits the attractiveness for an individual who is really concerned about high
inflation in the future.

Those seeking inflation protection specifically from the
annuity should go with options two or three. It is important to recognize,
though, that increased future payments mean a lower initial payout rate. I will
return to this issue of how to approach the management of inflation risk in Chapter
8.

The Popularity of Different Income Annuity Options
and Flavors in Practice

CANNEX (www.cannex.com)
is a Toronto-based company that provides a popular platform for learning
about annuity pricing. They provide frequent reports about the types of
searches being made by distribution companies and financial advisors that could
potentially result in an annuity sale. Their CANNEX Survey Experience
covering 2018 provides a lot of insight about the types of single premium
immediate annuities and deferred income annuities that are popular in the US
market. Here are some insights from this report.

The average age for when the premium will be paid on
quotes generated for primary annuitants is 66.6. By gender, it is 67.6 for
females and 66.0 for males. For primary annuitants, 1.73 percent are age 45
or less, while 3.63 percent are over age 85. When we look further at
immediate or deferred annuities, the average age for primary annuitants
looking at immediate annuities is 68.5. It is 61.5 for those considering
deferred annuities (income begins at least 13 months later).

73 percent of quotes will have payments begin within one
year (immediate annuities), while the other 27 percent of quotes have income
begin in more than one year. For deferred income annuities, the length of the
deferral period is relatively evenly distributed from one year to more than twenty
years. We can note that longevity insurance is not a particularly popular
annuity use, as only 6.2 percent have deferral periods in excess of ten years,
and only 1.8 percent of quotes have deferral periods in excess of 15 years.

For joint annuities, 93.6 percent have a nonreducing
payment upon the death of the first annuitant. This is a joint and 100
percent survivors benefit annuity. For the small remaining percentage, about
half of the remainder will have the annuity payment reduce by 50 percent upon
either the first death or the death of the person identified as the primary
annuitant.

As for the annuity flavor, the most popular option is to
include a cash refund provision (47 percent) in the event of an early death.
The next most popular option is life with ten years of certain payments (16.6
percent), followed by a life-only guarantee (14.4 percent). Other period-certain
options with some traction include five years (6.1 percent) and twenty years
(4.8 percent). The installment refund accounts for 3.9 percent of quotes. The
remaining 6.5 percent of quotes reflect other various period-certain options.

Nonqualified taxable accounts will be the source of
annuity funds with 58 percent of quotes, while the other 42 percent of quotes
are for various tax-qualified retirement plans.

Monthly payments are sought 81.5 percent of the time, with
annual payments 18 percent of the time, and only 0.5 percent seek payment
frequencies other than these two choices.

When a quote with a premium is provided, the average
premium was $288,155 for immediate annuities and $248,755 for deferred
annuities. Meanwhile, for those seeking the cost of providing a specific
payment, the average annual income sought was $35,745 for immediate annuities
and $36,670 for deferred annuities.

As for fixed or growing payments, 95.7 percent of quotes
are for fixed payments. Only 0.2 percent of quotes are for CPI-adjusted
income annuities, while 4.1 percent include different COLA options. The most
popular COLA options are 2 percent (1.9 percent of quotes) and three percent
(1.3 percent of quotes).

Putting this all together to create a baseline scenario
for our income annuity discussions, a few ideas that we can gain from the
CANNEX survey include that sixty-five is a reasonable age to consider an
annuity, joint annuities should have nonreducing benefits, cash refund and
life-only income annuities are both viable options, the majority will buy an
annuity with taxable assets, both immediate and deferred income annuities are
popular in practice, and fixed-income annuities without COLAs or other income
growth are by far the most commonly used choice.

Annuity Pricing 101

How are income annuities priced? It is not as hard as one
might think, as the basic recipe requires just three ingredients:

1.      Mortality
rates (which vary by age and gender) impact how long payments will be made. Younger
people will have longer projected payout periods, which means that payout rates
must be lower.

2.      Interest
rates impact the returns the annuity provider can earn on the underlying
annuitized assets. Higher interest rates imply higher payout rates because the
insurance company will be able to earn more interest on the premiums in their
general account supporting the annuity payments.

3.      Overhead
costs relate to extra charges an annuity provider seeks to cover business
expenses and to manage risks related to the accuracy of their future mortality
and interest rate predictions.

Pricing for a Life-Only Income Annuity

Exhibit 4.1 provides a simple example to illustrate the
basic pricing dynamics for an actuarially fair income annuity. This is
an annuity without any overhead costs, and it assumes the underlying
projections for mortality and fixed-income returns are correct. I use the capital
market expectations I described in Chapter 3, of which the relevant aspect is
that I assume the bond yield curve is flat at a nominal 3 percent interest
rate. For this example, we consider a sixty-five-year-old female who is offered
$10,000 of spending per year as long as she lives. Since we are using a nominal
bond yield curve, this spending is fixed. The income annuity is life-only, so
payments stop at death. How much is this protected lifetime income stream
objectively worth?

Exhibit 4.1

Calculating the Cost of a $10,000 Income Stream for
a Sixty-Five-Year-Old Female (Life Only)

Discount
Rate:

3.00%

Age

Income

Discount
Factor

Discounted
Value of Income

Survival
Probabilities

Survival-Weighted
Discounted Value

65

$10,000

100.0%

$10,000

100.0%

$10,000

66

$10,000

97.1%

$9,709

99.4%

$9,646

67

$10,000

94.3%

$9,426

98.7%

$9,302

68

$10,000

91.5%

$9,151

98.0%

$8,965

69

$10,000

88.8%

$8,885

97.2%

$8,637

70

$10,000

86.3%

$8,626

96.4%

$8,315

71

$10,000

83.7%

$8,375

95.5%

$8,000

72

$10,000

81.3%

$8,131

94.6%

$7,691

73

$10,000

78.9%

$7,894

93.6%

$7,389

74

$10,000

76.6%

$7,664

92.5%

$7,093

75

$10,000

74.4%

$7,441

91.4%

$6,801

…

…

…

…

…

…

95

$10,000

41.2%

$4,120

30.2%

$1,245

96

$10,000

40.0%

$4,000

25.7%

$1,029

97

$10,000

38.8%

$3,883

21.5%

$835

98

$10,000

37.7%

$3,770

17.5%

$660

99

$10,000

36.6%

$3,660

14.0%

$512

100

$10,000

35.5%

$3,554

10.8%

$384

101

$10,000

34.5%

$3,450

8.1%

$280

102

$10,000

33.5%

$3,350

5.9%

$199

103

$10,000

32.5%

$3,252

4.1%

$135

104

$10,000

31.6%

$3,158

2.8%

$89

Cost of
Annuity (Sum of Survival-Weighted Discounted Values):

$172,915

Annuity
Payout Rate:

5.78%

Source: Survival Probabilities are calculated from
the Society of Actuaries 2012 Individual Annuitant Mortality Tables with
improvements through 2019.

Finding how much the annuity is worth requires inputs for
investment returns to be earned on the premium financing these payments, and
the survival probabilities to each subsequent age. Our example calculation includes
some simplifications. With a typical upward-sloping yield curve, payments
coming sooner would earn less interest, and later payments would grow at a
faster rate. Additionally, many annuity providers will likely seek higher
returns than Treasury bonds offer by including high-quality corporate bonds
with higher yields to compensate for slightly higher default risk. Annuity
providers may also be using more refined mortality data that is better
connected to their customer base.

I also assume the full year of spending arrives at the start
of each year, rather than having income arriving on a more typical monthly
basis. But the simplifications here will capture the concept of annuity pricing
well enough.

The 3 percent bond yield and return acts as a discount rate
to reduce the value needing to be set aside today for the future $10,000
payments. For instance, the exhibit indicates that at age seventy-five, the
discount factor is 74.4 percent. The interpretation is if I put $7,441 in the
bank today, and it grows at an annual 3 percent compounding interest rate for
the next ten years, I can expect these assets to grow in value to $10,000 by my
seventy-fifth birthday. If I was building a bond ladder, this is the amount I
would need to invest into a ten-year zero-coupon bond to provide that $10,000
payment.

The process is the same for the $10,000 payment provided at
each age. The later payments are received, the more time they have to compound
and grow, requiring less to be set aside today to fund those payments.

The next columns are what differentiates an income annuity
from a retirement income bond ladder. For a bond ladder, the total cost is the
sum of the Discounted Value of Income column, which is $238,082 through age 104.
Annuity owners obtain a discount on the bond ladder pricing because the
survival probabilities to each subsequent age indicate whether these payments
will need to be made. Any one individual is either alive or dead. But for a
large pool of individuals representing the customer base of the annuity
provider, the company can rely on the law of large numbers to evaluate what
percentage of customers will remain alive at each subsequent age. This is risk
pooling.

The data from the Society of Actuaries suggests that a sixty-five-year-old
female has a 91.4 percent chance of living to seventy-five. An annuity provider
can expect 91.4 percent of their sixty-five-year-old female customers to be
alive and receiving income at seventy-five. The company does not know who
specifically from among their customers will be alive and receiving payments,
but they can be pretty confident with their planning that 91.4 percent of their
customers will be alive.

When we multiply this percentage by the discounted value of
the funds needed to provide the $10,000 payment at seventy-five, we see that
the annuity company plans $6,801 for the cost of providing this payment at age seventy-five.
This is the survival-probability weighted discount factor, and the same process
is followed for each age. For another example, a $10,000 payment at age 100
requires $3,554 to be set aside today with a 3 percent interest rate for the
purposes of an individual building a bond ladder. Given that there is a 10.8
percent chance for the sixty-five-year-old female to reach age 100, the annuity
provider further multiplies this amount by the survival probability so that the
expected costs for a $10,000 survival-contingent payment is only $384. A sixty-five-year-old
female need only pay $384 today for a guarantee to receive $10,000 at age 100
if she accepts that receiving the payment is contingent upon her surviving to
that age.

When we add survival-weighted costs by age, we see that the
total expected cost to provide $10,000 of annual spending to a sixty-five-year-old
female, at least through age 104, is $172,915. If this dollar amount represents
the premium charged, then the payout rate on the annuity is the $10,000 income
it provides divided by this cost. The payout rate is 5.78 percent. Note that
this is also 27 percent less than the cost of the bond ladder. The bond ladder
costs more, with the benefit that the bond ladder supports some legacy if
retirement lasts less than the full ladder length. But the bond ladder does not
provide any additional longevity protection beyond the end date of the ladder
as assets are fully depleted at that time. With the income annuity, that
longevity protection can be provided with 27 percent less funds.

Pricing for an Income Annuity with
Period-Certain Payments

We can also consider a few more examples to better
understand how this model for annuity pricing can be applied to different
annuity flavors. For instance, what happens to the price of this annuity if we
guarantee that income will be provided for at least ten years, even if the
annuitant does not live that long? This type of provision may be desired for
someone worried about an early death.

Practically speaking, to provide ten years
of certain income, the only adjustment needed in Exhibit 4.1 is that the Survival
Probabilities become 100 percent for the first ten years of payments. The
annuitant does not become immortal, but from the perspective of the actuaries
who are pricing this annuity, payments must be made regardless of the
annuitant’s survival status.

Mathematically, there is a 100 percent chance the first ten
payments will be made. This raises the cost of the first ten
payments. But because there was already a high probability that the annuitant
lives for at least ten years, the increase in cost will be relatively minor. The
ten-year period-certain provision raises our hypothetical annuity’s cost from $172,915
to $175,738. The increased cost lowers the payout rate (which is the initial
$10,000 income divided by the cost) from 5.78 percent to 5.69 percent. The
reduction in payout rate reflects the reduction of mortality credits that the
annuity purchaser has offered to the other participants in the risk pool by
requiring that payments are received for at least ten years.

Pricing for an Income Annuity with a Cash
Refund Provision

An income annuity with a cash refund is
priced in a similar way, though the math becomes a bit more complex. For each
age, we must also consider the probability that this age represents the age of
death for the annuitant in order to calculate the probability that the cash
refund will be provided to the beneficiary at that age. The probability of
death is the difference between the survival probability for the next year and
the survival probability at the start of the current year. The refund amount declines
with age as payments are received and is discounted by the factor for that age.

Exhibit 4.2 shows the more complex set of
calculations for pricing an income annuity with a cash refund provision. A cash
refund provision for the original life-only annuity from Exhibit 4.1 would
raise the cost from $172,915 to $185,784. Its cost is
$12,869. The increased cost lowers the payout rate from 5.78 percent to 5.38
percent. Calculating the $185,784 premium requires an iterative process because
the cost of the cash refund cannot be known without knowing the payout rate
that determines the cash refund amount. But the payout rate cannot be known
without knowing the cost of the cash refund.

The basic method to solve for this is to
slowly raise the premium level up from the life-only amount until reaching the
point where the guess for the premium amount matches the estimated premium from
the calculations for the cash refund. In this example, it happens when the
premium reaches $185,784.

Exhibit 4.2

Calculating the Cost of a $10,000 Income Stream for
a Sixty-Five-Year-Old Female (Life with Cash Refund)

Discount
Rate:

3.00%

Age

Income

Discount Factor

Survival Probabilities

Survival-Weighted Discounted Value

Probability of Death

Cumulative Income Received

Refund Amount

Survival-Weighted Discounted Refund

65

$10,000

100.0%

100.0%

$10,000

0.64%

$10,000

$175,784

$1,131

66

$10,000

97.1%

99.4%

$9,646

0.68%

$20,000

$165,784

$1,087

67

$10,000

94.3%

98.7%

$9,302

0.71%

$30,000

$155,784

$1,050

68

$10,000

91.5%

98.0%

$8,965

0.76%

$40,000

$145,784

$1,015

69

$10,000

88.8%

97.2%

$8,637

0.81%

$50,000

$135,784

$981

70

$10,000

86.3%

96.4%

$8,315

0.87%

$60,000

$125,784

$943

71

$10,000

83.7%

95.5%

$8,000

0.93%

$70,000

$115,784

$900

72

$10,000

81.3%

94.6%

$7,691

0.99%

$80,000

$105,784

$853

73

$10,000

78.9%

93.6%

$7,389

1.06%

$90,000

$95,784

$802

74

$10,000

76.6%

92.5%

$7,093

1.14%

$100,000

$85,784

$747

75

$10,000

74.4%

91.4%

$6,801

1.22%

$110,000

$75,784

$690

…

…

…

…

…

…

…

…

…

95

$10,000

41.2%

30.2%

$1,245

4.49%

$310,000

$0

$0

96

$10,000

40.0%

25.7%

$1,029

4.22%

$320,000

$0

$0

97

$10,000

38.8%

21.5%

$835

3.99%

$330,000

$0

$0

98

$10,000

37.7%

17.5%

$660

3.53%

$340,000

$0

$0

99

$10,000

36.6%

14.0%

$512

3.18%

$350,000

$0

$0

100

$10,000

35.5%

10.8%

$384

2.68%

$360,000

$0

$0

101

$10,000

34.5%

8.1%

$280

2.19%

$370,000

$0

$0

102

$10,000

33.5%

5.9%

$199

1.79%

$380,000

$0

$0

103

$10,000

32.5%

4.1%

$135

1.33%

$390,000

$0

$0

104

$10,000

31.6%

2.8%

$89

2.81%

$400,000

$0

$0

Survival-Weighted Present Discounted Value of Income:

$172,915

Survival-Weighted Present Discounted Value of the Cash
Refund:

$12,869

Total Cost of Income Annuity:

$185,784

Annuity Payout Rate:

5.38%

Note: Survival Probabilities are calculated from the
Society of Actuaries 2012 Individual Annuitant Mortality Tables with
improvements through 2019.

The trade-off for the cash refund is that
while the owner could receive the highest income with a life-only income
annuity, he or she can alleviate fears about not living long enough to fully receive
back the premium amount through annuity payments by adding the provision which
will create an opportunity for the beneficiary to receive this difference in
the event of the annuitant’s early death. A life-only income annuity offers the
highest payout to provide compensation for accepting the risk of an early
death. The cash refund means one is contributing fewer mortality credits to the
risk pool and should therefore expect to receive fewer mortality credits back
in return. This happens through a lower payout rate.

Academics who study income annuities generally
suggest a life-only income to fully maximize the income-producing power, with
legacy goals covered through other means. But these sorts of period-certain or
refund provisions are quite popular in practice, as noted with the overview of
Cannex searches. Psychologically, for many it is too difficult to overcome the
perceived lack of fairness with a life-only income annuity in which one could die
shortly after paying the premium and then receive back little in return.

Pricing for an Income Annuity with
Cost-of-Living Increases

Another income annuity option we can price
is an annuity offering a cost-of-living adjustment (COLA). Using a COLA
requires a minor adjustment to what was shown in Exhibit 4.1. If the COLA is 2 percent,
then rather than having a fixed income of $10,000 each year, the annuity
instead provides an income which grows by 2 percent each year. If income starts
at $10,000 at age sixty-five, it becomes $12,190 at age seventy-five, $14,859
at age eighty-five, and so on. Naturally, having the ability to receive more
income over time will raise the overall cost of the income stream.

In this case, the cost for a 2 percent COLA
increases the life-only annuity price from $172,915 to $219,460. While we must
remember that income increases over time with this provision, the payout rate
for the initial income amount falls from 5.78 percent to 4.56 percent. With a
lower payout rate, but 2 percent annual payment growth, the income payment in
year thirteen would finally match the initial income payment for the level
version if the same premium amount was applied to each contract. It takes
twenty-four years before the cumulative payments received are the same with
each contract. The trade-off is whether to accept a lower initial income in
order to gain the ability to have income grow over time, or to just annuitize
less assets to receive the same initial income amount that does not otherwise
grow.

By backloading annuity payments, a COLA
provision actually increases the amount of mortality credits received. Payments
become larger at the time that survival probabilities are less. Nonetheless,
income annuities with COLAs are not at all popular in practice. The Cannex
survey showed that 95.7 percent of searches were for level payments with no
COLAs or CPI adjustments. I believe this is justified. Rather than building in
cost-of-living adjustments into the annuity at a higher premium, I do think it
makes sense to annuitize less today for the same initial income. Other
remaining assets can then be invested to provide a source of inflation
protection. Later in retirement, some may find that ongoing expenses are not
growing, and so they still have sufficient protected income. Meanwhile, for
those who find that inflation is chipping away at the purchasing power of their
income annuity, it is always possible to revisit the annuity decision and make another
purchase to increase reliable income. I will address this point in greater
detail in Chapter 8.

Pricing for Longevity Insurance

Another option is to treat the income annuity as longevity
insurance. This involves, for instance, paying for a deferred income annuity at
age sixty-five and not receiving payments until a much higher age, such as eighty
or eighty-five. With a life-only version of longevity insurance, this really leverages
the power of mortality credits, as the costlier nearer-term annuity payments that
are more likely to be made have been removed from the calculus.

In Exhibit 4.3, the income provided between ages sixty-five
and eight-four is $0. Annuity payments begin at age eighty-five. The long
period for annuitized assets to grow and earn interest combined with the lower
probabilities for surviving to these advanced ages results in the annuity cost
being dramatically lowered to $32,444. Compared to the immediate life-only
income annuity, the cost for guaranteed income has fallen by 81 percent. The
payout rate from this annuity is the income divided by the cost, which has
grown to 30.8 percent.

Longevity insurance is a unique tool for retirement income
considering the relatively small amount of assets required to support such
distant spending needs. This allows retirees to better plan for a fixed horizon
until income from the deferred annuity begins.

Exhibit 4.3

Calculating the Cost of a $10,000 Deferred Income
Stream for a Sixty-Five-Year-Old Female Beginning at Age Eighty-Five (Longevity
Insurance, Life Only)

Discount
Rate:

3.00%

Age

Income

Discount
Factor

Discounted
Value of Income

Survival
Probabilities

Survival-Weighted
Discounted Value

65

$0

100.0%

$0

100.0%

$0

66

$0

97.1%

$0

99.4%

$0

67

$0

94.3%

$0

98.7%

$0

…

…

…

…

…

…

83

$0

58.7%

$0

77.9%

$0

84

$0

57.0%

$0

75.3%

$0

85

$10,000

55.4%

$5,537

72.3%

$4,003

86

$10,000

53.8%

$5,375

69.1%

$3,714

87

$10,000

52.2%

$5,219

65.5%

$3,421

88

$10,000

50.7%

$5,067

61.7%

$3,125

89

$10,000

49.2%

$4,919

57.5%

$2,828

90

$10,000

47.8%

$4,776

53.2%

$2,540

…

…

…

…

…

…

100

$10,000

35.5%

$3,554

10.8%

$384

101

$10,000

34.5%

$3,450

8.1%

$280

102

$10,000

33.5%

$3,350

5.9%

$199

103

$10,000

32.5%

$3,252

4.1%

$135

104

$10,000

31.6%

$3,158

2.8%

$89

Cost of
Annuity (Sum of Survival-Weighted Discounted Values):

$32,444

Annuity
Payout Rate:

30.82%

Note: Survival Probabilities are calculated from the
Society of Actuaries 2012 Individual Annuitant Mortality Tables with
improvements through 2019.

In practice, deferred income annuities are more
commonly used to prepay for retirement income, not as longevity insurance. For
instance, a fifty-five-year-old might purchase a deferred income annuity which
will begin income at sixty-five. We have already determined that the cost of a
life-only income annuity at sixty-five is $172,915. If a fifty-five-year-old
female wanted to provide lifetime income starting at sixty-five, we could
further discount the price in two ways—by the ability to earn interest for ten
years before income starts and by the probability that the fifty-five-year-old
will live to sixty-five.

The discount factor for ten years of
investment growth at 3 percent is 74.4 percent. The same mortality data also
reveals a 96.6 percent chance that the fifty-five-year-old lives to sixty-five.
Multiplying these two factors by $172,915 gives us a premium of $124,274 for a
deferred income annuity purchased at fifty-five. This represents an 8.05
percent payout rate.

Pricing for an 85-Year-Old Female

We looked at longevity insurance as it applies to a sixty-five-year-old female purchasing a deferred income
annuity with income starting at eighty-five. We may
also consider the alternative of just waiting until age eighty-five
and then buying an immediate annuity. During those twenty years, interest rates
and mortality tables can change in unexpected ways, which will impact the
future pricing calculations.

Exhibit 4.4 shows the calculated cost for this income
annuity if we assume that interest rates and mortality data remain the same (an
unlikely outcome, of course). An eighty-five-year-old
will experience higher mortality rates and a shorter time horizon, reducing the
cost of an income annuity at this age. In this case, the premium is $81,054,
which raises the payout rate to 12.34 percent.

This payout rate is noticeably higher than that available at
age sixty-five, but it is lower than that available
with the longevity insurance contract. Longevity insurance contains two key
differences: twenty years of asset growth within the contract and the survival-based
discount a sixty-five-year-old receives, thanks to her
lessened chance of living to eighty-five to receive
income.

Waiting until eighty-five to make
the purchase means sharing fewer mortality credits with the risk pool. If we
discount this $81,054 premium by the 72.3 percent survival probability from age
sixty-five and by twenty years of investment growth at 3
percent (a 55.4 percent discount factor), we arrive at the $32,444 premium (after
rounding) for the longevity insurance contract.

Exhibit 4.4

Calculating the Cost of a $10,000 Income Stream for an
85-Year-Old Female (Life-Only)

Age

Income

Discount
Factor

Discounted
Value of Income

Survival
Probabilities

Survival-Weighted
Discounted Value

85

$10,000

1.000

$10,000

100.00%

$10,000

86

$10,000

0.971

$9,709

95.56%

$9,278

87

$10,000

0.943

$9,426

90.66%

$8,546

88

$10,000

0.915

$9,151

85.31%

$7,807

89

$10,000

0.888

$8,885

79.53%

$7,066

90

$10,000

0.863

$8,626

73.56%

$6,345

91

$10,000

0.837

$8,375

67.30%

$5,636

92

$10,000

0.813

$8,131

61.02%

$4,961

93

$10,000

0.789

$7,894

54.57%

$4,308

94

$10,000

0.766

$7,664

48.23%

$3,697

95

$10,000

0.744

$7,441

41.80%

$3,110

96

$10,000

0.722

$7,224

35.59%

$2,571

97

$10,000

0.701

$7,014

29.75%

$2,087

98

$10,000

0.681

$6,810

24.23%

$1,650

99

$10,000

0.661

$6,611

19.34%

$1,279

100

$10,000

0.642

$6,419

14.95%

$959

101

$10,000

0.623

$6,232

11.24%

$700

102

$10,000

0.605

$6,050

8.20%

$496

103

$10,000

0.587

$5,874

5.73%

$336

104

$10,000

0.570

$5,703

3.89%

$222

Cost of
Annuity (Sum of Survival-Weighted Discounted Values):

$81,054

Annuity
Payout Rate:

12.34%

Note: Survival Probabilities are calculated from the
Society of Actuaries 2012 Individual Annuitant Mortality Tables with
improvements through 2019.

Payout Rates and Rates
of Return for Income Annuities

The pricing of an income annuity is typically described
using either the monthly income amount it generates, or as the annual payout
rate of the income received as a percentage of the premium amount. For instance,
using the example in Exhibit 4.1, an income annuity might offer $481.67 per
month for a $100,000 premium. For twelve months, that sums to $5,780, which is 5.78
percent of the initial premium amount. The annuity payout rate is 5.78 percent.
I generally describe annuity pricing using this annual payout rate, as the
payout rate is directly comparable to a sustainable withdrawal rate from
initial retirement date assets for an investment portfolio. Both rates incorporate
the idea that principal is spent in addition to any investment returns.

It is important to recognize that the payout rate is not a return
on the annuity, which may create some confusion. It is wrong to compare the
payout rate to an interest rate that involves the subsequent return of
principal. For instance, if you can earn 1 percent by holding a CD and 5.78
percent from an income annuity, the income annuity is not almost six times more
powerful than the CD.

The problem is that the 1 percent number for the CD only
represents its interest payments. The principal value is returned at maturity.
Meanwhile, a 5.78 percent payout from an annuity includes interest and
principal payments (as well as mortality credits—the true source of additional
returns beyond that provided by a fixed-income alternative). Principal is being
spent as well, and so the comparison to the CD rate is neither fair nor
meaningful. The annuity does have a return, but it is less straightforward to
calculate.

The Insurance Company’s General Account

As we discuss the returns from an income annuity, now is a
good time to address the underlying investment returns that the insurance
company earns by investing the premiums it receives for income annuities.
Premiums can be invested until it is time to make the annuity payments. The
returns that the insurance company expects to earn do feed into the payout
rate offered, with a higher return helping to support a higher payout rate.

When an insurance company receives a customer’s premium
for purchasing an income annuity, it invests those funds in its general
account. General account investments are designed with asset-liability
matching in mind. Actuaries have a sense of the insurance company’s payment
obligations to support annuity payments, life insurance death benefits, and
other insurance claims, and their investments are chosen to support these
anticipated cash outflows. The general account is highly
regulated with respect to the amount of assets to be maintained relative to
liabilities and to asset allocation. Assets must be sufficient to fund policy
claims after accounting for future premiums and investment returns. General
account investments typically include corporate and government bonds,
mortgages, loans, a small allocation to equities, and potentially other types
of alternative investments.

If we think strictly about returns for the
general account and the comparable returns on fixed-income assets that a
household could generate on its own, the general account may be able to
achieve higher returns than the household.

Regarding the underlying portfolio of
assets, the general account of the insurance company is better positioned
than the household to manage the risks involved in earning higher fixed-income
returns by accepting greater duration, illiquidity, and credit risk. The
general account can maintain a longer-term investment focus with assets held
to maturity, and with less liquidity required, that can offer higher yields
than households could otherwise muster within their own fixed-income
portfolios. Because insurance companies generally hold the fixed-income
assets to maturity, rising rates will not trigger realized capital losses,
but will instead allow new premiums to be invested at a higher rate. As well,
insurance companies obtain lower institutional pricing on their trades and
can better diversify their holdings among corporate bonds offering higher
yields and greater credit risk.

The general account has greater return
potential through its ability to invest in longer-term and less liquid
assets, and to diversify the credit risk of higher-yielding corporate bonds.
Households have less capacity to diversify and manage these risks. Asset
values for households are too small, their timeframes are too short, and their
liquidity needs are too high to compete with the return potential of the
general account. This provides an additional benefit from the income annuity
in that its payout is based on a higher assumed investment return than the
household could reasonably assume while maintaining the same level of risk
for the underlying asset base.

To know the annuity return, it is necessary to know
how long the annuitant will live and how many annuity payments will be
generated. Or, at least, returns can only be calculated by assuming how long
income payments will be received. A longer life means more payments from the
annuity, which helps to increase the return it provides. And if the underlying
investments in the general account provide a higher return, that feeds into a
higher annuity payout rate, which helps to boost the annuity’s return more
quickly as well. For life-only annuities, returns will be very low early on as
relatively little income has been received relative to the premium amount. With
enough time, the return can eventually exceed the payout rate.

Annuity returns are determined by the internal rate of
return (IRR) on their cash flows. The IRR is a mathematical calculation which
looks at the inflows and outflows of money over time and calculates the
investment return that would be needed to precisely allow the inflows of funds
to grow sufficiently so they can support the subsequent outflows of funds.

For example, suppose one deposits $1,000 into a bank today.
In each subsequent year on the anniversary of this bank deposit, the owner withdraws
$150 from the bank account. This continues annually until the ninth withdrawal,
at which point the bank account balance falls to zero. In total, the owner received
$1,350, but these cash flows were received at different points of time. What
interest rate must the owner earn on the remaining savings in the bank account
to make this stream of nine $150 withdrawals work out as planned? Answering
this involves an internal rate of return calculation, and it is the same
process we will use to calculate the return on an annuity. Exhibit 4.5 shows
how to set up this calculation in Excel. The answer is 6.46 percent. If the
bank account provides this annual compounded return on remaining funds, the
$1,000 will have sufficient growth to provide the nine $150 payments.

Exhibit 4.5

An Internal Rate of Return Calculation Example

Time Period

Cash Flow

0

-$1,000

1

$150

2

$150

3

$150

4

$150

5

$150

6

$150

7

$150

8

$150

9

$150

Internal Rate of Return:

6.46%

Perhaps the internal rate of return can be understood more
clearly by working in the reverse direction. Suppose I deposit $1,000 in the
bank, and it earns an annual interest rate of 6.46 percent. On each anniversary
of my deposit, I withdraw $150 from the account. The account balance grows with
interest but shrinks with withdrawals. When I take out the $150 withdrawal in
year nine, the account balance falls to zero, as expected. Exhibit 4.6
illustrates why the internal rate of return is 6.46 percent.

Exhibit 4.6

An Internal Rate of Return Calculation Example (in
Reverse)

Investment Return:

6.46%

Time Period

Cash Flow

Account Balance

0

$1,000

$1,065

1

-$150

$974

2

-$150

$877

3

-$150

$774

4

-$150

$664

5

-$150

$547

6

-$150

$423

7

-$150

$291

8

-$150

$150

9

-$150

$0

To understand the distinction between the payout rate and
the return on an annuity, we can consider the simple annuity example from
Exhibit 4.1 for a sixty-five-year-old female. She purchases a life-only income
annuity with a 5.78 percent payout rate. For a premium of $100, a payment of
$5.78 is received immediately, and on each anniversary date of the contract an
additional payment of $5.78 is received for as long as the annuitant lives.

The returns by age are shown in Exhibit 4.7. Returns start
out negative, as cumulative payments fall short of the premium paid. The return
crosses from negative to positive with the payment received seventeen years
later at age eighty-two. This is seen in Exhibit 4.7. The point at which the
return becomes positive is intuitive because with payments starting at sixty-five,
the age eighty-two payment is the 17th received, which pushes the total amount
of income received to $104.04 (17 x 5.78). This surpasses the initial $100
premium. We have entered the range of positive returns.

With the age eighty-eight payment, the return exceeds 3 percent,
which was the assumed return on the underlying assets. Age ninety represents
the median life expectancy for a sixty-five-year-old female, and with this
payment the return increases to 3.6 percent. Thus, the contract owner has a
greater than 50 percent chance that the return on the annuity will exceed the 3
percent return on fixed-income assets because the owner is also receiving
mortality credits which are amortized over the life of the annuitant. If the
annuitant lives to ninety-five, the return grows to 4.49 percent, and it
continues to rise. Eventually, the return will grow to exceed the initial
payout rate. This happens sooner when interest rates are higher.

With our 3 percent interest rate, the return does not exceed
the payout rate until sometime after age 110, so in this case it is not
realistic to discuss the payout rate in the same terms as a rate of return from
the annuity. Nonetheless, the most interesting aspect of this analysis is that
even before life expectancy, the return from an income annuity exceeds the
return from holding a portfolio of bonds without any mortality credits.

Exhibit 4.7

Mechanics of a Single-Premium Immediate Annuity
Payout Rate and Internal Rate of Return by Age of Death for Purchase by a
Female at Age 65

Exhibit 4.8 provides returns over time for different flavors
of the income annuity example we have used to help illustrate the trade-offs in
terms of mortality credits offered and received. The three annuity flavors are
the life-only version with a 5.78 percent payout rate, the life with ten-year
period certain with a 5.69 percent payout rate, and the life with cash refund
version with a 5.38 percent payout rate.

Compared to the life-only income annuity, the two other
flavors increase the returns in the event of a short life with the trade-off
that the returns are reduced in the event of a long life. For life with
ten-year period certain, payments will be provided for at least ten years, even
if the annuitant dies before that time. This leads the return for the first ten
years to match the return at ten years. Those payments were not life
contingent. Then, subsequently, returns grow with the length of life, but since
the payout rate is less, the returns over time are also slightly less as well.

As for the income annuity with a cash refund, the return
will be zero until the full premium has been repaid because the cash refund
covers the difference at earlier ages. The return is zero because cash inflows
match cash outflows. Then, after age eighty-two, returns become positive
because cumulative payments exceed the premium. The returns continue to grow
with age of death, but they always lag the returns for the other two flavors
because the payout rate is less. By receiving the protections for a shorter
retirement, the annuity owner has offered less mortality credits to the risk
pool and therefore receives less mortality credits back from the risk pool in
the event of a long life.

Exhibit 4.8

Mechanics of a Single-Premium Immediate Annuity
Payout Rate and Internal Rate of Return by Age of Death for Purchase by a
Female at Age Sixty-Five

Money’s Worth Measures
for Income Annuities

Annuities have a reputation for being a
high-fee financial product. Is this reputation deserved? We address this for
different types of annuities throughout the book, starting with income
annuities. It is a bit complicated to answer this for income annuities because they
do not have visible fees. There are no additional fees extracted from
the quoted payout rate, as the payout rate is a net number after fees have been
deducted internally. Simply, with the internal fees, the quoted
payout rate is lower than it could have otherwise been.

Fortunately, we can reverse engineer the fair
price for an income annuity without fees and then compare it with real-world
annuity payout rates in order to obtain a money’s worth measure for the income
annuity. We have already seen how to calculate annuity prices. The additional
complication relates to making reasonable assumptions for interest rates and
mortality rates.

It can be difficult for consumers to get a
handle on the sorts of fees and costs that are paid as part of purchasing an
income annuity. Some states may place a small tax (ranging from 0.5 percent to 3
percent) on annuity premiums taken from outside retirement plans, but annuity
costs are otherwise incorporated into the quoted prices and not explicitly
charged from the premium.

Costs are not transparent. For example, a
$100,000 premium may be quoted as supporting $600 per month for life. Without
any built-in fees, perhaps the fair monthly income could have been $610 or
$620. At the same time, perhaps the household could not invest for as much
yield as the insurance company or might have an unusually long expected
lifespan, such that a more personalized fair monthly income is only $580 or
$590. In this case, the annuity provides a great deal. These matters are not
transparent unless we are able to calculate the actuarially fair price for an
annuity and then compare it to the actual price.

Fortunately, this reverse engineering process lets
one estimate the costs built into an income annuity. If an income annuity
provides $600 per month, but we simulate that a fair price is to provide $610
per month, then the money’s worth of the annuity is $600 / $610 = 0.9836. In
this case, the commercial annuity pays 1.64 percent less than the fair price.
We could interpret this 1.64 percent as an upfront transaction cost or onetime fee
for purchasing the annuity.

In some cases, we may calculate fair annuity
payouts as lower than what commercial companies provide, which would lead the
money’s worth measure to be larger than one, indicating a particularly good
deal for the purchaser. These good deals may exist because income annuities
tend to be a small part of the insurance company’s overall business, and
actuaries may be slow in updating their pricing in response to fluctuating
interest rates and longevity estimates. It is also possible that the insurance
company anticipates earning a higher yield from the general account
investments, which could also justify better payout to customers than they
could otherwise achieve with their own investments. Alternatively, an
individual may enjoy better overall longevity prospects than the average member
of the annuity risk pool.

For a more practical real-world example of
this, in January 2019, the actual payout rate on a life-only immediate annuity
for a sixty-five-year-old female as described in Exhibit 4.1 is 6.52 percent,
according to ImmediateAnnuities.com. The payout rate we calculated is 5.78
percent. If our interest rate and mortality assumptions properly reflected the
prospects facing the insurance company when making their pricing decision, then
this income annuity appears to be a great deal. The actual payout rate of 6.52
percent divided by our estimated payout rate of 5.78 percent is 1.128. We
actually get 12.8 percent more income from the commercial annuity than we
expected to be able to receive as based on our assumptions. To calibrate the
actual payout rate with our mortality data, a flat yield curve of 4.15 percent
is needed, instead of the 3 percent used in that exhibit.

Separate from the objective money’s worth
measure, it is important to also consider the subjective value being received
by the annuity owner. For those with longevity risk aversion, the prospects of
spending from investments may be such that an income annuity could still support
more spending than the retiree otherwise would be comfortable taking from
investments. Just because money’s worth measures are less than one does not
necessarily mean that income annuities are a bad deal.

If retirees value the certainty provided by
guaranteed lifetime income, they may value income annuities at more than their
fair price. The income annuity provides risk pooling and mortality credits that
an individual cannot create on their own. Conservative retirees who are worried
about outliving their money and timid about investing aggressively in the stock
market could easily decide that they are willing to pay more than the estimated
costs derived from these money’s worth measures. Because of the certainty of
income provided, I might still derive benefit even if the money’s worth measure
was only 0.7, for instance. If so, then an actual money’s worth measure of
0.85, for instance, would be still be attractive.

The general account of the insurance company
also has the potential to invest for higher rates while still maintaining a
high degree of safety in ways that may not be accessible to the household. We
must consider three issues: how much does the retiree value mortality credits,
could the retiree earn a 4.15 percent return from their own investments with
the same risk level as the annuity, and how does the retiree’s personal views
about longevity compare with that of the overall risk pool?

Purchasing income annuities can be a win-win
situation both for the consumer and the insurance company, as the benefits
created through risk pooling are shared between both parties in the
transaction. This is the same idea as how one may derive value from owning a
mutual fund even after paying the expense ratio because it would not be
possible to create such diversification with limited household assets.

More generally, what I have just described is
true for any consumer good or service. If a producer can provide the good or
service for more cheaply than I could achieve when trying to create it on my
own, while still being able to generate a profit through their specialization
and economies of scale that I do not have access to, but for a lower price than
I value it, then I could derive a net benefit. The transaction is mutually
beneficial for both parties. It is important not to forget this fundamental
axiom of capitalism applies for insurance as well.

The previous sections explained how to
calculate the price for an income annuity. To do a proper money’s worth
calculation, though, we must be more detailed and specific about the
appropriate assumptions to make regarding interest rates and mortality data.
What longevity data is most relevant to the annuity owner? How could the owner
have invested the premium while maintaining a similar level of market risk if
left to his or her own devices? The answers are not clear cut.

Insurance Company Expenses

The annuity provider cannot be expected
to offer an income annuity for the actuarially fair price and hope to remain in
business. This does not mean that individuals with lesser investment prospects
or greater longevity prospects could not find that their personalized money’s
worth from an income annuity is greater than one. But it does mean that an
annuitant with an identical longevity profile as the typical customer and who
could invest their assets in an identical way as the insurance company must
expect a money’s worth measure of less than one. Having the provider stay in
business is a natural desire for the purchaser who wants to receive those
payments for life. The provider will need to charge more than the fair price to
cover business expenses.

Insurance companies face typical business expenses to pay
employees and to create a workplace just like any company. As well, insurance
companies generally pay a onetime commission of around 2 or 3 percent
to the insurance agent on record as having sold the annuity, and this must be
covered from premiums. While fee-only financial advisors cannot accept
commissions, they could direct a client to purchase an income annuity from a
third-party insurance company using the annuity platform from a major online
brokerage firm. That brokerage firm might receive a 1 percent commission, and
the company supporting the platform might receive a 1 percent commission, for
instance.

Additional financial buffers are also needed to protect from
the possibility that the insurer has misestimated their risks, as annuity
pricing requires long-term projections for interest rates and mortality rates.
If interest rates end up lower than expected—or if health improvements
accelerate faster and customers live even longer than projected—the actual
costs to the insurance companies of providing the guaranteed income will be higher
than the estimated costs used to calculate premiums.

Unexpected longevity improvements can be partially offset
for an annuity provider who also sells life insurance—systematic increases in
longevity mean more claims on annuities but fewer claims on life insurance—but
these risks cannot be completely neutralized. As a part of their risk
management, the provider needs additional reserves that raise the overhead
charge on the annuity and reduce the money’s worth measure.

Interest Rate Assumptions

A key question we must consider for
determining the money’s worth from an income annuity for an individual is to
decide whether that individual could invest in the same portfolio and earn the
same returns as the insurance company can obtain for its general account. The
insurance company may be able to obtain higher investment yields because of its
ability to diversify among higher-yielding bonds with greater credit risk, to
use asset-liability matching to hold less liquid and longer-term bonds, and to
receive institutional pricing on their purchases and to avoid the pricing
mark-ups faced by retail investors.

We might consider pricing annuities with
Treasury bond yields or corporate bond yields. Corporate bond yields tend to be
higher, and higher bond yields will support a higher annuity payout rate. For
this reason, simulating annuity prices with corporate bond yields will result
in a lower money’s worth measure than otherwise. But could an individual create
the same type of diversified ladder of corporate bonds at the same cost as the
insurance company?

An assumption that could better approximate
reality is that insurance companies could earn corporate bond yields on their
general account, while households should assume Treasury bond yields for what
their fixed-income assets could generate, at least net-of-fees. This assumption
will improve money’s worth measures and could even lead them to exceed one
(i.e. annuity purchasers should not really be worried about fees from the
annuity). This outcome is being driven by the differing investment prospects of
households and insurance companies when it comes to potential fixed-income
returns. For households who truly believe that they could earn higher
fixed-income returns on their own, this would reduce the money’s worth measures
for income annuities.

As well, Jeffrey Brown, Olivia Mitchell, James
Poterba, and Mark Warshawsky wrote in their 2000 book The Role of Annuity
Markets in Financing Retirement, that it is easier for annuity providers to
support better pricing relative to other fixed-income assets when interest
rates are low and steady. This allows the provider to get a better sense about
what future interest rates will be, and if rates tend to rise from their low
point then the future pooled assets of the insurance fund will benefit.

In contrast, if interest rates are high and
variable, insurance companies may worry about a future rate decrease making it
more expensive to fund future payments. They may decide to hold more reserves
to help protect assets from this risk. This would mean less competitive pricing
for the annuity. Because insurance companies tend to hold the fixed-income
assets in their portfolios to maturity, they are less exposed to interest rate
risk (needing to lock in capital losses by selling bonds at a loss after
interest rates rise) and more exposed to reinvestment risk (it becomes more
expensive to buy bonds in the future to cover liabilities if interest rates
decrease). Shortly, we will investigate historical and current money’s worth
measures for annuities, and this may serve as one of the explanations for why
money’s worth measures are improved at the present.

If the insurance company has better investment
prospects than the typical household investor, this can be a way to offset some
of the fees of the annuity and to increase their money’s worth measures.

Mortality Assumptions

Annuity owners tend to live longer than the average person.
In large part, this can be explained by adverse selection, which is the idea
that those who purchase annuities tend to have a sense that they may have above
average longevity prospects. Those with terminal illnesses will probably not be
in the market to buy income annuities.

Annuity customers are more likely to live longer and,
therefore, increase the costs to the insurer for providing the lifetime
guaranteed payments. Income annuities are not generally medically underwritten,
unlike with life insurance, and purchasers will have a better sense about their
own longevity than the insurance company. The insurance company must base its
pricing on the average mortality of the risk pool, which is its collection of
customers. Lower mortality rates lead to increased longevity, which leads to an
increased cost for the insurer to guarantee lifetime income.

It is important to be realistic about
longevity when determining whether an income annuity is priced fairly. Someone who
can reasonably expect to live longer than average should not try to calculate a
fair price using population-average mortality. If annuity prices are simulated
with mortality rates for the general population, that will cause the money’s
worth measures to be lower and annuities to look more expensive. This leads to
an inappropriate conclusion that the annuity is overpriced.

My readers will tend to display
characteristics that are associated with increased longevity, such as higher
education levels, more income, greater wealth, and a stronger health focus.
When this is the case, money’s worth estimates based on mortality tables
reflecting the longer lifespans of annuitants are more reasonable to use. The
Society of Actuaries data described in Chapter 1 is a reasonable starting
point. One cannot expect a payout rate as calculated with the longevity of the
average person because the average person does not buy an annuity and is not
part of the risk pool.

Longevity Risk Aversion and the Power of
Mortality Credits

Finally, there is a subtle psychological point
to consider regarding longevity estimates. The previous section sought insight
into an individual’s objective longevity estimates. In their March/April
2011 Financial Analysts Journal article titled “Spending Retirement on
Planet Vulcan: The Impact of Longevity Risk Aversion on Optimal Withdrawal
Rates,” Moshe Milevsky and Huaxiong Huang describe longevity risk aversion as
the fear people have about outliving their assets in retirement. This fear is
manifested by having individuals behave as though they will live much longer
than objective mortality data would suggest. They build financial plans that
will last to advanced ages well beyond their life expectancy.

With an investments-only strategy, this longevity risk
aversion is manifested through a lower spending rate from investment assets.
Because income annuities pool longevity risk, they can help to reduce the worry
individuals have about outliving their assets. The income annuity payout is
based on objective mortality statistics rather than subjective fears. Annuity
payouts stay the same, even for individuals who subjectively worry about a much
longer life and who would otherwise spend less from investments.

The case for an income annuity becomes stronger for
individuals more worried about longevity. Their retirement spending can be
linked to more objective measures of mortality, rather than the lower mortality
rates introduced through the psychological fears related to longevity risk aversion.
This concept is harder to work into calculations of money’s worth measures,
except to note that even when money’s worth measures are less than one, it does
not necessarily mean that an individual is not receiving value from the ability
to pool and manage longevity risk.

One way to see this concept applied in practice regards
building a financial plan in financial planning software. Someone with
longevity risk aversion may choose to build a financial plan through age 100,
despite the low probability of living to this advanced age. Adding an income
annuity to the financial plan can show improved outcomes in part because the
annuity could be worth more than it costs within the financial plan.

The annuity provider calculates the price of the annuity based
on objective mortality characteristics that would account for the rarity of
living to age 100. But the financial plan assumes that annuity income will be
received through age 100, leading the present value of the annuity payments in
the financial plan to be greater than the actual purchase price of the annuity.
This shows the subtle way in which annuities can create greater value for those
who are worried about outliving their assets and therefore plan to live longer
than average.

Historical Estimates of Money’s Worth Measures

This discussion has provided the backdrop for
considering actual money’s worth measures. First, we look at past academic
estimates, and then I update estimates for the present. Researchers Jeffrey
Brown, Olivia Mitchell, James Poterba, and Mark Warshawsky provided an
investigation of money’s worth calculations in a 1999 article that was
subsequently republished in their book, The Role of Annuity Markets in
Financing Retirement. This article created the concept of money’s worth
measures as a tool for understanding the implicit costs for an income annuity.

To give one example from their analysis of
1995 data, they found that for a sixty-five-year-old couple with a joint and 100
percent survivor’s life-only annuity, the money’s worth measures were as
follows based on the assumptions used:

·
With population-wide mortality table and the Treasury yield
curve: 0.868

·
With population-wide mortality table and the Corporate yield
curve: 0.792

·
With the annuitant mortality table and the Treasury yield curve:
0.929

·
With the annuitant mortality table and the Corporate yield curve:
0.841

As should be expected from our previous
discussion, the annuity is priced most attractively when using the annuitant
mortality table and assuming that the underlying funds are invested in Treasury
bonds. As noted, while this scenario does make the income annuity look the
best, it is worth considering that this may be the most appropriate and fairest
set of assumptions for readers to use when deciding on the value of the income
annuity.

In this case, the 0.929 value means that the
pricing on the commercial annuity provides 92.9 percent of the income that could
be expected from a fair priced annuity. By using the annuitant mortality table,
the impact of adverse selection has been removed from the calculations, so that
the 7.1 percent difference represents the cost or fee for the annuity that
covers company expenses, the build-up of additional reserves for risk
management, and company profit. As we have noted, the insurance company is likely
generating a better outcome than this estimate because of its ability to invest
in higher yielding assets than Treasury bonds, but we assume that the household
does not have access to such opportunities after accounting for fees and the
level of risk.

Next, when using the Treasury yield curve with
population-wide mortality, the money’s worth ratio is 0.868. The further difference
of 0.061 (or 6.1 percent) can be attributed to the impact of adverse selection
in the annuity purchasing population: annuity purchasers do tend to live longer
than the average person and pricing must reflect this. While this number would
be more appropriate for the typical person with average longevity prospects,
the typical person reading this book will experience better longevity prospects
than average. This calculation is less relevant for my readers.

As well, when switching to higher yielding
corporate bonds relative to Treasury bonds, the money’s worth measures decline
because the higher yielding corporates would support more income on an
actuarially fair basis. With the annuitant mortality table and the corporate
yield curve, the money’s worth measure is 0.841, implying an internal charge of
15.9 percent. While this number better reflects what the insurance company is
expected to obtain from the sale, this does not account for the additional
difficulty and credit risk that would be assumed by an individual trying to
purchase the same corporate bond ladder to fund retirement income.

The final number in the table, for the
population-wide mortality table and the corporate yield curve, is 0.792. This
is the lowest money’s worth measure, implying an internal charge of 20.8
percent. But it is not particularly relevant for my readers. It would be the
prospects facing an average American who could obtain the higher net-returns from
corporate bonds during retirement.

Current Estimates of Money’s Worth Measures

We now update money’s worth measures to January
2019. Exhibits 4.9 and 4.10 show money’s worth measures for life-only immediate
annuities and longevity insurance. For the real-world commercial income
annuities, payout rates were obtained from www.ImmediateAnnuities.com on
January 10, 2019. The premium amount is $100,000. Purchases are assumed to be
made in Georgia, which is a state that does not tax annuity premiums. Joint
annuities assume full continuation of benefits for the survivor. Prices reflect
the best available offer on that date from among insurance companies with at
least an A credit rating.

For the simulated annuity prices, mortality
data is based on cohort life tables from the Social Security Administration.
These cohort life tables are provided for birth years in intervals of ten
years, and the assumed birth year at each age is rounded accordingly to use the
closest available life table.

Unlike the more common Social Security period
tables, these cohort tables reflect assumed mortality improvements over time.
But they are for the general population rather than the subset of annuity
purchasers. Though annuity purchasers mostly enjoy greater longevity, use of
the annuitant mortality tables leads to money’s worth measures much greater
than one, suggesting that annuity companies are either not expecting Society of
Actuaries data to apply, or they have not otherwise updated their mortality
data to reflect these longevity improvements. Interest rate assumptions are
based on the yield curve for Treasury strips as of the start of 2019. For
payments beyond thirty years, the thirty-year yield is projected to apply at
subsequent maturities.

Exhibit 4.9 provides results for life-only immediate
annuities purchased at different ages for couples (joint), males, and females. Payout
rates are first shown for commercial annuities offered through
ImmediateAnnuities.com. Next, I provide simulated annuity payout rates for the
mortality and interest rate assumptions described. These simulations provide my
effort to calculate an actuarially fair price for the annuity. Finally, money’s
worth measures are shown. They represent the ratio of the payout rate on the
commercial annuity divided by the payout rate on the simulated annuity. If the
ratio is larger than one, we can conclude that the commercial annuity provides
a good deal relative to the actuarially fair pricing (which should not happen
on a regular basis). A ratio smaller than one allows us to observe an estimate
for the implicit costs built into the prices of commercial annuities, noting
our philosophical points regarding how to make a fair comparison. The
difference reflects both the impacts of adverse selection and the costs of
business and risk management for the annuity provider.

Exhibit 4.9

Estimated Money’s Worth for Life-Only Immediate
Annuities in January 2019

Age in January 2019

55

60

65

70

75

80

85

Payout Rate,

Commercial Annuity

Joint

5.09%

5.38%

5.80%

6.38%

7.31%

8.86%

11.14%

Male

5.65%

6.16%

6.83%

7.80%

9.29%

11.60%

15.53%

Female

5.50%

5.93%

6.52%

7.37%

8.69%

10.60%

13.93%

Payout Rate,

Simulated Annuity

Joint

4.17%

4.52%

4.98%

5.62%

6.57%

8.02%

10.26%

Male

4.74%

5.24%

5.92%

6.89%

8.35%

10.61%

14.16%

Female

4.57%

5.04%

5.65%

6.50%

7.76%

9.72%

12.77%

Money's Worth

Joint

1.2200

1.1896

1.1641

1.1353

1.1123

1.1044

1.0855

Male

1.1926

1.1740

1.1533

1.1322

1.1120

1.0936

1.0967

Female

1.2020

1.1769

1.1541

1.1342

1.1201

1.0898

1.0913

Notes: Payout
rates for commercially available income annuities were accessed at www.ImmediateAnnuities.com
on January 10, 2019. See text for simulated annuity assumptions.

For life-only immediate annuities, we can
observe several trends. First, money’s worth measures decrease with age and
tend to be the highest for couples, followed by females, and then males.

These observations reflect the idea that
money’s worth measures are larger when average remaining longevity is higher. Income
guarantees are riskier for insurance companies at advanced ages because
longevity risk increases. While remaining longevity is shortened with age, the
range of potential lifespans around the average widens on a relative basis with
age. One year of additional life has a much bigger impact when the insurance
company expects a person to live five more years as compared to twenty more
years. Insurance companies must set aside more reserves to cope with this risk,
which reduces the money’s worth measures.

As well, these money’s worth measures are
larger than one. This requires comment, as we must deal with the philosophical
issues and potential disagreements around the appropriate assumptions to be
used for the purpose of calculating actuarially fair pricing for income
annuities. We cannot expect money’s worth measures to remain greater than one
in equilibrium as that would cause insurance companies to consistently lose
money. Consumers should not expect to receive the entire value of risk pooling,
just as they do not receive the entire value from their investments after
accounting for fees. But at the present pricing appears reasonable from the
consumer’s perspective if we suppose that the investment alternative for the
consumer is treasuries.

Next, Exhibit 4.10 provides corresponding
results for longevity insurance, in which a sixty-five-year-old purchases a
life-only income annuity that will begin paying income at a later age ranging
from sixty-five (for comparison) to eighty-five. These money’s worth measures
are also greater than one and peak at age seventy-five.

Exhibit 4.10

Estimated Money’s Worth for Longevity Insurance (Life
Only) in January 2019

Longevity
Insurance for 65 Year-Old, Age that Income Begins

65

70

75

80

85

Payout Rate,

Commercial Annuity

Joint

5.80%

7.87%

11.53%

16.81%

not avail.

Male

6.83%

9.95%

15.95%

25.38%

44.90%

Female

6.52%

9.00%

13.79%

21.28%

36.47%

Payout Rate,

Simulated Annuity

Joint

4.98%

6.53%

8.99%

13.24%

21.85%

Male

5.92%

8.20%

12.09%

19.42%

35.93%

Female

5.65%

7.69%

11.09%

17.24%

30.39%

Money's Worth

Joint

1.1641

1.2050

1.2825

1.2698

not avail.

Male

1.1533

1.2129

1.3194

1.3068

1.2497

Female

1.1541

1.1696

1.2438

1.2340

1.2000

Notes: See notes
provided with Exhibit 4.9.

The assumptions I used to reflect money’s
worth were based on what consumers might be expected to manage when investing
on their own when not taking advantage of the more diversified and
higher-yielding asset base held by the insurance company. To the extent that
insurance companies can earn more than Treasury bonds on the invested premiums,
this would effectively lower the money’s worth measures from their perspective,
helping to ensure their sustainability. But because consumers cannot invest
that way on their own, such matters are not relevant when trying to investigate
money’s worth from the consumers perspective and to decide whether income
annuities provide a good deal.

Social Security as an Annuity

With this discussion of income annuities, it is worthwhile
to provide a reminder that Social Security is also an income annuity. Social Security
retirement benefits are provided for life. As a government-backed,
inflation-adjusted monthly income for life, Social Security benefits help to
manage longevity risk, inflation risk, and market risk. Social Security also
provides survivor benefits. Social Security is generally one of the largest
assets on the retirement balance sheet. For a high-earning couple, the
present value of lifetime Social Security benefits could exceed $1 million.

Retirement benefits can begin as early as age sixty-two,
but the benefits grow with delay credits through age seventy for those
willing to wait. If one views the lost benefits from ages sixty-two to
sixty-nine as a premium to buy a larger annuity income starting at seventy,
delaying Social Security can be viewed as the best annuity money can buy. By
delaying Social Security for those eight years, the lifetime subsequent Social
Security benefit will be 76 percent larger, implying a payout rate higher
than private insurance companies are able to provide.

Delaying Social Security should be the
first step for anyone considering income annuities as part of their
retirement income plan. Starting Social Security early and buying an
income annuity is inefficient. The first step to including annuities
in a retirement income plan is to delay Social Security benefits, at least
for the high earner in a couple. Then a decision can be made about whether
even more protected income is desirable for the financial plan.

The Annuity Puzzle:
Other Issues Impacting the Annuity Decision

This discussion has been fairly positive with regard to the
role of income annuities as a retirement income tool. My explanations follow
standard academic theory regarding income annuities and their role in pooling
longevity risk and providing mortality credits. Without this risk pooling,
retirees must be needlessly conservative in their spending to ensure they still
have something left if they live well beyond their life expectancy.

For this reason, economists have long wondered why people do
not make greater use of income annuities as retirement income tools. Often
cited in connection with this bafflement are Menahem Yaari’s research from 1965
about spending for an uncertain lifetime, and Franco Modigliani’s Nobel Prize
acceptance speech addressing the subject in 1985.

In The 7 Most Important Equations for Your Retirement,
Moshe Milevsky described this mystery in the words of Wharton professor Solomon
Huebner, the founder of The American College, who first defined the basic
puzzle in the 1930s:

The prospect, amounting almost to a terror, of living too
long makes necessary the keeping of the entire principal intact to the very
end, so that, as a final wind-up, the savings of a lifetime, which the owner
does not dare to enjoy, will pass as an inheritance to others. In view of these
facts, it is surprising that so few have undertaken to enjoy, without fear, the
fruits of the limited competency they have succeeded in accumulating. This can
be done only through annuities … Why exist on $600, assuming 3 percent interest
on $20,000, and then live in fear, when $1,600 may be obtained annually at age sixty-five,
through an annuity for all of life and minus all the fear?

The annuity puzzle, as defined by academic economists,
regards why income annuities are not more widely used. Numerous explanations
have been offered, some more legitimate than others. One obvious starting point
for resolving the puzzle is that many retirees may wish to build a legacy.
Maximizing personal spending is not the only goal. The desire to leave a legacy
may be a strong deterrent from annuitizing for those who have not fully thought
through the implications of different alternative approaches that do not
include annuities. When not accounting for the other retirement liabilities
that must be funded, it is easy to conclude that investments can support the
largest legacy. We explain the problem with this conclusion in Chapter 8.

It is important to also think about the dual impacts of
investment volatility. One might expect the uncertainty of investment returns to
motivate greater annuity use as a protection, but there could be another
countervailing force at work. Income annuities remove downside risks, but they
also eliminate upside for those assets. The annuity decision carries a sense of
finality as one is forever removing the possibility of picking the next winning
stock and striking it rich. For hopeful retirees, that loss of potential
financial betterment can be a deal breaker. It is important to remember,
though, that an annuity is not an all-or-nothing decision.

What’s more, real-world annuities will have overhead charges
as insurance providers must cover expenses, make a profit, and account for
adverse selection and misestimation risks. These costs reduce payout rates and
the potential gains from annuitization. Nonetheless, as we have discussed, the
fees built into income annuities do not appear as large as may be commonly
thought.

In addition, the standard economics model does not ascribe
importance to the idea that retirees may value the ability to maintain
flexibility and control over their financial wealth. Preferences, needs, and
circumstances may change, so holding off on making the irreversible decision to
annuitize holds value for many. The extra control may be partly an illusion, since
retirees face spending needs that must be met and risks of wealth depletion
that must be mitigated. Nonetheless, the behavioral need to feel like one is in
control is important. Income annuities may create the perception that one is
losing control over their hard-earned assets.

Another possible behavioral explanation is the feeling of
being poorer after annuitization because of the resulting noticeably lower
remaining account balance. This confuses total wealth with the spending power
available from that wealth, but it can exert a powerful psychological influence
on decisions. Individuals rarely like to see a drop in the value of their
financial assets. It is not fun to see $1 million on a financial statement one
month and $800,000 the next. Visually, this is what happens with the purchase
of an income annuity. The lump-sum paid for the lifetime income protection is
removed from the financial portfolio, even though the lifetime income stream is
an asset whose present value could be included on the more complete retirement
balance sheet. It is not common for individuals to think in these holistic terms.

Curtis Cloke provides a descriptive visual about this
behavioral thinking: he calls it the “Scrooge McDuck effect.” Envision Scrooge
McDuck diving into his vault of gold coins. He loves to touch and feel his
money. This is what we are describing. People like seeing a big number on their
financial statements and do not want to see that number reduced—even if they
can envision no plausible case where they would need to have full liquidity for
all their financial assets.

Perhaps related to this point, surveys have shown that
people have a difficult time thinking through the mathematics of translating
between lump-sum amounts and lifetime income streams. They may grossly
underestimate the value of lifetime income. One million dollars may sound like
a lot, but people are much less impressed to hear this might only sustain an
annual inflation-adjusted income of around $30,000 to $40,000. As such,
individuals may think that $30,000 of lifetime annual income is only worth
$300,000, for instance, even though the reality is that this income is worth
much more.

Often, retirees may also be thinking about annuities framed
in terms of a gamble on the possibility of a long life, rather than as a risk
reduction measure aimed at improving that possible long life. Retirees can more
easily visualize being run over by a bus after signing the contract than they
can being old and without income. They view this as unfair, thinking that the
insurance company wins at their expense, instead of the other members of the
risk pool. Another helpful technique is to use age-progression software to
create a picture of one’s future self, which can help make longevity risk more
concrete. In this regard, people may underestimate their life expectancies,
calibrating from birth rather than their current age, and not realizing they
may live significantly longer than average. Insurance exists to protect us from
bad outcomes, but annuities provide insurance against a generally good outcome:
living an unexpectedly long time. Emphasizing a break-even age one has to reach
for an annuity to provide higher returns misses the point about their insurance
value. This mind-set leads to undervaluing lifetime income and a reluctance to
annuitize.

It also turns out that framing annuities as an investment
makes them less attractive. A study by Jeffrey Brown, Jeffrey Kling, Sendhil
Mullainathan, and Marian Wrobel asked two different groups of randomly selected
individuals a question with only a very slight twist in the way the question
was worded for each group. They found that 70 percent of respondents would
annuitize to obtain $650 of monthly spending for life, compared to only 21
percent who annuitize to obtain a guaranteed monthly return of $650 for life.
The same concept with only a slight change in how it was framed led to a very
different result.

Another matter is that Social Security already provides an
inflation-adjusted annuity which may fulfill basic needs for many retirees. The
basic formulation of the annuity puzzle assumes no other outside income sources
beyond financial wealth, but Social Security provides such inflation-adjusted
lifetime income support. For middle class households, the present value of those
Social Security benefits may be larger than the financial portfolio, suggesting
that the household already has sufficient reliable income. Individuals have a
clear need to set aside a certain amount of financial assets to serve as a
contingency fund to cover uncertain and potentially large future medical and
long-term care expenses. With Social Security in place, many retirees may not
have enough additional financial assets to practically consider an annuity.

Many individuals may also worry about the long-term
viability of annuity providers and may view the annuity guarantee as anything
but a sure bet. Mistrust of the annuity provider could be related both to (a)
whether the provider is taking on too much risk and may be unable to fulfill
its promises, or (b) whether incomprehensible fine print exists within the
annuity contract that is detrimental to their interests. Fear that a systemic
crisis could overwhelm annuity providers and state guarantee associations is
common. Such concerns are probably overstated, but they create real fear.
Chapter 9 covers this matter in greater depth.

Looking ahead, variable and index annuities with income
guarantee riders were designed to overcome some of the behavioral concerns
mentioned. They provide liquidity to reduce the finality of the decision,
upside potential to keep that hope alive, the ability to keep the contract
value of the annuity visible as a financial asset, and the ability to leave a death
benefit to the estate. We consider these in upcoming chapters.

Further Reading

Brown, Jeffrey R., Olivia S. Mitchell, James M. Poterba,
and Mark J. Warshawsky. 2001. The Role of Annuity Markets in Financing
Retirement. Cambridge, MA: The MIT Press. [http://amzn.to/2FM0ggk]

Brown, Jeffrey R., Jeffrey R. Kling, Sendhil
Mullainathan, and Marian V. Wrobel. 2008. “Why Don't People Insure Late Life
Consumption: A Framing Explanation of the Under-Annuitization Puzzle.” NBER
Working Paper No. 13748.

Hegna, Tom. 2011. Paychecks and Playchecks:
Retirement Solutions for Life. Acanthus Publishing. [https://amzn.to/2K8bcKp]

Milevsky, Moshe A. 2013. Life Annuities: An Optimal
Product for Retirement Income. Charlottesville, VA: Research Foundation of
CFA Institute. [https://amzn.to/31qj2Vo]

Milevsky, Moshe A. 2012. The 7 Most Important
Equations for Your Retirement. Hoboken, NJ: Wiley. [http://amzn.to/2x2glw2]

Milevsky, Moshe A., and Huaxiong Huang. 2011. “Spending
Retirement on Planet Vulcan: The Impact of Longevity Risk Aversion on Optimal
Withdrawal Rates.” Financial Analysts Journal 67 (2): 45–58.

Modigliani, Franco. 1986. “Life Cycle, Individual
Thrift, and the Wealth of Nations.” American Economic Review. 76 (3):
297–313.

Yaari, Menahem E. 1965. “Uncertain Lifetime, Life
Insurance, and the Theory of the Consumer.” The Review of Economic Studies.
32 (2): 137–150.

Chapter 5: Variable
Annuities

Variable Annuities Caveat

In this discussion of variable annuities, I
am mostly making an implicit assumption that the annuity is competitively
priced. Fees reflect what is needed to support the guarantees provided by the
insurance company and to keep the company profitable. But fees are not
excessive such that the value to the consumer is eliminated.

It must be noted that not all variable
annuities are created equal. As will be discussed, they are complex financial
instruments, and that complexity can hide a lack of competitiveness in the
pricing of individual products. A variable annuity that is pitched along with
a free dinner presentation is possibly not the type of financial product I
have in mind. One should tread carefully. Due diligence and a comparison with
other annuity options is needed to make sure that the product is priced fairly
and will behave in the way that the purchaser understands it to behave. I do
not want the “bad” annuities out there to free-ride off of my explanations
about the potential positives that can be created by “good” annuities.

Generally, the most efficient means for
balancing protected income and investment upside is to combine life-only income
annuities with aggressive stock portfolios. However, this requires a degree of
investor self-control and long-term focus that may be difficult to achieve in
practice. It requires accepting both the loss of liquidity as annuity assets
disappear from the portfolio balance, as well as accepting a very aggressive
asset allocation for what remains on the portfolio statement.

As a means for accommodating the concerns of
real-world retirees, deferred variable annuities and fixed index annuities with
lifetime income protections have developed as a compromise between downside
protection and upside potential. We will cover variable annuities in this
chapter and fixed index annuities in the next chapter.

Owners continue to see the annuity assets remain
on their financial statements as part of the overall portfolio balance. As
well, those assets maintain exposure to market upside that is not provided
within an income annuity. This provides a behavioral benefit that makes the
retiree more comfortable in considering a safety-first strategy incorporating
risk pooling. The appeal to retirees is based on the combination of downside
protection with a protected income stream, upside growth potential through
their underlying investments (or links to investment indices in the case of
fixed index annuities), and maintaining liquidity for the underlying assets,
while also offering the potential for tax-deferral when compared with taxable
investments.

For variable annuities, retirees can see their
account values, they can continue to invest in funds (technically called
variable insurance trusts, but similar to mutual funds) within the annuity
subaccounts, and any funds remaining at death are generally available to beneficiaries
as a death benefit, all while ensuring protected income for life.

Lifetime income provides insurance against
outliving assets in retirement, resulting from a combination of either living
too long and/or experiencing poor investment returns. As well, there are
situations when variable and index annuities might help to achieve more
efficient outcomes in retirement in terms of providing a better combination of
spending and legacy. These relate to asset allocation and whether it may change
when an income guarantee is in place. Income guarantees provide greater
relative benefit to retirees who are either willing to invest more aggressively
because of the guarantee, or who would otherwise be uncomfortable using stocks
in retirement.

Those who accept the notion that the income
guarantee increases risk capacity, and are willing to use a more aggressive
asset allocation than otherwise both inside and outside of the annuity, could
find that the additional exposure to the stock market equity premium more than
offsets the annuity fees when markets perform well in retirement. The guarantee
would also prove valuable if it otherwise stops retirees from panicking and
selling stocks after a market drop. And when markets perform poorly, by paying
an insurance premium for the income protection, one should anticipate depleting
the underlying asset base sooner than with a lower-cost, investments-only
strategy. But the annuity still includes a lifetime guarantee to support
retirement spending after assets deplete, which is not the case with an
investments-only approach. Investments-only strategies might last a bit longer,
but spending stops completely once those assets are gone.

Second, variable and index annuities could
create better outcomes for those who would simply use a lower stock allocation
no matter the chosen retirement strategy, but who are unwilling to sacrifice
the liquidity foregone with an income annuity. With a low stock allocation,
investment assets are more likely to deplete, and again, the annuity provides
the opportunity to continue with income for life even after the contract value
of assets is gone. Without exposure to the risk premium, the contract value of
underlying assets is more assured to deplete in the event of a long retirement.
With investments-only, asset depletion ends the ability to spend, but an income
guarantee assures this continued spending ability for life.

It is not possible to make any overall
conclusions for or against variable annuities and fixed index annuities with
income riders, as this depends on the personal preferences of individuals about
the issues of upside and downside, the desire for liquidity, and the types of
asset allocations which would be used both with and without the income
guarantee in place. But there will certainly be cases when retirees can derive
value from these types of annuities. After providing a quick summary of various
annuity types, we explore this story first for a deferred variable annuity.

Overview of Annuity
Types

This chapter is about how the lifetime income protections
available through deferred variable annuities can support a retirement income
goal through risk pooling and mortality credits. The next chapter adds fixed
index annuities. We have already considered immediate and deferred income annuities.
It is worthwhile to start by stepping back to describe the universe of
available annuities more completely.

A fundamental component for the definition of
an annuity is that it is a contract which can be structured to provide a series
of payments from the insurance company, either for life or for a fixed period.
However, today there are many annuities where this payment aspect is
downplayed. As the tax code in the United States provides tax advantages for
annuities, other forms of annuities have evolved with a greater emphasis on
providing tax-deferred growth for the assets in the annuity with a de-emphasis
on their income-generating abilities. But any annuity must provide a method for
being annuitized into a series of payments.

Two broad classifications for annuities exist:
fixed and variable. Simply, fixed annuities credit interest to the underlying
assets in the annuity at a fixed rate (which can change over time), while
variable annuities position the premiums into subaccounts that allow for investments
into different funds earning a variable rate of return. Fixed annuities pool
assets in the insurance company’s general account, while variable annuities
hold assets in separate individual investment subaccounts. Since variable
annuities behave more like investments, those selling them need to be properly
licensed in most states to sell both insurance and investments.

This definition about fixed and variable
annuities can be confusing. First, income annuities are fixed annuities, but
they do not show an underlying account balance to which interest is credited.
Rather, the insurance company determines the payout rate based, in part, on the
interest it projects to earn on the underlying premiums held in its general
account.

Second, fixed index annuities can be
structured to credit interest based on the performance of a volatile investment
index. This can make them sound more like a variable annuity, but technically
it is just a matter that fixed interest is being credited as based on outcomes
for a volatile index. They provide principal protection. Unlike a variable
annuity, fixed index annuities do not provide subaccounts in which investments
are made. They only credit interest based on the performance of an associated
index.

An exception to this classification is
variable index annuities, which operate more like fixed annuities but do not
provide principal protection unless an additional optional rider is included. Finally,
variable annuities could include subaccount options that provide fixed returns
in the same manner as a fixed annuity, but the distinction is that variable
annuities position the assets in investment subaccounts, unlike fixed annuities
that hold them as part of the insurance company’s pooled general account.

One other potentially confusing way to
classify annuities is whether they are immediate or deferred. The confusion
relates to the idea that this classification is not related to when guaranteed
income begins, but rather to when the act of annuitization takes place. Some
deferred annuities could provide income immediately through structured lifetime
payments, while some immediate annuities may defer income payments. For the
former, the variable annuities and index annuities with income riders that we
discuss are both types of deferred annuities, even if guaranteed distributions
start immediately. The reason they are still called deferred annuities in this
case is that technically the contract does not annuitize until the contract
value of the underlying assets has fallen to zero.

Because the lifetime income rider supports
lifetime income in the same manner as an income annuity, I tend to become a bit
lazy about this distinction regarding when technical annuitization takes place,
colloquially suggesting that annuitization happens when guaranteed
distributions begin rather than when the contract value reaches zero. Again,
even if guaranteed distributions begin immediately from a deferred variable
annuity with an income rider, the annuity is not technically annuitized until
the value of the assets in the underlying subaccounts have been depleted, and
so we are talking about a deferred variable annuity.

Meanwhile, the income annuities discussed in
Chapter 4 are immediate annuities. The act of annuitizing the assets takes
place at the time the premium is paid. There is no liquidity for the underlying
premiums past that stage. “Immediate” immediate annuities begin income payments
within one year of annuitization, while deferred immediate annuities begin
income payments at least one year past annuitization. In Chapter 4, I used the
alternative name of deferred income annuity to avoid the seeming contradiction
of terms within the name “deferred immediate annuity.” But it is not really a
contradiction because the immediate part of the name refers to immediate
annuitization, and the deferred part of the name refers to the delay in starting
the annuitized payments.

It is worth mentioning a few other annuities
that could play a role in a retirement income plan, before digging into the
discussion of deferred variable and fixed index annuities.

Deferred Fixed Annuities

Deferred fixed annuities (DFAs), or multiyear guaranteed
annuities (MYGAs) may be used as an accumulation tool in the years leading up
to retirement. They are the annuity equivalent of holding CDs or other
shorter-term fixed-income investments to a targeted maturity date. These
annuities are deferred because they do not require immediate annuitization.
Though all annuities offer an ability to annuitize the assets into a stream of
payments, this may not be the priority for most DFA purchases. Rather, the
objective is to seek competitive after-tax fixed-income returns for assets.

When choosing between bonds, CDs, and deferred fixed
annuities, there are several differences to emphasize. First, deferred fixed
annuities provide protection from interest rate risk. Unlike a bond fund or
individual bonds not held to maturity, deferred fixed annuities do not
experience losses if interest rates rise. Principal is protected and secured, providing
a way to take risk off the table in the pivotal years before retirement.

Second, deferred fixed annuities offer the ability to seek
corporate bond yields held in the insurance company’s general account, relative
to treasuries, without being unduly exposed to the credit risk of individual
companies. Insurance company general accounts provide similar diversification
to a bond fund.

Finally, a deferred fixed annuity offers tax deferral,
unlike bonds held in taxable accounts that face ongoing taxes on their interest.
Tax deferral is only relevant when the annuity is purchased outside of a
qualified retirement plan. With this combination of volatility protection,
higher yields, and tax deferral, deferred fixed annuities may provide a higher
net return than households could achieve with other fixed-income choices. As
for disadvantages, deferred fixed annuities may have penalties or withdrawal
charges due on distributions taken before the end of the annuity’s withdrawal
charge period, which can mean that they offer less flexibility than bonds for covering
unplanned expenses requiring liquidation before maturity.

Investment-Only Deferred Variable Annuities

Deferred variable annuities were originally
created in the 1950s in the United States as a tax-deferred vehicle for
accumulating assets. They grew in popularity after the Tax Reform Act of 1986
limited the opportunities for tax-deferred savings in qualified retirement
plans. Though every annuity, by definition, must include a means to convert
into a guaranteed income stream, the attractiveness of early variable annuities
related to their ability to defer taxes rather than to generate income.

This may be the reason that annuities and
pensions evolved as two distinct words in American English. If not for the tax
code, the terms should be indistinguishable. Both were meant to serve as
sources of lifetime income with the only practical distinction being perhaps that
annuities were sold through commercial providers rather than being a benefit
offered by employers or the government.

In the 1990s, the emergence of income
guarantee riders for deferred variable annuities brought their
income-generating potential back to the forefront and the chapter will be
focusing on these shortly.

Nonetheless, even more recently there has been
a movement to bring back the traditional deferred variable annuity with low
costs and de-emphasized guarantees as a way to provide tax deferral for those
investors who have already filled the tax-deferred space in their qualified
retirement plans and still seek to invest further in tax-inefficient asset
classes that may generate ordinary income and short-term capital gains, such as
bonds, actively managed stock funds, alternative assets, and real estate
investment trusts. To benefit from tax deferral, it is vital that the annuity
costs are less than the tax deferral benefits.

Regarding lifetime income, if it is later desired,
the owner might investigate exchanging the annuity assets into a new annuity
with better guaranteed income provisions. This can be done as a 1035 exchange
in the tax code. Assets are exchanged into a new annuity without triggering a
taxable event at that time.

Though these investment-only variable
annuities are liquid, investors must remember that the tax deferral advantages
provided by the government for certain tax-qualified investments like these may
be accompanied by the need to pay taxes and an additional 10 percent penalty on
distributions taken before the age of 59.5. The government provides tax
benefits to encourage retirement savings and will take back these benefits and
penalize those using the tools for different purposes.

There are exceptions that can allow earlier
distributions without penalties. When penalties are not applied, gains are
still taxed at income tax rates. This includes long-term capital gains or other
qualified dividends that would have been taxed at a lower rate inside of a
taxable account. It would generally be unwise to hold stock index funds and
other tax-efficient investments inside variable annuities. Tax-inefficient
investments are taxed at income tax rates anyway.

When considering an investment-only variable
annuity, be sure to consider the investment options available, the explicit
costs for the annuity, and whether 12b-1 fees are included to increase the
expense ratios on the offered underlying funds. These 12b-1 fees are marketing
and distribution fees from the fund that can be incorporated into the expense
ratio. If the variable annuity includes 12b-1 fees, this would represent an
additional cost to weigh for those with other investment opportunities that do
not include such fees.

Immediate Variable Annuities

The main variable annuity discussion in this
chapter will be about deferred variable annuities. Immediate variable annuities
do also exist, and they do work differently. They do provide lifetime income protections.
However, while academics tend to like the concept of immediate variable
annuities, they are quite rare in practice. This rarity is why they are not
featured more heavily here.

Briefly, immediate variable annuities provide
a guaranteed income for life, but the amount of income provided over time
varies based on the returns to an underlying portfolio of assets and how these
returns compare to an assumed interest rate for the contract. Owners buy
annuity units with the premium, and these annuity units generate a variable
amount of income over time. They provide a way for someone to have a lifetime
income, but to accept some risk about the level of this income. If markets
underperform relative to the assumed interest rate, the amount of guaranteed
income decreases. But market outperformance relative to the assumed interest
rate will increase guaranteed income.

Each annuity unit provides a guaranteed
lifetime income, it is just unclear what this income amount will be per annuity
unit until market performance for the underlying annuity subaccounts is
realized.

Deferred Variable Annuities

Deferred variable annuities with income
guarantee riders have gained popularity as a retirement income tool providing
behavioral solutions for the annuity puzzle. Retirees are not always comfortable
seeing the premiums disappear from their portfolio balances when buying income
annuities that convert a lump-sum premium into a protected lifetime income.
Many features of a variable annuity could be replicated by combining an income
annuity with an aggressive investment portfolio, but both of those choices can
be tough for retirees to accept.

A deferred variable annuity can provide a
palatable alternative. Its appeal to retirees is based on its combination of
downside protection with a lifetime income stream, upside growth potential
through its underlying investments, and maintaining liquidity for the
underlying assets, while also offering the potential for tax-deferral when
compared with taxable investments. Retirees can see their account values, they
can continue to invest in funds within the annuity subaccounts, and any funds
remaining at death are available to beneficiaries as a death benefit. These
features can provide a happy compromise leading to a palatable way for retirees
to take advantage of risk pooling as a part of their retirement income plan.

Nevertheless, the features and workings of
deferred variable annuities with income riders can be rather complex.
Prospectuses about variable annuities can be hundreds of pages long. Frankly,
this is an area where I wish variable annuity providers would simplify matters by
adopting standardized features that are easier to understand and compare. But
because there are many moving parts to a variable annuity, and because
consumers tend to latch on to certain characteristics and downplay other important
characteristics, we find ourselves in a situation in which different providers
seek to tweak the characteristics of their product offerings in ways that will better
appeal to consumers while adjusting other less salient features in a less
attractive direction.

This process often leads to greater overall complexity.
It also means that not all variable annuities are created equal and some will
perform better than others. An important caveat for this discussion is that I
generally describe competitively priced variable annuities, and that is not a
description fitting all products on the market.

For those just starting to investigate deferred
variable annuities, complexities relate to understanding how the income
guarantee works and how its fees are structured. A few key terms include the
contract value of assets, the guaranteed benefit base, the possibility of step-ups,
and the rollup rate applied during the deferral period. Different companies
will use different names for these features and some translation from the terms
I use may be necessary when looking at a specific product.

A guaranteed lifetime withdrawal benefit rider
supports an income for life at a fixed withdrawal percentage (based on the age
when distributions begin) of the guaranteed benefit base. The guaranteed benefit
base is a hypothetical amount used to calculate the guaranteed withdrawals. It
initially equals the premium paid into the annuity, which is also the initial
contract value for the assets. Over time, the contract value of assets can rise
or fall depending on realized investment returns and as fees and distributions
are taken from the asset base. On any contract anniversary, if the contract
value of the underlying assets has reached a new high watermark and exceeds the
guaranteed benefit base, that base is stepped up to the new high watermark
value. This increases the subsequent amount of guaranteed income. If the
retiree does not take out more than the guaranteed withdrawal amounts,
guaranteed withdrawals never decrease, even if the account balance falls to
zero. One exception to this is that some companies market a feature that allows
for higher distributions when assets remain and lower distributions after
assets deplete. The contract may be terminated at any point with the contract
value of the remaining assets, net of any potential surrender charges, returned
to the owner. During the deferral period before distributions begin, a variable
annuity may also offer a guaranteed rollup rate to increase the benefit base
automatically over time if the value of the underlying contracted assets has
not otherwise grown larger on its own.

I’ll aim to provide a big picture overview of
the key features to understand when trying to figure out how a variable annuity
works and when trying to compare different variable annuity options. This will
hopefully prepare you with a list of questions to ask to make sure you
understand the variable annuity contract under consideration. This discussion
fits into four general categories: how do guarantees grow during the deferral
period, how are guaranteed withdrawals determined and how can they grow during
the distribution period, what is the death benefit, and how does the insurance
company manage the risk it creates by offering the guarantee?

Deferral Period

We begin with the growth process for the
guaranteed benefit base during the deferral or accumulation period before
distributions begin. This growth is important because it is subsequently used
to determine the amount of guaranteed lifetime income provided by the annuity.
The deferral period can be skipped if the retiree wants lifetime distributions
to begin immediately.

Deferred variable annuities with income
guarantee riders generally support the ability to lock-in a guaranteed growth
rate on the benefit base during the accumulation period before guaranteed
distributions begin, including the ability to define the benefit base as the high
watermark of the contract value of the underlying assets on anniversary dates over
the history of the rider. This benefit base is a hypothetical number used to
calculate the amount of guaranteed income paid during the withdrawal phase. It
is distinct from the contract value of assets, which is what the owner could
access based on actual account growth net of fees and any surrender charges.

For example, if the rollup rate for the
benefit base is an annually compounding 6 percent, the value of the benefit
base would double in approximately twelve years. The benefit base could be even
larger if the contract value grew larger on the relevant dates when this is
checked. Conversely, the actual contract value of the underlying assets will be
determined by market performance. After the twelve-year accumulation period has
passed, if the market has underperformed and the value of the benefit base is
significantly higher than the contract value of the underlying assets, then the
income guarantee is “in the money.” The benefit base is larger than the
contract value. In such a case, the owner may wish to continue paying for the
rider and to receive the guaranteed income as calculated on this higher benefit
base.

On the other hand, if markets performed well
during those twelve years, the contract value of the underlying assets may be
close to or the same as the value of the benefit base. In this case, the retiree
may consider whether it is worthwhile to begin taking distributions with the
income guarantee, to have the contract value of the underlying assets returned
to an unprotected investment portfolio, or to exchange into a different annuity
with better withdrawal opportunities for the contract value.

Generally, the benefit base can grow at the
higher of either a guaranteed rollup rate or the high watermark achieved
through investment growth of the contract value for the underlying assets held
inside the annuity. But the interaction of these two possibilities can get
confusing. I’ll talk about both rollups and step-ups, which are not interchangeable
terms. Rollups are a guaranteed minimum growth rate for the benefit base, and
step-ups are increases for the benefit base triggered when the contract value
of the underlying assets in the annuity subaccounts have grown to achieve a new
high watermark value. Let’s start with the rollup rate.

What is the guaranteed rollup rate for the benefit base? Is it a compounded
rate or simple rate?

To begin, we can consider a rollup rate that
is applied annually on the contract anniversary for when the annuity was
opened. If a variable annuity offers a 5 percent guaranteed compounded rollup
rate during the deferral period, then the benefit base supported by a $100,000
premium would grow to $127,628 after five years (100,000 x 1.05 ^ 5) and to
$162,890 after ten years (100,000 x 1.05 ^ 10).

If this were instead a 5 percent simple growth
rate, then 5 percent of the initial premium would be added to the benefit base
after each year, leading to $125,000 after five years and $150,000 after ten
years, for instance. The longer the deferral period, the more opportunity a
compounded rollup rate has to move ahead, with growth on past growth, relative
to a simple rollup rate on the initial premium. For instance, with these
numbers provided, we can see that a 5 percent compounded growth rate would beat
a 6 percent simple growth rate after ten years, as the latter would have only
growth to $160,000.

Exhibit 5.1 provides an example of $100,000
placed into a variable annuity at age fifty-five which offers a 5 percent annual
compounded growth rate on the benefit base. As mentioned, after ten years, the
benefit base has grown to $162,890. If the contract value of the underlying
assets never grew to exceed this guaranteed rollup rate when checked on the
relevant dates, then this would reflect the benefit base for the annuity.

It is worth emphasizing that the guaranteed
rollup rate is not a guaranteed investment return. It does not apply to the
contract value of assets. It only applies to the benefit base used to calculate
guaranteed income amounts. This detail is a constant source of confusion for
individuals.

Exhibit 5.1

Guaranteed Benefit Base for $100,000 premium in a Deferred
Variable Annuity with a 5 Percent Annually Compounded Rollup Rate

When are rollups vested into the benefit base?

Most commonly, the rollup rate is applied
annually on the anniversary date for when the contract went into effect, and
this is also when the benefit base would be vested at the new higher value. That
is the case illustrated in Exhibit 5.1.

Some variable annuities will apply the rollups
on a more frequent basis, such as daily, monthly, or quarterly. With
compounding, more frequent rollups can provide an edge because there is more
opportunity for interest to accumulate on interest. However, the question
remains about when the rollups become vested. More frequent rollups might still
only vest on the contract anniversary date. The only reason this could be a
problem is for someone seeking to begin distributions midyear. Even though
rollups are more frequent, if they do not vest until the anniversary date, then
the benefit base will not yet be higher when calculating the income guarantee.
Withdrawals before the anniversary date would not factor in any of the
potential growth for the year.

How long does the guaranteed rollup rate last? Does it have any other
features?

Guaranteed rollup rates for the benefit base
generally end once guaranteed distributions from the contract have commenced.
As well, in cases where those distributions do not begin for a long period of
time, the rollup rate may only last for a certain number of years.

Some variable annuities may have other
guaranteed growth features as well. For instance, one might see a bonus applied
to their initial premium, such that the initial benefit base is higher than the
premium. Another possibility could be that the benefit base is guaranteed to
double after a certain number of years if underlying contract value growth did
not otherwise jump far enough ahead of the guaranteed rollup rate to have
independently caused this.

How frequent are the step-ups to the benefit base? When are they applied?

Another reason that the benefit base can increase
is because the contract value of the underlying assets has grown to achieve a
new high watermark that exceeds the value of the guaranteed benefit base
provided through rollups. We must consider how frequently these new high
watermark step-up possibilities are checked for the benefit base and when they
vest. Most commonly, these step-ups are applied for contract value growth on an
annual basis at the contract anniversary date. If the contract is worth more than
the guaranteed benefit base on the contract anniversary date, then the benefit
base is adjusted upward to match the contract value at this time. In these
cases, if the contract value reached a new high watermark earlier in the year
but then dropped by the anniversary date, the higher earlier value would not
matter. Only the value on the designated dates is used to determine if a new
high watermark has been achieved.

Naturally, the ability to apply step-ups on a
more frequent basis, such as daily, monthly, or quarterly, is valuable to the
annuity holder. It creates more opportunities for growth in the contract value
to achieve new high watermarks for the benefit base. When these step-up
opportunities are applied more frequently than on an annual basis, it is
important to also know about when they vest. If they do not vest until the
anniversary date, then this can again create issues for those seeking to begin
distributions midyear if a new high watermark for the benefit base has not yet
vested to increase the guaranteed income.

How does the rollup rate interact with step-ups?

A final consideration for deferrals is how the
rollup rate reacts to step-ups for the benefit base. What happens when the
contract value achieves a new high watermark above the guaranteed rollup rate?
There are two basic options. The rollup rate might only be applied to the
original premium, or it may stack on top of new high watermarks achieved
through asset growth. The latter case is more advantageous to the annuity
owner. The easiest way to understand this is with an example.

Exhibit 5.2 provides such an example for a
$100,000 premium placed into a variable annuity with a ten-year deferral period
that offers a 5 percent annual compounded rollup rate that is vested on each
contract anniversary as in Exhibit 5.1. The contract value for the underlying
annuity assets is also shown in the exhibit. The growth of the contract value
was chosen for this example to more clearly illustrate the difference for stacking
the rollup rate on step-ups. The contract value trails the guaranteed rollup
rate until age fifty-nine when a very large market return pushes the contract
value well above the benefit base. This market growth creates a step-up to the
new high watermark for the benefit base. Then the contract value subsequently declines
and trails the benefit base for the remainder of the deferral period. With that
step-up at age fifty-nine, there are two ways that the rollups may respond.
Without stacking, the rollup continues to apply only to the original premium
and the benefit base stays at the high watermark level achieved at age fifty-nine
until age sixty-three when the cumulative rollups once again allow the benefit
base to grow. In this example, the benefit base at age sixty-five ends up at
the same $162,890 value. There was a temporary period between ages fifty-nine and
sixty-three where the benefit base was larger, which could have been beneficial
if the owner decided to begin lifetime distributions earlier than planned, but
it otherwise does not impact the amount of guaranteed income if distributions
begin at sixty-five.

We can observe how stacking leads to a much
better outcome in this example. With stacking, once the new high watermark was
achieved at age fifty-nine, the rollup rate begins to be applied to this new
high watermark, rather than only being applied to the original premium. This
allows for greater subsequent growth of the benefit base at the rollup rate
from that new high watermark. In this example, stacking allowed the benefit
base to grow to $194,477 at age sixty-five. This stacking has laid a foundation
for 19 percent more guaranteed lifetime income from the annuity.

Exhibit 5.2

Guaranteed Benefit Base for $100,000 Premium in a
Variable Annuity with a 5 Percent Annually Compounded Rollup Rate

Comparing the Benefit Base with Rollups Stacking
on Step-Ups

Distribution Period

The deferral period ends once guaranteed
lifetime distributions commence. We have entered the distribution period.
Guaranteed income will be set using an age-based guaranteed withdrawal or
payout percentage rate applied to the value of the benefit base. The guaranteed
withdrawal rate multiplied by the benefit base sets a guaranteed distribution
amount supported for life, even if the contract value of the underlying assets
is depleted. Guaranteed distributions may even increase through step-ups if new
high watermarks are reached for the underlying asset base on the designated
dates when this is checked.

What are the guaranteed withdrawal rates?

For deferred variable annuities with income
riders supporting a guaranteed lifetime withdrawal benefit, the guaranteed
withdrawal rates or payout rates are most typically based on the age that
lifetime guaranteed distributions begin, and on whether the distribution is
taken by a single individual or by a couple. These payout rates can vary between
companies and even for different versions of variable annuities offered by the
same company. The rates are set at the time of the contract and would not
change for that contract holder, though over time the rates may change for new
purchases.

For a simple example, a company might offer
the following payout rates to single individuals based on the age that lifetime
withdrawals begin: 4.5 percent for ages fifty-nine to sixty-four, 5 percent for
ages sixty-five to sixty-nine, 5.5 percent for ages seventy to seventy-nine,
and 6.5 percent for ages eighty and over. For couples, payout rates would
generally be 0.5 percent less (so, 4.5 percent at sixty-five, for instance) and
would be based on the age of the younger person. For couples, another
possibility could be that the payout rates remain the same as for singles, but
that a higher fee is charged to support the guarantee over the longer expected
joint lifetime. Variable annuity payouts generally do not make a distinction
between genders, which would provide benefit to longer living women relative to
men.

The payout rates on variable annuities at
different ages will generally be less than the payout rate offered by an
immediate annuity purchased at the same age (although this is not always true,
as it may occasionally be possible to find variable annuities with larger
income guarantees than an immediate annuity). This can be expected since the
variable annuity continues to provide liquidity for the underlying assets and
the potential for upside growth in the guaranteed income. However, the question
remains about how much less the payout rate is for a variable annuity relative
to an income annuity.

Exhibit 5.3 provides an example, showing the
payout rates on immediate annuities for couples at different ages alongside the
payout rates on the hypothetical variable annuity just described. The immediate
annuity payout rates were collected from ImmediateAnnuities.com on January 15,
2019, and they include a cash refund provision to match closer with the death
benefit provisions of the variable annuity. The gaps in provided income can be
quite large. Payouts are closest after the variable annuity payout increase at
age seventy when the immediate annuity provides 25 percent more income, and
they are the farthest apart at age seventy-nine when the immediate annuity
offers 58 percent more income. We will return to this issue later when we delve
into how to think about the upside potential of a variable annuity.

Exhibit 5.3

Guaranteed Withdrawal Rates for Couples

Immediate Annuity Payout Rates for Joint and 100 Percent
Survivors Benefit with Cash Refund Provision vs. Guaranteed Lifetime Withdrawal
Benefit Rate on Hypothetical Deferred Variable Annuity for a Couple

Next, we consider the joint impacts of rollup
rates and payout rates on the amount of guaranteed income the annuity can
support. When it comes time to begin taking guaranteed withdrawals, it is
worthwhile to investigate whether applying the contract value of the annuity
assets to a higher payout rate possibly available from other annuities could
result in more guaranteed income than applying a potentially lower payout rate
to the annuity’s benefit base.

For instance, consider a variable annuity with
a $1 million benefit base and a 4.5 percent payout rate at the current age. If
a different annuity is offering a 5 percent payout at this age when the owner
wishes to start income, then the owner would be better off exchanging to the
other annuity if the contract value is greater than $900,000 (as that would
guarantee more than $45,000 of annual income), but remain with the existing
annuity if the contract value is less than $900,000 (as $45,000 is guaranteed
from the benefit base).

Moshe Milevsky has described the separate
presentation of rollup rates and guaranteed withdrawal rates as telling
consumers the temperature in Celsius when individuals can only make sense of
temperatures provided in Fahrenheit. In this case, what a retiree will
understand is the amount of income guaranteed by the annuity (Moshe does take
the guaranteed income a step further and translates it into an equivalent
investment return that can be more directly compared to the returns offered by
other investment opportunities).

It may not be immediately obvious to someone
whether an annuity with a 5 percent rollup rate and 5 percent withdrawal rate
is better than an annuity with a 4 percent rollup rate and a 6 percent
withdrawal rate. The answer also depends on how long the deferral period lasts
before income begins, as longer deferral periods will increase the relative
importance of the rollup rate and shorter deferral periods mean one should
instead focus more on the withdrawal rate.

Exhibit 5.4 provides more clarity on how to
better understand the intricacies of rollup rates and withdrawal rates for
someone placing a $100,000 premium into a variable annuity and deferring for
ten years before distributions begin. For instance, with the example in the
previous paragraph, a 4 percent rollup and 6 percent withdrawal rate support
$8,861 of guaranteed annual lifetime income, which is quite a bit more than the
$8,144 provided by the 5 percent rollup and 5 percent withdrawal combination.
The former provides more guaranteed income, which is the whole point of a
lifetime income guarantee. To be clear, fees and investment opportunities also
matter in determining upside potential, but for now we stick to only
considering guaranteed income levels if no step-ups are ever realized.

Exhibit 5.4

Guaranteed Income Supported by a $100,000 Premium with
a Ten-Year Deferral Period Before Income Begins

Withdrawal Rate

Rollup Rate

4.0%

4.5%

5.0%

5.5%

6.0%

Compounded

4.0%

$5,921

$6,661

$7,401

$8,141

$8,881

4.5%

$6,212

$6,988

$7,765

$8,541

$9,318

5.0%

$6,516

$7,330

$8,144

$8,959

$9,773

5.5%

$6,833

$7,687

$8,541

$9,395

$10,249

6.0%

$7,163

$8,059

$8,954

$9,850

$10,745

6.5%

$7,509

$8,447

$9,386

$10,324

$11,263

7.0%

$7,869

$8,852

$9,836

$10,819

$11,803

Simple

5%

$6,000

$6,750

$7,500

$8,250

$9,000

6%

$6,400

$7,200

$8,000

$8,800

$9,600

7%

$6,800

$7,650

$8,500

$9,350

$10,200

10%

$8,000

$9,000

$10,000

$11,000

$12,000

Individuals considering variable annuities may
tend to focus on the guaranteed rollup rate. They may even misunderstand it to
mean a guaranteed return on their investment or contract value, rather than a
guaranteed return on a hypothetical benefit base that is then used to calculate
guaranteed income. This creates room to maneuver, as companies can raise the
headline rollup rate that receives the attention while more subtly reducing the
subsequent withdrawal rates attached to the benefit base. This avoids being on
the hook to support a higher guaranteed income level that one might otherwise
expect with a higher rollup rate.

Another example of this from the exhibit, for
instance, is that a 6 percent rollup and 4.5 percent withdrawal combination
provides less income ($8,059) than a 5 percent rollup and 5 percent withdrawal
combination ($8,144). If consumers are confused and only focus on which annuity
provides the higher rollup rate, then they may miss out on the opportunity to
achieve the highest guaranteed income for their premium dollars.

At a more extreme level, it is also important
to monitor whether the guaranteed rollup rate is presented as a compounding
growth factor with growth also available on past growth, or whether it is a
simple growth factor with growth only provided on the original premium. A
simple 5 percent rollup rate on a $100,000 premium for ten years would grow the
benefit base to $150,000, while a compounded growth rate would bring the
benefit base to $162,890. This does make a difference. We can observe in
Exhibit 5.4, for instance, that a 10 percent simple growth rate with a 4 percent
withdrawal provides less income ($8,000) than a 6 percent compounded growth
rate with a 4.5 percent withdrawal ($8,059). It is important to focus on the
guaranteed income provided by the rollup and withdrawal factors, rather than
trying to make some determination in isolation about which combination of
factors sounds better.

Many consumers misinterpret the guaranteed
growth rate on their benefit base as a guaranteed investment return, not
realizing that it is the combination of a growth rate on the benefit base and
the withdrawal rate applied to the benefit base that determine the level of
guaranteed income. These two factors cannot be disentangled. A higher rollup
rate combined with a lower payout rate does not necessarily leave consumers in
a better position.

Types of Living Benefits

Throughout this book, I am describing
lifetime income protections for deferred annuities as guaranteed lifetime
withdrawal benefits (GLWB). These are quite common today and are a reasonable
default for discussing a living benefit.

There are a few other types of living
benefits to be aware of as well. They were more popular in the past, and they
continue to survive in limited form at the present. First, the guaranteed
minimum income benefit (GMIB) promises access to a particular age-based payout
rate with the benefit base when the contract is annuitized. The GMIB is
similar to a GLWB, except that the GMIB requires annuitization, while the
GLWB begins a lifetime income while maintaining the deferral status for the
annuity. Second, a guaranteed minimum accumulation benefit (GMAB) promises
that the contract value grows to a minimum value. It is not linked to a
lifetime income. Third, the guaranteed minimum withdrawal benefit (GMWB)
guarantees that the return of principal or the value of the benefit base can
be distributed through systematic withdrawals. It does not guarantee a
lifetime income beyond this.

The unique features of the GLWB used
primarily in this book are that it does support a lifetime income and it does
not require annuitization to receive the lifetime income.

Are there cases when the amount of guaranteed income can be decreased?

Generally, if an annuity contract states that
a guaranteed income level remains for life then this is the case as long as
distributions do not exceed the guaranteed levels. But some annuity providers
make clear that there is an option to receive more income when assets remain,
if they are willing to reduce the amount of guaranteed income they will receive
after the contract value of annuity assets has been depleted. For instance,
rather than offering a 5 percent guaranteed payout for life, the contract may
stipulate that distributions are guaranteed to be allowed at 7 percent of the
benefit base until the contract value of assets has been depleted, and then the
level of guaranteed income drops to 3 percent of the benefit base (a 57 percent
reduction). This approach makes a distinction between maximum allowed
withdrawal amounts (7 percent) and protected income payments (3 percent).

At the surface, this sort of structure may not
sound very appealing. The purpose of having the guarantee in place is to
protect income if the contract value of assets has been depleted, and this
approach does guarantee less income. Advocates of this structure would argue,
though, that the higher initial withdrawal rate for the annuity means that less
assets can be moved to the annuity to achieve the same level of initial income.
This allows more to remain within the investment portfolio held outside the annuity.

If distributions are also taken from the
nonannuity investments, they can be less, which will help to preserve the
nonannuity portion of the portfolio. This could serve to support additional
income later in retirement from unguaranteed sources and it may be an appealing
way to achieve benefits from having guaranteed income sources while committing
less assets to the annuity.

What is the distinction between lifetime distributions and nonlifetime
distributions?

Variable annuities generally make a distinction
between distributions that are covered by the lifetime income guarantee rider,
and onetime distributions that are not covered by the guarantee. Nonlifetime
distributions may be allowed before guaranteed income begins. That distinction
is important, as it would generally allow rollups to continue, as rollups mostly
end once guaranteed distributions begin. As well, nonlifetime distributions
beyond the guaranteed level are allowed after the guaranteed distributions
begin, but this will reduce the subsequent guaranteed distribution amounts
proportionately.

One further note is relevant here. Some income
guarantees allow for market value adjustments or earnings-sensitive adjustments
which allow the owner to temporarily take a higher guaranteed distribution. These
would generally be structured to allow for larger distributions during periods
when the markets are experiencing gains.

How are guarantees affected if a distribution larger than the guaranteed
amount is taken?

If excess distributions beyond the guaranteed
level are taken, they will reduce the subsequent guaranteed distribution
amount. Different mechanisms may be used to make these adjustments, but the
general idea would be that the guaranteed distribution level would reduce
proportionately by the amount of the nonguaranteed distribution as a percentage
of the remaining contract value of assets.

In addition to a desire to have a larger
onetime distribution, required minimum distributions may trigger the need for
an excess distribution when the annuity is held inside of a qualified
retirement plan. If the contract is still within the period that surrender
charges apply, most companies will make an exception not to charge on
distributions specifically meant to meet this tax requirement. But if lifetime
distributions have begun, any excess distribution needed to cover required
minimum distributions (RMDs) will generally result in the
proportional reduction to the subsequent lifetime income guarantee. Retirees
may look to take the RMDs from other qualified assets rather than from the
annuity assets.

How are rollups and step-ups affected after lifetime distributions begin?

Typically, variable annuities end their
guaranteed rollup provisions once guaranteed lifetime distributions commence.
Step-up opportunities do continue for the guaranteed benefit base whenever the
underlying contract value of assets reaches a new high watermark on the relevant
dates. When step-ups can happen more frequently than annually, then the usual
process is that on the contract anniversary date there is a look-back to
determine the high watermark on the relevant dates over the past year and any
step-up is then vested at this time. Then, applying the guaranteed withdrawal
rate to the higher benefit base at the anniversary date will allow for larger subsequent
lifetime guaranteed withdrawals. It is important to keep in mind that step-ups
will become less likely after distributions begin because it will require the
contract value to achieve new high watermark values net of distributions and
fees.

Typically, the age when guaranteed lifetime
distributions begin will determine a guaranteed withdrawal rate from the
benefit base that remains in place for life. The withdrawal rates do not
increase with increasing age when new age bands are entered. But some annuity
providers may include provisions to increase payout rates over time.

One possibility is that if a step-up brings
the benefit base to a higher level again at a later age, the owner may be able
to apply the higher payout rate at that age to the new high watermark for an
even bigger increase in income. Another possibility is that as each age band when
a higher payout rate is reached, the company may check if applying that payout
rate to the account value will support an increase in income, and if so, may
then reset the guaranteed income level to this higher value. This could happen
without reaching a new high watermark if the contract value is close enough
that income would increase with the higher payout rate for the new age band.

Death Benefits

The standard death benefit for a deferred
variable annuity is the greater of the contract value of any remaining assets
at death, or the total premiums paid less distributions received by death. It is
provided to the beneficiary.

In addition to optional withdrawal benefit
riders (also called living benefits), many deferred variable annuities also
offer optional death benefit riders that create an opportunity for more than
the standard death benefit. One should look carefully at these as they could be
counterproductive for those focusing on getting the most guaranteed income from
their variable annuity. For instance, a common death benefit rider could
support a death benefit equal to the full value of the annuity premiums if at
least one dollar remains in the contract by an advanced age. One must consider
whether it is a wise choice if the focus is otherwise placed on maximizing the
spending power afforded by an income guarantee.

With our focus on maximizing spending power,
we maintain a willingness to deplete the underlying contract value for assets.
But to keep the death benefit, the contract value must stay above $0, which
could create complications because the income guarantee could never be
activated if the death benefit is to be maintained. Such a death benefit could
be more worthwhile for individuals who are not seeking to get the most possible
value out of their income guarantee, such as a strategy to pay RMDs from the
underlying assets while preserving their initial value as a death benefit.
Generally optional income benefit and death benefit riders should not be
combined because they serve different purposes.

Another optional death benefit guarantee may set
the death benefit at the higher of either the initial premium, the contract
value, or the benefit base, but then reduce the death benefit for any distributions
taken. It would not be worthwhile to pay extra for this when focused on taking
distributions.

Some retirees may consider these death benefit
options as an alternative to permanent life insurance (especially when no
longer insurable) if generating income is not the primary focus for this
portion of the asset base. Also, later in retirement if the sequence risk issue
did not materialize and the retiree is in good shape, the focus may start to
shift toward passing wealth to the next generation with minimal need for
further distributions, and a variable annuity with an additional death benefit
rider can be an option to consider in this circumstance. This emphasis on
legacy as the primary goal falls outside our scope. With our analysis, we do
seek to not needlessly sacrifice legacy, but the focus is on maximizing
sustainable retirement spending in the most efficient manner in order to
indirectly also support legacy.

Managing Risks for the Income Guarantee

Providing a guaranteed lifetime withdrawal
benefit is a risky endeavor for the insurance company. The insurance company
must manage both longevity and market risk, as they are obligated to provide
lifetime income payments at the guaranteed level if the underlying assets held
within the annuity have been depleted. The greater the investment volatility
and the higher the guaranteed withdrawals that the insurance company allows,
the greater is the cost for creating a risk management framework to support
that guarantee. Companies have several methods for managing these risks. First,
companies can create a strong culture of financial performance and risk
management. This may help to create an edge in obtaining efficiencies around
supporting the guarantees in the least costly way. It may be hard to
distinguish much in this regard between the leading insurance companies other
than to assess their strength and size, as well as their past performance with
supporting income guarantees during market downturns. Especially as the income
guarantees on variable annuities are not covered by the state guarantee
associations protecting fixed annuities, one must take care to choose a company
that is likely to be around and be able to support the guarantees it offers.

Beyond the company’s culture and approach to
risk management, insurance companies generally have the following levers for
managing the risks around supporting a lifetime income guarantee:

·
Supporting a lower guaranteed income amount

·
Choosing high-quality managers for the investment subaccounts

·
Limiting the volatility allowed within the investment subaccounts,
either by capping the allowed stock allocation (investment choices are each labeled
as risky or not risky, the allowed percentage of risky investments is capped) or
by requiring the use of volatility-controlled investment funds or cash
positions within the subaccounts

·
Increasing the fees for the variable annuity and the income
guarantee rider to provide more reserves and to support the purchase of more financial
derivatives to hedge the risk created by market volatility

For the first point, we have already discussed
how the insurance company can use different rollup, step-up, and payout
features to help better control the amount of guaranteed income it is
contractually obligated to support. Companies may reduce their obligations by
encouraging consumers to only focus on one detail such as a guaranteed rollup
rate. Guarantees can be weakened by using a lower rollup rate, by less frequently
vesting the rollups, by not stacking roll ups on step ups, or by connecting the
benefit base to lower distribution rates. But this sort of approach may only go
so far as it relies on behavioral mistakes by purchasers to focus on only one lever
of the income machine. Companies seeking to provide competitive levels of
guaranteed income must seek to manage these accepted risks through investment
controls and fees.

What are the investment options and constraints for the variable annuity
subaccounts?

The risk to the insurance company for
supporting an income guarantee grows as the contract value declines and falls
further away from the guaranteed benefit base. The insurance company maintains
the responsibility to continue funding the guaranteed income levels if the
underlying portfolio depletes. And so, as the contract value of remaining
assets falls relative to the guaranteed benefit base used to determine income,
risk to the insurance company increases. Insurance companies would like to keep
the contract value strong and close to the benefit base so that they are less
exposed to the costs of providing the lifetime income guarantee.

The ability to invest more aggressively is a
clear advantage provided to the retiree by an income guarantee, and this is a
risk that must be managed by the insurance company offering the guarantee.
Investing aggressively creates more upside potential for the retiree.
Investment growth that leads to step-ups means both a larger benefit base and a
larger contract value for assets. Retirees then only experience a portion of
the downside risk. Market losses will reduce the contract value, but the income
guarantee will provide spending power if the assets deplete through a
combination of portfolio losses and distributions. The income guarantee behaves
as a type of put option on the stock market, as it supports upside growth while
reducing the potential harm to the lifetime standard of living resulting from
market losses.

Ultimately, while the underlying contract
value of assets remains positive, retirees are spending their own money. The
insurance company pays from its own resources when the contract value depletes.
Contract value depletion is what triggers annuitization, and that is why these
are classified as deferred annuities.

Insurance companies can try to control this
exposure to market volatility and capital losses either by limiting the total
allocation allowed to risky assets, by choosing less volatile funds to be
included as part of the subaccount options, or by directly managing the amount
of volatility exposure through volatility-managed investment funds or dynamic
asset allocation that automatically shift assets away from equities at times of
market stress.

Variable annuities will vary by their depth of
investment offerings and by the constraints placed on these offerings. Most
will provide funds from a variety of leading mutual fund companies. Insurance
companies tend to carefully select and manage the fund choices within their annuities
with an eye to finding good performers. The insurance companies are
incentivized to avoid underperforming or poorly managed funds because
this could cause contract values to be depleted more quickly, forcing the
insurance company to make good on its guarantees.

As for constraints, the simplest is to create a maximum
allowed allocation to risky investment such as stocks. Annuity holders may have
investing freedom for choosing among the funds within the annuity universe, but
they would be restricted from increasing the overall risky allocation above
some limit such as 60 or 70 percent. Some companies will also require that 10 percent
of premiums remain in a secured value account that earns a fixed interest
amount based on short-term interest rates.

Another trend is to use volatility-managed funds, which
automatically reduce the stock allocation to keep a consistent volatility level
if volatility rises in the markets. Some companies may require the use of these
type of funds or may otherwise require that a portion of the assets within the
annuity be held in a cash account with minimal volatility.

What are the fees associated with the variable annuity?

While I discussed a variety of ways that
insurance companies manage the risks around supporting lifetime income
guarantees, fees are the headline mechanism for managing the guarantee risk.
Fees can be used to purchase financial derivatives and support other forms of
risk management for the guarantee.

Deferred variable annuities generally have
several types of ongoing fees. The first relate to the underlying funds
expenses that would be included with any mutual fund investment. The only issue
to consider here is whether the funds within the subaccounts have elevated fees
due to the inclusion of 12b-1 fees in their expense ratios, and whether
investment options available to the individual outside of the variable annuity
also include 12b-1 fees as well. These fund fees are charged on the contract
value of underlying assets and would end if the contract value depletes.

The second type of fee relates to mortality
and expense charges for the insurance company. These fees help to support the
risk pooling needs of the insurance company as well as basic annuity death
benefits (such as the return of the contract value or the total premiums paid
into the annuity not yet received as distributions, whichever is higher) and
also help to cover the costs of business and to support the profit needs of the
company. These fees are also generally charged on the contract value of assets.
The annuities may also have a small fixed annual fee as well, at least for
accounts with lower balances.

A third type of fee that may exist temporarily
are contingent deferred sales charges (or surrender charges) for those seeking
nonlifetime distributions above the allowed level in the early years of the
contract. Surrender charges receive much of the criticism related to the
fee levels for variable annuities.

Variable annuities are liquid in that they may be
surrendered with the contract value returned as an excess distribution above
the guaranteed distribution level. But in the early years of the contract, surrender
charges may limit the portion that can be returned without paying a fee. For
instance, surrender charges could work on a sliding scale basis starting at 7 percent
in the first year the annuity is held, and then gradually reducing by 1 percent
a year down to zero after the seventh year that the annuity is held. In this
case, after the seventh year the surrender charges end, and the contract value
will be fully liquid in all subsequent years.

The purpose of these charges is to help the insurance company
offset the large fixed costs involved in setting up a new annuity contract that
can otherwise only slowly be offset through the ongoing mortality and expense charges
of the annuity over longer periods. The largest of these fixed costs is the commission
paid to the adviser selling the variable annuity. Surrender charges would not
be charged on any guaranteed lifetime distributions, and often variable
annuities allow free annual withdrawals of up to 10 percent of the assets
before surrender charges begin. Surrender charges may also be waived for
required minimum distributions when held in qualified retirement plans.

Newer variable annuities designed for
noncommission advisors will generally have lower fees in part because the
advisor will charge for their service separate from the annuity rather than
being paid through the annuity. There is no longer an upfront commission
to be paid by the insurance company. Mortality and expenses fees should also be
less for these no-commission variable annuities since a portion of the fees is
no longer siphoned off to pay the advisor.

Rightly, the insurance company can offer these annuities as
a lower-cost option to consumers. However, consumers must monitor whether
ongoing charges from their financial advisor taken from outside of the annuity
may offset the lower costs within the annuity. Financial advisors will be paid
somehow, such that while shifting these fees from being collected within the
annuity to moving directly to the advisor outside the annuity will reduce the
internal costs to the annuity, it may or may not reduce the overall costs for
financial tools and advice for the end consumer. There are exceptions, but
variable annuities are rarely sold directly to consumers; most variable annuity
sales require the involvement of a financial advisor. One final point here is
that by lowering the internal costs to the annuity, there is a greater
opportunity to obtain step-ups and more lifetime income from the annuity.

Finally, optional riders providing living benefits
through a lifetime withdrawal guarantee or a stronger than standard death
benefit guarantee require an additional ongoing charge. The rider is charged while
the contract value remains positive. Rider charges end after the account is
depleted and the guaranteed benefits continue to be made with insurance company
resources.

Rider charges can be confusing because they
may be charged in three different ways. The most expensive option is to have
the rider charged on the benefit base. As the contract value approaches $0,
this will increase the rider cost as a percentage of remaining assets and work
to deplete the contract value more quickly. Two other options include charging
the rider on the contract value of assets and charging the rider on a declining
benefit base equal to the benefit base less cumulative guaranteed withdrawals.
Charging on the contract value could be more expensive in scenarios with market
upside and strong growth for the contract value, while charging on the
declining benefit base could be more expensive if the contract value declines
quickly and if there is a long deferral period.

For these optional riders, it is clearly
worthwhile not to pay for riders that you do not intend to use. It is often
counterproductive to pay for strong income guarantees and strong death benefits
on the same variable annuity because these benefits are often at odds. It is
also important to keep in mind that most variable annuity contracts allow
provisions for these fees to be increased (or decreased) and one should take
note of the maximum possible charges allowed by the contract.

With these various fees, it is possible that
total variable annuity fees could add up to three to 4 percent. This, along
with surrender charges, is how variable annuities have developed a reputation
as being a high-cost financial product.

The message about fees
is worth digging into further, as it presents one of the biggest objections
made to variable annuities. Variable annuities have generally come under attack
for the higher internal costs relative to an unprotected investment portfolio.
But it is important to frame the issue of variable annuity fees in terms of the
potential value the variable annuity can provide to a retirement income plan. Variable
annuities may have higher ongoing charges than nonannuity investment
portfolios, but a portion of those fees are to pay for the assurance of a
lifetime income in the face of longevity and market risk.

It may be easiest to think about the fee issue
by comparing to simple income annuities. Income annuities do not include
transparent fees, as has been noted. The fees are internal to the product and
the payout rate is provided on a net basis. Money’s worth measures can be used
to back out the implied fees for an income annuity. But if we frame the income
annuity in the same way as a variable annuity, we would conclude that the
income annuity has a 100 percent fee in its first year to provide the
guaranteed lifetime income. Once an income annuity is purchased, assets are
relinquished to the insurance company and will be inaccessible at any point in
the future when the annuitant remains alive (there could be a cash refund
provision at death). There is no contract value.

In contrast, the variable annuity provides
liquidity. Variable annuity liquidity allows for the guarantee to be ended at
any time and remaining assets can be returned. Excess distributions are allowed
with a proportional reduction to the guarantee. The fee drag will work to
gradually reduce the contract value over time rather than eliminating it
immediately.

In practice, we do not describe the income
annuity as having a 100 percent fee. Rather, we focus on the role its
guaranteed income can play in the overall financial plan. Variable
annuities maintain a contract value which has a higher cost associated with it,
but the focus should be on how many assets must be earmarked for different
retirement goals. With risk pooling, an income rider may allow fewer assets to
be earmarked to meet retirement spending needs and that is where its value
lies. A variable annuity with an income rider is then able to pay a guaranteed
income for life based on a fixed percentage of the hypothetical benefit base. The
most compelling aspect of the variable annuity is that even in cases when the
contract value of the underlying assets has been depleted, the income guarantee
will continue to pay for the lifetime of the annuitant.

More broadly, in the context of the retirement
income plan, focusing on the internal costs of a variable annuity is not the
best way to frame the problem we are attempting to solve. Is an
investments-only strategy with lower internal fees preferable if its approach
to managing longevity and sequence risk means that the retiree must either
spend less or delay financial independence because it is necessary to earmark a
larger overall asset base to ensure that retirement spending goals can be
covered? That is the context in which to assess fees: can they support better
outcomes through risk pooling that reduce the overall costs of the plan in
terms of the asset base required to meet the financial goals of retirement?

Income Guarantees, Risk Capacity, Upside
Potential, and Asset Allocation

If one maintains the same asset allocation
both inside and outside of the variable annuity, then the additional fees for a
variable annuity can be expected to deplete the underlying value of the assets
more quickly than if they were held in an unprotected investment account with
lower fees.

However, this outcome changes if one accepts
the notion that having an income guarantee in place can support using a higher
stock allocation within a variable annuity. In this case, when markets do well
in retirement, the additional exposure to the risk premium can more than offset
the higher costs of the variable annuity to allow for greater overall growth in
assets. If markets perform poorly in retirement, the additional costs within
the variable annuity could cause it to deplete assets sooner than otherwise.
But with poor returns, the investments-only portfolio will be on track to
depletion shortly thereafter.

With the variable annuity assets, at least,
the income guarantee continues to support spending after the contract value
depletes. With investments-only, spending power ends. Over time,
variable annuities with income guarantees could have lower remaining wealth
(due to fees) or higher remaining wealth if the guarantee moves someone to
accept a higher stock allocation and stocks perform well.

The assumptions made about asset allocation
for guaranteed funds and unguaranteed funds are incredibly important. It is
natural that retirees with income guarantees will feel more comfortable
accepting a more aggressive asset allocation, and ideally one should compare
approaches using the asset allocations a retiree would choose for both a
guaranteed and unguaranteed approach. This will be individual specific.
Moshe Milevsky and Vladyslav Kyrychenko have provided research based on over
one-million variable annuity policy holders showing that those with optional
income guarantees were willing to have about a 5 percent
to 30 percent higher stock allocation than those without
guarantees on their variable annuities. For instance, someone willing to hold 40 percent stocks without a guarantee may increase their stock
allocation to between 45 percent and 70 percent (if allowed) with an income guarantee in place.

Having the income guarantee supported with
actuarial bonds increases the risk capacity of retirees, as their retirement
standard of living is less vulnerable to a market downturn. This can provide
the capacity to use a higher stock allocation when a guarantee is in place,
both inside and outside of a variable annuity. Inside because the income
guarantee protects income on the downside while still offering upside
potential. Outside because the income guarantee reduces the harm created if
portfolio assets are depleted. Risk capacity is greater.

A retiree may be willing to invest more
aggressively within the variable annuity than with an investments-only
strategy. The variable annuity owner has the upside potential to grow the asset
base and increase guaranteed income with a higher stock allocation, while
knowing at the retirement income is protected and sustainable even if the
market is performing poorly in the pivotal early years of retirement.

The income riders on variable annuities
provide the ability to receive mortality credits, which can reduce the asset base
required to support a lifetime spending goal. The rider fees paid for the
income guarantee provide insurance that the spending will be protected in case
someone experiences a combination of either living too long or experiencing
sufficiently poor market returns that they outlive their underlying investment
assets and cannot sustain an income for life.

A higher variable annuity fee may provide
stronger protections, or it may provide more upside potential. Retirees seek to
evaluate variable annuities along the tradeoff between what can provide the
most certainty for the least cost to potential upside opportunities.

In evaluating a variable annuity guarantee, it
is important to first start with the level of guaranteed income it provides if
no upside is ever achieved. This can be compared with the guaranteed income
from an income annuity offering a cash refund, since this is the most comparable
to the standard death benefit for variable annuities. The difference in payouts
between the two better relates to the cost of upside and liquidity while alive.
Most frequently, the variable annuity guaranteed withdrawal rate will be less
than an income annuity. The differential reflects the guaranteed income one
would give up to receive the upside potential and liquidity in the contract.

With the investment options and annuity
features, how likely is it that the contract value can grow, and how important
is it to the retiree to maintain the liquidity provided by the contract for
those assets? About liquidity, we must remember that it may not be true
liquidity if those assets are earmarked for income because excess distributions
beyond the guaranteed amount will reduce the subsequent amount of guaranteed
income provided. But if a retiree values this liquidity nonetheless, then
comparing the amount of guaranteed income lost to provide the liquidity (and
upside) help to quantify the tradeoff for the decision between income annuities
and deferred variable annuities with income guarantees.

Marketing Approaches for Income Guarantees

We have outlined many factors that impact deferred
variable annuity performance: rollup rates and the frequency of their vesting,
as well as how long they are applied, step-ups and their frequency, whether
rollups stack on step-ups, guaranteed withdrawal rates, death benefits,
investment choices, allowed asset allocation and the range of investment
offerings, use of volatility-managed strategies, fees for the variable annuity
and the optional riders and what they are applied to, and so on.

What approach can provide the most certainty
to the retiree about guaranteed income while costing the least in terms of
opportunity for upside growth? Companies tend to take a particular marketing
approach toward framing their annuity products as the better option for
retirees. They may focus on a few of these aspects and downplay others. With so
many levers and possibilities, it is difficult to say which is best. Companies
with better financial policies and strength could offer a better overall
product, but at some level we should expect that among the best companies there
may not be that much underlying difference, net of costs. There will be an
associated cost for the risk accepted by the insurance company, and this will
not vary too much among companies. In the end, the decision may ultimately
center around choosing a strong company providing an approach and story that
makes the retiree feel the most comfortable.

The most salient features for marketing variable
annuities are the arms races that develop around which company is providing the
highest rollup rates and/or guaranteed withdrawal rates. Companies may be
strong on both, but without being the highest for either, can struggle to make
their message heard. But they may also focus on what really matters: showing
how their combination of rollup and withdrawal rates support more guaranteed
income than the competitors along the lines of the discussion with Exhibit 5.1.
Another position used here is to offer a higher initial guaranteed withdrawal
rate on the condition that guaranteed income decreases if the contract value
depletes, such as starting with allowed withdrawals equal to 7 percent of the
benefit base but reducing withdrawals to 3 percent of the benefit base after
contract depletion.

Along these lines, purchasers should remember
to remain cautious and not necessarily pick the company offering the highest
guarantees. Financial strength is important, and the company with the highest
guarantee may have mismanaged its risk. Weaker companies may not have properly hedged
their risks and the guarantees may not be sustainable.

Another marketing angle is to be the provider
with more frequent step-up opportunities. The consumer receives value if
step-ups can be locked in daily, rather than annually, as it increases the
probability for step-ups to happen and for new high watermarks to be achieved.
The contract anniversary is not always the date with the highest market level
over the previous year. It is even better for owners if these step-ups can immediately
vest and can have the rollup rate stacked on them.

Another approach is to be the provider
offering the most investment freedom. While remaining competitive with the
other means for reducing risk, a company may place emphasis on maintaining an open
investment architecture with no limits on the stock allocation and no
requirements that any sort of volatility-management approach be included for
the underlying asset base. Arguably, this allows a retiree to choose an asset
allocation appropriate to their situation rather than to the risk management
needs of the insurance company.

Finally, companies could focus on providing
the lowest costs for their guarantees, though this is not necessarily a key
focus for any company. Offering a low cost alone is not the point, as the
strength of the guarantees will also probably be less. The issue is more about
what variable annuity offers the most value for its cost. Supporting a stronger
guarantee is more costly, and paying a higher cost is not necessarily bad for a
guarantee that provides greater value to the retiree.

Further Reading

Milevsky, Moshe. 2009. “Annuity Analytics: What is a
Guaranteed Rate Really Worth?” Research Magazine (August).

Milevsky, Moshe A., and V. Kyrychenko. 2008. “Portfolio
Choice with Puts: Evidence from Variable Annuities.” Financial Analysts
Journal, Vol. 64, No. 3 (May/June), p. 80–95.

Chapter 6:
Fixed Index Annuities

Fixed Index Annuities
Caveat

In this discussion of fixed index annuities,
which use to be called equity indexed annuities, I am mostly making an
implicit assumption that the annuity is competitively priced. Internal costs
reflect was is needed to support the guarantees provided by the insurance
company and to keep the company reasonably profitable. But costs are not
excessive such that the value to the consumer is eliminated. As well, I
assume value is created because the annuity has a clear role to play in the
financial plan and is not being sold by an unscrupulous financial advisor
only to generate a commission.

It must be noted that not all fixed index
annuities are created equal. As will be discussed, they are complex financial
instruments, and that complexity can hide a lack of competitiveness in the
pricing of individual products. A fixed index annuity that is pitched at a
free dinner presentation is more likely not the type of financial product I
have in mind, especially if it is misused.

One should tread carefully. Due diligence
and a comparison with other annuity options is needed to make sure that the
product is fairly priced and will behave in the way that the purchaser
understands it to behave. I do not want the “bad” annuities out there to
free-ride off of my explanations about the potential positives that can be
created by “good” annuities.

A fixed index annuity (FIA) with an optional guaranteed
lifetime withdrawal benefit (GLWB) shares many similarities with its variable
annuity (VA) counterpart. Both are deferred annuities that may take advantage
of rollup rates and step-up opportunities to increase guaranteed income. Both
provide guaranteed withdrawal rates. Both also provide tax deferral benefits
outside of qualified retirement plans. FIAs may also have surrender charges on
excess distributions taken in the early years of the contract beyond the free
withdrawal allowances provided. The following discussion assumes familiarity
with the content about variable annuities from the previous chapter because
there are so many similarities between the two. Here I will emphasize the
differences.

Where fixed index annuities are most different from variable
annuities is the underlying mechanism for asset growth. VAs allow for the direct
investment of premiums into subaccounts. FIA premiums are added to the general
account of the insurance company and credit interest to the owner based either
on a fixed return or on the performance of a linked market index. FIAs offer
index-linked interest, but they are not invested directly into the underlying
index. They simply pay interest to the owner using a formula linked to the
performance of the index.

With FIAs, the credited interest (or returns) can be
structured more precisely in terms of controlling downside and upside exposures.
Many FIAs will protect principal in the sense that 0 percent interest is
credited even if the underlying index declines significantly in value. To
obtain this protection, FIA owners should expect to receive only a portion of
any positive gains experienced by the index. These types of structured outcomes
can lead to a different investing experience that could have implications for
retirement income planning and sequence-of-returns risk. Overall, FIAs may
generally reduce the potential volatility of the underlying contract value
relative to a variable annuity. On the spectrum of risk, index-linked FIAs fall
in between fixed annuities with a fixed interest rate and variable annuities
with volatile subaccount investments.

FIAs also differ from VAs in that, as with an income
annuity, FIA fees tend to be structured internally to the product such that
there are no observable fees to reduce the contract value. Fees can be kept
internal because they are based on a spread, like other banking products. The
insurance company earns more from investing the premiums than it pays to the
owner. As with income annuities, it is also possible to reverse engineer and
estimate the internal costs for the FIA, though this process does get more
complicated, as will be explained.

FIAs do not have mortality and expense charges and they do
not invest in funds such that there are no investment fees. Internal fees are
reflected through the limits placed on the upside growth potential. Of course,
upside growth potential must be limited in order to support the downside risk
protections. The internal fees for the FIA just mean that upside growth
potential is less than it could have been if the insurance company did not need
to cover its expenses and profit needs.

At the same time, though, households may not be able to earn
the same rates of returns on their funds as an insurance company that obtains
institutional pricing on trades, better diversification, and longer-term
investment holding periods. It is not always the case that households could
easily replicate on their own what the FIA provides as an accumulation tool.

The exceptions to the lack of external fees include that
FIAs may still have a surrender charge schedule in the early years for excess
distributions. This is done to allow the insurance company to invest the
premium in longer-term assets and to cover the company’s fixed expenses for
providing the annuity. These surrender charges will gradually disappear for
long-term owners. As well, any optional lifetime income benefits or enhanced
death benefits added to the contract have observable fees that will be deducted
from the contract value. Though otherwise protected, the contract value of the
FIA could decline on a net basis after accounting for optional rider expenses.

Another key difference from VAs is that, related to their
potential to protect principal, fixed index annuities may also be emphasized as
an accumulation tool in the preretirement transition years to help lock-in a
wealth accumulation target at the retirement date with a high probability. The
FIA can be treated as an asset class alongside stocks and bonds, but with the
unique property that it protects from downside losses. After accounting for its
tax deferral, the question becomes whether it provides enough upside exposure
to compete with other fixed-income investment opportunities on a risk-adjusted
basis. For these accumulation uses, the optional lifetime income benefit may not
be emphasized.

In other applications, though, the FIA can be discussed alongside
other annuities providing lifetime income as a tool to better manage longevity
and market risk and to meet a retirement spending goal with less earmarked
assets. For some FIAs, using an income rider may be required.

This chapter continues by explaining in greater detail how
interest is credited to FIAs, how the insurance company determines the terms it
offers for the FIA, how FIA returns behave in relation to stocks and bonds, and
other details about understanding how an FIA can function as a retirement tool.

Crediting Interest with
an Annual Reset One-Year Term Point-to-Point Crediting Method

We start with considering how interest is credited to fixed
index annuities, since this is the area that differs the most from variable
annuities. Since FIAs are fixed annuities, crediting interest is the
technical term for the returns generated by the contract value. As with
variable annuities, it can be difficult to provide a standard explanation for
how these returns are calculated on FIAs. Almost countless methods are used in
practice and there is a trend to increase the complexity of the methods used.
The discussion here cannot be comprehensive, but I will try to provide enough
of a general understanding of the main options found in practice.

FIAs will generally provide options to either credit
interest at a fixed rate, or as based on the performance of an external index.
The amount of interest received depends on both the index and the crediting
method chosen.

Perhaps the most common FIA design is to credit interest
through one-year point-to-point crediting with a cap and an annual reset. At
the end of each yearly term on the anniversary date of the contract, the
interest-crediting formula uses the index gain for that year (the price return
for the index over the one-year term) to credit interest. A floor of 0 percent
is protected, and full participation is provided for upside gains up to a cap
rate. The cap rate can be changed, subject to a minimum allowed value, and is
redetermined in advance of each new annual term starting on contract
anniversary dates. This is a necessary feature to account for the market
conditions surrounding the ongoing costs for creating the FIA protections.

Digging deeper, we must consider the index used with the
FIA. Insurance companies generally offer access to different index options as
well as a fixed interest option. Contract owners can often combine these
options in any way they choose and can change the allocations at the start of
each new term. Common index choices include the S&P 500 for large
capitalization US stocks, or the MSCI EAFE index that provides representation
for international stocks. Companies may also offer other index options seeking
lower volatility, such as an effort to pick a subset of less volatile stocks
from the wider S&P 500. Lower volatility can help to support better
parameters that link returns to the interest credited. Increasing complexity
may also be found with dynamic allocation options that will vary the
allocations based on predetermined formulas which adjust to volatility. To keep
this discussion manageable, I will describe the S&P 500 as the index of
choice for an index-linked FIA. It is a commonly used index in practice and
matches the general assumption throughout much of this book that the stock
market is represented by large capitalization US stocks.

Another important matter must be addressed regarding the
index. As mentioned, annuity premium dollars are not actually invested in the
underlying index. Rather, the insurance company is purchasing financial
derivatives that provide a return based on the index performance (more on this
shortly). An implication of this process is that interest-crediting is not
based on the total returns from the underlying index. Dividends are generally excluded
from the calculations. Only the price returns (capital gains or capital losses)
play a roll. This is an important detail because, historically, dividends have
been an important part of the total return for the S&P 500.

For the Morningstar data on S&P 500 returns from 1926
through 2018, the compounded growth rate for the S&P 500 was 10 percent.
However, with dividends excluded, the price returns were only 5.8 percent. It
is the latter number that matters for determining FIA interest.

The dividend issue requires extra caution because there is a
tendency to confuse this point in the marketing literature for some fixed index
annuities. As will be discussed, FIAs should be considered as a potential
alternative to other fixed-income assets, but some marketing literature emphasizes
that an FIA can beat its corresponding stock index, suggesting higher returns
with less risk. The comparison may be in terms of the cumulative growth for FIA
assets relative to the S&P 500 from some starting date, with the idea being
that the FIA provides a greater wealth accumulation at the end. While it is
possible for an FIA to outperform its linked stock index occasionally,
especially if the time period included significant market downturns that let
the FIA shine, this should not be expected as a typical outcome.

The problem is that marketing comparisons are made in terms
of comparing the FIA returns against the price returns of the S&P 500 with
dividends excluded. That comparison might be justified since the FIA
performance is based on the price returns. But I find it misleading because if
an individual were comparing an FIA with a corresponding stock index mutual
fund or ETF, the corresponding fund would provide total returns including
dividends. It will be more difficult for an FIA to beat the total return performance
of the corresponding index than to just beat the price returns.

I have found that the compliance departments of insurance
companies are usually quite strict and take great care to properly disclose matters
and to avoid misleading consumers. And while such marketing literature does
provide small-print disclosures that the price index is being used instead of a
total returns index for the investment alternative, I can only imagine that the
vast majority of individuals reading the marketing piece would overlook, or not
otherwise understand, this vital detail. It may lead individuals to believe
that FIAs can reliably outperform the stock market without accepting the
downside risk of the stock market.

Again, the joint combination of downside protection along
with a portion of upside may occasionally be adequate to outperform the
associated index, but FIA owners should not expect this to happen regularly, as
it would defy the financial maxim that there is no such thing as a free lunch
in terms of earning higher returns without taking on greater risks.

As for credited returns, FIAs provide downside protections
with limited upside potential as based on the performance of the linked index.
For instance, having a floor of 0 percent on credited interest ensures that if
the index experiences a loss during the contract term, the contract value of
the FIA is protected from loss. Even bond funds have downside risk for capital
losses when interest rates rise. FIAs are usually structured to avoid such
losses. Because there is a cost for creating protection for the contract value
against a loss when the index declines in value, one should not expect to
receive the full upside potential from the index. FIAs do not provide a
way to get the returns from the stock market without accepting the risk of the stock
market.

With the chosen index, interest crediting will generally be
based on a formula that can include floors, caps, participation rates, spreads,
and, less commonly, buffers. To explain these basic features, it helps to have
a basic annuity design. We will consider an annual reset one-year term point-to-point
crediting method.

Though it is a mouthful, an annual reset one-year term
point-to-point crediting method is probably the most straightforward and
intuitive way to understand and use an FIA. Allowing for longer term lengths to
also be included in this category, it is likely the most common as well. The
one-year term and the point-to-point method means that the changes in the index
values on one-year contract anniversaries will be used to calculate interest. Annual
point-to-point looks at the change in the index at two different dates, one
year apart. The term could be longer, such as three, five, or seven years.
Whatever the term length, it is the cumulative change in the index value over
the term that is relevant for crediting interest. The term length is also
important because at the end of each term, the insurance company may change these
parameters (such as caps or participation rates) used to calculate interest for
the following term.

As for the annual reset design, this reflects how interest
crediting calculations start fresh for each term. If the index lost 10 percent
in the previous term and credited 0 percent interest for that term, it is only
the new point-to-point change for the current term that matters to calculate
the new term’s interest. In other words, there is no need for cumulative gains
to make up for previous losses when the annual reset provision is included.

Regarding interest calculations, the first step is to
identify the floor on returns. This provides protection from downside
risk and is generally a key feature of FIAs, except for ones using a buffer
approach instead. The floor provides a minimum value that credited interest
cannot fall below. Typically, it is 0 percent in order to provide full downside
protection, but it could be less or more. If the floor is less than zero, then
the annuity is technically a variable index annuity and maintains most
characteristics of the FIA except that it is also regulated as a security
because it can experience losses. If the index price return is less that this
floor value, the interest credited will instead be equal to the floor.

In terms of how an FIA works, a simple way to think about
the downside protection with the guaranteed floor is that the insurance company
buys enough bonds with the annuity contract value that the growth of that
portion with interest will match the original contract value at the end of the
term. Suppose the yield on the insurance company’s general account is 4 percent,
and I have $100 as a contract value in my FIA. Simplifying with an annual interest
payment assumption, if the insurance company invests $96.15 in bonds, this
amount will grow to $100 in a year with the 4 percent interest. The $96.15
investment fully protects my principal and creates a 0 percent return floor. It
also leaves $3.85 for the insurance company to use for both covering their needs
and providing upside potential.

Note that if the floor is less than 0 percent, the amount of
bonds needed to guarantee it would be less. For instance, if the FIA (or,
technically, a variable index annuity in this case) guaranteed that returns
will not be less than -2 percent, then $98 must be protected. That would
require $94.23 growing at 4 percent, leaving $5.77 to be used for other
purposes. Conversely, the floor return could be positive. With yields of 4 percent,
the guaranteed floor could not be greater than 4 percent because sufficient
assets are not available to guarantee a higher return. It requires the full
$100 to guarantee a 4 percent return when yields are 4 percent.

Let’s return to the 0 percent floor example, which takes
$96.15 to protect if the general account assets are yielding 4 percent. No
financial product is truly free. But many FIAs can be marketed as no-cost as
there are no external fees quoted on the product. FIAs do not charge for mutual
fund expenses or a mortality and expense charge on the contract value in the
same way that a variable annuity does. But fees will be accounted for internally.
Fees can only be observed by comparing the upside potential an FIA provides
after creating its downside protection to the actuarial fair upside potential
possible if there were no internal charges to the contract value.

Fortunately, there is a simple way in practice to observe
the yields on FIAs net of the internal fees for a participating company. We may
not know the gross returns for the insurance company investments, but we can
know the net amount after fees as based on the FIA’s one-year fixed return
option not linked to an index. In this example, suppose the insurance company separately
offers a guaranteed fixed return option of 2 percent for the current term. It
must be yielding more than this to cover its expenses and profit motives. With
a 2 percent fixed return, it takes $98.04 to protect principal (or $100 to
guarantee 2 percent growth). The $98.04 to protect principal, when it is based
on the guaranteed fixed return option offered by the FIA, implies that the
combined cost to support the floor and cover company expenses is $98.04. The
remaining $1.96, which is the difference in the floor protection cost at the
assumed general account gross yield, less the floor protection costs based on
the net yield offered by the company’s fixed interest option, is the options
budget that remains to seek the upside growth for the FIA when it is linked to a
volatile market index instead of accepting a fixed return.

Related to what the household can do on its own, that
internal fee may be less on a net basis than what it seems. This is because the
insurance company can earn higher returns from its fixed-income holdings than a
household could independently achieve. The insurance company can receive
institutional pricing for its purchases as a type of size discount, and its asset-liability
matching emphasis allow for diversified long-term holdings. The insurance
company can seek higher return premiums relative to a household from holding
assets with longer maturity dates, greater credit risk, and less liquidity than
a household can generally justify. Households using an FIA in place of holding
bonds in taxable accounts can also benefit from the tax deferral aspect of the
FIA.

The next step is to see how upside potential develops
through a participation rate. The insurance company can use the
remaining funds to buy a one-year at-the-money call option on the S&P 500
index. This is a financial derivative that provides its owner with the right,
but not the obligation, to buy shares of the S&P 500 at the option’s strike
price. The option is at-the-money if the strike price matches the current value
of the index.

Suppose the S&P 500 index is currently at 1000, and the
insurance company buys a call option to purchase the index at 1000 after a
one-year period. If the index has declined in value at the end of the year, the
insurance company will not exercise its option to buy the index at the now higher
strike price. The option expires, worthless. With the bond, the contract value
was protected at $100 and no additional upside is received because the credited
interest linked to the index is $0. This represents the principal protection of
the FIA.

However, if the S&P 500 index price has increased in
value at the end of the year through capital gains (not including reinvested
dividends), then the insurance company exercises the option to buy the S&P
500 at the now lower strike price. What happens in practice is that the shares
are not actually purchased, but the call option owner receives a payment equal
to the gain in the index relative to the strike price from the seller of the call
option. For example, if the index ended the year at 1060, it experienced a 6 percent
price return, and this gain is received by the insurance company. The gain can
then be credited to the contract value of the annuity.

The assumed $1.96 left in this example is probably not
enough to buy a call option on a full share of the S&P 500. Suppose, for
example, a one-year call option costs $3.50. In this case, the $1.96 options
budget represents 56 percent of the call option price. This means that the index
annuity could offer a 56 percent participation rate on the upside from the
S&P 500 price return. The FIA could offer a protective floor through bond
purchases with the potential to receive 56 percent of the upside growth through
the call option purchase with the remaining funds. If the S&P 500 price
return was 4 percent, for instance, then the annuity would be credited with a 2.24
percent gain. Owning a bond and a call option on the index allows the insurance
to guarantee a minimum interest value while also offering upside exposure to
the index.

As an alternative, FIA owners might seek to maintain an
ongoing participation rate of 100 percent. One way that this can be
accomplished is by introducing a cap on interest that can be credited.
To create 100 percent upside participation, the insurance company could also
sell call options on the S&P 500 to provide additional funds beyond the
$1.96. This would support buying more of the at-the-money call option. In our
simple example, to provide 100 percent participation, the insurance company
would like to buy a full call option costing $3.50. It needs to raise an
additional $1.54 to do this. Call options become cheaper as the strike price
increases since the market would need a bigger gain before any payment from the
option is due. There will be a strike price that would support call option
pricing at $1.54. The key is to find what this value is. It would then serve as
the cap for the current term of the FIA. The insurance company sells a call
option at a higher strike price to raise additional funds in order to buy a
full at-the-money call option.

By selling the call option, the insurance company is then on
the hook to pay any gains on the index above that strike price to the buyer of
the option. Suppose a one-year out-of-the-money call option with a strike price
of 1060 is the right level so that the option price is $1.54. The insurance
company could sell one call option with the 1060 strike price and then buy the
full call option with the strike price of 1000. Then, any gains between 0 percent
and 6 percent can be accrued to the contract value with full 100 percent
participation. But the gains are capped at 6 percent because any return above
that reflects an obligation the insurance company must pay to the owner of the call
option it sold.

A subtle detail that must be emphasized is whether the cap
is an interest cap or an index cap. I have been describing an interest cap,
which is more advantageous to the consumer, assuming everything else remains
the same.

With an index cap, instead, the amount of the index gain
realized is capped before then calculating the amount of interest applied. For
instance, suppose an FIA has a 50 percent participation rate and a cap of 10 percent,
and the index return is 25 percent. If that cap is an interest cap as we have
been assuming, the total interest credited is calculated as 50 percent of 25
percent, which would be 12.5 percent, but it is capped at 10 percent. However,
if the FIA instead has an index cap of 10 percent, then 10 percent of the gain
is realized for determining interest. With the 50 percent participation rate on
the 10 percent index gain realized, credited interest is only 5 percent. This
makes a difference and it is important to understand which method is used by
the insurance company.

Another method for increasing the participation rate without
introducing a cap is to add a spread to the FIA interest-crediting formula.
Continuing with our same simple example in which we found a 56 percent
participation rate, suppose the insurance company could offer a 75 percent
participation rate with a 2 percent spread. What this means is that the FIA
provides interest of 75 percent of the market gain less 2 percent, but still
with the same principal protection in place. In this case, the index would need
to experience a 2.67 percent gain before interest is credited because 75
percent of 2.67 percent is 2 percent.

The spread allows for a higher participation rate because it
allows for the call option to be purchased with a higher strike price and
therefore at a lower cost. In this example, the strike price for the call
option can be 2.67 percent higher than its current price because the option
only needs pay interest once this level is exceeded to meet the terms of the
FIA. In this simplified example, this outcome could have been determined if the
price for the call option with that higher strike price is $2.61. Then the
options budget allows for 75 percent of an option to be purchased, providing 75
percent of any gains above 2.67 percent.

Another variation on interest-crediting for these one-year
point-to-point FIAs is to introduce a buffer. But, again, to be clear,
this will change the FIA into a variable index annuity (VIA) because principal
is not protected. Buffers may reduce downside losses, but they do not provide
principal protection. For instance, a VIA that provides a 10 percent buffer
would mean that the interest credited is zero percent for any index loss
between 10 percent and 0 percent. If the index loses more than 10 percent, then
this approach would credit the amount of the loss in excess of 10 percent. For
instance, an 18 percent loss on the index would lead to a loss of 8 percent for
the VIA, but an 8 percent loss for the index would lead to no loss for the VIA.
Accepting this greater downside risk can support more upside potential. But because
these types of buffer VIAs do not create a floor for returns, they do not share
the same general philosophy about how FIAs are known for providing principal
protection.

Other Fixed Index Annuity Crediting
Approaches

The crediting method we have described thus far is a term
end-point method with a reset for each subsequent term. We mostly considered
an annual point-to-point design but explained that longer terms are also
possible. This method only compares the end point to the start point and
ignores any gains or losses in between these points.

There are countless other crediting methods also used in
practice, although some of these may be quite rare. Jack Marrion and John
Olsen provide a more detailed explanation about a wide variety of crediting
methods in their book Index Annuities: A Suitable Approach. For the
purposes of understanding how FIAs work, I do not think it is necessary to
explain other methods in detail, but I recommend the Marrion and Olsen book
for those seeking further details. We will consider a few other methods.

Yield spread design

Another possibility is to use a yield spread
over the term. Instead of choosing a cap to obtain 100 percent participation
rate up to the cap, the insurance company could instead determine the spread
that would allow the options budget to provide full participation above the
spread. The compounded return over the term is calculated, and then a yield
spread is deducted from this to determine the interest that will be credited.
In the annual case, if the index returned 7 percent and the spread is 4 percent,
then the annuity would be credited with 3 percent interest. If the return is
less than the spread, interest credited would match the floor value.

For instance, if the floor is 0 percent, the
spread is 4 percent, and the return is 2 percent, then the interest credited
is 0 percent. This method could provide more interest than a participation
rate when gains are large, but it is likely to be less when gains are more
moderate.

High watermark design

Another possibility is to focus on high
watermark values during a term to determine interest, but this method is more
expensive and is not common.

Rolling average design

Another possibility is a rolling average of
index values during the term. An example of this could be a monthly method to
credit interest based on the average value of the index at the end of each
month during a longer term such as a year. These averaging methods will
moderate the interest credited relative to term end-point methods. Averaging
drives the index values toward the middle with both gains and losses, which
means that a higher participation rate could be offered than otherwise with
everything else being the same.

Monthly sum design

A more extreme and potentially confusing method
is called monthly sum. Each month, upside growth has a cap, but there is no
monthly floor. At the end of the term, the monthly values are added to
determine the interest credited for the term. If the monthly cap is 2 percent,
the interest could be as high as 24 percent for a year, but this would be a
very rare event. It would require consistent gains of over 2 percent for each
month of the year. If the index was up 3 percent each month for eleven
months, but lost 25 percent in the twelfth month, then the interest credited
for the year is 0 percent, assuming a 0 percent floor. This method’s best
opportunity to work is to experience steady upward growth without any market
dips.

There are other methods as well, and this discussion
provides just a taste of the possibilities.

Factors Affecting the
Parameter Values for Fixed Index Annuities

The previous discussion makes clear that the parameters
offered by an FIA (floors, participation rates, caps, spreads, and buffers) will
depend in large part on the level of interest rates and the cost of financial
derivatives for the associated index. Higher interest rates mean that principal
can be protected with less assets, which then leaves more that can be devoted
to the options budget used to purchase upside exposure. Participation rates can
conceivably be higher than 100 percent if interest rates are high enough and the
call options are cheap enough. On a related point, it should also be clear that
if the owner is willing to accept a lower floor, it would be possible to gain
more upside potential since less is needed for bonds and more is available to
purchase call options.

The key factors that influence the price of call options
were formulized with the Black-Scholes formula in the 1970s. The Black-Scholes
formula shows the relationship and factors for determining the price of a European-style
call option, which is relevant for FIAs that credit interest on a
point-to-point basis. European options can only be exercised at the end date
for the option and the price at that time is what matters for determining the
value to the option owner. An American option can be exercised at any point
before the maturity date and are even more complex to price. But even for
European options, a complex mathematical relationship exists between the
factors and the option price (a Nobel prize was awarded to those who figured it
out) and the theorem still relies on simplifying assumptions that may not
always accurately reflect market option pricing. Nonetheless it can provide a
decent approximation. Generally, a call option’s price will be based on six factors.

Implied Volatility

The implied volatility of the underlying
market index may be the most important factor. Greater index volatility will
increase the cost of a call option. Increased volatility creates more
possibility that the index price will increase, which would require a larger
payoff to the option owner. Implied volatility can be difficult to measure in
practice because it depends on future beliefs about how volatile the markets
will be. It is typically estimated from calculating the market’s recent
volatility, with the idea that investors might expect recent volatility to
continue at the same pace. For example, one might look to the annualized
volatility of monthly stock market returns over the previous year as an
estimate of the implied volatility for the purchase of a new option on the
index. But this is only an estimate and it may not be precise. Since 1993, the
VIX has been available from the Chicago Board Options Exchange as a market
estimate of implied volatility for the S&P 500. It can be used as an
estimate of implied volatility, but prior to its introduction any estimates of implied
volatility will be less reliable. The development of low-volatility index
options can be explained, in part because the lower volatility will allow for cheaper
option pricing, which in turn supports more advantageous parameters with the
upside growth exposure.

Current Index Price

This current price of the index is important
with regard to how it relates to the strike price for the associated option.

Option Strike Price

Another important variable is the relationship
between the strike price of the option and the current price of the index. The
strike price represents the price that the index can be purchased. As the
strike price increases relative to the current market price, the option is
out-of-the-money and less likely to provide a payoff. Call options only make
payment when the index price ends up higher than the strike price. The option
will be cheaper with a higher strike price. An at-the-money call option has a
strike price matching the current index price. The strike price could be less
than the current price (it is in-the-money) which makes it more likely to
provide a payoff and more expensive to the purchase. This also explains why an
FIA that includes a spread can offer a higher participation rate than
otherwise. It allows for the call options purchased with the options budget to
have a higher strike price, and therefore less cost.

Risk-Free Interest Rate

The risk-free interest rate is another relevant
variable, though it has a smaller impact. It represents the return on a
risk-free bond during the interval of the option. With a one-year term FIA, the
call option would have a one-year maturity, and the risk-free rate could be
approximated with a one-year Treasury rate. Higher interest rates will cause a
slight increase in the option price, though this will usually be more than
offset by allowing for a bigger options budget to support upside exposure since
fewer bonds are needed to protect the principal.

Term to Maturity

A fifth factor is the term to maturity. We mostly
spoke of a one-year term, but some FIAs will have longer terms of even seven
years or beyond. A longer term does increase the price of the call option, but
not on a one-to-one basis. Longer terms can allow for more attractive FIA
parameters. In other words, the participation rate can be higher when the terms
are longer because the call option price is increasing at a less than linear
rate as the term length increases.

Dividend Rate

Finally, if the market index pays a dividend,
this becomes a final input for the options price. With this input, the strike
price can be entered when thinking in terms of a total return, but then it is
reduced by the entered dividend to make the option cheaper in terms of an
effective strike price. For example, an index priced at $100 with a strike price
of $96 and a dividend yield of 4 percent would create the same call option cost
as for an index priced at $100 with a strike price of $100 and no dividend
yield. Because dividends could be removed and accounted for separately, it is
not mandatory to include the dividend rate as an input for estimating the
option price.

It is interesting to also note that the expected return for
the index is not one of the factors used to price its call option.

It is also vitally important to understand that the amount
of upside potential that can be offered by an FIA will vary over time as
interest rates and call option prices change. With an annual reset design, the
insurance company must repeat this process each year and will face different
interest rates and call option pricing as these variables change values over
time. More upside potential is possible with higher interest rates and cheaper
call options, and vice versa.

This is the reason why insurance companies maintain the
freedom to change the contract parameters (such as the fixed rate,
participation rate, cap rate, or spread) at the beginning of each new term,
subject to a minimum or maximum value allowed for each parameter within the
contract. For those minimum or maximum limits, the boundaries of what the
insurance can use may be extreme, such as the potential to cap interest at 0.25
percent for a term. This flexibility is necessary because the insurance company
does not know beforehand what the ongoing options pricing and interest rates will
be when it is time to renew the process at the start of each new term.

Insurance companies have discretion to change the FIA
parameters in a way that would make them less competitive after the fact. A
company could offer good introductory parameters on the FIA, but it could change
the parameters in an adverse way for subsequent terms in a manner not justified
by fair pricing. A company could reduce the options budget so that it keeps
more. In comparing FIAs between different companies, it is also important to
investigate a company’s history regarding changes to its FIA parameters. Does
the company have a history of adjusting parameters in an adverse direction,
especially during years when surrender charges still applied? If so, this could
serve as a red flag about purchasing that company’s product.

Some companies will be more effective than others in
managing potentially adverse changes from the consumer’s perspective. For FIAs
with surrender charges, insurance companies will often invest in longer-term
bonds matching the length of time that surrender charges remain and will seek
as best they can to avoid any adverse change in parameter values before the end
of the surrender charge period.

Companies must maintain the right to change parameter values
at the start of new terms in order to reflect the realities of changing capital
markets, but high-quality companies will make the effort to place the
customer’s interests first and to not use this nontransparent process to
extract additional value from the consumer.

This discussion should also help to make clear why it
becomes more difficult in practice to simulate the performance of FIAs. Modeling
their performance is more complex than modeling returns for traditional asset
classes like stock and bonds. The simplest approach to modeling FIAs is to
assume that their current parameters (such as floors, caps, participation
rates, and/or spreads) would have applied equally in the past. However, this is
not satisfactory because changing market conditions over time would have led
those parameters to also be different. As well, many FIAs have just been
created recently, and the oldest FIA dates back only to 1995, so that relying
on their historical returns or historical parameter values is not an option.

To obtain a better sense about what their past parameters
could have been, a more complete model to price FIAs must account for the
risk-free interest rate, the broader yield curve and credit spread, internal
insurance company costs and the amount available for the options budget, the
implied volatility of the underlying index linked to the FIA, and the dividend
yield for the underlying index.

Many of these variables are outside the scope of what Monte
Carlo simulations would generally include. Some of these variables are not
readily observable. In particular, insurance company expenses and assumptions
about the performance of their investments, as well as the implied volatility
of the stock market are variables that will require assumptions. Simulations of
FIA performance will only be as reliable as the underlying assumptions used.

To summarize, the factors affecting the degree of upside
participation that can be offered by an FIA include the level of interest
rates, the factors affecting options pricing, the strength of the downside
guarantee protection, company expenses, company pricing assumptions and whether
the company is pricing the FIA to be competitive in the marketplace.

The Choice of Crediting Method

Before the fact, the various crediting methods available should
be approximately equal in terms of long-term performance. Performance after the
fact will be different as the actual index return will be translated into
different interest credited as based on the crediting method. But before market
performance is realized, the different methods are all using the same options
budget to purchase financial derivatives that are priced with the same inputs.

Companies face the same market prices for options and
interest rates. While companies can be creative about designing their crediting
methods, at the end they have to use similar methods to support the guarantees
and upside offered. This means that the parameters (such as participation
rates, caps, floors, or spreads) will have to be adjusted to match the reality
of interest rates and option prices. Different crediting methods are just
different ways to bundle these parameters together. One method is not
inherently better than another. The different methods just structure the
returns of the index differently when calculating the interest to credit. After
the index performance is known, there is a crediting method that will have
worked best with it.

To better illustrate this, we can consider an example of a
one-year point-to-point crediting design with a participation rate or a cap. Is
a cap combined with a 100 percent participation rate better than having a lower
participation rate but with no cap? Before we know the realized index return,
it does not make a difference if both FIAs are priced competitively based on
options pricing. But after the fact, one will perform better. The capped FIA
will do better when returns are positive but lower, while the participation
rate FIA will do better when higher returns are realized. In fact, there is a
formula that can determine the break-even return for this calculation. Suppose
FIAA offers a participation rate and FIAB offers a cap
rate. The break-even return needed for A to outperform B is:

With our earlier simple example, we discussed A as having a
participation rate of 56 percent and B as having a cap rate of 6 percent. This
formula then leads to a break-even return of 10.7 percent. If the price return
on the index exceeds 10.7 percent, then the owner is better off with A that
offers a lower participation rate but with no cap.

A 15 percent return, for instance, means that A credits an
8.4 percent gain while B’s gain is capped at 6 percent. But if the price return
falls below 10.7 percent, then the owner is better off with B even though the
return is capped at 6 percent. A 10 percent index return, for instance, only credits
a 5.6 percent return for A but a 6 percent return for B. If the index gained 5 percent,
then A would credit a 2.8 percent gain versus a 5 percent gain credited for B.

Exhibit 6.1 helps to illustrate this. In broader terms,
introducing principal protection with a cap leads to the creation of two posts.
Returns will tend to fall at either the floor or the cap with fewer returns in
between. The participation rate version without the cap will instead have a
broader range of returns above the floor. This may lead it to have higher
volatility for the returns, but that is reflected more on the upside, as large
positive returns will provide bigger gains for the participation rate version.

Exhibit 6.1

Comparing FIAs with Participation Rates and Caps

For investors who have different beliefs about what future
market returns will be, I mentioned how the different crediting methods could
provide a benefit based on one’s expectations. But to the extent that knowing
future market performance is not feasible, one does not need to worry too much
about the complexity of various crediting methods. When FIAs are priced
competitively, then one cannot easily predict in advance which crediting method
will perform best. The choice of a crediting method should be based more on
what we are comfortable using.

The annual reset one-year term point-to-point
crediting method is relatively easy to understand and is commonly used with
FIAs offering lifetime income benefits. Being common, it also has a better
opportunity to be found with competitive pricing, as it can be hard to know
whether other complex and uncommon crediting methods are offering reasonable
pricing.

The key to FIA performance is not so much the
crediting method, but the insurance company behind it and how it treats its
customers. When resetting parameters at each term, does the company continue to
price competitively or keep more for itself. Do they manage their expenses well
in order to keep the most available for the options budget? Negative market
movements could understandably result in a need to change parameter values in
an adverse direction. But a good company will not take advantage of this fact
as well as consumer inertia to create worse terms for the consumer upon term
renewal.

Lifetime Income Benefits

FIAs also frequently offer optional lifetime income
guarantee benefits in the same manner as variable annuities (VAs). These guaranteed
lifetime withdrawal benefits (GLWBs) are what can make FIAs particularly
valuable in a retirement income plan. Though the names for different pieces may
vary, the discussion from the previous chapter still applies in terms of rollup
rates, the potential for step-ups, guaranteed withdrawal rates, and so on. The
lifetime guaranteed rates vary by age and are also available for joint
contracts at a reduced level or a higher fee. These aspects are all designed to
work in similar ways as with a VA. As well, FIAs are deferred annuities.
Receiving lifetime income through the optional rider does not formally annuitize
the contract while a positive contract value remains.

With these optional income benefits, it is important to
emphasize that principal protection for an FIA is on a gross basis and would
not apply net of the fees for included optional riders. Principal would be
protected in terms of zero interest being credited when the index lost value,
but the optional benefit charge would then reduce the value of the principal.

In practical terms, one difference from VAs is that upside
potential for step-ups with FIAs may be more limited. The interest crediting method
might even prevent the possibility of a step-up during the accumulation period.
This could happen when a cap on credited interest is less than the rollup rate,
especially when the optional rider fee would reduce the net cap applied. With
the distribution phase as well, the capped gains could be less than the
guaranteed withdrawal amount plus the rider fee, preventing the possibility for
step-ups.

For this reason, greater focus with FIAs should be on the
guaranteed income to be generated without necessarily thinking that step-ups
will provide much chance to increase this amount, except there are a number of
FIAs that automatically increase income over time with a cost-of-living
adjustment that does not require a step-up. Certain variable annuities and possibly
FIAs that use participation rates instead of caps could provide more upside
potential in strong market environments, but caps would limit the ability to
benefit from upside.

Some find the idea of using a lifetime income guarantee
benefit on an FIA as a bit puzzling. The three reasons to use an income benefit
include that one expects to take income from the annuity, there is a
possibility of significant decreases in the portfolio value, and there is a
possibility of outliving the portfolio. For these three reasons, the second
does not apply with an FIA because principal is protected. In the absence of
upside, one can calculate with certainty how long the underlying asset base
will last with distributions. This is different from a variable annuity in which
a market drop could significantly reduce the contract value of the annuity
assets and create greater uncertainty about when the contract value may
deplete. In this regard, the FIA income protection is more about pure
management of longevity risk, not the joint impact of longevity and market
risk. The FIA could be viewed as an income annuity that also provides liquidity
for the underlying assets.

This naturally leads the comparison of an FIA with an income
benefit to an income annuity. The tradeoff is that the FIA should be expected
to offer a lower payout rate than an income annuity because it provides
liquidity for the asset base and some upside exposure.

However, it is the case that FIA payout rates for their
income benefits do occasionally exceed the payout rates on income annuities.
Moshe Milevsky wrote a column about this anomaly in 2013 at Research
Magazine. He found that especially for females, and for long deferral
periods before income begins, the FIA payout can beat an income annuity payout.
Reasons include that FIA payouts are gender neutral, while females receive a lower
payout rate on income annuities since they live longer. As well, with a long
deferral period, the insurance company can expect that some FIA owners will
lapse and not take the guaranteed distributions from the FIA despite paying for
the income rider. This takes the insurance company off the hook for making good
on its guarantee, and through competitive pricing some of this benefit is
returned to the other owners in the risk pool. With an income annuity, ending
the contract is not possible and so there will be no lapsation.

The practical impact of the optional rider fee will be to
reduce the contract value a bit more quickly leading to a lower death benefit
than otherwise. But with the focus on income rather than accumulation, the
rider fee is of secondary importance. The goal is not to find the lowest rider
fee, as it would generally support a less generous guarantee, but to find the
FIA that offers the most value through lifetime income to the individual for a
given rider cost. When the individual survives long enough that the contract
value of the FIA is depleted, the benefit continues to support lifetime income.

There is another way that lifetime income benefits can be
structured that moves away from the hypothetical benefit base and the rollup
rate. This alternative approach also exists for deferred variable annuities,
but it is more commonly found with FIAs and so is discussed here.

In the alternate formulation, a lifetime withdrawal
percentage, which is still defined by age bands, is determined at the time the
income rider is added to the FIA. In this case, it is the age that the benefit
is purchased rather than the age that income begins. Then, rather than using a
rollup rate with a benefit base, there is a deferral credit that increases the
withdrawal rate for each year that the owner defers the start of their lifetime
income distributions. When lifetime distributions begin, they are set as a
percentage of the contract value at that time, where the percentage is rising
over time on account of the deferral credits.

For example, suppose a fifty-five-year-old purchases an FIA
that includes this type of income rider. For this contract, the withdrawal
percentage when purchased at fifty-five is 4.5 percent, and the deferral credit
is 0.3 percent for each year that the individual delays the start of income.
The individual plans to retire at age sixty-five, which would provide ten years
of deferral. That would mean that the lifetime withdrawal percentage is 7.5
percent (4.5 + 0.3 x 10) of the contract value at that age. In this case,
principal is protected only on a gross basis before the rider fee is applied at
the end of each year. If the annual rider charge is 1 percent, then in the
extremely unlikely event that the index experiences a negative return for all
ten years, the rider fee would reduce the contract value on a $100,000 premium
to $90,438. With a 7.5 percent withdrawal rate, this provides $6,783 of
lifetime income. However, this minimum amount is extremely unlikely to be realized,
as it would require ten consecutive years of negative market returns—imagine
what this would do to an unprotected investment portfolio—and any upside growth
and positive crediting during these ten years would contribute to a higher
level of protected lifetime income.

This is just an alternative way to account for potential
market growth during the deferral period that can be alternatively applied
through a higher payout rate with a deferred income annuity or with a rollup
rate for a VA or FIA. As always, rather than getting caught up with thinking
about how the different factors interact, it is better to investigate what the
guaranteed income level would be at the targeted retirement date, and to then
consider whether there are additional reasons to choose an annuity with less
guaranteed income, such as the liquidity provisions or the upside growth
potential.

Other Fixed Index
Annuity Details

Fixed index annuities can be complex financial products, and
I will conclude this chapter by discussing some of the other various features
one may come across when investigating FIAs.

We begin with surrender charges or, more formally,
contingent deferred sales charges. FIAs are meant to serve as long-term tools
and surrender charges help the insurance company to invest in longer-term bonds
with higher yields and to recover its initial fixed costs for setting up the
contract. Surrender charges will only apply to excess distributions in the
early years of the contract. As one example, surrender charges might apply
during the first seven years of a contract. These charges could start at 8 percent
and decrease until they are eliminated entirely after year seven.

There are numerous exceptions that allow one to avoid a
surrender charge, including a 10 percent free withdrawal from the contract
value for each term. Surrender charges can also be exempted for death benefit
payments during the surrender period, or if it is necessary to take required minimum
distributions from the contract. As well, there could be exceptions for
terminal illness or a nursing home stay, and the allowed benefits for an
optional income benefit rider are exempt from surrender charges. Note also that
because the government provides special tax treatment for annuities to be used
for retirement, a federal income tax penalty may apply for distributions taken
before age 59.5.

Someone intending to use the FIA for its long-term income
provisions and who has sufficient liquidity elsewhere in the financial plan may
even prefer a contract with higher surrender charges. Higher surrender charges,
which will not be paid, could support more favorable features elsewhere in the
contract.

For distributions subject to surrender charges, a market
value adjustment is also applied to protect other annuity owners from capital
losses if the insurance company is forced to liquidate bonds at a loss to cover
the distribution. The adjustment is based on interest rates and is a way to
transfer interest rate risk to the annuity owner. Annuities are meant to be long-term
investments, allowing the insurance company to purchase longer-term bonds with
higher yields. With excess withdrawals, the insurance company must sell bonds
and could realize losses on these sales if rates have risen. The market value
adjustment shifts such potential losses to the annuity owner making the
withdrawal. Market value adjustments will reduce the contract value further for
distributions taken if interest rates have risen, but they could increase the
contract value relative to the amount of the distribution if interest rates
have declined at the time of the distribution.

An FIA contract will also include a minimum surrender value that
overrides surrender charges and market value adjustments if those factors would
have resulted in less. An FIA is a fixed annuity instead of a variable annuity
because it pays a guaranteed minimum interest rate in this way. The minimum
interest rates paid by an FIA may not always be stated explicitly but gets
reflected through the minimum guaranteed surrender value of the annuity should
one wish to close the annuity contract.

The minimum surrender value implies a guaranteed interest
rate that is different from the 0 percent annual floor. This guaranteed minimum
surrender value is payable upon a full withdrawal, death, or if the contract
value is to be annuitized. As an example, it may be 87.5 percent of the
purchase payment at the start. This value then accumulates at a guaranteed
minimum surrender value interest rate, but it is reduced for withdrawals and optional
rider costs. This minimum surrender value reflects an underlying minimum
interest rate that is part of the contract and that is distinct from any floor
on credited interest applied on an annual basis. If the floor return was
repeatedly realized because of a string of negative index performance, the
contract value could be less than this minimum surrender value, and the
insurance company would have to credit additional interest to apply
retroactively at the time of surrender to meet this obligation. However, with
the annual reset design, with just a couple positive index returns, it is
likely that the contract value will exceed this minimum guarantee.

To summarize this discussion, for someone seeking to take a
full distribution of the contract value, after the surrender period ends the
amount is the larger of the contract value or the guaranteed minimum surrender
value. During the surrender charge period, the distribution amount is the
larger of the guaranteed surrender value (which is not affected by a market
value adjustment) and the contract value net of surrender charges and the
market value adjustment. The market value adjustment is only applied during the
surrender period. These matters could vary slightly if the full distribution is
triggered either by death or by annuitizing the contract. To be clear,
annuitizing the contract is different from turning on the guaranteed lifetime
withdrawal benefit, and most owners would choose the latter.

As well, we have discussed an FIA as providing annual terms.
Interest is credited and new parameters are announced at each anniversary date.
But there is no particular reason for the FIA term to be one year. It could be
longer. The potential appeal of using an FIA with a longer term is that it may
be able to provide more upside potential than rolling shorter-term periods.
Though the costs of call options increases with the term length, it is not a
linear increase. A call option with a two-year term does not cost double of an
option that otherwise has the same features but with a one-year term.

Also, less bonds can be purchased because they have more
time to grow before needing to match the floor value on interest. This can
allow for more participation in the upside after protecting a floor. The other
potential attraction for a longer term is that current FIA parameters will be
locked in for a longer period before subsequent adjustments take place. This
would help if economic trends drive toward less attractive upside opportunities
(lower interest rates and more expensive call options). But if conditions
improve through higher interest rates and less expensive call options, one
would also miss out for longer on taking advantage of these better terms.

Another important caveat about longer terms is that interest
is not credited until the end of each term. Any distributions taken before the
end of the term, including the death benefit, may not be credited with any
partial interest for the term. For instance, an owner who takes a distribution
five-years and 364 days into an FIA contract with a six-year term would not
receive any credited interest for this period, even if, for example, interest
that would credit the account value with 90 percent growth could have been
received just one day later on the anniversary date. The contract value would
still be the same as at the start of the term.

This aspect requires extra caution when choosing a longer
term. One also misses out on the annual reset opportunities to lock in a gain
and protect it from subsequent index losses. Some contracts may provide
exceptions and credit partial interest in the case the owner seeks to annuitize
the contract or if the owner dies and the death benefit is distributed. But
this is not the case with all contracts.

Regarding the death benefit, it is typically the remaining
contract value or the minimum guaranteed value, whichever is larger. The
standard death benefit may be enhanced with optional riders to support a larger
amount.

An FIA may also offer a premium bonus providing an immediate
increase of several percentage points to the initial contract value of assets.
One reason this may be offered is to help the insurance company to obtain a
longer-term commitment from the consumer, as the bonus will be recaptured for
early withdrawals. Bonuses may also be a salient feature that draws attention
from consumers. With a premium bonus, individuals must remember that there is
no free lunch, as other less salient features would be adjusted in adverse
directions in order to support the bonus.

Though this book is focused on retirement income, FIAs are
not always used primarily for their income generating optional benefits.
Rather, they may be used as an accumulation tool. Fixed index annuities provide
protection from interest rate risk and other sources of investment volatility.
Unlike a bond fund or individual bonds not held to maturity, they do not
experience losses if interest rates rise.

Principal is protected and secured. This can provide
powerful behavioral benefits. Fixed index annuities also offer tax deferral,
unlike investment assets held in taxable accounts that face ongoing taxes on
their growth. Upside may be limited, but protecting principal is where the
index annuity has an opportunity to shine relative to other accumulation tools.

FIAs can function as an asset class within an accumulation
portfolio to better manage downside risks while still providing participation
in the market upside. The ability to better manage downside risks can lay a
foundation for either needing less assets to successfully retire, or to be able
to enjoy a higher standard of living from a given asset base.

Risk averse households will seek a high probability of
success that their financial plan will work, which implicitly leads them to
assume a lower rate of return from their investments. This matter was addressed
in detail in Chapter 3. By managing downside risks through a more structured
approach that creates a floor in which the asset return cannot be negative, a
fixed index annuity used within an accumulation portfolio can allow for greater
wealth accumulation at lower percentiles of the distribution of outcomes when
markets perform poorly. This protection makes it easier to retire successfully
in down market environments.

The FIA may serve as a suitable replacement for bonds or
other asset classes with a low correlation to the stock market within an
accumulation portfolio. Even if the overall portfolio standard deviation
increases with the inclusion of an index annuity, the ability to protect from
downside losses may serve to reduce risk for the distribution of wealth
outcomes. Returns for the index annuity do not follow a traditional bell-shaped
distribution.

One final point to include in the general discussion of FIAs
is a philosophical question regarding whether we should think about FIAs as a
stock-like asset or as a bond-like asset. With a 0 percent floor it has less
downside risk than either, but can enough upside be captured with the FIA to
beat either stocks or bonds on a risk-adjusted basis? Though the interest they
credit is linked to the S&P 500, the returns on FIAs will be closer to
bonds than to stocks. However, they are not exactly like bonds either, since
principal is protected for FIAs, while bonds can experience capital losses when
interest rates rise.

Owners should not think about FIAs as an alternative to
owning stocks but rather as another option for fixed-income assets that
protects principal and has the potential to outperform bonds when considered
net of taxes and fees. With their principal protection, retirees may even
consider increasing their stock allocation when replacing bonds with an FIA.
One might occasionally observe that the cumulative returns from an FIA exceed
the cumulative returns from its corresponding index, but this would have to be
triggered by a large market loss in one year that the FIA protects so that its
limited upside allows it to jump ahead. This will not be common outcome.

Ultimately, a fixed index annuity offers a tool to securely
get assets to retirement by managing market volatility and the sequence-of-returns
risk in the pivotal years leading to retirement. This can better set the stage
for retirement and for creating more lifetime retirement income from a given
asset base. Our focus is on lifetime income, and we will return to the use of
FIAs in a retirement income plan when we compare different tools in Chapter 9.

Further Reading

Marrion, Jack, and John Olsen. 2010. Index Annuities:
A Suitable Approach. St. Louis: Olsen & Marrion, LLC. [https://amzn.to/2WXEB03]

Milevsky, Moshe A. 2013. “Annuity Anomaly: EIA + GLB
> SPIA?” Research Magazine (July).

Chapter 7:
Life Insurance

Thus far, the risk
pooling discussion has focused on annuities. Another form of risk pooling for
longevity is available through life insurance, and this chapter explores the
ways that life insurance can potentially be incorporated into lifetime
financial planning. This discussion is mostly about whole life insurance in
comparison to term life insurance, but other forms of permanent insurance will
be discussed briefly at the end of the chapter.

Whole life insurance can provide a foundation
to allow the household to spend more and still be able to provide a bequest, or
to increase spending even further by using the cash value as a volatility
buffer for the investment portfolio. Whole life insurance can provide a source
of funds to support legacy, liquidity, and even long-term care if a rider is
added for that purpose. With life insurance playing this role, the retiree may
also feel more comfortable using an annuity with lifetime spending protection,
which provides the benefits of risk pooling to meet a retirement spending goal
using a smaller asset base.

As well, when viewed as an investment, whole
life insurance can provide an attractive alternative to holding bonds in an
investment portfolio. Premiums are invested in the insurance company’s general
account, which, as we have discussed, can provide advantages for fixed-income
investments relative to what a household can obtain on its own. Life insurance
also provides tax deferral for its cash value, and when properly structured,
the cash value can be accessed on a tax-free basis during life (meaning that
the cash value of life insurance behaves similarly to a Roth IRA). The death
benefit is also provided on a tax-free basis. Because of limits on how much
that can be invested into tax-deferred retirement plans, this aspect of life
insurance can provide a way to obtain more tax-deferral for savings after
exceeding other limits.

That being said, the traditional purpose of
life insurance is to provide a death benefit to help support surviving family
members or a family business in the event of the policyholder’s untimely death.
In this context, the amount of life insurance one seeks to hold is what
dependents would need to sustain their lifestyle or meet other obligations in
the absence of the policyholder being able to contribute to the family through
wages or other caretaking. As noted, life insurance can play other roles in a
retirement income plan as well. This chapter investigates life insurance from
the broader retirement income perspective.

Just as annuities with income guarantees use
actuarial science and risk pooling to support a spending level consistent with
living to life expectancy, life insurance is also based on actuarial science and
provides mortality credits and risk pooling. Life insurance works as the
counterpart to lifetime income. While lifetime income protections reduce the
cost of funding a long life, life insurance provides higher realized returns to
a household in the event of a shorter life. These two contrasting uses of risk
pooling can work together effectively in lifetime financial planning.

During the preretirement period, human capital
is an important asset for households. Human capital is the present value of all
the wages individuals expect to earn during the remainder of their working
years. For those with families or other fixed obligations that depend on
receiving human capital in the form of those future wages, the life insurance
death benefit can serve as a replacement for lost wages in the event of an
early death during the working years. We usually think of life insurance as a
tool for replacing lost income, but even a homemaker who does not earn wages
may consider life insurance to help the household that would then have to pay
for more services related to childcare and household management in the event of
the homemaker’s death.

For this basic human capital replacement
framework, one generally does not associate a need for life insurance after
retirement begins. The value of human capital approaches zero as the working
years end, though those continuing with part-time work in retirement may still
be reliant on and need protection for their human capital. Once fully retired,
the household subsequently funds lifestyle with assets accumulated during the
working years. They have converted their human capital into financial assets.

Term life insurance supports the role of human
capital replacement. With term life insurance, one purchases a contract to
receive a death benefit should death occur within a certain number of years or
by a certain age. The term could be chosen to end once family needs or other
financial obligations no longer depend on the future earnings of the worker. A
mantra of “buy term and invest the difference” developed in the investing world
as the way to approach the life insurance decision. Because the death benefit
is temporary with term life insurance, and it also does not include a savings
component, term life premiums will be smaller than with other forms of life
insurance. For a given pool of funds, this affords a greater remaining amount
to be invested after life insurance obligations are met, as long as the
individual follows through and invests those additional dollars not spent on
life insurance premiums.

For lifetime financial planning, is it really
best to pay the smallest amount possible for life insurance in order to invest
as much as possible in the financial markets? This chapter puts the concept of
“buy term and invest the difference” to the test by investigating whether there
are better ways to approach life insurance from the context of comprehensive lifetime
financial and retirement income planning. The focus of this chapter is about
whether other forms of permanent life insurance should be considered by the
household as part of a longer-term retirement strategy that can be set into
motion during the accumulation phase. Even though term insurance premiums are
lower, this type of life insurance may not always provide the best value in the
context of financial planning outcomes related to getting the most spending
power and legacy from the available asset base.

I will focus particularly on whole life
insurance as an alternative to term insurance. For life insurance, there are
natural parallels between different types of insurance products and different
types of annuities. Whole life insurance corresponds most closely to income
annuities. For both, premiums enter the insurance company’s general account and
the insurance company invests those premiums with a heavy focus on fixed-income
assets and asset-liability matching. Whole life insurance consists of a death
benefit and a cash value savings component. A difference between whole life
insurance and income annuities is that whole life policies are frequently participating
policies that can earn dividends when realized outcomes fair better than the
insurance company’s conservative pricing projections, while participating
income annuities are still relatively rare. Unlike income annuities, whole life
insurance is underwritten, and different pricing is available based on health
classification.

To conclude the chapter, I will briefly also
consider other forms of life insurance that roughly approximate the role of
variable and index annuities. These forms of life insurance include variable
and index universal life insurance. In the context of retirement income
planning, the potential role for these types of insurance policies is to create
a source of supplemental retirement income that may provide net benefits when
the tax-advantages of life insurance contribute more value that the insurance
costs of the policies.

Term Life Insurance

Term life insurance offers a death benefit if
death occurs during the fixed period covered by the contract, when premiums have
been paid and the policy remains in force. When not viewing life insurance
within the framework of retirement income planning, term life insurance offers
the lowest premiums to support the human capital replacement needs of the
household. Other types of life insurance are a combination of term life
insurance and a savings vehicle. This makes it important to begin the discussion
with a clear understanding about how term life insurance premiums are
calculated.

Exhibit 7.1 shows the basic mechanics for
determining the premium payments required to support a term life insurance
policy providing a $500,000 death benefit received on a tax-free basis. The
costs of insurance relate to the mortality risk during the period covered by
the contract. As such, insurance premiums will vary by age, gender, and health
status as determined through the underwriting process. This example is provided
for a forty-year-old male using average mortality in the United States for Social
Security participants born in 1980 without any assumed underwriting. In
practice, nonsmokers in good health will get a more preferred status with lower
premiums while others with medical conditions may not even qualify to purchase
life insurance. All else being the same, premiums rise with the policy starting
age as mortality rates increase. Life insurance is also cheaper for women than
for men, since women live longer on average.

As with the previous discussion about how
income annuities are priced, Exhibit 7.1 uses a few simplifying assumptions to
make it easier to understand the basic structure for how term life insurance
works. These simplifications relate to interest rates, mortality and fees. I
simplify interest rates to assume that fixed-income assets always and forever earn
3 percent. Interest rates do not change in the future and we do not worry about
other fixed-income assets like corporate bonds that may offer higher yields
accompanied by greater credit risk. Since interest rates do not change, there
is no interest rate risk or reinvestment risk. The insurance company can
determine prices knowing with certainty what interest rates will be in the
future, so there is no need to accumulate additional reserves to support future
claims in the event of an unfavorable fixed-income investing environment.

For mortality data, I use the 1980 Social
Security Administration cohort lifetime, which is the closest available life
table for current forty-year-olds. This table provides mortality data including
projections for the total population of Social Security participants born in
1980. I assume that there is no risk about unexpected changes in mortality so
that the insurance company can determine pricing without holding excess
reserves to support claims in the event of unfavorable surprises.

This mortality data source is a cohort life table, rather
than a period life table. Cohort life tables track mortality for the same
individual over time. When a sixty-five-year-old in 2019 turns eighty-five in
2039, his mortality rate at eighty-five will most likely be lower than that of
an eighty-five-year-old in 2019. A cohort life table uses projections for
future mortality improvements when calculating life expectancies. Even if the
projections end up being wrong, they are probably closer to being correct than
assuming no mortality improvements at all. Cohort life tables will project
longer lives and are surely a better choice for considering longevity when
building a retirement income plan. The Social Security Administration also
provides cohort life tables for Social Security participants born at different
points in the past.

Also, as mentioned, most insurance companies
use underwriting to further classify their customers by mortality risk. Some
may not qualify for life insurance while others who demonstrate good health and
a lower mortality risk can obtain better insurance rates. I assume there is
just one life insurance policy for the whole population with the same age and
gender, and everyone can qualify without underwriting. This will make my
simulated pricing more expensive for those who could otherwise qualify for
preferred categories. Another implied assumption is that no one lapses on their
insurance policy. All policyholders are assumed to hold onto their policies for
their full term.

Finally, I am assuming that the insurance
policy provides actuarially fair pricing without expenses deducted for operating
the insurance company. This will support direct comparisons in the later
analysis between investments and insurance where both are treated as not having
fees. Later in the chapter I will describe the implications of changing these
assumptions.

The way to understand how premiums are
calculated on a term life insurance policy is to recognize that term life
insurance is a collection of renewable one-year term policies. Consider that I
buy a one-year term policy as a forty-year-old male. Given the mortality data I
am using, the insurance company projects that over the next year, 224 forty-year-old
males out of 100,000 will die, and this is the number of death benefits that
must be paid. The insurance company must collect enough premiums to support
these claims. For the population of 100,000 policy holders, this requires
charging each participant $1,120 for their one-year of protection providing a
$500,000 death benefit to those who die.

Next, suppose I seek protection for two-years
instead of one. I still buy the policy at age forty, but I now wish to
calculate the cost of protection at age forty-one as well. At age forty, I
effectively buy a one-year policy that allows me to renew for the second year
without going through additional underwriting. Mortality rates increase with
age. But the insurance costs this implies will be partly offset by the fact
that there is a smaller pool of survivors from the original pool of
policyholders to which the increased mortality rates apply. Of the original
100,000 policy holders, 999,776 remain alive at forty-one and a further 239 of
them are expected to die. The life insurance company must collect enough
premiums to support these claims. Calculating the premium required today means
looking at this cost of insurance in one year, but then further discounting the
cost of insurance by the fact that by collecting premiums today, the insurance
company can grow that money at the 3 percent rate for one year before it is
needed to pay claims. With this discounting, the premium is $1,162. This
process continues at each age that coverage is provided. Though not all ages
are shown to conserve space, age eighty-seven is the year that the highest
number of original policy holders (3,794) are expected to die. Even though
mortality rates continue to grow with age, applying them to a dwindling pool of
survivors means that the overall number of deaths subsequently declines. At age
100, 754 of the original policy holders are expected to die. The cost of
insuring against death between the 100th and 101st birthdays is $640,
reflecting the number of deaths among the original policyholders at that age as
well as the discounting for the premium paid today that grows at 3 percent for
many years before it is used to pay for those death benefit claims.

Summing these insurance costs through age 119,
the cost of providing a $500,000 death benefit is $164,927 if paid as a single
premium today. This is reflecting the power of compounding interest as well as
the role of risk pooling. Death is certain to happen at some point; paying $164,927
today would ensure a death benefit of $500,000 will be paid when death happens.
Naturally, the sooner death happens, the higher would be the implied rate of
return earned by the policy holder.

Though it is conceivable to buy a permanent
term insurance policy as just described, this is not typically how most people
approach term insurance. Instead, a term policy may be used in a temporary
manner to protect human capital. The cost of a policy, then, is simply the
cumulative costs of those one-year term policies for as long as coverage will
be maintained.

Consider the case in which someone wishes to
have the death benefit protection until reaching an anticipated retirement age
of sixty-five. With insurance coverage ending on the 65th birthday, the cost is
the sum of the twenty-five one-year policies from age forty through sixty-four.
This cost is $40,934. The forty-year-old male could pay this amount today to
receive the protection of $500,000 should death happen before age sixty-five.
We can gather from the pool of survivors that 87,460 out of 100,000 would still
be alive at sixty-five, and so 12,540 members of the pool would have received
the death benefit by that time. The premiums of the survivors subsidize the
death benefit payments for those who did not make it. This is risk pooling and
mortality credits in the life insurance context.

One final matter to consider is that most
people do not use this single premium payment method to pay for the term
policy. Policyholders typically wish to spread those payments over time. How
much should the insurance company charge as an annual premium to cover this
term life policy through age sixty-five? To determine this, we can view the
shift from a single premium to ongoing premiums as a loan provided by the
insurance company to the policy holder. The insurance company needs $40,934
today to fund the term policy expiring at age sixty-five. In effect, the company
provides a loan of this amount to the policyholder, and the policyholder pays
back the loan over time in the form of annual premium payments. Assuming that
the insurance company uses the same 3 percent interest rate for this
calculation and that premiums are paid at the start of the year, the matter is
to determine the annual premium needed to repay this loan. An annual premium of
$2,282 is the solution to this PMT equation:

= PMT (3%,
25 years, -$40,934, $0)

Exhibit 7.1

Pricing a Term Life Insurance Policy for a Forty-Year-Old
Male

Death
Benefit:

$500,000

Interest
Rate:

3%

Age

Discount
Factor

Pool of
Survivors

Deaths

Discounted
Cost of One-Year Term Insurance

40

1.000

100,000

224

$1,120

41

0.971

99,776

239

$1,162

42

0.943

99,537

257

$1,210

43

0.915

99,280

274

$1,254

44

0.888

99,006

291

$1,293

45

0.863

98,715

311

$1,341

46

0.837

98,404

331

$1,385

47

0.813

98,073

346

$1,407

48

0.789

97,727

359

$1,416

49

0.766

97,368

368

$1,410

50

0.744

97,000

379

$1,411

…

…

…

…

…

65

0.478

87,460

1,140

$2,721

66

0.464

86,320

1,239

$2,872

67

0.450

85,082

1,337

$3,011

68

0.437

83,744

1,434

$3,133

69

0.424

82,311

1,529

$3,245

70

0.412

80,781

1,634

$3,366

…

…

…

…

…

99

0.175

3,793

970

$848

100

0.170

2,822

754

$640

101

0.165

2,068

578

$476

…

…

…

…

…

118

0.100

0

0

$0

119

0.097

0

0

$0

Cost of
Term Life Policy Through Age 119:

$164,927

Cost of
Term Life Policy Through Age 65:

$40,934

Annual
Premiums for Term Life Policy Through Age 65:

$2,282

Regarding taxes, premium payments are made
with after-tax dollars and the death benefit is received on a tax-free basis.
This taxation structure for term life insurance is most similar to Roth IRAs as
gains within the policy resulting from the death benefit being larger than the
cumulative premiums paid are not taxed.

If one is thinking about term life insurance,
an important policy option to consider for an additional cost is a provision
allowing the owner to later convert the policy to permanent life insurance.
This option would help to protect from the risk that one later determines a
need for additional life insurance coverage but has also incurred a health
problem causing him or her to no longer qualify for a new life insurance
policy. Such conversion options generally will last for a fixed period or until
a particular age.

Whole Life Insurance

Whole life insurance receives its name because
it provides the owner with a death benefit for the whole lifetime. It is a form
of permanent life insurance. Whole life also includes an accumulation and
savings component through its cash value. Whole life insurance may be viewed as
a fixed-income investment vehicle that incorporates a permanent death benefit
as well. When structured properly, a whole life policy provides a tax-free
death benefit and tax-deferred growth for its cash value. There are ways to
access the cash value on a tax-free basis as well, as will be discussed. Whole
life policies include provisions that guarantee the amount and duration of
premium payments. The policy endows at the point that the cash value has grown to
equal the amount of the death benefit. Whole life policies are typically
designed to endow at either age 100 or age 121. If the policy also matures at
one of these ages, then the cash value is paid to the policy holder, with gains
in the policy being taxable. Policyholders may prefer to have the policy endow
rather than mature, which allows the policy holder to maintain the policy until
death so that the cash value can be received as a death benefit without having
to pay taxes.

Before digging into the details about how whole
life insurance can fit within a retirement income plan, it is worth beginning
this discussion with a simple explanation about how to calculate premiums on a whole
life policy without extra features. As with term life insurance, the costs for
the death benefit are structured as a lifetime series of one-year term policies.
But there is one important difference related to cash value accumulation that
helps to reduce the insurance costs within a whole life policy over time
relative to term insurance.

Exhibit 7.2 provides the mechanics for a whole
life policy designed to endow at 100. The death benefit is available when death
occurs before age 100. At age 100 the cash value has grown to equal the death
benefit and the policyholder could receive the death benefit if still alive,
but any gains in the policy would be taxable. If left untouched, the cash value
and death benefit can continue to grow with interest and the death benefit
could be received at death without triggering a taxable event.

With whole life insurance, there is as a
policy cash value that provides a portion and eventually all of the death
benefit. The cash value represents the amount that the policy holder could
receive by surrendering the policy before death. This is a feature not provided
with term life insurance.

The cash value represents an asset for the
policy holder and the cost to the insurance company of providing the full death
benefit is not the full amount of the death benefit. Rather, it is the
difference between the death benefit and the cash value. This is an aspect that
helps to reduce the costs of insurance implicit inside the whole life policy
over time relative to a term policy. When death occurs, the insurance company
only needs to cover the difference between the death benefit and the cash
value.

For those needing life insurance for human
capital replacement, the ability of whole life to reduce insurance costs
through the cash value helps to make cash value growth more competitive relative
to buying term insurance and investing the premium difference in bonds. With
“buy term and invest the difference,” the outside investments have no impact on
the cost of insurance. With whole life insurance, the portion of the premium
that goes into the cash value is working double-duty by accumulating a return and
by helping to offset the future costs of the life insurance by reducing the portion
of death benefit at risk for the insurance company. A single-premium whole life
policy would grow the cash value most quickly to reduce the subsequent costs of
insurance within the policy, while policies that extend premium payments out
for longer periods would have relatively less prefunding and higher relative insurance
costs.

Moving now to Exhibit 7.2, the first four
columns are the same as with term life insurance in Exhibit 7.1. The fifth
column in the exhibit is different. With term insurance, the insurance company
must always support the full death benefit. But with whole life insurance, the
insurance company only needs to support the amount of the death benefit that
exceeds the cash value in the policy. This column reflects the $500,000 death
benefit less the cash value accumulated at the end of the previous year. Now,
the amounts shown in the discounted cost of one-year term insurance are
impacted by four factors: rising mortality rates with age, the declining number
of surviving policy holders, the discount factor on the amount set aside today
to fund that future insurance cost, and the declining value of the net death
benefit.

This leaves two remaining columns to be
explained: premium and cash value. They are interrelated. The cash value is an
asset of the policy holder. Any premiums paid are first used to pay for the
cost of insurance, and the remainder is accumulated as cash value. With our
assumptions, cash value also grows at the same economy-wide assumed 3 percent
interest rate. The policy in this exhibit is designed to allow premiums to stop
after twenty-five years at age sixty-five when the individual is anticipating
retirement. The costs of insurance must still be paid; they are deducted from
the cash value that is still otherwise growing at 3 percent each year. In this
example, the $6,873 premium is specifically chosen so that the cash value grows
to match the value of the death benefit at age 100 even after paying all
insurance costs. A smaller premium would leave the cash value falling short of
the death benefit at age 100, and a higher premium would cause the cash value
to reach the death benefit amount too soon.

Though not shown in the exhibit, separate
calculations indicate that a single premium of $119,662 at age forty would
support the same whole life policy with $500,000 of death benefit coverage and
with cash value growing to the value of the death benefit at age 100. Again,
the reason the whole life single premium is less than the permanent term
insurance premium (which was $164,927) is because of the role the cash value
plays in reducing the net amount of the death benefit the insurance company must
cover.

Exhibit 7.2

Pricing a Whole Life Insurance Policy for a Forty-Year-Old
Male

Death
Benefit:

$500,000

Discount
Rate:

3%

Age

Discount
Factor

Pool of
Survivors

Deaths

Death
Benefit Requiring Insurance

Discounted
Cost of One-Year Term Insurance

Premium

Cash
Value

40

1.000

100,000

224

$500,000

$1,120

$6,873

$5,926

41

0.971

99,776

239

$494,074

$1,149

$6,873

$11,999

42

0.943

99,537

257

$488,001

$1,181

$6,873

$18,222

43

0.915

99,280

274

$481,778

$1,208

$6,873

$24,603

44

0.888

99,006

291

$475,397

$1,229

$6,873

$31,154

45

0.863

98,715

311

$468,846

$1,258

$6,873

$37,873

46

0.837

98,404

331

$462,127

$1,280

$6,873

$44,770

47

0.813

98,073

346

$455,230

$1,281

$6,873

$51,873

48

0.789

97,727

359

$448,127

$1,269

$6,873

$59,201

49

0.766

97,368

368

$440,799

$1,243

$6,873

$66,776

50

0.744

97,000

379

$433,224

$1,223

$6,873

$74,599

51

0.722

96,621

395

$425,401

$1,214

$6,873

$82,665

52

0.701

96,226

416

$417,335

$1,217

$6,873

$90,971

53

0.681

95,810

442

$409,029

$1,230

$6,873

$99,512

54

0.661

95,368

475

$400,488

$1,257

$6,873

$108,281

55

0.642

94,893

512

$391,719

$1,288

$6,873

$117,282

56

0.623

94,381

554

$382,718

$1,321

$6,873

$126,519

57

0.605

93,827

598

$373,481

$1,351

$6,873

$136,002

58

0.587

93,229

644

$363,998

$1,377

$6,873

$145,743

59

0.570

92,585

693

$354,257

$1,401

$6,873

$155,752

60

0.554

91,892

747

$344,248

$1,424

$6,873

$166,037

…

…

…

…

…

95

0.197

10,545

2,162

$68,010

$289

$0

$444,652

96

0.191

8,383

1,838

$55,348

$194

$0

$457,791

97

0.185

6,545

1,522

$42,209

$119

$0

$471,402

98

0.180

5,023

1,230

$28,598

$63

$0

$485,479

99

0.175

3,793

970

$14,521

$25

$0

$500,018

Exhibit 7.3 provides a visual representation for
the numbers in this whole life example. At the top, the exhibit shows a steady
death benefit of $500,000 from age forty to 100. Next, the cash value grows to
equal the value of the death benefit at age 100. This example includes premium
payments until age sixty-five. By sixty-five, the cash value of $107,380 is
higher than the $85,925 of cumulative premiums paid. But it took twelve years
for positive returns net of insurance costs to manifest for the cash value.
Whole life insurance is not designed to be a short-term strategy. After age
sixty-five, the cash value continues to grow net of the continuing insurance
costs until the policy endows at age 100.

Exhibit 7.3

Whole Life Insurance Policy Values for a Forty-Year-Old
Male

Whole Life Insurance in
a Lifetime Financial Plan

With this understanding about how life
insurance is priced, I can create a simple model to consider four different
potential roles for this whole life insurance policy in retirement income
planning. First, the death benefit for life insurance provides a method to meet
a legacy goal using risk pooling and tax advantages that is distinct from
preserving investment assets for this purpose. This can allow the retiree to
potentially enjoy a higher standard of living in retirement than otherwise
possible, while also ensuring that assets have been earmarked to meet the
legacy goal.

Second, a permanent death benefit supported
through whole life insurance can be integrated into a retirement income plan by
helping the retiree to justify the decision to buy an income annuity and to
overcome the behavioral hurdles that lead to the annuity puzzle. It can also
allow the retiree to purchase a life-only single life annuity that offers the
most mortality credits to the risk pool and therefore offers the highest payout
rate to the owner. Wealth Building Cornerstones, the firm that developed this
strategy, calls it the covered-asset strategy.

The key idea is that the retiree can feel
comfortable buying an income annuity because of the understanding that the life
insurance death benefit will return the amount spent on the annuity premium to
the household at the time of death when annuity payments cease. As opposed to
obtaining a form of life insurance for the household through the annuity by
adding cash refund provisions or a joint life option, this integrated approach with
a separate life insurance policy creates greater flexibility for the household
by reducing the required annuity premiums needed to meet a spending goal.

Next, the cash value of whole life insurance
also provides a few interesting options for a retirement income plan. Cash
value may serve as a volatility buffer to help manage sequence risk in
retirement. This strategy was also developed by Wealth Building Cornerstones.
Cash value does not experience downside risk for capital losses in the face of
rising interest rates. It is guaranteed to grow and can provide a temporary resource
to supplement retirement spending rather than being forced to sell portfolio
assets at a loss during poor market environments.

Finally, when considered net of fees, taxes,
and insurance needs, cash value accumulation within a whole life policy can
serve as an alternative and competitive means for investing in fixed-income
assets as opposed to using bonds or bond funds within a traditional investment
portfolio. We consider each of these four ideas in turn with a case study.

The Case Study

For these comparisons, I create a case study
for a forty-year-old married couple with two children who are now constructing
a lifetime financial plan. Jerry and Beth have determined
that it is time to get serious about retirement and life insurance planning.
Jerry is employed and Beth is a homemaker. These gender roles could be
switched, but since life insurance is less expensive for women because of their
heightened longevity, having the male be the worker is the more conservative
case to consider. Jerry is seeking an additional amount of life insurance death
benefit equal to $500,000. This, along with his other life insurance, will be adequate
to support his family in the event of his death prior to age sixty-five.

Jerry presently has $60,000 saved in a 401(k)
plan with his employer, which is invested with an equity glide path strategy
representative of a typical target date fund: 80 percent stocks to age forty-five,
65 percent stocks from forty-five to fifty-four, 50 percent stocks from fifty-five
to sixty-four, 40 percent stocks from sixty-five to seventy-four, and 30 percent
stocks thereafter. He would like to plan for retirement at sixty-five. I will
investigate a portion of his assets to be saved in the future that is
equivalent to 401(k) employee contribution limits in 2019 with assumed
inflation adjustments: $19,000 can be saved each year until age fifty, and then
$25,000 thereafter until age sixty-five to account for the allowed catch-up
contributions at those ages.

These contribution limits are
inflation-adjusted such that real savings are kept the same, but the nominal
amounts increase. Because life insurance premiums are fixed without inflation
adjustments, the percentage of the savings directed to insurance decreases over
time in real terms. Jerry expects to be in a combined 25 percent marginal tax
bracket (22 percent for federal taxes and 3 percent for state taxes) in both
his preretirement and postretirement years.

For investment returns, I follow the approach
explained in Exhibit 3.11 from Chapter 3. Stock returns are simulated with a
randomized risk premium above the fixed 3 percent bond yield. That risk premium
has a 6 percent average value with a 20 percent volatility. Inflation is fixed
at 2 percent annually. This implies a 1 percent real interest rate. Interest
rate risk is eliminated from the analysis, as there is no possibility for
fluctuating interest rates to create capital gains or losses for the underlying
bond portfolio. The risky asset is based on large-capitalization stocks in the
United States. Overall, this represents a 9 percent arithmetic average for
stocks (7 percent in real terms). The compounded real growth rate for stocks is
5 percent. The investment portfolio is modeled using 10,000 Monte Carlo
simulations for investment returns based on these capital market expectations.
I assume investors earn these returns net of any investment or advisory fees.
As investments are held in tax-deferred accounts, there is no further tax drag
to worry about. Investors earn the gross returns and portfolio distributions
are taxed as income.

Life insurance is priced using the 3 percent
interest rate and the Social Security Administration 1980 cohort life tables
for mortality. Pricing for the term and whole life policies was provided in
Exhibits 7.1 and 7.2. Income annuities are priced in the same manner using the
Society of Actuaries mortality data as explained in Chapter 4, assuming an annual
2 percent cost-of-living adjustment for payments to match the assumed inflation
rate. In Chapter 4, the income annuity was priced for females. It offered a
4.56 percent payout rate.

In this case study, we use income annuities
for males and couples, and we must also account for the fact that the annuity
will not be purchased for twenty-five years. The corresponding payout rates for
males and couples with annuities purchased today are 4.83 percent and 3.93
percent, respectively. However, with the longevity improvements assumed by the
Society of Actuaries over the next twenty-five years, the male and joint income
annuity payout rates at that time are 4.47 percent and 3.75 percent,
respectively. These latter numbers are what I use. It makes sense to use
different mortality tables to price the life insurance and annuities on account
of the different populations that use these financial products. Annuity owners
will tend to live longer.

To better understand the impacts of investment
volatility on the upside and downside, Monte Carlo simulations are used to
create a distribution of outcomes. The exhibits report the 10th percentile,
median, and 90th percentile from this distribution. We can interpret the 10th percentile
outcome as a bad luck case with poor investment returns. It is possible that
retirement outcomes could be even worse, but generally Jerry and Beth could
expect better retirement outcomes than seen at the 10th percentile. The median
reflects more typical outcomes. It is the midpoint of the distribution, with a 50
percent chance for worse outcomes and a 50 percent chance for better outcomes.
These are reasonable outcomes for Jerry and Beth to expect. The 90th percentile
is a good luck outcome in which investments perform very well, supporting
greater spending and larger account balances.

Note that these results are presented in terms
of nominal dollars to avoid reader confusion about why inflation-adjusted
dollars are less than nominal dollars. This decision does not impact any
comparisons for the relative outcomes between scenarios. However, readers
should understand that the purchasing power of a given amount of income or
wealth will be less in the future. For today’s forty-year-olds, the real
purchasing power of money will be about 60 percent of what it is today at age
sixty-five, and about 30 percent of today at age 100, assuming 2 percent
inflation.

A review of the tax principles used herein is
also in order. Investments are made in Jerry’s tax-deferred 401(k) plan. This
means that taxes are not paid initially on the plan contributions, but any
withdrawals from the plan will be subject to ordinary income tax rates. At
retirement, Jerry completes a rollover of his 401(k) to a traditional individual
retirement account (IRA). This is not a taxable event. With a tax deferred
account, the government effectively owns a portion of the account as identified
by the tax rate. Taxes are deferred until withdrawals are made.

The investment account values are expressed in
posttax terms assuming a 25 percent combined marginal tax rate. Life insurance
premiums are paid with posttax funds. No taxes are due on the death benefit,
making it a posttax number. As well, a life insurance policy can be arranged so
that funds can be borrowed from the cash value without being taxed. When
distributions are properly structured, cash value represents a posttax number
as well.

If an income annuity is purchased at
retirement, this purchase is made with qualified retirement funds in the IRA. The
annuity income is then fully taxable at income tax rates as it is received from
the qualified account. Because the annuity is purchased in a qualified account,
someone seeking to purchase an annuity with funds equivalent to the life
insurance death benefit would need to inflate their purchase to account for the
differing tax treatment. For example, a nontaxed death benefit of $500,000 is
equivalent to $500,000 / (1 - 0.25), or $666,667, in the IRA when the tax rate
is 25 percent.

Jerry must decide whether to purchase a term
life insurance policy to increase his existing coverage to meet his human
capital replacement value for his family, or to otherwise purchase a whole life
insurance policy that can serve his additional human capital replacement value
need as well as be integrated into his retirement income strategy. From the
portion of his annual savings I have outlined, he will pay for life insurance
premiums and the taxes to cover those premiums, and the remainder will go into
his tax-deferred 401(k) plan.

In all scenarios, I assume that Jerry is
directing at least enough to the 401(k) to satisfy the conditions for the
highest possible company match, though I do not specifically model any company
match when simulating retirement income. More generally, Jerry and Beth may
also have other resources in retirement that I am not analyzing. I am modeling
the relevant features about how to best make the investment and insurance
decisions for the described annual set-asides to meet life insurance needs and
to obtain the most desirable retirement outcomes.

Jerry will decide between term life and whole
life insurance. The term policy lasts for twenty-five years with a $500,000
death benefit and has an annual premium of $2,282. Taxes on the pretax income
required to cover this premium are $761. After paying the term life premium and
taxes, he contributes the remaining $15,957 to his 401(k). As mentioned, these
savings increase over time with inflation following the employee contribution
limit increases on the 401(k), while life insurance premiums remain fixed.

The whole life policy Jerry considers also
carries a death benefit of $500,000. The annual premium is $6,873. The policy
accrues cash value that can serve as an additional spendable asset for the
household and that helps to reduce future insurance costs relative to the term
policy. The policy is designed to have premiums paid until age sixty-five. At
this age, the policy becomes fully paid up. Subsequent insurance costs are
covered by the cash value. The policy endows at age 100 when the cash value
grows to match the value of the death benefit. Taxes to cover the whole life
premium are $2,291. With a whole life policy, Jerry can contribute $9,836 to
his 401(k) at age forty, with that value subsequently growing with the described
contribution limits.

An important methodology issue for the case
study relates to asset allocation. With a whole life policy, the cash value is
a liquid asset contained outside the financial portfolio. It behaves like fixed-income,
though it is not exposed to interest rate risk (i.e. the accessible cash value
does not decline when interest rates rise). Cash value is not precisely the
same as holding bonds in an investment portfolio, as there is not a practical
way to rebalance the portfolio between stocks and policy cash value. As well,
the premium for an income annuity can be viewed as a fixed-income asset. It is
not liquid, but it is repositioning assets into the insurance company general
account to support protected lifetime income.

I assume that Jerry will incorporate the cash
value of life insurance and any annuity premium into his asset allocation
decisions to maintain the overall proportion between stocks and bonds for household
assets. For example, if the target date fund calls for a 50 percent stock
allocation, then the actual stock allocation Jerry uses will be 50 percent of the
sum of the financial portfolio balance, the pretax value of life insurance cash
value, and any annuity premium already paid, divided by the portfolio balance.

Though this could conceivably call for a stock
allocation of greater than 100 percent when the actuarial bond holdings
(annuities and cash value life insurance) are large relative to the financial
portfolio, I constrain the maximum possible stock allocation for the financial
portfolio to not exceed 100 percent. This higher stock allocation in the
investment portfolio can be justified because it is just one part of the asset
base and the goal is to maintain a particular stock allocation in relation to
overall household assets rather than just to the investment portfolio. This
does require the retiree to accept this line of thinking, and this is a topic I
will return to in Chapter 8.

Efficiently Funding a Legacy Goal with Whole
Life Insurance

The most natural use for permanent life
insurance is to fund a legacy goal. Exhibit 7.4 compares the effectiveness of
two strategies for meeting a legacy goal during retirement: “buy term and
invest the difference” in Scenario 1 and using whole life insurance in Scenario
2. Values are expressed on an after-tax basis with a combined 25 percent tax rate applied to qualified plan
distributions and legacy values. The cash value and death benefit from the
whole life policy are not treated as taxable assets.

As Jerry and Beth are now getting more serious
about their financial planning, they begin to also think about their legacy
goals for their children. The couple anchors onto their $500K current life
insurance need and believe that an appropriate overall legacy goal would be to
leave the children this amount upon Jerry’s passing no matter the age. The
couple would like to support the highest living standard possible while still
maintaining a 90 percent chance that
a $500K after-tax legacy goal can continue to be met by age 100. His legacy
goal for the investment assets inflates to $666,667 so that the after-tax
amount of $500K can be achieved. With permanent life insurance, a substantial
safety margin with investments is not needed for legacy.

The question becomes: what is the most
efficient way to meet a $500,000 after-tax legacy goal while also being able to
support the highest retirement lifestyle from this same pool of assets in a way
that does not jeopardize the legacy goal? The couple targets a 90 percent
success rate for their financial plan.

If Jerry uses whole life insurance, he can now
seek the highest spending rate for his remaining investment assets that
maintains a 90 percent chance that
the portfolio is not depleted by age 100. He no longer needs to preserve a
safety-margin of $667K at age 100 for his after-tax legacy goal to be met with 90 percent confidence. This allows for a higher
spending rate from investments. This is the trade-off that
we must test empirically: can the couple spend more when using whole life
insurance after considering the higher insurance premiums and less 401(k)
assets at retirement, but the ability to use a higher distribution rate from
investments since there is no longer a need to maintain the safety-margin with
investments for legacy?

In Scenario 1, the couple purchases term
insurance to provide a death benefit for human capital replacement until age
sixty-five. For the remainder of savings, they invest in their 401(k) and use
this pot of investment assets to support their spending and postretirement
legacy goals.

In Scenario 2, the couple maintains a whole
life policy into retirement to cover legacy and invests the remainder in their
401(k) to cover retirement spending. Because the whole life premiums are
larger, the couple can generally expect to have less in their 401(k) at
retirement. The difference ranges from 17 percent less at the 10th percentile of the distribution to about the same amount
at the 90th percentile. Accumulations are generally less because less is
invested, but it is possible to accumulate more because of the asset allocation
impact in which the cash value is treated as a fixed-income asset, and so the
401(k) asset allocation can be more aggressive in response. The more aggressive
asset allocation helps the most when markets perform well. Median 401(k) assets
at retirement are $883K in Scenario 1 and $836K in Scenario 2.

Note that if we add the cash value in Scenario
2 to the 401(k) assets, overall wealth is greater because the whole life policy
supports lower life insurance costs in the preretirement years, and because
taxes will not be paid on the cash value. This outcome alludes to the
efficiencies of cash value as a fixed-income investment when life insurance is
otherwise needed for the financial plan.

Next, the exhibit shows that the sustainable
withdrawal rate is 2.71 percent in Scenario 1 and 3.48 percent in Scenario 2.
They are different for two reasons. First, in the second scenario, the asset
allocation is more aggressive for investment assets because of the role played
by cash value as a fixed-income asset. Second, and more importantly, Scenario 1
requires a substantial safety reserve to support legacy. To meet the legacy
goal, Scenario 1 requires a lower spending rate to support a 90 percent chance
that remaining assets are not less than the after-tax legacy goal at age 100.
The IRA must maintain $667K to support the $500K goal after taxes. In Scenario
2, it is only necessary to maintain a 90 percent chance that investment assets
remain above $0 by age 100. Life insurance supports the legacy goal. This
allows for a higher distribution rate to be used with investment assets.

The higher distribution rate allows for more
spending in Scenario 2 while also meeting the legacy goal. In the median
outcome, these assets can support 22 percent more inflation-adjusted spending
throughout retirement. At the tenth and 90th percentiles, the percentage
increases in spending for Scenario 2 are 7 percent and 29 percent.

Finally, the exhibit shows legacy wealth at
age 100. The couple sought a 90 percent chance to meet their legacy goal and we
see that approximately $500K is left after taxes in both scenarios at the 10th percentile
of the distribution. For the remainder of the distribution, legacy wealth is slightly
larger in Scenario 2 despite also supporting more spending. Legacy is 5 percent
more at the median and 2 percent more at the 90th percentile. The couple must
spend less in Scenario 1 to ensure that investments can support their stated
legacy goal.

Nonetheless, with the addition of the death
benefit, whole life insurance can consistently support more legacy. Whole life
insurance provided the couple a more efficient way to meet the legacy goal,
which allows them to enjoy a higher standard of living in retirement with these
assets without the tradeoff of a lower legacy when markets perform well in
retirement. Scenario 2 is more efficient than Scenario 1 in terms of meeting
legacy goals while supporting more spending and legacy.

Though not the case here, in cases when
spending is higher and legacy is less, it can be difficult to compare the
tradeoff. The last measure of discounted lifetime spending power in the exhibit
helps to remedy this. It is the discounted value (at the 3 percent interest
rate) of the lifetime spending and age 100 legacy supported by the strategy. We
can also observe that Scenario 2 supports more lifetime spending power across
the distribution of outcomes.

Exhibit 7.4

Whole Life Insurance for the Legacy Goal

Scenario 1

Scenario 2

Investments

+ Term Life

Investments

+ Whole Life

Term Life Premiums

$2,282

$0

Whole Life Premiums

$0

$6,873

Taxes Paid

$761

$2,291

Age 40 Remaining Contribution
to 401(k)

$15,957

$9,836

All Subsequent Values are
Provided on a Posttax Basis

(Assuming a Combined 25% Tax Rate)

Distribution of 401(k)
Assets at Age 65

% change from Scenario 1

10th Percentile

$541,072

$451,277

-17%

Median

$883,222

$836,288

-5%

90th Percentile

$1,504,396

$1,511,566

0%

Life Insurance Values at
Age 65

Cash Value

$0

$210,043

Death Benefit

$0

$500,000

Sustainable Spending Rate
from 401(k) Assets (with 90% Success)

2.71%

3.48%

Distribution of Systematic
Withdrawal Income at Age 65

10th Percentile

$14,663

$15,704

7%

Median

$23,935

$29,103

22%

90th Percentile

$40,769

$52,603

29%

Distribution of Legacy
Wealth at Age 100

10th Percentile

$506,769

$503,612

-1%

Median

$1,689,769

$1,778,037

5%

90th Percentile

$4,461,739

$4,544,957

2%

Discounted Lifetime
Spending Power

10th Percentile

$599,014

$628,048

5%

Median

$1,275,408

$1,455,344

14%

90th Percentile

$2,718,783

$3,089,803

14%

Because investments are used as the source of
legacy in Scenario 1, it becomes necessary to remain extra cautious about
retirement spending to maintain the desired legacy safety margin for investments.
Scenario 2 allows for a higher standard of living in retirement with more
inflation-adjusted spending, while still providing the desired confidence that
the legacy goal can be met.

Exhibit 7.5 also helps to visualize this
process by showing the median spending and legacy across the age range. If the
couple’s goal is to maximize their standard of living in retirement while still
ensuring that their heirs received $500,000 after taxes as a legacy, Scenario 2
accomplishes this more effectively than Scenario 1. As well, the legacy in
Scenario 2 has contractual protections, while in Scenario 1 there is still an
accepted 10 percent probability that legacy assets will fall below the intended
goal. Across the range of ages, spending and legacy is higher when whole life
insurance is used. Whole life insurance can be incorporated into a lifetime
financial plan as a more efficient means for meeting a legacy objective, which
allows for a higher standard of living to be supported from the remaining
assets.

Exhibit 7.5

Whole Life Insurance for the Legacy Goal: Median
Spending and Legacy

Integrating Life Insurance with Lifetime Income

Another way to use life insurance as part of a
lifetime plan is to view the death benefit as the psychological support needed to
purchase a life-only income annuity as part of an integrated plan combining
investments, whole life insurance, and income annuities. I create three
additional scenarios for this investigation:

·
Scenario 3 uses the same “buy term and invest the difference”
strategy as Scenario 1, but now there is no specific legacy goal to be funded. The
couple may spend more aggressively from their investment assets in retirement
than in Scenario 1.

·
Scenario 4 also uses term life insurance prior to retiring, but
the couple will also purchase a joint life income annuity at the retirement
date to help support retirement spending.

·
Scenario 5 integrates investments with a whole life insurance
policy and with a single life income annuity purchased at retirement.

Upon reaching age sixty-five in twenty-five
years, Jerry and Beth will consider whether a single-premium immediate annuity
(SPIA) might be a worthwhile addition to their retirement income plan. As
discussed in Chapter 4, income annuities offer a variety of options regarding
whether income starts immediately or is deferred, whether income covers a
single life or joint lives, whether there is a certain payment for a set number
of years, whether any cost-of-living adjustments will be made to benefits, and
whether cash or installment refund provisions are included in the event of an
early death.

To simplify our analysis, I consider two basic
possibilities: Jerry buys a single life-only immediate annuity at sixty-five on
his life, or Jerry and Beth buy a joint life and 100 percent survivor annuity.
Both income annuities include a 2 percent annual cost-of-living adjustment that
matches the assumed inflation rate, so that the annuity income adjusts to keep
the purchasing power consistent throughout retirement. In both cases the
annuities are purchased with qualified retirement funds after Jerry has stopped
working and completes a rollover from his 401(k) to a traditional IRA.

A male life-only income annuity offers the
highest payout rate (the most income) because the buyer offers the most
mortality credits to the risk pool by accepting the higher short-term mortality
risk. As mentioned in the case study overview, income annuities are priced
using Society of Actuaries mortality data and the assumed 3 percent interest
rate. With these interest rate and mortality assumptions and with the 2 percent
cost-of-living adjustments on the annuity payments, I price a male life-only
annuity for a forty-year-old when purchased at age sixty-five at 4.47 percent.
The corresponding joint life annuity rate for the couple is 3.75 percent. The
single life income annuity provides 19 percent more spending power for a given
premium relative to the joint life income annuity.

With the accumulated investment assets, all retirement
income in Scenario 3 will be generated with a systematic withdrawal strategy. Jerry
seeks annual spending adjustments that match the overall 2 percent inflation
rate. The couple uses the highest withdrawal rate possible that keeps investments
above $0 by age 100 with a 90 percent probability. This means accepting a 90 percent
chance that the spending level can be maintained at the initial amount in
inflation-adjusted terms. In Scenario 3, spending from these assets falls to $0
once the portfolio balance depletes.

Scenario 4 shares many similarities with
Scenario 3. Jerry uses the same term policy and invests the remainder in a
tax-deferred account, leading to the same retirement date wealth accumulation.
The difference happens at the retirement date. In Scenario 4, Jerry and Beth purchase
a joint life and 100 percent survivorship income annuity with a premium amount
equal to up to the pretax equivalent of the death benefit for the whole life
policy at age sixty-five. With a 25 percent combined marginal tax rate, the
pretax amount to be annuitized is up to $666,667. In simulations where the
couple’s 401(k) balance has not grown sufficiently to leave at least $100,000
remaining after the annuity is purchased (to provide the couple with a pool of
liquid assets to support contingency expenses), then the couple only annuitizes
the amount that leaves $100,000 of liquid investable assets (on a pretax basis)
after the annuity is purchased.

Though Jerry does not use the whole life
policy in this scenario, annuitizing this pretax equivalent amount allows for a
proper comparison between Scenarios 4 and 5. After annuitization, the remaining
portfolio balance will be utilized for retirement spending using a systematic
withdrawal strategy that maintains a 90 percent probability that the account remains
above $0 by age 100. The joint life and 100 percent survivor income annuity
provides income growing at 2 percent annually for as long as one member of the
couple is alive, and any systematic withdrawals will supplement this income for
as long as financial assets remain. Portfolio depletion is less drastic in this
case, as at least the inflation-adjusted annuity income continues for life.

Next, in Scenario 5 Jerry uses a whole life
insurance policy rather than term life insurance. Because of the higher
premium, he invests less (starting at $9,836 instead of $15,957) in his 401(k)
plan. Second, Jerry buys a male life-only income annuity at sixty-five with the
same amount of assets from his retirement portfolio as in Scenario 4. He can now
opt for single life instead of joint life because the death benefit from his
whole life insurance policy will replace the annuity income stream upon his
death.

If desired, Beth could then use part of the
death benefit to buy another single life income annuity. As payout rates
increase with age, the death benefit should be sufficient to support at least
as much annuity income after a few years have passed to account for the lower
payout rates for longer-living females. The difference in annuity payout rates
(4.47 percent instead of 3.75 percent) allows for 19 percent more income to be
generated by the same annuity premium as compared to Scenario 4. Any remaining investment
assets will be utilized with a spending rate that supports a 90 percent chance
that assets remain by age 100.

Like Scenario 2 in the previous case study,
Scenario 5 also treats the cash value as part of the fixed-income allocation
and adjusts the stock allocation in the remaining investment portfolio to keep
the overall targeted ratio between stocks and bonds at each age. As well, the
annuity purchase in Scenarios 4 and 5 is also counted as part of the bond
allocation to increase the stock allocation for remaining investment assets. This
is important because otherwise, a strategy which combines an investment
portfolio with the same asset allocation as before, with a conservatively
invested whole life insurance policy and income annuity, would create a more
conservative overall asset allocation from the retirement balance sheet
perspective. This would reduce growth potential within the strategy.

With these adjustments, I am essentially
asking whether the fixed-income component for household assets should be
allocated only to traditional bonds or also to actuarial bonds like whole life
insurance and income annuities.

Exhibit 7.6 outlines the retirement outcomes
for Jerry and Beth. The first part of the exhibit summarizes how they allocate
their savings between insurance and Jerry’s 401(k) for the three scenarios, as
described earlier.

Scenario 3 presents the strategy for buying
term insurance and investing the difference in a target date fund. In after-tax
terms at retirement, the wealth accumulation ranges from $541K at the 10th percentile
to $1.5 million at the 90th percentile, with a median outcome of $883K. With
the capital market expectations and asset allocation decisions, the sustainable
spending rate that supports a 90 percent chance that assets remain at age 100
is 3.36 percent. This spending rate supports after-tax inflation-adjusted
retirement income ranging from $18,180 at the 10th percentile to $50,548 at the
90th percentile, with a median of $29,676.

As for legacy wealth at age 100, it ranges
from $3,294 (effectively $0) at the 10th percentile to $3.36 million at the 90th
percentile, with a median amount of $1.02 million. Legacy wealth consists of
the after-tax value of any remaining financial assets in the investment
portfolio and any life insurance death benefit. With Scenario 3, there is no
annuitization or death benefit. Investment assets are the only resource to
support spending and legacy in retirement.

Scenario 4 also uses term life insurance, but
the difference is that partial annuitization takes place with a joint life
income annuity at the retirement date. The use of an annuity allows for a
slight increase in the distribution rate from investments on account of the
higher stock allocation for the investment component in retirement. A joint life
income annuity with a 3.75 percent payout rate is purchased with assets of up
to $666,667 as described. Before taxes, this supports annuity income of up to $25,000,
which reflects $18,750 on an after-tax basis. This is the annuity amount at the
median and 90th percentile, but there were insufficient assets at the 10th percentile
to annuitize this much and preserve $100,000 for liquidity. This explains the
smaller $17,478 amount at the 10th percentile.

Annuity income grows with the same 2 percent
cost-of-living adjustment to match the assumed overall inflation rate. A 3.53
percent withdrawal rate is then applied to any remaining investment assets to
generate additional retirement income for Jerry and Beth. Scenario 4 supports
total income at retirement ranging from $20,125 to $54,205 at the tenth and 90th
percentiles, with a median income of $32,278. These numbers are larger than in
Scenario 3 (11 percent larger at the 10th percentile, 9 percent larger at the
median, and 7 percent larger at the 90th percentile). This demonstrates the
potential for mortality credits through the income annuity to pool risk to
support more spending relative to an investments-only strategy designed to work
with a high probability of success.

Exhibit 7.6

Whole Life Insurance Combined with Investments and
Income Annuities

Scenario 3

Scenario 4

Scenario 5

Investments

+ Term Life

Investments

+ Joint Life SPIA

+ Term Life

Investments

+ Single Life SPIA

+ Whole Life

Term Life Premiums

$2,282

$2,282

$0

Whole Life Premiums

$0

$0

$6,873

Taxes Paid

$761

$761

$2,291

Age 40 Remaining Contribution
to 401(k)

$15,957

$15,957

$9,836

All Subsequent Values are
Provided on a Posttax Basis

(Assuming a Combined 25% Tax Rate)

Distribution of 401(k)
Assets at Age 65

% change from Scenario 3

% change from Scenario 3

10th Percentile

$541,072

$541,072

0%

$451,277

-17%

Median

$883,222

$883,222

0%

$836,288

-5%

90th Percentile

$1,504,396

$1,504,396

0%

$1,511,566

0%

Life Insurance Values at
Age 65

Cash Value

$0

$0

$210,043

Death Benefit

$0

$0

$500,000

Sustainable Spending Rate
from 401(k) Assets (with 90% Success)

3.36%

3.53%

3.69%

Distribution of Annuity
Income at Age 65

10th Percentile

$0

$17,478

$16,820

Median

$0

$18,750

$22,350

90th Percentile

$0

$18,750

$22,350

Distribution of Systematic
Withdrawal Income at Age 65

10th Percentile

$18,180

$2,648

$2,768

Median

$29,676

$13,528

$12,409

90th Percentile

$50,548

$35,455

$37,327

Distribution of Total
Income at Age 65

10th Percentile

$18,180

$20,125

11%

$19,587

8%

Median

$29,676

$32,278

9%

$34,759

17%

90th Percentile

$50,548

$54,205

7%

$59,677

18%

Distribution of Legacy
Wealth at Age 100

10th Percentile

$3,294

$1,277

about same

$500,000

+ + +

Median

$1,019,022

$936,733

-8%

$1,485,222

46%

90th Percentile

$3,357,267

$3,402,587

1%

$4,469,206

33%

Discounted Lifetime
Spending Power

10th Percentile

$527,035

$582,608

11%

$739,116

40%

Median

$1,210,048

$1,256,909

4%

$1,517,932

25%

90th Percentile

$2,620,572

$2,742,009

5%

$3,268,306

25%

With legacy, Scenario 4 generally provides
less, at least before accounting for the fact that it provided higher spending.
Because partial annuitization with a life-only income annuity removes a
significant chunk of investment assets, the distribution of legacy wealth is
less able to recover across the distribution of outcomes. By age 100, the
investment portfolio is also about to be depleted at the 10th percentile,
though annuity income is still available to the couple for as long as they
live. Legacy is 8 percent less at the median, and 1 percent more at the 90th percentile.
Scenario 4 has taken advantage of only one-type of actuarial bond, creating potential
trade-offs when compared with Scenario 3: more retirement income, but less
legacy wealth.

Nevertheless, when we evaluate the combined
lifetime spending power, we do find that Scenario 4 is more efficient, with
increases across the distribution of outcomes. In particular, at the median the
9 percent boost in lifetime annual spending more than offsets the 8 percent
drop in legacy on a net basis.

Next, Scenario 5 integrates investments with
whole life insurance and income annuities. The value of 401(k) assets at Jerry
and Beth’s retirement age is less (17 percent less at the 10th percentile, 5 percent
less at the median, but about the same at the 90th percentile) than in Scenario
3. Again, this results from less being invested in the 401(k) as more went to
the higher whole life insurance premiums, and from the asset allocation in the
401(k) being more aggressive when treating cash value as a bond. The after-tax cash
value is $210K at age sixty-five. When adding the cash value to the 401(k) assets,
more is obtained at retirement. This results from the tax advantages of life
insurance and from the lower internal insurance costs of whole life insurance
as cash value reduces the amount of death benefit at risk for the insurance
company.

We next consider how much income can be
generated by these assets. With partial annuitization through a single life income
annuity with a 4.47 percent payout for an amount equal to the death benefit of
the whole life policy at age sixty-five, inflation-adjusted annuity income is $22,350
after taxes are paid. The 3.69 percent withdrawal strategy (driven by the more
aggressive asset allocation that accounts for the cash value and annuity
premium) is then applied to remaining investment assets, generating additional
income. Total retirement income at age sixty-five ranges from $19,587 to $59,677,
with a median of $34,759. Compared to Scenario 3, retirement income is 8 percent
larger at the 10th percentile, 17 percent larger at the median, and 18 percent larger
at the 90th percentile.

As for legacy wealth at age 100, Scenario 5 maintains
the death benefit of $500K after taxes, which is still available despite
investments depleting at the 10th percentile. At the median, Scenario 5
supports legacy wealth of $1.49 million, which is 46 percent larger than in
Scenario 3. Of this, $500K is the death benefit and the other $949K is the
remaining portfolio balance after taxes. At the 90th percentile, legacy wealth
is 33 percent larger than in Scenario 3. Even after accounting for the higher
supported spending, legacy wealth is still larger in Scenario 5 in 94 percent
of the simulations. Discounted lifetime spending is greater across the
distribution of outcomes, reflecting the greater spending and legacy potential
of this integrated strategy.

Exhibit 7.7 provides a visualization of these
three strategies in terms of median spending and legacy between ages sixty-five
and 100. The investments and term life strategy of Scenario 3 supports the
least spending, though it does offer the highest median legacy until age eighty-three.
After that point, Scenario 5 with the whole life insurance and single life
income annuity offers a higher legacy as well as the highest spending across
the age range. Scenario 4 with the investments and joint life annuity offers spending
that falls between the other two strategies, but legacy is the least as the
high level of annuitization leaves too little in the investment portfolio to
grow and catch up.

Exhibit 7.7

Whole Life Insurance Combined with Investments
and Income Annuities: Median Spending and Legacy

Generally, the integrated approach provides
more legacy wealth while also supporting more retirement income. At the median,
Scenario 5 provides 17 percent more lifetime spending and 46 percent more
legacy than Scenario 3, with 25 percent growth in overall lifetime spending
power. This is the meaning of greater efficiency. The upside growth potential
of investments is insufficient to beat a more integrated approach using
actuarial science and mortality credits alongside investments.

Adding Whole Life Insurance Cash Value as a
Volatility Buffer in Retirement

The next potential use for whole life
insurance in lifetime financial planning is using the cash value as a volatility
buffer asset to help manage the sequence-of-returns risk for investment
portfolio distributions. Retirement spending can be
sourced to the cash value after a market downturn to avoid selling portfolio
assets at a loss. Returns for buffer assets should not be correlated with the
financial portfolio, since the purpose of buffer assets is to temporarily
support spending when the portfolio is otherwise down. This attempts to allow
for portfolio recovery before distributions from it resume. The cash value of whole
life insurance has this characteristic since it is contractually protected from
declining in value.

Exhibit 7.8 compares Scenario 3 from before to
the new Scenarios 6 and 7. The new scenarios incorporate the volatility buffer
strategy in different ways. In Scenario 6, investments are combined with whole
life insurance, and the cash value is available to be used entirely as a
volatility buffer to help support the portfolio and maximize retirement
spending. Scenario 7 maintains investments and whole life insurance while also
incorporating a single life income annuity as part of the spending strategy.
Scenario 7 follows the previous Scenario 5 except that policy loans from the
cash value are also used on a limited basis (so the policy loan balance does
not exceed the cost basis by age 100) to bolster retirement spending. Policy
loans are taken with the cash value serving as collateral to avoid taxes on
these distributions. A conservative (as in higher than the assumed 3 percent
economy-wide interest rate) loan interest rate of 5 percent is used to grow the
loan balance.

I assume that the whole life policy uses
nondirect recognition, which means that there is no adjustment to the growth
for the cash value that has been used as collateral for loans. This is a
conservative assumption, as policies with direct recognition would support a
higher growth rate on the cash value for the loan amount, since the 5 percent
loan rate I assume is larger than the 3 percent interest rate earned by assets
in the general account. Legacy values at age 100 reflect
any remaining investment assets along with the remaining net life insurance
death benefit after offsetting cash value surrenders and any loans plus
accumulated interest.

Scenario 6 allows more aggressive cash value
use through policy loans, and I do have to be careful that interest on the loan
balance does not push the loan balance over the limit of the available cash
value. Such an outcome must be avoided so that taxes are not triggered to be due
on all life insurance policy gains in one tax year.

The maximum amount that can be taken from the
cash value in any year is the amount that would not grow with 5 percent interest
to exceed the slower growing cash value by age 100 (with an additional $5,000
buffer of protection so that the net cash value does not fall entirely to $0).
This process ensures that the loan balance growth stays below the cash value,
protecting the policy from blowing up. In practice, this
outcome can be avoided by monitoring the policy and paying down the loan
balance if it is approaching too closely to the total cash value limit. This
matter is not a concern for Scenario 7 because the cash value is used on a more
limited basis throughout to keep the loan balance less than the policy cost
basis by age 100.

The cash value of
whole life insurance can be used as a buffer asset to help manage the sequence-of-returns
risk exacerbated by taking distributions from a volatile investment portfolio.
Maintaining fixed distributions from investments in retirement increases
exposure to sequence risk by requiring a higher withdrawal rate from remaining assets
when their value declines. Temporarily drawing from the cash value of life
insurance has the potential to mitigate this aspect of sequence risk for an
investment portfolio by reducing the need to take portfolio withdrawals at
inopportune times. By reducing exposure to sequence risk, this can either support
more spending or preserve greater overall legacy wealth. Whether or not this
strategy will work becomes an empirical question to be tested.

Aggressively using the volatility buffer to
support more retirement spending involves making a conscious decision to focus
on increasing spending at the potential cost of legacy. The investments-only
strategy forces spending to be conservative, feeding instead into a larger
legacy because of its inefficient approach for managing longevity and market
risk. Nonetheless, limited use of the volatility buffer may not reduce legacy.
Though the volatility buffer reduces the net death benefit, the investment
portfolio may ultimately grow by more than the reduction to the death benefit,
potentially leaving a larger net legacy. This happy outcome can result from the
peculiarities of sequence risk and the ability to avoid selling portfolio
assets at a loss. The cash value provides a stable income
source not impacted by market volatility. Life insurance also receives tax
benefits, and the distribution from the cash values can be less since taxes are
not paid on the proceeds.

Much of this discussion about using cash value
as a buffer asset has a corresponding parallel to opening a line of credit with
a reverse mortgage and treating it as a volatility buffer asset. I discuss the
latter strategy extensively in my book Reverse Mortgages: How to Secure Your
Retirement with a Reverse Mortgage. The Sacks and Sacks coordinated
strategy from the reverse mortgage book matches how the cash value volatility
buffer is typically described by insurance companies. The idea is to spend from
cash value in years after a market downturn, while spending from the investment
portfolio in years after positive market returns. I will use this same method
for deciding when to draw from the cash value as a volatility buffer.

In Exhibit 7.8, Scenario 3 is first repeated
to serve as a baseline for comparison. Scenario 3 is the classic “buy term and
invest the difference” strategy. Scenarios 6 and 7 switch from term life
insurance to whole life insurance and make the cash value available as a
volatility buffer. In Scenario 6, the couple spends from the cash value in
years after market downturns, as long as the loan balance is not projected to
exceed the cash value before age 100 (with an additional $5,000 buffer). In
Scenario 7, the cash value is used as a volatility buffer in a more limited way,
and a single life income annuity is purchased to merge this aspect of Scenario
5 with a volatility buffer.

Because the cash value provides an additional
base of assets to replace some portfolio distributions as well as a fixed-income
resource that allows the stock allocation in the investment portfolio to be
increased, the initial withdrawal rate for investments increases from 3.36
percent in Scenario 3 to 3.78 percent in Scenario 6, while still maintaining a 90
percent chance that investment assets remain at age 100. Investment
holdings at retirement can generally be expected to be lower because of the
higher whole life premiums, and this along with the withdrawal rate change
leads to inflation-adjusted spending in retirement to change from a 4 percent
decrease up to a 13 percent increase across the distribution. The median
increase in retirement lifestyle is 6 percent.

Meanwhile, legacy assets are also better
supported in Scenario 6 on account of the synergies created by the volatility
buffer in managing sequence risk for the investment portfolio. At the median,
legacy assets are 28 percent larger at age 100 after already supporting a 6 percent
larger lifestyle as well. Across most of the distribution of outcomes, spending
and legacy are larger in Scenario 6, as is the discounted lifetime spending
power. Whole life insurance used as a cash value volatility buffer can beat
“buy term and invest the difference” for a lifetime financial plan initiated by
the forty-year-old couple. It is a more efficient strategy.

Moving to Scenario 7, an income annuity is
combined with a partial volatility buffer up to the cost basis of the life
insurance policy. By age sixty-five, the policy cash value is $210,043. It
consists of a cost basis equaling $171,825, which represents twenty-five years
of $6,873 annual premiums. Combining the income annuity with the volatility
buffer further increases spending relative to Scenario 3 from 11 percent at the
10th percentile to 25 percent at the 90th percentile with a median increase of 21
percent. The withdrawal rate from investments providing a 90 percent chance for
success also increases to 4.04 percent because partial annuitization reduces the
portfolio size, and the stock allocation increases to offset how the annuity
and cash value are treated as bonds. At the median, legacy at age 100 is 34
percent larger as well. Because the cash value was used in a more limited way,
the remaining death benefit is still $332K at the 10th percentile. Legacy
wealth is larger across the distribution as well, as is the discounted lifetime
spending power after accounting for more spending and more legacy.

My personal thought is that Scenario 7 is an
appealing way to integrate insurance into a retirement strategy. By limiting
cash value use to the policy’s cost basis with loan growth, Scenario 7 helps to
dramatically reduce exposure to sequence risk and to increase sustainable
spending with noticeably less offset to legacy. It also includes the income
annuity as an additional risk pooling tool in addition to the remaining life
insurance death benefit. For those with a greater emphasis on legacy relative
to spending, Scenario 6 with the pure volatility buffer is also a viable
choice. Integrating insurance in this manner allows for more efficient
retirement income than the traditional buy term and invest the difference
strategy found in Scenario 3.

Exhibit 7.8

Whole Life Insurance as a Volatility Buffer

Scenario 3

Scenario 6

Scenario 7

Investments

+ Term Life

Investments

+ Whole Life

Volatility Buffer

(Full Use)

Investments

+ Single Life SPIA

+ Whole Life

Volatility Buffer

(Cost Basis)

Term Life Premiums

$2,282

$0

$0

Whole Life Premiums

$0

$6,873

$6,873

Taxes Paid

$761

$2,291

$2,291

Age 40 Remaining Contribution
to 401(k)

$15,957

$9,836

$9,836

All Subsequent Values are
Provided on a Posttax Basis

(Assuming a Combined 25% Tax Rate)

Distribution of 401(k)
Assets at Age 65

% change from Scenario 3

% change from Scenario 3

10th Percentile

$541,072

$459,454

-15%

$459,454

-15%

Median

$883,222

$834,603

-6%

$834,603

-6%

90th Percentile

$1,504,396

$1,506,620

0%

$1,506,620

0%

Life Insurance Values at
Age 65

Cash Value

$0

$210,043

$210,043

Death Benefit

$0

$500,000

$500,000

Sustainable Spending Rate
from 401(k) Assets

3.36%

3.78%

13%

4.04%

20%

Distribution of Annuity
Income at Age 65

10th Percentile

$0

$0

$17,185

Median

$0

$0

$22,350

90th Percentile

$0

$0

$22,350

Distribution of Systematic
Withdrawal Income at Age 65

10th Percentile

$18,180

$17,367

$3,030

Median

$29,676

$31,548

$13,518

90th Percentile

$50,548

$56,950

$40,667

Distribution of Total
Income at Age 65

10th Percentile

$18,180

$17,367

-4%

$20,215

11%

Median

$29,676

$31,548

6%

$35,868

21%

90th Percentile

$50,548

$56,950

13%

$63,017

25%

Distribution of Legacy
Wealth at Age 100

10th Percentile

$3,294

$14,162

330%

$332,267

9988%

Median

$1,019,022

$1,303,411

28%

$1,361,593

34%

90th Percentile

$3,357,267

$3,743,948

12%

$3,941,638

17%

Discounted Lifetime
Spending Power

10th Percentile

$527,035

$507,277

-4%

$699,410

33%

Median

$1,210,048

$1,362,315

13%

$1,507,355

25%

90th Percentile

$2,620,572

$2,939,197

12%

$3,182,914

21%

Exhibit 7.9 provides a visual illustration for
the median outcome of these strategies by age. Scenario 7 supports the most
spending across the age range, but Scenario 6 without the income annuity
supports the most legacy across the age range until very late in retirement.
Scenario 3 supports the least spending, but it leads to greater legacy than
Scenario 7 until about age eighty-five.

Exhibit 7.9

Whole Life Insurance as a Volatility Buffer:
Median Spending and Legacy

Treating Cash Value as a Fixed-Income
Investment Choice

Though it requires patience, as it takes time
for the initial policy creation costs to be recovered and for cash value to
accumulate, long-term investors may find that the long-term net returns on cash
value accumulation within a whole life policy may be competitive with the fixed-income
returns a household could otherwise obtain from traditional bond investments. This
fourth role for life insurance focuses on cash value growth, with the
postretirement death benefit serving as an afterthought. In this regard, one
might even consider whole life insurance as an alternative source for a
temporary death benefit instead of term insurance with the intention to build
tax-deferred cash value to later surrender as an alternative to buying term and
investing the difference in bonds.

Cash value life insurance provides a way for
the policyowner and the insurance company to share the benefits of tax-deferral
afforded to life insurance. To be comparable with cash value, the net return on
bonds would have to be evaluated as the gross return less investment expenses,
taxes, and the term premiums required to purchase an equivalent death benefit
for preretirement human capital replacement needs.

The ability for cash value returns to
potentially outperform other fixed-income investments relates to several
factors. First, regarding the underlying portfolio of assets, the general
account of the insurance company is better positioned than the household to
manage the risks involved in earning higher fixed-income returns by accepting duration,
illiquidity, and credit risk. Actuaries at insurance companies generally can
make reasonable estimates about their future claims-related expenses. This
allows for a longer-term investment focus with assets held to maturity that can
offer higher yields than households could otherwise muster within their own
fixed-income portfolios.

The general account is highly regulated with
respect to the amount of assets to be maintained relative to liabilities and to
asset allocation. Assets must be sufficient to fund policy claims, including
death benefits, policy surrenders, and loans, after accounting for future
premiums and investment returns.

General account investments typically include
corporate and government bonds, mortgages, policy loans, a small allocation to
equities, and potentially other types of alternative investments. The general
account has greater return potential through its ability to invest in
longer-term and less liquid assets, and to diversify the credit risk of
higher-yielding corporate bonds. Households have less capacity to diversify and
manage these risks. Asset values for households are too small, their timeframes
are too short, and their liquidity needs are too high. Policyholders do not
have individual accounts within the general account. The account value is
aggregated across all policyholders.

The general account of the insurance company
is using projections about the inflows of premiums and outflows of benefits and
surrenders/loans and is using an asset-liability matching framework so that
bonds do not have to be sold at a loss. Because insurance companies generally
hold the fixed-income assets to maturity, rising rates will not trigger capital
losses, but will allow new premiums to be invested at a higher rate. Any policy
dividends should generally be more closely related to interest rate movements,
slowly rising after interest rates rise and slowly falling after interest rates
fall. Because insurance companies use asset-liability matching, a rise in
interest rates allow subsequent bond purchases to be made at higher yields.
This stable value aspect of cash value is a key motivator for using it in the
volatility buffer strategies.

As well, fixed-income returns must be
considered net of taxes. For bonds held in a taxable account, taxes must be
paid on the annual interest payments, reducing the compounding growth potential
of the assets. Likewise, in a tax-deferred account, taxes must be paid when
distributions are made. Cash value within life insurance accumulates on a tax-deferred
basis while the asset can potentially also be accessed without needing to pay
any additional taxes.

Furthermore, cash value accumulation is already
reported net of fees. Fees are internal to the policy and loaded into the
stated premium. To be comparable, investment and advisory fees charged on bonds
must be incorporated so that bond returns are identified on a net-of-fees
basis.

Finally, cash value life insurance also
provides a valuable death benefit. If we assume that a preretiree needs life insurance
and is considering between term and permanent life insurance, the net returns
on a bond portfolio would also need to be reduced to account for the cost of
term premiums as a percentage of the whole life premiums. Bond investments
could only be made with remaining funds after paying for the term premiums
covering the preretirement life insurance need.

The ability for the insurance company’s
general account assets to earn returns that exceed what households could
otherwise obtain, combined with the tax deferral provided by the insurance
policy, means that it is possible for life insurance to serve as an attractive
long-term fixed-income investment even net of its insurance costs for a
lifetime death benefit. It is worth exploring the simple possibility that life
insurance cash value can be a viable alternative to include in a household’s
fixed-income investment portfolio. It is possible for the net returns on cash
value to exceed the net returns on other fixed-income investment opportunities.

Exhibit 7.10

Whole Life Insurance Cash Value as a Fixed-Income
Alternative

Interest Rate:

3.00%

Additional Yield Premium for
General Account:

0.00%

Bond Portfolio

Gross Yield:

3.00%

Less Taxes (25% Tax Rate):

-0.75%

Less Investment Fees:

0.00%

Less Term / Whole Life Ratio
($2,282 / $6,873):

-1.00%

Net Yield:

1.25%

Exhibit 7.10 provides the details for this
analysis. These numbers could be modified to account for different
circumstances. I consider the case for a forty-year-old who could either pay a
higher premium for whole life insurance to support a permanent death benefit
while also growing cash value in the policy, or who could pay a lower premium
to support his preretirement death benefit needs with term insurance and then
invest the difference between the whole life and term life premiums into a
fixed-income portfolio. In this example, I maintain the assumption that
interest rates remain fixed at 3 percent, and I do not assume any additional
yield premium for investments in the general account relative to what is
available to the household on their own. As explained, the insurance company’s
general account may be positioned to yield higher returns than available to
households.

For bonds, the gross yield is 3 percent, but I
must account for the impact of taxes, fees, and life insurance needs to
determine the net yield. Assuming this individual will remain in the 25 percent
tax bracket, the net yield on fixed-income assets must be reduced by 25 percent,
or 0.75 percent of the 3 percent bond yield to pay the annual tax bill. As for
fees, to be consistent in this example I assume that bonds can be obtained
without fees as I do not otherwise charge fees within the insurance policies.
Finally, in the term life scenario, the premium for term insurance is one-third
of the premium for whole life insurance. Assuming this individual seeks life
insurance through retirement at sixty-five, only two-thirds of the potential
funds are available to be invested into the bond portfolio. This reduces the
net returns on bonds by an additional 1 percent. Overall, the net return on
bonds in this example has fallen to 1.25 percent.

As for the returns on cash value, the problem
is slightly more complex because the insurance costs vary over time (recall the
discussion of Exhibit 7.2). The complexity is accounted for by using an internal
rate of return calculation. The internal rate of return is the compounded
growth rate required on policy premiums to generate the cash value of the
policy. These returns can be calculated both for the cash value and for the death
benefit. I specifically seek to calculate them for the cash value growth shown
in Exhibit 7.2.

Life insurance cash value is not meant to serve
as a short-term investment. Exhibit 7.11 tracks the net returns for cash value
over the life of the policy through age 100. Cash value returns remain negative
until age fifty-one. This is when the cash value amount ($82,665) first exceeds
the cumulative premiums paid up to that point ($82,476). It took eleven years.
Then, at age fifty-nine, the net returns on cash value exceed those of the bond
portfolio for the first time. As time passes, the net returns on cash value
continue to grow. They exceed 2 percent at age eighty-two and are 2.27 percent
at age ninety-nine. Meanwhile, the life insurance also supports a permanent
death benefit.

As for bonds, the death benefit with the term
policy ends at age sixty-five. Subsequent net bond returns at age sixty-five
could be higher (2.25 percent) if life insurance is no longer used, but this
would not cause cumulative net returns to immediately jump to this higher
level. If I account for the term premiums that did not enter into the bond
portfolio in the same manner that part of the whole life premiums are used to
fund the life insurance, I find that the net returns on bonds would trail the
cash value returns for life, despite the term strategy not providing a
permanent death benefit. Expressing the internal rate of return on the value of
the bond portfolio relative to the cash flows used to invest in bonds and pay
for term life insurance, the net return on bonds reaches only 1.44 percent at
age ninety-nine in this scenario.

With term insurance, there is no cash value to
help offset future insurance costs as happens with whole life. This leaves the
“buy term and invest the difference” strategy lagging behind permanently. Exhibit
7.11 further shows the net lifetime internal rates of return on the bond
investments after also accounting for the term premiums. Bonds do not have an
opportunity to catch-up to the permanent life insurance approach even after the
term insurance ends and the subsequent net returns become higher in absence of
the continuing death benefit.

Exhibit 7.11

Net Returns on Whole Life Insurance Cash Value
and on Bond Investments

This analysis has demonstrated the potential
for the net returns on cash value to exceed those on other fixed-income assets.
It is important to remember that this is accomplished with less risk as well,
because cash value is not exposed to interest rate risk. We must also not
forget that a permanent death benefit also accompanies this cash value even
after age sixty-five. Moving away from our simplified world, comparisons would
have to consider the potentially higher returns on the general account, the
impacts of fees for both insurance and investments, and the interest rate risk
experienced for bond assets.

All considered, net cash value returns may be
quite competitive with net bond returns, so that even aside from the death
benefit, whole life insurance could provide a preferable way to invest in fixed-income
assets for the household with a long-term focus.

Additional
Considerations for Whole Life Insurance

I described four uses for whole life insurance
in retirement income planning using a simplified model that allows for an
understanding of the underlying mechanisms at work without being bogged down by
additional real-world complexities. This simplified model with interest rates
remaining forever fixed and without uncertainty about future mortality rates
allowed me to price my own life insurance policies to be compared on an equal
basis with investment strategies sharing the same underlying market
assumptions. This provides a good foundation for understanding how to compare
integrated strategies with life insurance against investments-only strategies. But
it is important to explain the additional real-world complexities and how they
may impact the previous conclusions regarding the contribution that whole life
insurance can provide to a retirement income plan.

The simplified framework in the earlier
analyses included the following features of whole life insurance:

·
Level premiums that are guaranteed not to increase

·
A guaranteed death benefit and guaranteed cash value growth for
the policy (guarantees are dependent on the claims paying ability of the
insurance company)

·
Tax deferral for the cash value growth

·
The opportunity to receive the death benefit free from any income
or estate taxes

·
The ability to surrender the policy for its cash value

·
The ability to withdraw funds from the policy on a tax-free basis
when structured properly by partially surrendering or borrowing up to the
premium paid into the policy, and then taking policy loans against cash value
gains

Actual whole life policies have additional
features that are too complex to properly simulate cash value and death benefit
growth with Monte Carlo simulations, so that the policies can be compared on an
equal basis with investments-only strategies. Additional complications include
the broader diversification of the investment holdings in the insurance
company’s general account, the ability for participating policies to pay
dividends to policy holders, differences between actual and estimated outcomes
for mortality and company expenses and the role played by accumulating reserves
for these contingencies, different underwriting categories for life insurance, and
whether the company has other business lines that may generate profits returned
to policy holders through dividend payments.

Previous sections let us investigate the key
issues about the role of whole life insurance without adding these complexities
by assuming the mortality and interest rate experience matches expectations and
that all retirement income tools are priced fairly and do not include fees.

Exhibit 7.12 summarizes the remaining issues
to be discussed around creating more realistic comparisons between whole life
and investments. This discussion includes understanding the underwriting
process, the options available for whole life insurance, the differences for
dividend-paying participating policies and the accumulation of reserves to
better cushion uncertainty about the assumptions.

Exhibit 7.12

Additional Considerations for Comparing Whole Life
Insurance and Investment Strategies

Reasons Whole Life
Insurance Premiums

Could be Higher

Could be Lower

Insurance companies price
policies with higher premiums to also cover company expenses.

Life insurance policies are
underwritten. Premiums relate to age, gender, and health classification.
Nonsmokers in good health could obtain substantially lower premiums than when
pricing policies for the average person.

Premiums must be higher to
support additional reserves to cover mispricing related to market returns,
mortality, and company expenses. When experience is better than the
conservative pricing projections, premiums were too high, and dividends are
paid to holders of participating policies as a way to return these excess
premiums.

Policies may be priced to
endow at age 121 rather than age 100, which lowers premiums as cash value
returns play a larger role relative to premiums in supporting policy growth.

Many policies include
additional riders such as a waiver of premium to keep the policy in force if
the owner becomes disabled, or options to purchase paid-up additions without
additional underwriting. Such options provide value that is reflected through
higher premiums.

Returns on the insurance
company general account may be expected to exceed fixed-income returns
available to households.

For whole life insurance,
generally being younger is advantageous for starting a policy. The earlier
one starts, the more it becomes possible to rely on compounding growth for
the cash value rather than to rely on premium payments. Nonetheless, it is
possible to wait to later ages to begin a policy, as long as one remains
insurable. Premiums will increase with starting age for the policy and with
limited-pay policies using shorter premium periods.

Some policyholders will lapse
before receiving their death benefits, which reduces costs to the insurance
company. This will be reflected through lower insurance premiums.

Other Factors Impacting
the Comparisons Between Insurance and Investments

Investments have fees as well,
which must be included in scenarios assuming fees on insurance.

Participating whole life
insurance policies provide the potential to pay dividends to policyholders,
which can be used to purchase paid-up additions that grow the death benefit
and cash value.

A term insurance policy with a
fixed death benefit is not directly comparable to a participating whole life
policy with a growing death benefit.

The tax brackets individuals
face pre- and postretirement are important. Those in higher tax brackets will
receive relatively more benefit from using a properly structured life
insurance policy.

Outcomes for life insurance
are dependent upon the solvency of the life insurance company.

In some states, life insurance
can provide additional protections from the claims of creditors.

Life Insurance Underwriting

While most annuities do not require
underwriting, life insurance is generally underwritten. The life insurance
company wants to determine that purchasers do not have health issues which may
lead them to expect an earlier age of death. The life insurance company may
seek to determine more about your health status with a questionnaire and a
physical examination conducted by a qualified medical professional.

Life insurance companies use different health
classifications to help match policyholders to their potential health status and
longevity. Those determined to be in better health can be expected to live
longer and will receive a better health classification that results in lower
premium payments. Smokers and those deemed to be in a lower health
classification may still qualify for life insurance but will have to pay higher
rates for their coverage. Some individuals may have preexisting health
conditions that disqualify them from life insurance eligibility. This becomes a
risk for waiting to start life insurance coverage, as at some point individuals
may incur a health event that subsequently disqualifies them from obtaining
coverage that they could have previously been eligible to receive.

This also suggests the potential value of
adding riders to an insurance policy that allow for additional coverage to be
purchased later (renewal and convertibility options) without needing to go
through the underwriting process again. The earlier examples were based on
average longevity numbers; those with better insurance classifications could
obtain lower premiums after the underwriting process.

Whole Life Insurance Premiums and Options

Choices exist regarding how long premiums will
be paid for whole life policies. For an ordinary whole life policy, premiums
are paid for as long as the policy is in force. This means premiums are
collected for life or to an advanced age when the policy otherwise endows.
Another option is a limited-pay whole life policy in which larger premiums are
paid for a fixed number of years so that the policy is fully paid-up by a
particular age. A compelling reason for a limited-pay policy would be to ensure
that no further premiums would need to be paid after the planned retirement
date, for instance. Examples of this option include a twenty-pay policy (the
policy is fully paid-up after twenty years of premiums), a ten-pay policy, or
even a single-premium policy. The earlier case study used a limited-pay policy
in which premiums stopped at age sixty-five.

A potential point of confusion about ordinary
life policies is that they may sometimes look like limited pay policies in
policy illustrations that assume premiums will eventually be paid by
nonguaranteed policy dividends, rather than paying out-of-pocket. For
limited-payment policies, premium payments end rather than assuming they are
covered through dividends.

Next, while most life insurance policies today
have level premiums, it is not strictly a requirement. Level premiums mean that
the premium amount stays fixed over time. It is worth considering this aspect
further. If one were to buy a new one-year term life policy each year, costs
would rise with age to accompany the increasing mortality rates associated with
aging. This explains why the quoted level premiums offered by an insurance
company will be higher when purchased at later ages.

By choosing a level premium, one is
essentially overpaying for the life insurance in the early years of the policy
and then underpaying for the insurance in the later years of the policy. The
earlier overpayments provide a surplus of funds that are invested by the
insurance company and earn interest and are then able to help to subsidize
later insurance costs. For whole life insurance, the surplus is reflected
through the policy’s cash value growth as an asset for the policyholder.

From the policyholder’s perspective, this
approach for providing level premiums can make sense, which is probably why
this structure is so common. The implied returns from life insurance are
extremely high in the event of an early death as fewer premium payments support
the same death benefit. These implied returns decrease with age as more
premiums are paid and the receipt of the death benefit is pushed further away
from when the policy started. Level premiums work to help smooth the
differential in these implied returns experienced for different ages of death,
as they lower the already high returns in the event of an early death but help
to boost the returns in the event of a later death.

One important caveat to provide about level
premiums is that they do hurt those who lapse on their life insurance policies.
By overpaying early on and then surrendering the policy, one loses the
opportunity to receive those later insurance cost subsidies. The subsidies
instead go to those with participating policies that remain in force. They are received
as policy dividends. Indeed, those maintaining their participating whole life
policies on a permanent basis do benefit when their counterparts lapse. But
level premiums should help to reduce the overall lapsation rates by helping to
keep premiums at an affordable level at advanced ages even as insurance costs
rise.

Another set of options with whole life
policies relate to both the ages that the policy endows and that the policy
matures. A whole life policy endows when its cash value grows to match the
death benefit. If a policy matures, it means that the individual has lived long
enough that they receive the death benefit (or more precisely, the cash value
that matches the death benefit) while still alive. Many past whole life
policies matured at age 100, which is not necessarily a desirable outcome. By
being forced to receive the cash value at that age, it means that any policy
gains represent taxable income. For this reason, age 121 has now become a
common maturity date for newer whole life policies.

The endowment date and maturity date can be
different. A policy that matures at age 121 could endow at age 100 or age 121,
for instance. If the policy endows before maturing, different companies have
different procedures for what happens. There should no longer be any life
insurance costs or premium payments for an endowed policy, but those holding
onto the policy may still be able to receive dividends that grow the cash value
(which now matches the death benefit). The policyholder may elect to take the cash
value of the policy, but this could trigger taxes. Maintaining an endowed
policy until death can allow the death benefit to be received with its usual
tax advantages. A policy that endows at a younger age will require higher
premiums than otherwise because the cash value must grow more quickly to reach
the death benefit sooner.

Insurance companies also provide optional riders
for life insurance policies for additional benefits and flexibility. Riders
providing attractive benefits to policyholders will often require an additional
charge that is included in the overall premium paid.

A common rider is the waiver of premium rider
for disability. It stops the need to pay premiums without losing any coverage
in the event of becoming disabled. This can be an attractive option because
otherwise, the lack of income triggered by disability could make it difficult
to continue paying life insurance premiums and could force the policyholder to
involuntarily lapse on the policy if the household finances become too tight.

Another potential option on a whole life
policy is the reduced premium offset. This can allow one to stop making premium
payments at some point in exchange for being willing to accept a lower death
benefit. It may be an option one would like to implement at retirement as a way
to reduce stresses on the retirement income plan caused by paying life
insurance premiums after retiring. The reduced premium offset works by using
the policy’s cash value to buy a single premium permanent life insurance policy
at that point in time based on the underwriting and classifications when the
policy was first taken out. This option has value because while an individual
could always discontinue a policy and receive the cash value, changes in health
status may mean that one can no longer qualify for new coverage. The reduced
premium offset allows part of the policy to remain in force while stopping the
need to pay premiums.

Additional riders can also allow the life
insurance policy to help fund long-term care expenses by accelerating access to
the death benefit while still alive in order to pay for long-term care. This
acceleration of benefits will generally be allowed using the same criteria
necessary to also qualify for receiving benefits from traditional long-term
care insurance policies.

Another common and important rider provides
the option to purchase paid-up additions for the policy. This allows one to add
additional out-of-pocket funds to the policy beyond the required premium
payments to increase the death benefit and cash value without needing to go
through the underwriting process again. This allows the policy holder to expand
coverage without having to start a new policy. The additional payments are
essentially providing layers of fully paid up or single-premium life insurance.
The dividends provided through participating policies could be used as a source
of funds to purchase these paid-up additions, and life insurance illustrations
may be provided which show dividends being reinvested into the policy in this
way.

Finally, life insurance does not have to be
based on only one life. A couple could choose a joint life policy that could
pay the death benefit based either on the first-to-die or on the second-to-die.
The latter option would be noticeably cheaper since joint longevity is greater
than for a single individual.

Participating Policies and Dividends

A key difference between the simplified whole
life policy I used in the earlier case studies and actual whole life policies
is the ability for participating whole life policies to pay dividends. When purchasing a participating whole life policy, the
insurance company will provide an illustration about the projected future
performance of the policy, including projections about dividends. These
illustrations will include both the guaranteed projections for the death
benefit and cash value, as well as anticipated levels for dividend payments
based on the current dividend scale used by the company. The actual dividends received
could end up higher or lower than illustrated, depending on how the factors
used to determine dividends subsequently perform.

Because of the conservative nature of the
assumptions used to build illustrations, responsible companies provide a
greater chance that actual policy performance could exceed even the illustrated
values. An aggressive company may produce an illustration that is too
optimistic, making it more likely that actual outcomes will lag. For this
reason, it is not a good idea to compare policies from different companies
based solely on the illustrated outcomes.

Whole life premiums may be higher that shown
in my example about policy pricing. Exhibit 7.2 was based on there being no
uncertainty about future interest rates and mortality. Because of real-world
uncertainty, life insurance premiums build in a degree of extra caution to create
reserves as a cushion in case the company’s experience deviates too far from its
assumptions about investment returns on the general account, mortality rates,
and company expenses. Company expenses may include loads to pay commissions,
premium taxes, administrative expenses, additional allowances to cover
contingencies, and a profit motive. A margin of protection is built-in with a
higher premium charged than will probably be necessary.

If those contingencies do not happen, then
participating policies return the surplus premiums to the policy holders
through dividend payments. Dividend payments are treated as the return of
surplus premiums, so the cost basis of the policy is total premiums paid less
total dividends received. However, dividends do not reduce the cost basis of
the policy if they are returned to the policy through the purchase of paid-up
additions or to pay premiums.

One use of dividends is to purchase paid-up
additions to increase the cash value and death benefit above the minimum
guaranteed levels. Exhibit 7.13 provides an example of a life insurance
illustration for an actual policy providing an initial $500,000 death benefit
for a forty-year-old male in good health with limited-pay premiums through age
sixty-five. For our earlier case studies, the simplified assumptions meant
there were no role for dividends. The death benefit and cash value reflected
what could be guaranteed by the policy as there was no uncertainty to build
reserves against. With dividend paying policies, I must distinguish between the
policy’s basic guarantees and what the policy could accomplish if dividend
payments are received and used to purchase paid-up additions. For this policy,
the guaranteed death benefit is $500K, and the policy endows at age 100 when
the cash value reaches this level.

Meanwhile, the illustrated death benefit and
cash value grow much larger with dividends. The policy still endows at age 100,
but the death benefit and cash value by this age have exceeded $2.25 million in
the policy illustration based on the company’s current dividend scale.
Dividends are not guaranteed, and the actual realized performance of the policy
could end up being better or worse than the illustrated numbers. If any
dividend can be paid, even just once, the policy will provide a better outcome
than its guaranteed level. While past performance does not predict future
outcomes, the large mutual life insurance companies that have been around since
the 1800s are proud of their consistent track records for paying dividends.

Exhibit 7.13

Illustrated Whole Life Insurance Policy Values
when Dividends are Used to Purchase Paid-Up Additions

Besides using
dividends to purchase paid-up additions of coverage, other dividend uses
include receiving them as cash payments, using them as a source of funds to pay
for insurance premiums, or depositing them in an interest-bearing account with
the insurance company.

Mutually owned life insurance companies are
owned by the holders of participating policies, as opposed to publicly held
companies owned by shareholders. Mutuals can focus on paying dividends to their
policy holders rather than to their stockholders. This may give them an edge in
providing dividends to the owners of their participating whole life policies.

A final note is that policyholders can request
in-force illustrations from the insurance company to show updated trajectories
for cash value and death benefit given the realized policy performance as well
as for a variety of assumptions around future dividends or future actions
around policy loans or surrenders.

Variable and Universal Life Insurance

Our discussion of whole life insurance
included two critical elements that reduce its risks when incorporated into a
retirement income plan. These elements include that premiums are fixed and
guaranteed not to increase, and that cash value is guaranteed to grow at a
fixed rate. Participating policies can allow for additional upside growth
potential for cash value when dividends are paid and are used to purchase
paid-up additions, but there is otherwise an underlying guaranteed cash value accumulation
in the policy.

These elements are relaxed for other types of
life insurance, which include variable life insurance, universal life
insurance, variable universal life insurance, and index universal life
insurance. These types of insurance policies also combine a death benefit with
a cash value accumulation account. Deductions from the cash value are made to
cover policy fees and the costs of providing the life insurance death benefit,
and the remainder remains invested as an asset for the policy holder. The types
of life insurance differ based on how the cash value is invested.

First, variable life insurance shares the
similarity with whole life insurance that premiums are fixed and guaranteed not
to increase. What differs is that variable life insurance allows policyholders
to invest the cash value into subaccounts with investment risk and growth potential
through mixtures of stock and bond investments. This creates volatility for
cash value; there is greater upside growth potential but also the possibility
for losses to be incurred. Policyholders bear market risk with variable life
insurance.

The other main type of permanent life
insurance is called universal life insurance, and it has several different
variations. The primary characteristic of universal life insurance is that
premiums are flexible, and their levels are not guaranteed. Premiums may
increase beyond what policyholders anticipate or expect. Related to the ability
to adjust premium payments, some universal life insurance policies also offer a
flexible and adjustable death benefit. For universal life insurance, the Option
1 death benefit works similarly to whole life insurance in that it remains
level, and the costs of insurance decline as the cash value increases and
reduces the amount at risk for the insurance company. With an Option 2 death
benefit, the amount of death benefit at risk for the insurance company remains
fixed as the total death benefit is equal to the cash value plus the fixed
amount of the death benefit above the cash value.

Fixed universal life insurance credits a fixed
interest rate to cash value in a similar manner as whole life insurance. This
most basic form of universal life insurance combines a permanent death benefit
with tax-deferral and a variable interest rate return for cash value that
includes a guaranteed minimum return.

Next, universal life insurance also offers
variable and index versions. Variable universal life insurance serves as the
life insurance counterpart to deferred variable annuities. Rather than using a
fixed savings account, variable universal life allows for diversification of
invested premiums across a range of investment options including multiple asset
classes. One could potentially invest in 100 percent stocks with a variable universal
life policy. Its premiums are not fixed and may require increases to keep the
policy in force.

Likewise, index universal life insurance
serves as a counterpart for fixed index annuities. Premiums enter into a
savings account with returns linked to market indices such as the S&P 500.
These policies will include the same types of floors and caps or participation
rates as index annuities, which help to control volatility for the assets by
giving up some potential upside to provide greater downside protections. For a
stock index, performance will be based on price returns with dividends
excluded. Index life insurance provides a degree of risk somewhere between
fixed and variable universal life insurance. Floors may help to alleviate
against the possibility of negative returns than can happen with variable
policies.

Though variable and universal life insurance policies
could potentially be used in the same manner as discussed for whole life
insurance, they may not work as effectively for those purposes, and this is
generally not the way that insurance professionals describe using these
policies. The death benefit tends to be underplayed, though it could potentially
serve to provide a legacy goal or as a backstop to justify the use of an income
annuity. As for the volatility buffer strategy, especially with variable life
insurance, the policy returns may be correlated with the investment portfolio
and render the policies ineffective as a volatility buffer.

Instead, advocates for these forms of life
insurance within retirement income planning tend to support using the cash
value as a tax-efficient source of supplemental retirement income. For this
discussion, it is worth revisiting the tax situation for retirees. There are three potential ways to obtain tax advantages:

1.      One
could receive a tax deduction for contributed funds, which reduces current taxable
income.

2.      Gains
could accumulate on a tax-deferred basis.

3.      The
distribution of gains could be obtained free of additional taxes.

It is rare to find a financial tool that
offers all three of these advantages. Health savings accounts available to
those using qualified high-deductible health insurance plans and when tapping the
account to pay for qualifying health expenses are one example.

A traditional IRA or a 401(k) retirement
account does provide #1 and #2 as tax advantages, but all distributions from
these accounts are then treated as taxable ordinary income. Variable and index
annuities provide the second advantage of tax deferral and may serve as a means
for obtaining additional tax deferral once retirement account contributions
reach their maximum allowed limits. Distributions from these annuities will be
taxed as ordinary income.

Meanwhile, there are three general tools that
can provide tax advantages #2 and #3. These include Roth IRAs, municipal bonds
(on a limited basis), and the cash value and death benefit of life insurance
policies. Roth IRAs generally have low contribution limits and income limits
for contributions. Once one exceeds these limits, permanent life insurance
becomes the primary tool to obtain both tax-deferral and tax-free distributions
for after-tax dollars when policies are structured properly with surrender of
cost basis and policy loans.

Among life insurance advocates, there are a
strain of supporters that focus a great deal on promoting the tax advantages of
life insurance to minimize taxes paid in retirement. In explaining their views
and approach to retirement income, these advocates first tend to focus on how
tax rates are presently at historic lows, and that one should expect much
higher tax rates in the future. Higher tax rates should be expected for reasons
including currently high levels of government debt and borrowing, future
strains to pay promised Social Security and Medicare benefits, and other fiscal
and demographic issues centered around how there will be fewer working age
members of the population to support the expanding population of retirees. As
well, retirees may find that their taxable income does not fall by as much as
anticipated due to fewer deductions as the mortgage is paid and children become
adults, and as required minimum distributions are applied to the assets held in
qualified retirement plans.

These advocates explain that you will be
better off paying taxes now at lower rates to avoid paying taxes in the future
at higher rates, which naturally leads to advocating for tools that support tax
advantages #2 and #3. But Roth IRAs have contribution limits, and one may wish
to limit holdings of municipal bonds. This could leave life insurance, with practically
unlimited contribution limits, as an important tool for obtaining additional
tax-advantages for savings and wealth.

An ideal financial plan for these advocates
would involve having just enough saved in qualified retirement plans such as a 401(k)
that required minimum distributions do not push these taxable income amounts
above the level of standard deductions, then perhaps have some funds in taxable
investment accounts from which taxable gains can be drawn without pushing the
tax rate out of the 12 percent level (which keeps the tax rate on long-term capital
gains at zero), and then taking everything else as distributions out of Roth
accounts and life insurance.

One would also take care to try avoiding
taxation on Social Security benefits, which are triggered when the modified
gross income (including half of the Social Security benefit and interest
on otherwise nontaxable municipal bonds) exceeds certain thresholds. One could
potentially fund a quite sizable amount of spending power in retirement without
having to pay any federal income taxes.

It is important to consider this strategy
further because the implications related to volatile cash value returns may
reduce the efficiency of this strategy in terms of supporting retirement
spending in the same way that trying to maintain a legacy goal with an
investment portfolio can force a lower level of spending. The issue is that a
larger cash value reserve must be maintained to avoid the possibility that the
loan balance from the insurance policy grows larger than the remaining cash
value in the policy. Cash value that is exposed to volatile and potentially
negative returns requires extreme care to avoid having the accumulated loan
balance exceed the total available cash value.

If this happens, it terminates the life
insurance policy and the policy gains that have been loaned above the cost
basis will subsequently be treated as taxable income in one tax year. This can
trigger very adverse tax consequences. As such, care must be taken to not
borrow too much of the cash value and to monitor the relative values of the
loan balance and the cash value to ensure that the former does not exceed the
latter.

To reemphasize, this requires taking
precautions to not borrow too much of the cash value to avoid being in the
position to have to make payments on the loan balance at a time in late
retirement when there may be less flexibility for using remaining investment
assets. Especially for variable life insurance, in a down
market environment that negatively impacts cash value, it could become
necessary to pay down the loan balance to avoid creating a taxable event for
the policy gains. Some policies do provide overloan protection riders at an
additional cost which can help prevent a policy from lapsing for these reasons.

Modified Endowment Contracts (MECs)

Endowment contracts for life insurance fell
out of general use in the 1980s after tax reform removed their tax
advantages. Simply, endowment contracts were life insurance contracts in
which the cash value could be expected to grow more quickly to reach the
value of the death benefit at an earlier age than what is considered as a
proxy for the maximum length of life (such as the 100 or 121 ages now commonly
used). With a smaller death benefit, cash value could grow more quickly
because internal insurance cost will be less. Those using cash value as an
investment will wish to keep the cash value as high as possible relative to
the death benefit.

Because life insurance receives tax
advantages, it is tempting to treat the cash value accumulation as an
alternative to traditional investment assets, and to treat the death benefit
as an afterthought. The tax-deferral properties of cash value make it very attractive,
such that individuals might be looking to use life insurance primarily for
its cash value rather than for its death benefit. Tax officials caught onto
this. While policymakers believe it is worthwhile to provide tax advantages
to encourage life insurance for its death benefit, they did not want these
tax advantages to extend to those who were buying life insurance primarily as
a tax-advantaged savings vehicle and not for the death benefit.

As such, there are now rules about modified
endowment contracts that provide tests about whether a cash value life
insurance policy is eligible to receive its tax advantages. For whole life
policies, the cash value accumulation test is used. It checks whether the
cash value is larger than the net single premium needed to fund the policy’s
death benefit. The cash value must be less to maintain its tax advantages. A
separate guideline premium and corridor test is more common for universal
life policies to make sure that they are also not accumulating cash value too
quickly relative to the death benefit.

Those policies deemed to have too much cash
value accumulation could be deemed to function as modified endowment
contracts and would lose their tax advantages. Policy gains become taxable
and distributions are treated on a last-in first-out basis so that
distributions are taxable gains first before the return of premium. The
policies also fall under the same rules for qualified retirement plans that
create penalties for distributions taken prior to age 59.5.

These modified endowment contract rules make
it important to work with a qualified life insurance professional when using
life insurance with a desire to emphasize its cash value properties. Care
must be taken to make sure that the policy does not run afoul of the modified
endowment contract rules that would eliminate the policy’s tax advantages.
This could happen at any point within the life of the policy and it requires
ongoing monitoring. It is not a onetime matter when the policy is first
created.

When comparing variable universal life
insurance to an investment account holding the same underlying investment
funds, the two strategies are pitting the tax deferral and death benefit
protections of the life insurance against the lower costs associated with the
investment account that does not have to pay insurance costs and policy
expenses, mortality charges, and any potential surrender charges. If the
purpose of the policy is to supplement retirement income, then the question
really simplifies to whether funds that would otherwise have to be invested in
a taxable account could find that the tax advantages of insurance lead to
better posttax financial outcomes despite the higher insurance costs.

This is the specific question that Russ
DeLibero explored—under my supervision for his PhD dissertation at the American
College—in research that we subsequently published called, “Life Insurance as a
Retirement Income Tool,” in the Financial Services Review.

This research looks at a forty-five-year-old
who uses a variable universal life insurance policy with a 100 percent stock
allocation to accumulate for nineteen years, and then to take supplemental
distributions from the policy for the first fifteen years of retirement. Using
historical simulations of past stock returns, it seeks to identify a
combination of assumed accumulation and distribution rates that could continue
to keep the policy in force for an additional twenty-one years through age 100.
This is to build in protection that the growing loan balance based on the fifteen
years of distributions remains below the cash value until at least age 100.

The policy is designed to provide the smallest
death benefit allowed to avoid creating a modified endowment contract, with a
focus on maximizing cash value growth by keeping insurance costs as low as
possible. The amount of spending the policy can generate that would have worked
in 95 percent of the historical rolling periods of data is then compared to a
taxable portfolio of stocks to determine the probability that it could keep
pace with the life insurance distributions. Because of the 100 percent stock
allocation, these strategies are meant to provide a supplemental source of
discretionary retirement income rather than serving as a reliable income
resource.

This comparison pits the tax deferral and
tax-free distribution advantages from the life insurance against the internal
life insurance costs and the necessity to remain conservative with distributions
to keep the policy in force despite the volatility for the underlying cash
value and the growing loan balance. When comparing to assets held within a
taxable account, we found that for a policy holder with a preferred no-smoker
classification, the probability of success for the investment strategy falls
below the life insurance strategy if the qualified dividend and long-term
capital gains tax rate exceeds 15 percent.

This happens as well for a standard nonsmoker
if the tax rate exceeds 20 percent. The life insurance strategy can be very
competitive for assets otherwise held within a taxable account, which is likely
the most relevant comparison for most individuals. As for comparisons to assets
held in a tax deferred account, it is much tougher for life insurance to keep
up due to the need to be conservative with spending to make sure that the
policy stays in force. Tax rates would have to rise substantially (such as a postretirement
combined marginal tax rate of 55 percent) for life insurance to come out ahead.
What this suggests is that these life insurance strategies may have value when
compared to holding assets in taxable accounts, but one would probably not wish
to divert assets to life insurance from a tax-qualified plan when seeking the
most efficient ways to generate supplemental retirement income.

Concluding Thoughts

Contrary to conventional wisdom, there can be
a role for permanent life insurance as part of the retirement income plan. This chapter looked at how permanent life insurance may be integrated
into lifetime financial planning. To finish the chapter, it is worth
emphasizing some caveats about the use of life insurance in order to have a
better understanding of the situations when it may be most helpful:

·
Including life insurance in a retirement income plan is meant to
be part of a long-term strategy. It takes time to accumulate cash value, and
surrender charges may apply in the early years to cover the policy acquisition
costs for the insurance company. These strategies require patience and a
willingness to stick with the plan.

·
When using volatility buffer strategies or using cash value in
other ways, it is important to continue monitoring the policy to ensure that
any loan balance does not exceed the policy’s cash value. Such action would
trigger a surrender on the policy, making all policy gains taxable. One must
monitor the loan balance and pay it down if this becomes a risk either because
the interest rate on the loan increases or the cash value is not growing as
quickly as anticipated.

·
When making plans based on the illustrated growth for the cash
value and death benefits, it is important to recognize that the illustrated
values are not guaranteed. Actual outcomes could be less or more than
illustrated, and the retiree must be comfortable with any actions that may be
needed to support the policy if dividends are less than anticipated.

·
For those more interested in the tax-deferred growth for cash
value than the death benefit, it is important to monitor the MEC status of the
contract and to not let the cash value grow too quickly relative to the death
benefit.

·
Guarantees depend on the credit worthiness of the insurer. Look
for companies with strong financial performance as well as low costs. It is
important to consider company credit ratings from agencies such as A.M. Best,
Fitch, Moody’s, and Standard & Poor’s.

·
Universal life does not have guaranteed premiums. They can be
changed.

Further Reading

Copeland, C.W. 2015. McGill’s Life Insurance (Tenth
Edition). Bryn Mawr, PA: The American College Press. [https://amzn.to/2SLlge5]

DeLibero, Russell, and Wade D. Pfau. 2017. “Life
Insurance as a Retirement Income Tool.” Financial Services Review. 26.

Lynch, Kevin M., and Glenn E. Stevick. 2011. Fundamentals
of Insurance Planning (Fourth Edition). Bryn Mawr, PA: The American College
Press.

McKnight, David. 2013. The Power of Zero: How to Get to
the 0% Tax Bracket and Transform Your Retirement. Boston: Acanthus Publishing.

Pfau, Wade D. 2015. “Optimizing Retirement Income by
Combining Actuarial Science and Investments.” Retirement Management Journal.
5 (2): 15–32.

Chapter 8: Fitting
Income Annuities into a Financial Plan

Though the discussion in this chapter could be
applied to any annuity offering lifetime income benefits, the focus for now returns
to income annuities. This is done to keep the discussion more manageable. We
will return to the consideration and comparison of different annuity types for
an overall product allocation framework in the next chapter. Previous chapters
have introduced the role annuities can play in retirement income plans. Here we
dig deeper into the why and how.

Income annuities provide bond-like returns with an
additional overlay of mortality credits. For someone wishing to spend at a rate
beyond what the bond yield curve can support, bond investments will essentially
ensure that the plan will fail. Income annuities are actuarial bonds. They
provide longevity protection which is unavailable with traditional bonds.
Retirees receive the bond yield curve plus mortality credits. Income annuities
are like a bond with a maturity date that is unknown in advance, but which is
calibrated and hedged specifically to cover the amount of spending needed by
retirees when they are alive to enjoy it.

Since the insurance company providing the annuity is
investing those funds primarily in a fixed-income portfolio, we should view
income annuities as part of the retiree’s bond allocation. There is less of a
need for bonds for the remaining nonannuitized assets. Annuities increase risk
capacity because retirement lifestyle is less vulnerable to a market downturn. Also,
distributions from the stock portfolio can be lessened, reducing sequence risk
and helping to preserve the investment portfolio.

Liquid financial assets can potentially be larger later in
retirement with partial annuitization. Legacy is not irreversibly harmed. We
provide analysis to demonstrate these points and then dive deeper into
questions about how much to allocate to the annuity, how to invest the rest,
how to manage inflation risk within the plan, and at what ages to buy annuities
and to begin their income.

The Fundamental Logic of
an Income Annuity

The question is why should a retiree hold any bonds in the
portion of their retirement portfolio designed to cover retirement spending
(longevity and lifestyle goals)? Premiums for the income annuity are invested
in bonds (the insurance company adds your premium to its bond-heavy general
account) and provides payments precisely matched to the length of time they are
needed. Stocks provide opportunities for greater investment growth. Individual
bonds can support an income for a fixed period of time, but they do not offer
longevity protection beyond the horizon of the bond ladder created. Bond funds
are volatile, exposing retirees to potential losses and sequence risk while
still not providing enough upside potential to support a particularly high
level of spending over a long retirement. Risk pooling with an income annuity
can support a higher level of lifetime income compared to bonds. Stocks also
offer the opportunity for higher income without any guarantee if stocks can
outperform bonds and provide capital gains during the pivotal early years of
retirement.

Income annuities can be viewed as a type of coupon bond
which provides payments for an uncertain length of time, and which does not
repay the principal value upon death. Another way to think about income
annuities is that they provide a laddered collection of zero-coupon bonds that
support retirement spending for as long as the annuitant lives. Much like a
defined-benefit pension plan, income annuities provide value to their owners by
pooling risks across a large base of participants. Longevity risk is one of the
key risks which can be managed effectively by an income annuity. Investment and
sequence risk are also alleviated through the more conservative investing and
asset-liability matching approach on the part of the insurance company for the
underlying annuitized assets. The payout rates for income annuity assume
bond-like returns and longevity is further supported through risk pooling and
mortality credits, rather than by seeking outsized stock market returns.

Longevity risk relates to not knowing how long a given
individual will live. But while we do not know the longevity for any one
individual, the actuaries working at insurance companies can estimate how
longevity patterns will play out for a large cohort of individuals. The
“special sauce” of the income annuity is that it can provide payouts linked to
the average longevity of the participants because those who die early end up
leaving money on the table to subsidize the payments to those who live longer.
Though it may seem counterintuitive to subsidize payments to others, this act
can allow all participants in the risk pool to enjoy a higher standard of
living while alive than could be supported with bonds. All participants know
that the mortality credits will be waiting for them in the event of a long
life.

Meanwhile, sequence risk relates to the amplified impacts
that investment volatility has on a retirement income plan that seeks to
sustain withdrawals from a volatile investment portfolio. Even though we may
expect stocks to outperform bonds, this amplified investment risk also forces
conservative individuals to spend less at the outset of retirement, in case
their early retirement years are hit by a sequence of poor investment returns.
Many retirement plans are based on Monte Carlo simulations with a high
probability of success, which implicitly assumes lower investment returns. An
income annuity also avoids sequence risk because the underlying assets are
invested by the annuity provider, mostly into individual bonds which create
income that matches the company’s expenses in covering annuity payments.

In hindsight, those who experienced either shorter
retirements or who benefited from retiring at a time with strong market returns
would have probably preferred if they had not purchased an income annuity. But
income annuities are a form of insurance. They provide insurance against
outliving assets. In the same vein, someone who purchased automobile insurance
might wish they had gone without if they never had an accident. But this misses
the point of insurance. We use insurance to protect against low-probability but
costly events. In this case, an income annuity provides insurance against
outliving assets and not having sufficient spending power late in retirement.

Nonetheless, there is still an important benefit from income
annuities even to those who do not make it long into retirement, especially for
those who are particularly worried about outliving their assets. That benefit
can be seen by comparing it to the alternative of basing retirement spending
strictly on a systematic withdrawal strategy from an investment portfolio. In
order to self-annuitize, a retiree must spend more conservatively to account
for the small possibility of living to age ninety-five or beyond while also
being hit with a poor sequence of market returns in early retirement. The
income annuity supports a higher spending rate and standard of living than this
from the outset. All income annuity participants, both the short-lived and
long-lived, can enjoy a higher standard of living while they are alive than
they would have otherwise felt comfortable with by taking equivalent amounts of
distributions from their investments.

Upon entering retirement, a retiree has several options in
terms of allocating between stocks, bonds, and income annuities. Let us
consider a simple example with four different approaches. With the basic
understanding in place, we can dig in deeper.

Bonds

Suppose a retiree wants to stretch the nest-egg over twenty years
and will earn 0 percent returns by investing in bonds. We could assume higher
bond returns, but that would simply complicate the math without any loss of
generality for this explanation. Since insurance companies also invest in
bonds, higher interest rates would increase the annuity payout rate as well. These
bonds allow for spending at 5 percent of the initial portfolio balance—the
sustainable spending rate—every year of retirement, but it leaves nothing to
support spending beyond year twenty.

Income Annuities

Now suppose life expectancy is twenty years and add
longevity risk to the equation. Some will not make it twenty years; others will
live longer. With the 0 percent returns the annuity provider earns from bonds,
the provider could still support this 5 percent spending rate through risk
pooling and mortality credits no matter how long a participant lives.

Self-annuitization

Now suppose the retiree self-annuitizes instead by managing
this longevity risk without insurance. This requires picking a planning age one
is unlikely to outlive. Suppose the retiree decides to plan under the
assumption that retirement will last for thirty years. In this case, to spread
assets out over thirty years with a 0 percent investment return, the spending
rate must fall to 3.33 percent. Note as well, the spending rate could only be
2.5 percent to support wealth lasting for forty years. The longer one wishes
for the money to last, the less one can spend. In terms of an unintended
legacy, if one did live for twenty years, then a third of the assets would
still remain with a thirty-year plan, or half of the assets would still remain
with a forty-year plan.

Stocks

Alternatively, one could seek an investment return higher
than 0 percent by including stocks. With a fixed annual investment return of
3.1 percent, the retiree could support the 5 percent spending rate for thirty years.
With a 4.2 percent investment return, spending could be supported for forty years.
The question then centers around how likely it is for the portfolio to earn
these higher rates of return through a stock-heavy focus.

Stocks creates risk. Seeking this higher investment return
forces the retiree to accept portfolio volatility with a growing allocation to
stocks. Spending from investments further heightens sequence risk. A few poor
returns early on could easily derail the attempt to support that 5 percent
spending rate for as long as the plan targets. Often one might get the higher
returns needed to support a bigger spending level in this way, but there is no
guarantee that this approach will be successful. The stocks strategy provides
greater upside potential for wealth to grow, but it also creates greater downside
risk that the retiree cannot meet the spending goal throughout retirement.

Annuitized assets do not provide upside in the sense that a
legacy could be left when markets do well, but it also eliminates downside
spending risk. The long-lived do receive a form of upside through mortality
credits. The effective return from the annuity matches what the stocks needed
to earn to support those longer retirements. Self annuitizing requires lower
spending, and stocks could support higher spending with upside growth, but it
does add risk as well. As for bonds, ultimately, the question is this: why hold
any bonds in the part of the retirement portfolio designed to meet spending
obligations? The income annuity invests in bonds and provides payments
precisely matched to the length of retirement, while stocks provide
opportunities for greater investment growth above bonds. Bonds alone hold no
advantage.

The income annuity provides a license to spend more from the
start of retirement by being able to pool risk. Supported spending from an
income annuity is higher because it is based on reaching life expectancy, and
should the retiree live beyond life expectancy, the higher income continues to
be sustained because of the subsidies arriving from those who died early. The expectation
that subsidies will arrive as needed allows spending to increase for everyone
from the very start of retirement. Exhibit 8.1 highlights how mortality credits
represent a third source of spending with an income annuity beyond the
spenddown of principal and the interest generated by that principal.

Regarding sequence risk, for those who self-annuitize, there
are two options for deciding how to spend from investments. One is to spend at
the same rate as the annuity with the hope of either dying before running out
of money, or the hope that the investments earn strong enough returns to
sustain the higher spending rate indefinitely. This approach requires
acceptance of the possibility that the standard of living may need to be cut
substantially later in retirement should the hopes for sustained investment
growth not pan out. The alternative is to spend less early on and, should good
market returns materialize, increase spending later. The problem with intending
to increase spending over time is that it is the reverse of what most people
generally wish to do, which is to spend more early in retirement and cut back
as life slows down at more advanced ages.

Exhibit 8.1

Sources of Income Annuity Payouts

The four financial goals for retirement are lifestyle,
longevity, liquidity, and legacy. We have just discussed how an income annuity
potentially enhances lifestyle from the starting point of retirement,
especially for more conservative individuals who spend less because they are
more worried about outliving their assets. Additionally, longevity is the
fundamental reason to consider an annuity. But what about liquidity and legacy?

Income annuities do not provide liquidity or legacy without
adding provisions which reduce the value of the mortality credits. For those
less willing to subsidize the payments to others in the event of an early
death, there is less right to earn the subsidies from others in the event of a
long life.

But there is more to the story about liquidity and legacy,
and it is related to how an income annuity fits into an overall plan. Often the
discussion around income annuities frames the matter incorrectly, as if it is
an all-or-nothing decision. Partial annuitization lets us think about how we
allocate assets toward meeting different goals.

An important point to understand about assets in a liquid
financial portfolio is that one’s degree of control over the assets may be
overstated. There is a stream of lifestyle spending goals which must be
financed in order to have a successful retirement. Those spending goals
represent a liability which must be financed by assets somewhere on the
retirement balance sheet. The assets earmarked for that purpose do not provide
true liquidity, as discussed in Chapter 1.

For example, consider a couple who believes that the 4 percent
rule serves as an appropriate guide for their retirement spending. They seek to
spend $40,000 per year with inflation adjustments, and they have $1 million
invested in stocks or bonds through their brokerage account. Does this couple
have any liquidity? Technically, we could say yes, since they do have $1
million of liquid financial assets. But in a meaningful sense, this couple does
not have liquidity. They are not free to use that $1 million for other
purposes. The full amount must be tied up in order to support their spending
objectives. Spending it for other purposes jeopardizes their ability to
continue meeting their retirement spending goal later in retirement.

Certain assets on the balance sheet must be earmarked to
fund liabilities and this has implications for how those assets should be
managed. Many real-world retirees end up earmarking more assets than necessary
to support income, and therefore spend less than possible because there is no
guarantee component with investments, and they worry about outliving their
assets. It is necessary to consider whether an income annuity provides an
explicit way to earmark the assets needed for income in such a way that it does
free up other assets to provide meaningful liquidity.

For a partial annuitization strategy, Iowa-based financial
planner Curtis Cloke refers to the nonannuitized assets as “unfettered assets,”
as they are no longer tied down to cover the spending needs met by the income
annuity. This creates more flexibility for the unfettered assets to support a
liquid reserve to cover unexpected expenses or other surprises to the financial
plan, or to otherwise support legacy goals. Allocating other assets in a way
that accounts for a more secure spending floor can allow a spending goal to be
met with fewer assets than a pure systematic withdrawal strategy based only on
volatile investments. With each retirement income plan, it is important to
investigate how to support spending goals most efficiently.

Income Annuities and
Legacy

With this extremely simplified example completed, we now
return to our baseline market assumptions to add realism, though we will
maintain fixed returns for a bit longer. The status of legacy will be clearer
with another simple example comparing an investments-only retirement strategy
with a partial annuitization strategy. Consider a sixty-five-year-old female
who is ready to retire.

We return to the assumptions about investments and annuities
from Chapters 3 and 4. Inflation is 2 percent and bonds provide an additional 1
percent real return. These values are fixed. Stocks support an arithmetic average
6 percent risk premium above bonds with a 20 percent volatility. A portfolio
combining stocks and bonds will experience a weighted average return based on
those components. For a 50/50 annually rebalanced asset allocation, for
instance, the portfolio nominal arithmetic return is 6 percent, the real return
is 4 percent, and the volatility is 10 percent. The compounded real return for
this portfolio is 3.5 percent. For annuities, with the 3 percent bond yield, a
life-only income annuity for this sixty-five-year-old female offers a 5.78
percent payout rate. In this section, we base the analysis assuming the
portfolio earns the average compounded return, which represents a median
outcome for a broader analysis that would include simulated volatile returns
and sequence risk.

For this analysis, we will simplify fixed-income investments
to assume a flat and unchanging yield curve. This eliminates interest rate risk
from the analysis, as there is no possibility for fluctuating interest rates to
create capital gains or losses for the underlying bond portfolio. In reality,
if interest rates rise, the value of a fixed-income portfolio declines, but the
present-value cost of funding a future spending objective also decreases. If
the duration of the bond portfolio matches the duration of the spending
liability, then interest rate fluctuations have offsetting effects on the asset
and liability sides of the balance sheet and interest rate risk is hedged.

Alternatively, we could think of our retiree as holding
individual bonds to maturity, which means that any capital gains or losses from
interest rate fluctuations would not be realized as the bonds reach maturity
and provide their face value as a source of retirement spending for that year.
This simplification about fixed-income does not meaningfully impact the
decision between stocks and income annuities; it simply lets us focus more
directly on the equity risk premium and risk pooling without also having to
worry about fluctuating interest rates. Bonds may be riskier for retired
households than implied by our analysis, but this is not our focus.

With a nest egg of $1 million, she budgets for $47,873 of
spending from her portfolio—with a planned 2 percent annual spending increase
to cover inflation—for the rest of her life. This represents a 4.78 percent
withdrawal rate from the retirement date portfolio balance. This spending
amount is chosen as the value that will deplete the portfolio precisely after
thirty-five years with the 3.5 percent compounded real return assumption. In
this case, she does account for longevity risk by planning for a lengthy
retirement to age 100 (for which she still has an 11 percent chance to
outlive). But the market assumptions for this example are favorable to investments.
The return corresponds to the median outcome for investments, and with her
spending goal, she could expect to deplete her portfolio 50 percent of the time
before the thirty-five-year planning horizon.

We know that her investment wealth will last for precisely
thirty-five years in the investments-only case with a 50 percent stock
allocation. Legacy is $0 at age 100 and she cannot support spending beyond that
age. But what happens to her remaining investments if she allocates part of her
portfolio to an income annuity? The answer will depend on how she adjusts the
asset allocation for her remaining investments in response to the carve-out for
the annuity premium. I will consider three asset allocation options for the
remaining investments and base the accompanying example on a plan to allocate 30
percent of assets to an income annuity at the start of retirement.

First, the more conservative response to partial
annuitization is to not change the asset allocation for her remaining
investment portfolio. She maintains the same 50/50 asset allocation as in the
investments-only case, but her overall stock holdings have been reduced since
the stocks are 50 percent of the 70 percent that remains after annuitization.
Stocks are now 35 percent of the overall asset base. As will be discussed, this
is not the recommended approach for managing asset allocation when using any
type of annuity with lifetime income.

The second option will provide the most aggressive overall
adjustment. In this case, the fixed asset allocation for investments is
permanently adjusted to treat the annuity premium as a bond and to hold the
same amount of stocks both before and after annuitization. The stock allocation
is adjusted upward so that stocks remain as 50 percent of the original wealth
holdings before annuitization. With 30 percent of assets annuitized, the stock
allocation for the remaining portfolio increases to be 50 percent divided by
the 70 percent that remains, or 71 percent of the remaining investments.
Treating the income annuity as part of the fixed-income investment, she shifts
$300K into the income annuity from her bond holdings while preserving the same
amount ($500K) of stocks as before. With the remaining $700K in the financial
portfolio, the new asset allocation is 71 percent stocks.

The third approach is to adjust asset allocation over time
so that the stock allocation remains at 50 percent of the combination of the
remaining portfolio balance plus the present value of remaining annuity
payments. This will be the most complex method to use in practice since it
requires ongoing adjustments and updating calculations for the annuity present
value. In this case, the present value of annuity payments is calculated using
the 3 percent bond interest rate and the assumption that the retiree lives to
her planning age of 100. This assumption about living until 100 to match the
planning age increases the annuity present value relative to the premium paid.
Annuity pricing is based on survival probabilities that do not assume such a long
lifespan. With a 3 percent discount factor, the present value of the
thirty-five annuity payments is $384K, which is $84K more than the $300K annuity
premium.

The financial plan is not evaluated with objective
mortality. The retiree seeks additional conservatism for the financial plan by
choosing a planning age she is less likely to outlive, and this increases the perceived
value of the annuity with respect to the role it will play in her financial
plan. The annuity is not objectively worth $384K, but it holds this value given
her conservative planning age. This higher annuity valuation does increase the
initial stock allocation for the strategy, but over time the present value of
remaining annuity payments will decline faster than the remaining portfolio
assets, leading the stock allocation to decline as time passes. Overall, this
approach is more conservative than the second one, which maintains a high stock
allocation despite the decline in the present value of remaining annuity
payments over time. Exhibit 8.2 illustrates these three stock glidepath
assumptions.

Exhibit 8.2

Stock Allocation Glidepaths for the Three Responses
to Partial Annuitization

With 30 percent of assets totaling $300K used to purchase an
income annuity paying at 5.78 percent, annual annuity payments total $17,430.
In the first year of retirement, this leaves $30,533 to be withdrawn from the
remaining $700K in the portfolio. The initial withdrawal rate from the
investment portfolio is reduced from 4.78 percent to 4.36 percent. The reduced
withdrawal rate helps to reduce the initial exposure to sequence-of-returns
risk as a market downturn is less likely to escalate an increase in the
withdrawal percentage needed to meet ongoing expenses from what remains.
However, the entire subsequent inflation adjustments for the spending goal will
need to come from the remaining investments as the annuity payment is fixed.
This creates more pressure for the portfolio over time. This is an interesting
tradeoff pitting lower initial spending against greater subsequent spending
growth that we can start to evaluate with the next exhibit. We will also discuss
this point further when we consider whether to incorporate inflation protection
into the annuity.

Exhibit 8.3

Remaining Investment Assets: Investments Only vs.
Partial Annuitization

Exhibit 8.3 illustrates the amount of investment assets that
remain over time for the different retirement strategies. As noted, with the
investments-only strategy, the spending goal was specifically designed to
deplete the investment portfolio precisely at age 100. Will partial
annuitization cause portfolio depletion sooner or will it extend the life of
the portfolio?

The exhibit reveals that the answer depends on how the asset
allocation is adjusted in response to shifting some portfolio assets to the
annuity. If the stock allocation remains at 50 percent of what is left, then
the overall stock allocation has been reduced because the annuity is a
bond-like asset. This loss of investment growth potential leads the portfolio
to deplete two years prior to the planning age. A portion of spending is still
available with the income annuity. But with the growth of the spending goal for
inflation, the annuity income is far from adequate at this point in the
retirement plan.

The results are much more favorable if the annuity is
treated like a bond and the stock allocation for the remaining investments is
increased to reflect this. With the more aggressive fixed stock allocation, $425K
remains at the planning age, and with the variable asset allocation that
accounts for the shrinking present value of remaining annuity payments, $362K still
remains at the planning age. In these cases, the retiree is able to fund her
spending goal equally well and partial annuitization supports a great
subsequent legacy. In the long-term, these latter two cases are more efficient
than an investments-only approach.

Exhibit 8.3 tracks the amount of liquid financial assets
remaining after also meeting the spending goal. In early retirement, liquid financial
assets will naturally be less with partial annuitization. The value of
financial assets falls by 30 percent with this partial annuitization. With a
lower required distribution rate, financial assets grow and eventually catch-up
to investments-only by the mid to late 80s. As this is just below life
expectancy, this places the odds squarely in favor of having more liquid
financial assets at death with partial annuitization. Short-term sacrifice supports
long-term gain. Because the income annuity provides a bigger initial payout,
there is less pressure on the portfolio in the early retirement years. This
allows liquid financial assets to grow more quickly over time.

The portfolio withdrawal rate stays less with partial
annuitization than the investments-only case for three reasons. First, the
payout rate from the income annuity is higher than the sustainable spending
rate from the investment portfolio. Even though the annuitized assets do not
benefit from a risk premium, they do benefit from being calibrated to a shorter
planning horizon through risk pooling.

Second, as retirement continues, the income annuity supports
more of the income goal with mortality credits, while the bond component of the
investment portfolio continues to create a drag on the sustainable amount of
spending. Over time, more of the cumulative retirement spending has been funded
by the mortality credits from the income annuity, which relieves pressure on
the amount of withdrawals needed from the remaining financial assets.

Third, the partial annuitization approach also supports
greater growth for remaining assets through the higher stock allocation, which
is justified at the initial retirement date by considering the allocation to
the income annuity as part of the fixed-income portfolio. The greater risk
capacity afforded through partial annuitization allows remaining assets to be
invested more aggressively for the subset of the retirement balance sheet
representing the financial portfolio.

When retirement is short, partial annuitization leads to a
smaller legacy, though the remaining legacy from investment assets is still
reasonably large. For longer retirements, partial annuitization offers sound
spending support while also fortifying a larger legacy. By requiring less
assets to meet spending, risk capacity increases and the withdrawal rate from
remaining assets decreases. Nonannuity assets can grow with less sequence risk,
creating better long-term opportunities for legacy.

If income annuities include provisions for cash or
installment refunds, an early death may not leave beneficiaries in any worse
shape than a plan excluding income annuities. This would lose some of the kick
from mortality credits, so it would effectively trade more legacy wealth in
early retirement for less in later retirement. However, it is an option for
retirees not fully convinced by the life-only strategy.

Income Annuities and
True Liquidity

As discussed, there are three general financial goals for
retirement planning related to the four Ls: funding retirement spending
(longevity and lifestyle), providing a legacy to the next generation, and
supporting liquidity to cover contingencies. We have considered the first two,
and it is worth adding a few comments about liquidity. When we compare the
roles of risk pooling (income annuities) and risk premium (stocks) in a
retirement income plan, the idea is that annuities do not necessarily provide a
direct source of liquidity, but that risk pooling can help to support other
goals more efficiently and leave more remaining investment assets available to
provide true liquidity for the financial plan.

The risk premium strategy will use an investment
portfolio to meet the financial goals. The risk pooling strategy is an
integrated strategy: an income annuity (risk pooling) is used to meet spending
goals, life insurance may contribute to legacy goals, and an investment
portfolio is otherwise used to support liquidity and other goals that are more
discretionary in nature.

Maintaining liquidity is an important tool for managing
unanticipated spending shocks in retirement. But the nature of liquidity in a
retirement income plan must be carefully considered. An investment portfolio is
a liquid asset, but some of its liquidity may be only an illusion. Assets must
be matched to liabilities. Some, or even all, of the investment portfolio may
be earmarked to meet future lifestyle spending goals. In financial advisor
Curtis Cloke’s language, the portfolio is held hostage to income needs. A
retiree is free to reallocate her assets in any way she wishes, but the assets
are not truly liquid because they must be preserved to meet the spending goal.
While a retiree could decide to use these assets for another purpose, doing so
would jeopardize the ability to fund future spending.

This is different from true liquidity, in which assets could
be spent in any desired way because they are not earmarked to cover other
liabilities. True liquidity emerges when there are excess assets remaining after
specifically accounting for ongoing spending goals. This distinction is
important because there could be cases when tying up part of one’s assets in
something illiquid, such as an income annuity, may allow for the spending goal
to be covered more cheaply (i.e. with less assets) than could be done when all
assets are positioned in an investment portfolio.

In simple terms, an income annuity that pools longevity risk
may allow lifetime spending to be met at a cost of twenty years of the spending
objective, while self-funding for longevity may require setting aside enough
from an investment portfolio to cover thirty to forty years of expenses.
Because risk pooling allows for less to be set aside to cover the spending
goal, there is now greater true liquidity and therefore more to cover other
unexpected contingencies, such as long-term care or health care shocks, without
jeopardizing core-spending needs.

In order to calculate the true liquidity for an investment
portfolio that is also supporting a spending goal, we must make assumptions
about how much of the portfolio shall be earmarked for the spending goal. We
discussed this in Chapter 3 in terms of how asset allocation combined with
capital market assumptions, the retirement time horizon, and the desired probability
for plan success all work together to determine a sustainable spending rate for
the retiree. The asset base to support a spending goal is the spending goal
divided by this estimated safe withdrawal rate. If the current portfolio value
is larger than this threshold, then the excess reflects the true liquidity for
the financial plan. True liquidity can be negative (the spending goal has a
shortfall at the accepted level of risk) if current assets are less than what
is needed to create comfort that the retirement spending goal will be met.

If a retiree chooses to fully cover a spending goal through
the partial annuitization of her portfolio, then remaining assets in the
portfolio are not earmarked to cover spending. With this integrated strategy,
risk pooling is used to earmark assets for spending, and the risk premium is
used for liquidity. True liquidity will be larger whenever the payout rate for
the annuity is greater than the determined “safe” withdrawal rate from
investments as based on the retiree’s risk aversion.

Allocation to an Annuity

The earlier example demonstrated the impact of allocating 30
percent of the investment assets to an income annuity. This amount was picked
arbitrarily. What is the right amount? I am sometimes asked about how much to
put into an annuity as though it was another asset class in an asset allocation
problem: how much to stocks, to bonds, and to annuities? The better way to
approach this is to ask how much annuity income is needed to meet the longevity
spending goals.

The Retirement Income Optimization MapTM (RIO MapTM)
in Exhibit 8.4 provides a proper summary of how to approach the retirement
income problem. This exhibit draws on attributes from the safety-first approach
to consider the entire retirement balance sheet and to match assets and
liabilities. At the same time, this approach is not overly regimented and
includes both probability-based and safety-first plans, as the relative sizes
of the reliable income and diversified portfolio boxes can be adjusted to
create a plan that meets the psychological needs of the individual implementing
it. It works by positioning the four Ls as the financial goals on the left and
translating them into the liabilities and expenses associated with those goals
on the right.

Retirement assets are matched to those goals after
positioning assets in three general categories: reliable income resources, the
diversified portfolio, and reserve assets. Reliable income includes protections
to help manage retirement risks. Examples include Social Security and pension benefits,
individual bonds, and different types of annuities providing lifetime income
protections. The diversified portfolio is the traditional investment portfolio
and can also include life insurance for matching to a legacy goal or for
coordinating with investments to cover spending. Reserves are remaining assets
that have not been earmarked to cover other goals and are available to help
support retirement contingencies.

With this framework, the amount of portfolio assets to
earmark as an annuity premium is based on how much is needed to support
longevity goals after accounting for the other reliable income resources
available to the household. For example, suppose an individual reaches
retirement with $1 million in an IRA and Social Security benefits worth
$30,000. This retiree seeks to spend $70,000 per year, of which $45,000 is
deemed as essential expenses. After Social Security, there is a $15,000 gap for
reliable income. The sixty-five-year-old female facing a 5.78 percent payout
rate on a life-only income annuity with level payments could purchase an
annuity with $259,516 and precisely close the gap. This represents 25.9 percent
of portfolio assets, and it would serve as the starting point for analyzing the
annuity allocation. This would be the portion of assets to earmark to the
annuity and the retiree must evaluate whether this is a reasonable portion of
the overall asset base.

Exhibit 8.4

Retirement Income Optimization MapTM
(RIO MapTM)

Partial Annuitization
and Asset Allocation for Remaining Investments

In the earlier example, we could observe the importance of
treating annuity premiums as a fixed-income asset so that overall stock
holdings do not decrease with a partial annuitization strategy. Treating the
matter in this way is justified. We now elaborate on why it is justified to
treat the annuity as a bond and to become more aggressive with the remaining
assets in the investment portfolio so that total stock holdings are not changed.

For someone who worries and loses sleep about outliving his
or her portfolio, does not have much additional income from outside the
portfolio, mostly faces fixed expenses without much room to make cuts, and does
not have much in the way of backup reserves in the absence of annuitization, it
may be necessary to spend and invest very conservatively in order to achieve a
high probability of plan success. This will imply using a lower stock
allocation and a lower spending rate.

However, for someone who has less fear about outliving his
or her portfolio, has a number of additional income sources from outside the
portfolio, has the flexibility to cut portfolio spending without adversely
impacting the living standard, and has sufficient additional reserves, a higher
spending rate and more aggressive asset allocation could be quite satisfactory
and optimal. By repositioning a portion of assets into an income annuity, a
number of these latter characteristics can be better achieved.

A good starting point for this discussion is to review the
Retirement CARE AnalysisTM introduced in my book How Much Can I
Spend in Retirement? It is a framework I developed to outline the factors a
retiree should consider when choosing an initial spending rate and asset
allocation. This framework provides the details for how to decide on the
aggressiveness of both spending and asset allocation within a retirement income
plan. This framework is based on Capacities, Aspirations, Realities, and
Emotions. Exhibit 8.5 provides the factors to keep in mind.

Exhibit 8.5

The Retirement CARE Analysis™

CAPACITIES (Resiliencies)

Reliable Income

What proportion of your
spending goals are covered through reliable income sources from outside the
investment portfolio that will not be diminished by market downturns?

Spending Flexibility

Is it possible to reduce
portfolio distributions by making simple lifestyle adjustments without
significantly harming your standard of living?

Funded Ratio

Are there sufficient assets to
meet retirement goals without taking market risk? Is there excess
discretionary wealth, or are you underfunded with respect to goals?

Availability of Reserves and
Exposures to Spending Shocks

How much exposure is there to
large and uncertain expenses? What insurance policies or other reserves are
available to manage these shocks? Are there reserve assets?

ASPIRATIONS (Goals)

Lifestyle

What is the retirement budget?
How does it change over time? How closely connected is it to consumer price
inflation?

Legacy

What are the legacy goals? How
important is legacy, relative to other goals?

RETURNS (Assumptions)

Capital market expectations

What are reasonable market
return assumptions for different asset classes and inflation to guide
simulation of the retirement income plan? How are returns impacted by
investor behavior, fees, taxes, and investment vehicle choices?

EMOTIONAL COMFORT
(Constraints)

Traditional risk aversion

How much short-term portfolio
volatility can you stomach before it affects your sleep and leads you to
panic and change course if markets are down?

Longevity risk aversion

How fearful are you about
outliving your investment portfolio? Greater concern means more longevity
risk aversion, implying that one should choose a higher planning age.

Financial tool aversion

Are you willing to consider
different types of retirement tools, such as annuities and reverse mortgages,
or are some tools simply nonstarters for you?

Susceptibility to behavioral
mistakes

When it comes to investing and
long-term planning for complex situations, how prone are you to making a
variety of behavioral mistakes? Will you be able to stick to your financial
plan?

Financial plan complexity

What is the acceptable degree
of complexity and involvement needed to manage your finances? Do you enjoy
the planning process, or would you prefer to outsource management to others?
Would you prefer more simple set-it-and-forget-it types of solutions?

Financial savvy of all
household members

How is financial planning
knowledge and savvy distributed among household members? What is the degree
of vulnerability of others in the household if the more financially savvy
member experiences cognitive decline or an unexpected death?

For our discussion about how to adjust asset allocation when
using a partial annuitization strategy, the decision to use an annuity will
have already been based on a number of these factors: lifestyle and legacy
goals, capital market expectations, longevity risk aversion, financial tool
aversion, susceptibility to behavioral mistakes, financial plan complexity, and
the financial savvy of all household members. With the lifestyle and longevity
distinction of the Four Ls financial goals, the issue of spending flexibility
has also been addressed, as the annuity is matched to goals for which there is
less flexibility.

The remaining factors from the Retirement CARE Analysis that
still can apply to asset allocation include three of the capacity factors
(reliable income, funded ratio, and availability of reserves) and the emotional
comfort factor of traditional risk aversion.

This discussion implies that a retiree could become even
more aggressive with an annuity in place, increasing their overall stock
holdings. That is certainly a possibility, but I have not pushed the analysis
quite so far. The partial annuity strategies considered were instead an effort
to keep the overall exposure to market risk the same before and after the
annuity purchase by treating the annuity as an alternative to a portion of the
bond holdings.

For those with longevity risk aversion, which helped prompt
annuity use in the first place, the three capacity factors have all been
strengthened in terms of being able to implement a more aggressive asset
allocation for the remaining investment portfolio.

First, reliable income has increased through the annuity.
More of the spending goal is now covered by reliable income assets that are not
exposed to downside market risk. I use the term GRIP, or Guaranteed Retirement
Income Percentage, to describe this concept. When the GRIP increases, more of
the total spending budget is covered by resources with lifetime protections. This
reduces the harm of investment portfolio depletion because more retirement
spending is still available, and the longevity goals have been more fully
covered. With less exposure to downside market risk, the retiree has greater
risk capacity and can rest more easily with a higher stock allocation for what
remains. In other words, adding protected lifetime income can strengthen one’s GRIP
on retirement.

I was part of a research effort with Michael Finke and
Duncan Williams to explore these issues in a March 2012 article in the Journal
of Financial Planning titled “Spending Flexibility and Safe Withdrawal
Rates.” We investigated withdrawal rates and asset allocation after adding
other income sources from outside the investment portfolio. Also, instead of
focusing on the traditional objective of worrying only about using a low
failure rate, we sought a better balance between the competing trade-offs for
wanting to spend and enjoy more while one is still alive and healthy against
not wanting to deplete the investment portfolio and having to rely only on
nonportfolio income sources in later retirement.

We completed this analysis using more formal economic models
of utility maximization in which the retiree decided to maximize the expected
lifetime satisfaction to be received from across the distribution of outcomes.
As for what is most relevant here, we found that a risk tolerant retiree with $1
million of portfolio assets would be willing to increase the stock allocation
by 10 to 30 percent when reliable income is increased from $20,000 to $60,000.

The second capacity factor is the funded ratio. The funded
ratio is a tool that quantifies the shape of the RIO Map shown in Exhibit 8.4. It
quantifies the size of the various asset and liability boxes. The idea of
calculating an individual’s funded ratio is to treat personal retirement
planning in the same manner as a corporate pension fund. On a lifetime basis,
are the assets large enough to meet the liabilities? A funded ratio of one
means that a retiree has just enough assets to meet liabilities, while
overfunded and underfunded individuals have more or less than this,
respectively. We can also make those comparisons in terms of the subcategories
on the RIO Map, looking at how well the different liabilities associated with
the four Ls have been funded.

Assets are the resources available to fund liabilities,
while liabilities are the planned expenditures to be made over the lifetime. Streams
of lifetime income and expenses are each calculated as present values.

For future income and spending needs, it may be easiest to
keep track of these cash flows in inflation-adjusted terms, as this provides a
translation for the value of future amounts in terms of what can be understood
today. To express matters in inflation-adjusted terms, future income and
spending needs, as well as the discount rate used in the calculations, are all
adjusted downward to account for inflation. It is important to be consistent
about expressing all terms either with their real or nominal values. The
natural discount rate is the bond yield, which we have treated as 1 percent in
real terms and 3 percent in nominal terms.

Assets can be divided among three general categories:
financial capital, human capital and social capital. The present discounted
value of assets includes the current value of the financial portfolio and other
resources currently owned (such as the value of a home) which could potentially
be sold to fund future spending needs. It also includes the present value of
other available income sources over the lifetime, such as future employment
income, Social Security benefits, pensions, and annuities. Meanwhile,
liabilities include current debts, such as a mortgage or loan balance, and the
discounted present value of an individual’s expenditures over the remaining
lifetime. The funded ratio is then calculated as the present value of assets
divided by the present value of liabilities.

An implication of the funded ratio is that optimal asset
allocation varies with the funded status. Mathematically, the optimal
allocation to volatile assets like stocks follows a U-shaped curve with a
minimum equity allocation when the funded ratio is one, and allocations
becoming more aggressive when moving further away from one in either the up or
down direction. A few additional points about this are in order, however.

First, when the funded ratio is less than one, the
mathematical optimization suggesting a higher stock allocation should be
accepted with caution. While attempts to make a Hail Mary pass to salvage a
financial plan may maximize the probability for a plan’s success, matters could
also just as easily backfire leaving the funded ratio in an even more dire
condition.

Meanwhile, in fortunate situations where the funded ratio
exceeds one, the implication is to think in terms of portfolio insurance in
which investment risk increases as the funded status increases but decreases
with a decreasing funded ratio to avoid it having fall below one. Regarding this
point, financial author William Bernstein asks the question, why continue to
play the game if you have already won? The danger is that the funded ratio
falls below one, and the individual is subsequently unable to restore the
funded status, which means that the individual had, and subsequently lost, the
ability to meet the lifetime financial goals.

This returns us to the point about the impact of partial
annuitization for a retiree experiencing longevity risk aversion and planning
for a retirement lasting beyond life expectancy. With this subjective view
toward longevity, the annuity asset is worth more than the premium, and it
increases the funded ratio for the plan. This helps to reduce the risk that a
market drop shifts the plan from overfunded to underfunded. The remaining
portfolio is available for more discretionary uses, and the retirement is more
secure, justifying a higher stock allocation for the portfolio piece of the
asset base.

The third factor is the availability of
reserves. What other resources are available that have not been earmarked to
manage spending and can be used to cover contingencies? Having more reserves
available means less reliance on the assets covering other goals to outperform
and to create reserves through market gains. For this point, we have already
discussed how by helping to meet spending goals with less assets, the income annuity
creates additional reserves that provide true liquidity. With this added
flexibility, the retiree can feel more comfortable with the aggressive asset
allocation because they are less exposed to the possibility of having to sell
assets at a loss to cover contingencies, and then not have enough left to cover
their other spending needs in subsequent years.

Finally, traditional risk aversion is the countervailing
force, and this is the factor that may receive the most attention. Though the
investment portfolio is now a smaller portion of the overall asset base, the
retiree must still be comfortable with the greater short-term portfolio
volatility that a more aggressive asset allocation will imply. Conceptually
this is justified, as we have discussed. But the retiree must accept and
understand these points to avoid vulnerability to panicking and not following
the strategy during market downturns.

We must clarify the meaning of risk from the perspective of
retirement and personal finance. Risk is not only related to short-term market
volatility, though the ability of a risk-averse investor to stomach portfolio
volatility is an important constraint for asset allocation decisions. Rather,
the fundamental nature of risk for retirees is the threat that events take
place (unexpectedly long life, poor market returns, spending shocks) that
trigger a permanently lowered standard of living in subsequent years. Retirees
must decide how much risk to their lifestyle they are willing to accept, and
this is a different decision than how much short-term volatility is found with
their investments.

Ultimately, this is an important factor that will reduce the
benefit of annuitization if the retiree cannot make the distinction about how
the annuity is still an asset even though it does not appear on the portfolio
statement. To be effective, retirees should view the annuity as part of their
bond holdings and adjust their portfolio accordingly. If they cannot overcome
the psychological hurdle to accept this rationale, then the effectiveness of
partial annuity strategies will be weakened.

Inflation Risk
Management and Income Annuities

Another common question relates to inflation protection and
whether it should be incorporated into the annuity. We can distinguish between
whether the retiree needs the annuity to provide inflation protection
and whether the retiree wants the annuity to provide inflation
protection. With a lower payout rate, an income annuity providing income growth
and inflation protection will require a larger premium to build up the same
initial spending power. Alternatively, the same premium amount will buy less
initial income when this income grows over time. This concept is illustrated in
Exhibits 8.6 and 8.7, using the life-only annuity payout rates calculated in
Chapter 4 for a sixty-five-year-old female.

The payout rates are 5.78 percent for a life-only income
annuity providing a level amount of spending and 4.56 percent for lifetime
income that grows annually by 2 percent. With a $1 million premium, annual spending
is $57,800 for the level flavor, which starts 27 percent higher than the
initial $45,600 for the cost-of-living adjusted flavor. With the 2 percent spending
growth, spending from the COLA flavor surpasses the level flavor with the thirteenth
payment received at age seventy-seven. With a 3 percent discount rate,
cumulative lifetime spending received from the COLA flavor is larger at ages
ninety-two and beyond. Obtaining inflation protection means trading less spending
early on for more spending later.

Exhibit 8.6

Comparing Female Age Sixty-Five, Life-Only Income
Annuities with $1 Million Premium (Nominal Dollars)

Level Amount (5.78 Percent Payout) vs. 2 Percent
COLA (4.56 Percent Payout)

To be clear about the impact of inflation on the purchasing
power of spending, Exhibit 8.7 shows the same dollar amounts as provided by the
income annuity but adjusts them for their real purchasing power. With assumed
inflation of 2 percent, the annuity with a COLA allows the purchasing power
keep up with economy-wide price growth. Meanwhile, though the purchasing power
of the level version starts off at a higher level, its lack of growth leads it
to lose pace over time. Its real purchasing power will drop in half at age 100.

Exhibit 8.7

Comparing Female Age Sixty-Five, Life-Only Income
Annuities with $1 Million Premium (Real Dollars)

Level Amount (5.78 Percent Payout) vs. 2 Percent
COLA (4.56 Percent Payout)

With these considerations in mind, an important question
remains about how to best weigh the choice between income annuities with level
payments and income annuities which provide a cost-of-living adjustment. To
consider this further, we return to the earlier example about partial
annuitization and the impact on legacy. The retiree has $1 million and a
spending goal of $47,873 that subsequently grows with inflation. With an
investments-only strategy and a 50/50 asset allocation, this spending goal was
chosen alongside the capital market expectations so that the investment
portfolio depletes precisely at age 100. In addition to this investments-only
strategy, we consider two partial annuitization strategies that involve a
decision to use an annuity to support 30 percent of the initial spending goal. Initial
annuity income of $14,362 is sought, and the rest of the spending goal will
then be distributed from the remaining investment assets.

With these partial annuitization strategies, we do use the
more aggressive way to adjust asset allocation for the remaining investments,
which is to treat the annuity premium as a fixed-income asset and permanently
adjust the asset allocation for the remaining investments so that stocks still
represent 50 percent of this wealth. For this comparison, the income annuity
with level payments requires annuitizing 24.9 percent of the asset base so that
the annuity covers 30 percent of the initial spending goal. It is a lower
percentage because the payout rate is higher than the necessary withdrawal rate
from the full initial wealth. Meanwhile, with its lower initial payout rate,
the income annuity with the COLA requires annuitizing 31.5 percent of assets to
initially cover 30 percent of spending. The tradeoff is that with level annuity
spending, the remaining investment portfolio must also cover the subsequent
inflation adjustments that the level annuity does not provide. This leads to a
larger distribution amount over time. As well, for the annuity with level
payments, the asset allocation for the remaining investments is 66.5 percent.
Because more assets are annuitized, the stock allocation for remaining
investments is 73 percent in the case of the annuity with a COLA. Exhibit 8.8
illustrates this differing distribution need as the level annuity will call for
faster growth in the distribution from remaining investments in order to also
cover the inflation adjustment for the annuity portion.

Exhibit 8.8

Comparing Portfolio Spending Needs After Partial
Annuitization

Female Age Sixty-Five with $1 million funding 30 Percent
of Spending Goal with Annuity

Level Amount (5.78 Percent Payout) vs. 2 Percent
COLA (4.56 Percent Payout)

Exhibit 8.9 plots the evolution for the remaining investment
assets with these three strategies. As before, we see that the annuity premium payment
does initially reduce the amount of remaining investments. For the COLA flavor,
the drop is a bit larger to meet the initial goal with the lower payout rate. Over
time, the advantage moves in favor of the partial annuity strategies as they
support a higher stock allocation and a lower distribution need from the
remaining investment assets. The lower withdrawal rate from investments can
help assets to grow and to manage sequence risk, such that the higher spending
need later in retirement can be more effectively managed. The level annuity
case supports more investment wealth than investments-only by age eighty-seven,
and the COLA annuity supports more investment wealth by age ninety. After age
ninety-four, the COLA strategy supports the most investment wealth. At age 100,
the investments-only strategy has depleted the portfolio, while $346K remains
with the level annuity strategy and $451K remains with the COLA annuity
strategy.

Exhibit 8.9

Remaining Investment Assets: Investments Only vs.
Partial Annuitization with Level and COLA Flavors

Level Amount (5.78 Percent Payout) vs. 2 Percent
COLA (4.56 Percent Payout)

In comparing the investments-only strategy with the level
annuity strategy, these results show that the retiree does not need the
annuity to provide inflation protection. The level annuity approach has better
positioned the investment portfolio so that it can more easily support the
inflation adjustments that the annuity misses in subsequent years. Meanwhile,
the decision about whether the retiree will want inflation protection
for the annuity involves comparing the results for the level annuity case with
the 2 percent COLA case. This is a tougher decision. The income annuity with a
COLA provides more mortality credits because it backloads payments to later in
life when survival probabilities are less. Eventually, it will provide a better
outcome. But in this example, it requires waiting until age ninety-four before
this happens. This is well beyond life expectancy and it is a personal decision
as there is no correct answer. It is more understandable if a retiree opts
against a strategy that does not provide a better outcome until she is in her
midnineties.

A final important matter must be addressed regarding the
fact that this discussion has been based on a simplified model in which future
inflation is fixed and known. There was no possibility for unexpectedly high
inflation. The possibility of high inflation would make the inflation-adjusted
annuity a more attractive choice. In that regard, we can also consider what
real world pricing implies for the cost of inflation protection in the annuity.

To better understand this point, it is not necessary to
introduce an entirely new model for the capital market expectations that
integrates randomized inflation. Instead, we can just look to the situation
with current real-world annuity pricing.

In May 2019, the market for CPI-adjusted income annuities is
not well developed. ImmediateAnnuities.com only lists one company as offering
this type of annuity. The payout rate for a true CPI-adjusted income annuity
for a sixty-five-year-old female is 4.28 percent. Meanwhile, the top two payout
rates for an income annuity with a 3 percent annual cost-of-living adjustments are
4.3 and 4.4 percent. Lifetime inflation would have to exceed an annualized amount
of a bit less than 3 percent for the CPI-adjusted annuity to provide more real
income. This is higher than the 2 percent inflation that markets anticipate
over the next thirty years as determined by the differences between traditional
treasuries and TIPS. Two reasons for this higher break-even inflation rate
within the CPI-adjusted annuity include the difficulty of hedging lifetime
inflation risk with TIPS that only have maturities for up to thirty years and the
lack of competition in this specific market.

Nevertheless, it is possible that inflation could exceed the
break-even level. The retiree must decide whether it is worth paying the
additional cost to obtain contractually protected lifetime inflation-adjusted
income beyond what Social Security provides, or whether to instead use a lower
initial premium to obtain level income from the annuity. The retiree can then
try to manage the inflation risk through the investment portfolio and through
the synergies of reducing sequence risk by being able to use a lower
distribution rate from the remaining investments. My research suggests that the
latter approach is generally worthwhile, and it is not just because the
portfolio is assumed to grow faster than inflation.

It is important to understand that while the
probability-based mind-set leads to a conclusion that stocks will grow faster
than inflation, this relationship is far from perfect and there can be significant
periods of time where this does not happen. The benefit of the annuity with
level payments is also that it allows for the distribution rate from remaining
investments to be lower as well. Less premium is needed to meet a targeted
initial spending amount, which leaves more in the investment portfolio, which
then allows for a lower withdrawal rate to cover the rest of the spending goal
from the remaining investments. This reduces the exposure to sequence-of-returns
risk, making it more likely that the portfolio will be better positioned to
support the later stress of funding the inflation adjustments for all the
spending, including what the annuity does not provide. Level annuity purchases
could also be laddered over time to support inflation adjustments. Nonetheless,
for someone sufficiently concerned about inflation risk, the value of
inflation-protection is greater, and it is not a bad decision to use the
inflation-adjusted annuity.

One additional important point about this discussion is that
it has presupposed that retirees desire their overall spending to consistently
keep pace with inflation. The reality, which I addressed in greater detail in
my book How Much Can I Spend in Retirement?, is that the inflation-adjusted
spending for many retirees can be expected to decline with age. Other income
sources, such as Social Security, will adjust their benefits with inflation.
And as partial annuitization means that only a fraction of overall income is
provided by the annuity, it may be the case that an income annuity with level
payments will match the spending needs of real retirees more precisely. In
other words, having those inflation adjustments may not even be necessary for
many retirees. In cases where retirees do find that their income is falling
short of their spending on account of inflation, it is always possible to
ladder in purchases of additional annuities over time to support growth for
reliable income.

In this regard, retirees may wish to consider whether using
a level income annuity might be more advantageous to their situation to obtain
more income early on for the same premium (or, the same amount of initial
income could be purchased for a smaller premium). As well, as more initial
income could mean devoting less to the annuity, remaining financial assets
could be focused toward growth which may outpace inflation. This could allow
additional annuity purchases to be made over time to provide additional income.
The decision to annuitize more income can then be revisited later in retirement
once it is clear how spending needs are evolving.

A CPI-adjusted income annuity is the closest thing to a risk
free asset in retirement. Any other approach to seeking investment growth which
outpaces inflation will require accepting some degree of risk. Investment
growth does not always outpace inflation in the relatively short time horizons
which may matter to retirees. Nonetheless, with the lower distribution rate
needed, investments will have a better fighting chance to accomplish this.

Participating Income Annuities with Dividends

For another angle on inflation protection, a recent
innovation for income annuities is the creation of participating income
annuities that may help to provide protection against unexpected inflation. A
participating income annuity will offer a lower guaranteed payout rate than a
traditional income annuity, but payments enjoy the opportunity to grow
through the receipt of dividends from the general account. This process works
in the same general way as participating whole life insurance.

As a reminder, dividends are a return of surplus to policy
owners of the insurance company after accounting for investment returns,
company expenses, and the mortality experience of policy owners. Higher than
anticipated returns on the general account funds, then, is one of several
factors that could lead to higher dividend payments. Payments will grow over
time if interest rates rise and new bonds are purchased offering higher
yields. An important explanation for rising interest rates is an uptick in
inflation. The owner is not locking into the bond yield curve at the time of
purchase as with traditional income annuities. A changing interest rate
environment will impact subsequent dividend payments.

Participating income annuities can also provide a way to
help manage sequence risk, as dividends can be received as cash to spend when
markets are down, and reinvested for increased protected income when markets
perform well. Participation in the general account through the ability to
receive dividends can lay a foundation for retirees to earn higher income
payments over time in a manner that may be able to better keep pace with
inflation. This provides an alternative way to seek inflation protection
outside of using a COLA or CPI adjustment for income annuity payments.

When to Purchase and When to Start Income

This discussion has been about immediate annuities. Deferred
income annuities were also introduced in Chapter 4. In this section we will
consider issues related to when to annuitize assets and when to begin income payments.
We look at longevity insurance for an individual retiring at sixty-five. Would
it make more sense to purchase an immediate annuity at sixty-five, purchase a
longevity insurance deferred income annuity at age sixty-five, which begins
income at age eighty-five, or wait until age eighty-five and then purchase an
immediate annuity at that time? We will dig deeper into the tradeoffs involved
with these decisions.

As well, though we do not provide simulations, another
possibility relates to actions taken in the final preretirement accumulation
years. For someone aged fifty-five who is seeking to retire at sixty-five,
would it make more sense to purchase a deferred annuity at fifty-five or to
wait until sixty-five to purchase an immediate annuity? We will also consider
how laddering annuity purchases over time can provide another way to manage
these tradeoffs and provide better diversification opportunities.

There are risks related both to annuitizing assets sooner and
later. First, for risks related to annuitizing sooner instead of waiting, it is
important to consider how an income annuity is generally an irreversible
decision. By annuitizing today, an individual loses flexibility for the
decision and the option value of waiting. There is value from maintaining the
option to annuitize without following through, as it keeps the option open. Benefits
from waiting include that the retiree could die early, making the annuity
decision unnecessary. A health shock or other spending shock requiring
liquidity could also take place, and annuitized assets are no longer available
to provide liquidity.

However, as discussed, partial annuitization may increase
the true liquidity of the plan. As well, interest rates could increase in the
future, which would help support a higher subsequent payout rate from
annuities. Payout rates on income annuities also otherwise increase with age as
remaining longevity shortens. If the assets waiting in reserve to be annuitized
do not experience too large of capital losses with the rising interest rates,
it is possible that a greater amount of annuitized income could be generated in
this way. Less likely, but still a possibility, is that mortality rates could
systematically increase in unexpected ways that would allow for higher payout
rates in the future.

There are also risks associated with waiting to purchase an
annuity. Unexpected mortality improvements or declining interest rates would
both make annuitization more expensive in the future. If people live even longer
than actuaries are currently projecting, future payout rates will be further reduced
and those who purchased before this realization will be better off. Insurance
companies can better manage this systematic mortality risk by also selling life
insurance. Unexpected mortality improvements mean the annuities will have to
pay more but life insurance claims will decrease, and vice versa. Also, by
waiting, one does miss out on receiving mortality credits at younger ages. These
lost mortality credits may be relatively small until reaching the age range
where mortality rates start to increase in earnest. As well, if the assets are
kept invested in the markets, market volatility could lead to portfolio losses so
that fewer assets are available to annuitize in the future.

Laddering income annuity purchases over time does provide a
practical way to balance these tradeoffs. Laddering creates option value as not
all annuitization takes place at once. This also reduces the risk of exposure
to current interest rates and does provide an opportunity to diversify annuity
purchases between different companies, reducing the impacts of a company
failure and helping to keep annuity purchase amounts under state guarantee
limits.

On the matter of the low interest rate environment, this is
sometimes used as a reason to avoid annuitizing at the present and forever
locking in the current bond yield curve. This idea is worth a discussion, as it
is not correct. The case for an income annuity becomes stronger in a low
interest rate environment for someone who is already retired and spending from
assets.

With low rates, the mortality credit component of the
annuity payout becomes even more important, making annuities even more
attractive relative to bonds. The bond interest component for spending is
reduced for both tools as interest rates decrease, but annuities are hurt less
by lowering interest rates, since the mortality credit component for spending
is not impacted by interest rates.

Exhibit 8.10 illustrates this by showing the costs for an
income annuity and a bond ladder through age 100 for flat yield curves at
different interest rates. The exhibit shows the cost of purchasing
a dollar of lifetime income, which is just one divided by the annuity payout
rate, or the sustainable spending rate from the bond ladder. We can observe how
lower interest rates do increase the cost of funding an income stream
with an annuity. But the point is that the cost of funding a bond ladder grows
faster than the cost of an annuity with lower interest rates. At the 3 percent
interest rate we have been using, the life-only income annuity payout for a
sixty-five-year-old female is 5.78 percent. The cost of funding one dollar of
lifetime income is 1 / 0.0578, or $17.30. As for the bond ladder cost, the
present value of thirty-five annual dollar payments to age 100 with a 3 percent
interest rate is $22.14. The bond ladder cost is 28 percent higher than the
annuity cost. If interest rates are higher, the gap in costs narrows. For
instance, at 5 percent interest rates, the annuity cost for one dollar of
lifetime income is $14.10, compared to $17.19 needed to purchase a bond ladder through
age 100. At this interest rate, the bond ladder cost is 21.9 percent higher.
Though the absolute cost for any strategy increases with lower interest rates,
the bond ladder cost grows faster than the annuity as the mortality credits
become a relatively more important source of spending power.

Exhibit 8.10

Relationship Between the Cost of Purchasing $1 of
Lifetime Income and Interest Rates, for a Sixty-Five-Year-Old Female with a
Planning Age of 100

As well, if we consider changing interest rates and their
associated risk, increasing interest rates would mean capital losses for the
bonds. One could not simply sell bonds for their earlier value to take
advantage of the higher annuity rates. While waiting for rates to rise, if that
happens, the retiree will be spending their principal when spending exceeds
interest and dividends. The likelihood of needing to dip into the principal
increases.

Even if rates do rise, retirees may not be able to purchase
more income as they are multiplying a higher rate by a smaller pool of assets
at this stage. If interest rates do not rise, bonds do not have capital losses,
but the annuity payout rates do not increase. Waiting entails risk. For
retirees investing conservatively like the insurance company, it is likely that
one burns through assets fast enough to not benefit from any possible future increased
annuity payout rate. Retirees also give up some mortality credits by waiting.

This brings us to the relationship between annuity payout
rates and age. We return to the 3 percent interest rate assumption used
throughout the book. Exhibit 8.11 shows simulated payout rates with immediate
annuities for females with purchase ages ranging from sixty-five to
eighty-five, and for deferred income annuities purchased at sixty-five with
income start ages ranging from sixty-six to eighty-five. These relationships
are not linear. Payout rates rise more quickly as purchase age increases due to
higher mortality rates at advanced ages. The effect is particularly pronounced
as the deferred income annuity becomes longevity insurance with the more
advanced income start ages. As described in Chapter 4, the immediate annuity at
age sixty-five has a payout rate of 5.78 percent. The payout rate on the
immediate annuity purchased at age eighty-five is 12.34 percent, and the payout
rate for longevity insurance purchased at sixty-five with an income start age
of eighty-five is 30.82 percent.

The difference between the 12.34 and 30.82 percent payout
rates is determined by both the opportunity for annuity premiums to grow for
twenty years inside the annuity and by the probability that a sixty-five-year-old
female lives to receive the first payment at age eighty-five. Intuitively,
higher ages support higher payout rates because the remaining life expectancy
is less, so the annuity provider expects to make fewer payments. In this
regard, nothing is gained by waiting to annuitize assets or to begin income.
For immediate annuities, mortality credits at the younger ages are lost as one
ages.

Longevity insurance provides the opportunity to more highly
leverage the mortality credits by committing at a younger age and then skipping
payments for which there is still a high probability to be alive to receive.
This is an important part of the explanation for the higher payout rate
relative to just waiting to a more advanced age to annuitize assets. In this
example, the probability of surviving from sixty-five to eighty-five is 72.3
percent. The other aspect is the growth of the annuity premium at 3 percent for
twenty years, which leads to a discount factor of 55.4 percent for the assets
needed at age sixty-five to start income which begins at age eighty-five. The
longevity insurance payout rate of 30.82 percent can be converted to the payout
rate for an immediate annuity at age eighty-five by multiplying these factors:
30.82 x 0.723 x 0.554 = 12.34 percent.

Exhibit 8.11

Relationship Between Purchase Age and Annuity
Payout Rates for a Female

Immediate Annuities (SPIA) and Deferred Income
Annuities (DIA) at a 3 Percent Interest Rate

Exhibit 8.12 repeats this analysis to show how the cost of
one dollar of lifetime income relates to the age it is purchased. The cost
decreases with age because every year someone lives before purchasing an income
annuity is another year income does not have to be paid. However, the cost does
not reduce by one dollar per year. Life expectancy does not reduce on a
one-to-one basis as people continue to live. That difference is the mortality
credit lost by waiting to annuitize. With the deferred income annuity, the
costs plummet more quickly with the delayed start date, making it possible to
hedge the tail risk for longevity at a lower cost.

Exhibit 8.12

Relationship Between the Cost of Purchasing $1 of
Lifetime Income and Purchase Age for a Female

Immediate Annuities (SPIA) and Deferred Income
Annuities (DIA) at a 3 Percent Interest Rate

To provide more clarity for this discussion, consider an
example which uses partial annuitization in three ways for a sixty-five-year-old
female based on the same spending, market, and annuity pricing assumptions as
in the earlier examples. Her spending goal is to start retirement with $47,873
of spending and to adjust this for inflation in subsequent years. In addition
to an investments-only strategy, she could immediately annuitize 30 percent of
her spending goal with a life-only and level income annuity offering a 5.78
percent payout rate. This requires 24.9 percent of her assets, and she permanently
adjusts her stock allocation from 50 percent to 66.6 percent to treat the
annuity premium as a bond.

The second option is to purchase longevity insurance as a
level and life-only annuity that covers 100 percent of her spending goal at age
eighty-five but will lag by inflation in subsequent years. This option will
require 23.1 percent of her assets and she adjusts her stock allocation to 65
percent.

The third option is to wait until age eighty-five and to
then purchase a level life-only immediate annuity at that time to cover 100
percent of her age eighty-five spending goal. This requires a premium of
$576,473 from her remaining $851,614 at age eighty-five. Because she is doing
this late in life it may be more difficult to treat this annuity premium as a
bond, as it would require using 100 percent stocks for the remaining portfolio
at an advanced age. To be more realistic with this third option, I assume she
keeps the 50 percent stock allocation for her remaining assets after this
partial annuitization.

Exhibit 8.13 compares the outcomes for these three different
approaches to the timing of partial annuitization and how they compare to each
other as well as an investments-only strategy. At age 100, the longevity
insurance strategy has come out ahead with the largest remaining legacy value
for assets. However, the road to get there was rough, as the legacy value of
assets was dramatically less at various earlier points in retirement. Remaining
assets were the lowest at age eighty-five, as it was necessary to spend down
the remaining investment assets more aggressively using a higher withdrawal
rate after paying for an annuity which does not begin income until later. This
concept is similar to viewing the decision to delay Social Security benefits,
though it is more extreme in this case even though about the same amount of
assets were annuitized as with the immediate annuity case.

With volatile markets, this strategy would also increase
exposure to sequence risk by requiring a higher distribution rate from
remaining investment assets, and it is important to build a bridge to help
avoid this exposure, such as the strategy to combine a twenty-year bond ladder
with a deferred income annuity beginning payments in year twenty-one.

Longevity insurance also requires overcoming another
behavioral hurdle, which is the concern one may have with paying a premium to a
company and then hoping the company is still in business in the distant future
when payments finally begin. In the end, it is understandable if the wealth
glidepath for this longevity insurance strategy is not appetizing.

Coming in second at age 100 is the strategy to wait until
age eighty-five and then purchase an immediate annuity. This strategy benefits
from the growth rate on investments at 3.5 percent being larger than the growth
rate inside the annuity of 3 percent. But the ultimate outcomes are similar to
the longevity insurance case, which reflects the actuarial nature of the
decision. Mathematically the decision for when to annuitize does not matter as
much in the end. There are various tradeoffs along the way, and it is important
that individuals make a decision that is right for them.

Finally, the strategy to immediately annuitize a portion of
assets provides the third largest legacy at the end, but it also offered the
highest legacy for the period between ages eighty-seven and ninety-seven. Using
an immediate annuity at the start of retirement is quite competitive with the
other two strategies that defer in some way. It is a reasonable baseline for us
to use, and there is no single correct answer for choosing among these options.
The decision must be based on the tradeoffs we have discussed and the comfort one
has with the different strategies. The ultimate point from this discussion is
that any form of risk pooling can help manage longevity risk more effectively
than reliance on an investments-only strategy.

Exhibit 8.13

Remaining Investment Assets: Investments Only vs.
Partial Annuitization with Various Timings for Payments

The previous example helped us to delve a bit deeper into
the issue of what age to purchase an immediate annuity. Though purchasing at
the start of retirement is a very reasonable baseline, as I suggested, it is
not necessary to purchase the annuity right away. There is value in waiting,
and the case for annuitization does become stronger with age.

York University professor Moshe Milevsky developed and
trademarked a measure he calls the Implied Longevity Yield (ILY) to better
understand the implications of delaying an annuity purchase. Assuming interest
rates and mortality rates do not change, his measure identifies the rate of
return that would be required on an investment portfolio to match payments from
an annuity and then leave enough to purchase an annuity providing the same
income at a later age. It shows the return hurdle that investments need to meet
to justify procrastinating on the decision to buy an annuity. We can consider
an example of this using the income annuity payout rates illustrated in Exhibit
8.12.

Exhibit 8.14 provides an example for a female seeking $1,000
of annual lifetime income provided at the start of each year who is deciding
whether to purchase an income annuity today or to wait five years and then
purchase an income annuity. For example, a sixty-five-year-old would need pay
$17,291 today for this lifetime income through a life-only immediate annuity
with a 5.78 percent payout rate. Alternatively, if she has this amount of
assets today, she could take $1,000 annual distributions from her investments
with the intention to purchase an income annuity at age seventy. At seventy,
the annuity payout rate is 6.58 percent, and it takes $15,197 to fund the
subsequent lifetime payments. The implied longevity yield is the internal rate
of return needed on her assets at age sixty-five to fund the five years of
distributions and still have enough left to purchase the annuity at age
seventy. In this case, it is 3.75 percent. Assuming no changes in interest
rates or surprises to mortality rates, so that today’s payout rates can be
applied in the future, she would need to earn at least 3.75 percent annually on
her investments to justify delaying the purchase of an income annuity to age
seventy.

To match risk levels for the annuity, we should think of the
investment portfolio as being primarily bonds, which we are assuming will
provide a 3 percent return. It falls short of the implied longevity yield. This
is a justification for purchasing the annuity today at age sixty-five.

Exhibit 8.14

Implied Longevity Yield: Waiting Five Years to
Purchase an Income Annuity for $1,000 of Annual Lifetime Income

Female with Simulated Immediate Annuity Payout
Rates at 3 Percent Interest Rate

Current Age

$1,000 of Lifetime Income

with SPIA today

$1,000 of Lifetime Income

with SPIA in 5 Years

Implied Longevity Yield

65

$17,291

$15,197

3.75%

70

$15,197

$12,920

4.09%

75

$12,920

$10,493

4.68%

80

$10,493

$8,105

6.08%

85

$8,105

$6,045

9.25%

Nonetheless, what we also observe in Exhibit 8.14 is that
the implied longevity yield increases with age. By age eighty-five, the implied
longevity yield is 9.25 percent, which is greater than the arithmetic average
return assumed for the stock market. These increases result from the
acceleration of payout rate increases with age, as mortality rates increase and
the remaining life expectancy shortens. This is the source of the common notion
that it is best to wait until more advanced ages to purchase an annuity, as
mortality credits increase with age. To be clear, mortality credits do not
increase by waiting. Mortality credits for the younger ages are lost by waiting
to purchase the annuity. But with advancing age, the higher mortality rates
serve to amortize the mortality credits over a shorter period which makes it
appear that mortality credits increase. The mortality effects start to dominate
the interest rate effects on annuity pricing. It becomes increasingly difficult
for investments to beat the return hurdle needed to keep pace with an annuity.

Though the rising ILYs with age are often treated as a
justification to delay buying an annuity, the ILY at age sixty-five is already
sufficiently high to consider the annuity at that age. It exceeds the return
that can safely be obtained from bonds, and accepting risk is required for
investments to beat the ILY from delaying the purchase. The case for
annuitizing at sixty-five is already strong, it just becomes even stronger at
more advanced ages. Again, there is no single correct answer about the best age
to purchase an income annuity, as it depends on the comfort each individual has
when assessing the various tradeoffs. But this analysis certainly allows for
the conclusion that it is justified to purchase the annuity sooner rather than
later.

Risk Pooling vs. Risk
Premium: A Monte Carlo Investigation

Thus far in this chapter we have been considering the impact
of longevity risk by using a planning age of 100. For a sixty-five-year-old
female and assuming the Society of Actuaries (SOA) 2012 Individual Annuity
Mortality tables with built-in projections for mortality improvements through
2019 is the appropriate data to reflect her situation, she has an 11 percent
chance to outlive this age. But she accepts this risk because the tradeoff
would be spending even less to further stretch out the asset base for
investment-only strategies. She plans for thirty-five years of retirement
spending with an assumption she will pass away on her 100th birthday.

Market and sequence risks have not directly appeared yet in
this chapter since markets are assumed to provide their median fixed rates of
return. In this section, we reintroduce market risk for stocks in order to make
a more complete comparison between risk pooling and the risk premium. We
maintain the simplified approach for bonds in which retirees and the insurance
company have access to a flat and unchanging yield curve at 3 percent. But now,
stocks provide a risk premium of 6 percent above bonds with a 20 percent
volatility. We consider funding retirement spending with bonds, with an income
annuity, or with a diversified investment portfolio.

With a one percent real interest rate and two percent
inflation, a retiree with $1 million could build a bond ladder providing annual
inflation-adjusted income starting at $33,667. With this spending level, her
asset base depletes at age 100.

Alternatively, an income annuity allows risk pooling to
become an additional source of spending power for her retirement income plan.
As described in Chapter 4 for these assumptions, the payout rate for the income
annuity providing inflation adjustments is 4.56 percent for a sixty-five-year-old
female. A $1 million premium could support $45,600 of annual inflation-adjusted
income for her entire lifetime.

Exhibit 8.15 illustrates the spending sources for these two
retirement income tools. The bond ladder supports spending through the
spenddown of principal and the interest earned on remaining principal. With the
same assumptions for interest rates, the income annuity also provides these
sources of spending plus risk pooling through mortality credits. The mortality
credits are the subsidies to the long-lived, but they are amortized to the
present to allow a higher spending level throughout retirement. Retirees can
feel more comfortable spending at a higher level because protections are in
place to support retirement spending in the event of an extremely long
lifetime. Risk pooling allows for 35 percent more inflation-adjusted spending
over her lifetime when her planning age for investments-only strategies is 100.
Risk pooling provides a unique additional source of spending power beyond what
bonds can provide. For those demonstrating longevity risk aversion (and who
therefore use a planning age somewhere beyond their statistical life
expectancy), higher income is supported no matter how long one actually lives.

Exhibit 8.15

Sources of Inflation-Adjusted Spending for a Bond
Ladder and an Income Annuity

Purchased by Sixty-Five-Year-Old Female with $1 Million

The question then becomes whether the risk premium from the
stock market will provide sufficiently higher returns for a diversified
investment portfolio to sustain the same spending level that is contractually
protected by the annuity. For this comparison, stocks receive the benefit of
the doubt that historical risk premiums will persist. As explained in Chapter
3, the premium used here is 6 percent in arithmetic terms with a 20 percent
volatility. Stock returns are modeled using a lognormal distribution based on a
9 percent arithmetic average and a 20 percent standard deviation.

Exhibit 8.16 shows the probability of success for meeting
this spending goal for different asset allocations using 10,000 Monte Carlo
simulations. The retiree only cares about the curve for the planning age of
100, but others are included to tell a more complete story. Starting with 0 percent
stocks, or an all-bond portfolio, bonds can successfully match annuity spending
for a twenty-year planning horizon to age eighty-five, but the bond portfolio
will deplete before age ninety and success falls to zero. By ninety, the
annuity has reached beyond what bonds could accomplish on their own. The
exhibit also makes clear that for someone to consider the risk premium as a
retirement solution, it is important not to be timid with the stock allocation.
Without risk pooling, only the portion of assets exposed to the risk premium
can create the opportunity for returns exceeding bonds. With a planning age of
100, the best opportunity for matching the annuity is with 100 percent stocks,
but the probability of success is only 66 percent. In 34 percent of cases, an
all-stock portfolio will deplete before the planning age when trying to match the
spending protected by the annuity.

The introduction of stock market risk requires two
additional elements for the decision-making of our risk averse retiree. What
failure probability does she comfortably and willingly accept that her
portfolio will not be able to support spending through the planning age? As
well, how high of stock allocation is she willing to accept, in terms of her
ability to stomach the daily volatility experienced by her investment
portfolio? With volatile investments and a fixed spending goal, some
probability for portfolio depletion must be accepted by anyone seeking upside
growth potential through the equity risk premium. Though success is highest
with 100 percent stocks, it is still not particularly high, and the retiree may
not feel comfortable with that much exposure to market volatility. If the
retiree considers 50 percent stocks, the success rate is 54 percent.

In almost half of the simulations with a balanced portfolio,
investments are not able to keep pace with the spending that is protected by
the annuity. As well, this assumes the historical risk premium, and these estimated
success rates would be even less for those concerned that the outperformance of
the stock market will be less in the future.

Exhibit 8.16

Probability of Success for a Sixty-Five-Year-Old
Female Seeking to Match Protected Income Annuity Spending through Portfolio
Distributions

For the retirement income showdown between risk pooling and
risk premium, we have seen that risk pooling provides stronger support for
meeting a retirement spending goal than may be commonly assumed. Though not
impossible, it is difficult for the risk premium from the stock market to
provide enough excess returns to match what an income annuity is able to
contractually protect through risk pooling.

This example did use a specific set of assumptions and it is
worth providing comment on how varying the assumptions could impact the
outcomes. First, regarding the choice of a sixty-five-year-old female, retirees
could of course have different ages or genders, and we could consider the case
for a couple. This assumption is fundamentally about the length of the planning
horizon. If the planning horizon is longer (because younger or a couple),
spending must be reduced for either strategy. A joint and survivor income
annuity may be used. Income annuities will pay less, but portfolio
distributions must also be reduced to account for the longer planning horizon. Likewise,
the planning age could be higher (greater longevity risk aversion) or lower
(less longevity risk aversion). A retiree with less longevity risk aversion
could plan for a shorter time horizon, which would allow for relatively more
spending from investments with greater accepted risk. Risk pooling becomes
increasingly favorable as longevity risk aversion increases.

As well, this example assumes that the retiree seeks
inflation-adjusted spending. Switching to a level spending goal shifts the
focus to nominal interest rates, which increases initial spending for both
strategies. By using a higher interest rate (3 percent nominal instead of 1 percent
real, in this case), the gap between the annuity and the bond ladder would
narrow from 35 percent to 28 percent.

Finally, instead of using a life-only income annuity,
provisions could be added to refund a portion of the premium in the event of
early death, which reduces the payout rate. Such annuity provisions will work
to improve the chance that investments can keep pace as the income payout rate
of the annuity is reduced.

Ultimately, the key message is that risk premiums do not
obviously outperform risk pooling to meet retirement spending goals as well as
providing support for contingencies and legacy.

For risk averse retirees, risk pooling funds retirement
spending goals more cheaply and with contractual protections, which in turn
allows for greater true liquidity for nonannuitized investment assets. The main
advantage for the investments-only risk premium strategy is that it allows for
a larger legacy should the retiree die early, but at the cost of not having a
contractual guarantee for income, and having less true liquidity, as more must
be set aside to provide sufficient confidence that the spending goal can be
funded. In the event of a long retirement, the legacy advantage of the risk
premium strategy gradually declines as partial annuitization can ultimately
support a larger legacy in the long-term. These tradeoffs suggest that greater
care should be taken to consider how risk aversion and desires for legacy
impact the relative advantages of risk pooling and the risk premium as
strategies to fund retirement spending goals. It is not obvious that an investments-only
retirement income strategy will outperform a partial annuity strategy when
seeking to meet various retirement goals and managing retirement risk.

Further Reading

Branning, Jason K., and M. Ray Grubbs. 2010. “Using a
Hierarchy of Funds to Reach Client Goals.” Journal of Financial Planning
23, 12 (December): 31–33.

Cloke, Curtis V. 2011. “Breaking the Income Annuity
Liquidity Myth.” LifeHealthPRO (March 25).

Finke, Michael, Wade D. Pfau, and Duncan Williams. 2012.
“Spending Flexibility and Safe Withdrawal Rates.” Journal of Financial
Planning 25 (3): 44–51.

Frank, Sr., Larry R., John B. Mitchell, and David M. Blanchett.
2012. “An Age-Based, Three-Dimensional Distribution Model Incorporating
Sequence and Longevity Risks.” Journal of Financial Planning 25, 3
(March): 52–60.

Milevsky, Moshe A. 2005. “The Implied Longevity Yield: A
Note on Developing an Index for Life Annuities.” The Journal of Risk and
Insurance 72, 2 (June): 302–320.

Milevsky, Moshe A., and Huaxiong Huang. 2011. “Spending
Retirement on Planet Vulcan: The Impact of Longevity Risk Aversion on Optimal
Withdrawal Rates.” Financial Analysts Journal 67, 2 (March/April): 45–58.

Pfau, Wade D. 2017. “Retirement Income Showdown: Risk
Pooling Versus Risk Premium.” Journal of Financial Planning 30
(February): 40–51.

Pittman, Sam, and Rod Greenshields. 2012. “Adaptive
Investing: A Responsive Approach to Managing Retirement Assets.” Retirement
Management Journal 2, 3 (Fall): 45–54.

Chapter 9: Product
Allocation for Retirement

We have now provided context for how a retirement income
strategy should extend beyond traditional wealth management to better manage
the changing risks of retirement. We have covered important topics to help
inform decisions about sustainable spending rates from investments and
insurance.

The process of building a retirement income strategy
involves determining how to best combine retirement income tools to optimize
the balance between meeting your retirement goals and protecting
those goals from the unique risks of retirement. Retirement risks come in many
forms, including unknown planning horizons, market volatility, inflation, and other
spending shocks. Each of these risks must be managed by combining different
tools and tactics, each with different relative strengths and weaknesses. No
single tool can cover every risk. We require a framework that incorporates
capacities, aspirations, realities, and emotional comfort. Then we can combine
tools to determine how to best develop an overall plan.

In doing this, it becomes hard to counter the notion that
risk pooling and insurance can play an important and valuable role. We have
introduced various types of annuities, and in this chapter, we consider further
about advantages and disadvantages for each and how to think about choosing
between them.

As a simple starting point, income annuities, when treated
as bonds, will frequently be the most efficient way to incorporate lifetime
income into planning. However, there can be exceptions. Deferred variable
annuities and fixed index annuities play a role for those attracted to the
upside and liquidity features they offer compared to income annuities. There
are also cases where these types of annuities may provide greater efficiency in
terms of higher protected income levels or a better overall asset allocation
for retirees struggling with the concept that income annuities should replace bonds.
Deferred annuities also offer greater flexibilities for the income start date
and the opportunity to exchange into a better annuity in the
future, as there is less lock-in when the contract has not already been
annuitized. FIAs also provide principal loss protection.

This chapter is about product allocation. Exhibit
9.1 illustrates the idea. Retirement spending goals can be met through
distributions from the investment portfolio, through annuitized income
annuities, and through lifetime distributions from deferred annuities. Product
allocation is about how to combine them into an overall plan.

Exhibit 9.1

The Product Allocation Framework

The Efficient Frontier
for Retirement Income

In 2003, Peng Chen and Moshe Milevsky published an article
in the Journal of Financial Planning that developed the concept of an
efficient frontier for retirement income. They extended the efficient frontier
from modern portfolio theory (described in Chapter 3) beyond its single-period
focus into a concept that works for lifetime financial planning. The efficient
frontier is about the tradeoffs between risk and return and finding asset
allocations that cannot provide greater advantage for one without creating loss
for the other. Rather than looking at single-period portfolio returns and
volatility, Chen and Milevsky focused on the trade-off between satisfying
spending goals for life and preserving financial assets for legacy and
liquidity. Product allocation considers how different combinations of stocks,
bonds, and annuities with income provisions perform in meeting these
objectives. Efficient allocations will do a better job at meeting both lifetime
objectives by supporting spending even in bad market environments while
preserving the legacy value of assets.

In a February 2013 Journal of Financial Planning
article, “A Broader Framework for Determining an Efficient Frontier for
Retirement Income,” I developed my own take on their product allocation
research. Among the assets I considered in the article were stock funds, bond
funds, income annuities, and a simple variable annuity with a GLWB. I focused
on how to best meet two competing financial objectives for retirement:
satisfying spending goals for life and preserving financial assets. What I
found with my simulations is that the efficient frontier for retirement income
generally consists of combinations of stocks and income annuities. Bond funds
do not make it to the frontier, and they do not serve a useful role for meeting
spending goals in the optimal retirement income portfolio. Though they may not
be as efficient as income annuities, competitively priced deferred annuities
with lifetime income provisions will beat bonds because of the mortality
credits they provide to help support spending in the event of a long
retirement. They can provide a better outcome for those who are otherwise not
comfortable with using a life-only income annuity along with a very aggressive
asset allocation for the remainder of the portfolio.

Exhibit 9.2 provides a stylized representation of the
efficient frontier from that research. Meeting more spending and preserving
more assets means moving in the upper-right hand direction, and the shark-fin
shape of the efficient frontier shows how combinations of stocks and income
annuities beat combinations of stocks and bonds.

Exhibit 9.2

Retirement Income Efficient Frontier

Mixing in other deferred annuities may not lead to product
allocations that are right on the efficient frontier, but they can be close. In cases that variable or index annuities offer payout rates that are
comparable to income annuities, this can help greatly in moving the annuities
toward the efficient frontier. Similar levels of income are protected on the
downside through the guarantee provisions, while the upside exposure can create
more opportunity to support legacy relative to a cash refund provision on the
income annuity that implies a 0 percent rate of return on the underlying
assets. When not on the frontier, deferred annuities can also provide a
more satisfying outcome for retirees that seek to maintain control over their
assets and to avoid any regret about the irreversible nature of the annuitization
decision.

For those who do not accept the aggressive asset allocation
for remaining investments when using the annuity, deferred variable annuities
have another possibility to shine. Perhaps the put option style
guarantee on the variable annuity allows the retiree to feel more comfortable
increasing their stock allocation in the variable annuity relative to an
unprotected portfolio. A higher stock allocation in the variable annuity
provides greater upside potential for growing income and assets, which can make
it hard for the unprotected portfolio with a lower stock allocation to keep
pace. Greater exposure to the equity premium inside the variable annuity in
these cases can potentially provide additional returns that more than offset
the annuity fees. This can support greater legacy after meeting the same
spending goal. Meanwhile, in poor market environments, the income protection
will continue to cover a portion of spending after the contract value or investment
portfolio depletes.

Upside Exposure,
Downside Protection, and Liquidity Provisions

A key criterion for choosing among annuities with the
objective of supporting retirement income is to understand the amount of
contractually guaranteed income offered through annuitization or through taking
lifetime distributions with an optional living benefit rider attached to the
contract. Writing in his book The Annuity Stanifesto Stan Haithcock
argues that focusing on the minimum guaranteed income is the only worthwhile
matter for those using the annuity tool as a source of spending. Liquidity and
upside potential are not relevant for the decision-making, he argues, because
it is too easy to be blinded by upside potential without fully understanding
whether it is likely to ever be realized. It is hard to assess the true upside
potential with so many moving parts in deferred annuity contracts. His slogan
is to, “Own an annuity for what it will do, not what it might do.”

Nonetheless, an important selling point of deferred
annuities is that they provide more than just a minimum guarantee withdrawal
benefit. There is also a tradeoff in that higher fees on deferred annuities can
support better downside protections with less upside exposure, and a focus only
on guarantees would lead one to only one factor in the decision without
considering the tradeoffs.

The difference in worst-case guaranteed income levels from
different annuities reflects the effective cost one must accept for other
features of the annuity such as liquidity provisions, upside growth potential,
and additional death benefits. If growth potential is achieved for deferred
annuities, then step-ups may be realized, and lifetime income could be higher
than the minimum guaranteed level.

In theory, simple income annuities should offer the highest
payout rates. Their simple design lacks any special features like liquidity and
upside potential. More generally, fixed annuities should have higher payout
rates than variable annuities because they do not have to support guarantees
even in the event of capital losses for the contract value. We also covered how
fixed index annuities can provide competitive payout rates to income annuities
on their optional guaranteed lifetime withdrawal benefits on account of the
insurance company being able to assume some lapsation for income guarantee
owners. Not everyone paying for the income rider will take advantage of their
guaranteed lifetime distributions to the full potential and therefore will be
less likely to deplete the contract value and make the insurance company
responsible for continued payments. For those seeking a deferral period, this
could especially be true, and it is worth comparing the payout rate on deferred
income annuities against the guaranteed income payments offered through
guaranteed living withdrawal benefit riders on fixed index annuities. The
latter could be higher. Nonetheless, for annuities purchased at advanced ages,
simple income annuities will often have the edge in terms of providing a higher
payout because there will be less time for FIA owners to lapse.

Payouts for variable annuities will typically be less as
their age-based brackets are based on annuitization rates for younger ages.
There can occasionally be exceptions in which variable annuities can offer
comparable guarantees. I am aware of one commercial variable annuity that
requires the use of a bond fund for the subaccount and provides competitive
payouts to other types of annuities for a broad range of ages. Couples should
also check variable annuities more closely as the reduction in guaranteed
benefits for couples in a variable annuity can be less than the reductions in
fixed annuities.

Indeed, the type of annuity offering the most guaranteed
income can vary depending on household characteristics, the length of deferral,
and as product offerings and pricing change over time. It is worth shopping
around between different types of annuities to make sure that one is finding
the best opportunities at any given moment.

We can move beyond minimum guaranteed income provided by the
annuity. Annuities with competitive guaranteed payouts alongside other benefits
for upside and liquidity have an edge. The next part of deciding about an
annuity is to choose whether it is worth accepting a lower guaranteed payout in
order to have access to other benefits from the annuity.

As mentioned, accepting a lower guaranteed income from one
annuity is a way to understand its costs in terms of receiving the other
benefits provided. This does become a harder decision because it can be quite
difficult to assess the true upside potential of a deferred annuity when there
are so many moving parts inside the contract. Companies focus on a particular
angle to market their variable annuities, and this can add complexity that
becomes harder to analyze and compare. Upside exposures and step-ups can also
depend on whether aggressive asset allocations are allowed within the annuity.

In separate research, I compared the potential for step-up
opportunities from a stylized variable annuity and found that they do depend on
asset allocation. In terms of median outcomes, step-ups were not provided with
an all bond allocation. For 50 percent stocks in the variable annuity, I found
that step-ups supported 11 percent more income after a ten-year deferral
period, and then another 13 percent income growth over a subsequent thirty-year
distribution phase. Meanwhile, if 100 stocks were allowed, step-ups allowed 48
percent more guaranteed income after ten years, and another 70 percent increase
in income over a subsequent thirty-year distribution period. Upside potential
is real, and it does depend on asset allocation. As well, upside potential may
be greater for contracts with weaker guarantees and lower expenses. There are
tradeoffs to be considered.

As mentioned, in my research, I have made attempts to
simulate the upside potential for different types of representative annuities.
Gradually, there are starting to be more commercial services that seek to
provide tools to compare different annuities in terms of their guaranteed
benefits and potential for upside. Cannex, for instance, now has Monte Carlo
simulation tools to estimate average income provided by different commercial
annuities after accounting for upside potential within the contracts. These
tools can be helpful to make decisions.

Competitive variable annuities provide the most upside
potential, especially with lower costs, higher quality investment choices,
investment freedom to choose an aggressive asset allocation, and the ability to
stack rollups on step-ups. FIAs will fall in between variable annuities and
income annuities regarding upside potential. They provide some upside
potential, but it is more limited, and there may be little potential to provide
step-ups after lifetime withdrawals have begun. Income annuities do not provide
upside potential. Generally, accepting less upside potential allows for the
possibility of more robust downside protections, but there can be exceptions.
In comparing about this tradeoff, retirees should also consider about the tax
treatment and credit risk for different types of annuities.

Tax Treatment

Taxation on annuities can get complex, especially when it
comes to issues related to their death benefits or when using them in trusts.
Our discussion will not consider these cases, but it is worth having a basic
understanding about how the taxes for annuities work when they are being used
by households as a source of ongoing spending during the owner’s lifetime. This
discussion will remain basic and should not be interpreted as specific tax
advice. A tax professional should always be consulted for specific tax
questions, but it is nonetheless possible to provide a basic understanding of
the tax issues at work. A great resource for more in-depth treatment of annuity
tax issues is John Olsen and Michael Kitces’ book The Advisor’s Guide to
Annuities.

When it comes to basic tax treatment for annuities, we
distinguish between annuities held in nonqualified or taxable accounts, and
annuities held in qualified retirement plans such as IRAs and 401(k)s. As well,
we must distinguish between annuities that have been annuitized into a stream
of payments and annuities that remain in the deferral stage, which includes nonlifetime
distributions from annuities and lifetime distributions from annuities obtained
through an optional lifetime withdrawal benefit rider. Income annuities,
including single-premium immediate annuities and deferred income annuities, are
already annuitized and provide the ability to lock in income.

Deferred annuities such as variable and index annuities
provide more flexibility because they are not annuitized, but they offer upside
potential, the ability to annuitize within the contract, but the option to add
a lifetime income rider that will support guaranteed lifetime distributions
without annuitization. Deferred annuities are purchased for growth with an
option to guarantee income later by annuitizing or with an income rider. We
consider these cases in greater detail.

Annuitized Contracts in Taxable Accounts

In taxable accounts, the basic idea for annuities is that
distributions representing return of premium are not taxed, but distributions
representing any interest or gains through market growth or mortality credits
are taxed. Taxation occurs at the point of distribution rather than when
interest is earned, which allows for continued tax deferral for the underlying annuity
assets until distributions are made.

For income annuities and other annuitized contracts that
were purchased in a taxable account, the basic idea is that two of the three
sources of annuity payments (interest and mortality credits) are taxed as
income, and the third source (return of premium) is received tax-free. To
determine how much of the annuity payment is classified as the return of the
initial premium, the IRS provides details for how long an annuitant should
expect to receive payments from the annuity. The portion of each annuity
payment considered to be a return of principal is the amount of the premium
payment divided by the total annuity income to be received during the expected
lifetime. This is the exclusion ratio. It is the portion of annuity payments
excluded from taxable income.

Once the full amount of premium has been returned as income
at the life expectancy, subsequent annuity income then becomes fully taxable
for the remainder of one’s lifetime. This process helps to defer some taxes to
the latter part of retirement after surpassing the IRS measure of life
expectancy. This concept also applies to deferred income annuities, as
annuitized assets grow tax deferred within the contract and then the exclusion
ratio is applied once payments begin.

For example, consider our sixty-five-year-old female with an
income annuity that begins payments immediately and is life-only. The payout
rate is 5.78 percent. For a premium of $100,000, the annuity pays $5,780 per
year. As a simple example, suppose the IRS documentation requires using a life
expectancy of 18.2 years. This is a shorter life expectancy than what the
average annuity owner will experience. The total income received over the life
expectancy is 5,780 x 18.2 = $105,196. The portion treated as the return of
premium is the $100,000 premium divided by the total $105,196 income, or 95.1
percent. This portion is excluded from taxable income.

The inclusion ratio represents the remainder of the income
that is treated as gains through interest and mortality credits. It is 4.9
percent of the payment. This is $283 per year, and it is the taxable income for
the first eighteen years of the contract. After that point, the full $5,780
becomes taxable income as it fully reflects gains to the recipient beyond the
premium paid, at least with respect to the mortality tables used by the IRS.
Most services providing annuity quotations will provide either the inclusion
ratio or the actual amount of annuity payments that are taxable when the
premium will be drawn from a taxable account.

This nature of taxation for annuitized annuity contracts can
be beneficial when combined with other strategies, such as Roth conversions,
that lead to generating more taxable income in early retirement in order to
reduce the amount of other taxable income later in retirement when the annuity
income switches to become fully taxable. These actions will help keep the
marginal tax rate lower early on because less annuity income is taxable, and
lower in the future when higher taxes on the income annuity are offset by
having other taxable income sources already reduced.

Annuitized Contracts in Qualified Retirement
Plans

For annuities that have been annuitized inside of retirement
plans, distributions are taxed at ordinary income tax rates as they are
received. This is straightforward. The aspect that can get trickier relates to
determining RMDs for the annuity assets.

For annuitized contracts, the RMD calculation does not include
any annuity premium or present value of payments. The annuity income is
accepted as covering the RMDs for the annuitized assets. At younger ages,
annuity income might be larger than the RMD that would have been required for
those assets, but the annuity income could be less than the RMD at later ages. These
differences are assumed to balance out over time, though, since the annuity is treated
as an accepted way to spend down the assets over retirement.

To be clear, in the early years, when the annuity income is
larger than the RMD would have been on the annuitized assets, the retiree does
not get to use the annuity income to cover the RMDs on other assets remaining
in the qualified plan. This could be viewed as a disadvantage with a partial
annuity strategy, as the retiree pays taxes on the annuity distributions and the
annuity distributions cannot be counted against any other RMDs due on remaining
assets.

Though the tax treatment is relatively simple for an immediate
annuity in a qualified plan, there are problems with using a deferred income
annuity in a qualified plan when income is to begin past the age 70.5 RMD
starting point. This creates a technical violation for RMD rules as annuity
income covers the RMDs for the annuitized assets, but there is no annuity
income when that income was deferred. In July 2014, the Treasury Department
created new regulations for QLACs to help rectify this problem. Qualifying
contracts for annuitized premiums up to $130,000 or 25 percent of the combined
balances held in qualified plans, whichever is smaller, can now delay annuity
income to age eighty-five without violating the RMD rules.

Not many 401(k) plans or other qualified retirement plans
that are set up by employers offer the ability to purchase annuities. This may become
more common in the future. For those who do have this option, it is worth
exploring whether the annuities inside the employer plan may provide a better
opportunity than annuities outside the plan. Women can particularly benefit
from the unisex pricing that is required for annuities held inside employer
retirement plans. If good annuity choices are not available in the 401(k), then
the common process after retiring would be to rollover the 401(k) assets into
an IRA and then purchase the annuity inside of the IRA. When these steps are
correctly followed, no taxable events have transpired until distributions are
received.

Deferred Annuities in Taxable Accounts

Deferred annuities provide a way to obtain tax deferral for
assets that would otherwise experience ongoing taxation in a taxable account. This
tax deferral is subject to the usual limitations the government provides, which
are that all subsequent gains, even long-term capital gains, are taxed at ordinary
income tax rates. A 10 percent penalty also applies for distributions taken
prior to age 59.5, if certain conditions are not met to allow an exemption for
the penalty.

The tax penalty was created to deter using the annuity for
reasons other than as part of a retirement plan. There are exceptions to paying
the penalty for distributions taken before age 59.5. These include events such
as death of the owner, the taxpayer becomes disabled, or for payments from an
immediate annuity (but not a deferred income annuity). An exception also exists
for those taking substantially equal periodic payments over the lifetime.

Tax deferral can be a powerful benefit for annuities in
taxable accounts. Assets held in taxable accounts face ongoing taxes on
interest, dividends, and realized capital gains, which can eat into the
compounding growth potential for the assets. A tax drag is created relative to
being able to defer those taxes until later. As discussed in earlier chapters,
this tax deferral has motivated the use of annuities as accumulation vehicles
with a de-emphasis on their original purpose of providing periodic
distributions on fixed dates. If annuities are used for less tax-efficient
asset classes that mostly generate ordinary income rather than long-term
capital gains, then this tax deferral could provide net positive value for the
owner.

When distributions are taken from a deferred annuity, the
tax treatment is different than the exclusion ratio used for annuitized contracts.
Both types of annuities will provide the return of premium tax-free, but rather
than having premium returned as an ongoing part of the distributions, a
deferred annuity is taxed on a last-in-first-out (LIFO) basis. Any
distributions from the deferred annuity, either as guaranteed distributions through
a living benefit rider or unguaranteed distributions, are treated first as
gains from the contract. The original principal is received only when there are
no remaining gains to be taken. When a deferral period has been used, this
pushes larger taxable income distributions toward the early part of the
contract distribution period, rather than later like with the exclusion ratio
for annuitized contracts. On a case by case basis, there could be value in diversifying
between annuitized and deferred contracts in order to smooth the levels of
taxable income over time.

One other point that is relevant for deferred annuities is
that the IRS allows for 1035 exchanges. These rules prevent a taxable event
from being created when exchanging a life insurance policy into an annuity, or
for exchanging from one annuity contract to another. This can provide a way to
switch to an annuity offering more attractive guaranteed income payments or
other features.

For example, perhaps one has used a variable annuity with an
income rider that has experienced strong growth for investments, and the
contract value is worth about the same amount as the benefit base. Rather than
turning on the guaranteed income for this contract, it may be possible to
exchange into a fixed annuity contract with better annuitization rates, or even
a fixed index annuity (or another type of variable annuity) with more
attractive withdrawal benefits. This can be accomplished without creating a
taxable event. This feature of the tax code only applies to deferred annuities
since annuitized contracts are not liquid and cannot be exchanged in such a way.

Deferred Annuities in Qualified Retirement
Plans

With deferred annuities in qualified plans, distributions
from the annuity are treated as taxable income when they are received. This is
the same as for annuitized contracts. It is important to emphasize that since
retirement plans already provide tax deferral, this is not a distinct advantage
of holding an annuity inside a qualified plan. There must be some other benefit
from the annuity, such as the desire to receive protected lifetime income, to
justify its placement this way. For lifetime income, a reason why the annuity
may be more attractive inside a retirement plan, despite already having the benefit
of tax deferral, is that taxable investment holdings may have large embedded
capital gains that would trigger a large tax bill if sold to pay the annuity
premium. There is no 1035 exchange for moving assets from a taxable investment
portfolio to an annuity.

For deferred annuities, the contract value of the annuity
remains liquid, and RMDs are calculated on it. Unlike with annuitized
contracts, deferred annuities allow their distributions to be aggregated into
the overall RMD calculations. This can be a benefit at younger ages, when the
distribution from the annuity may exceed the RMD on the underlying contract
value, so that part of the annuity income can also be counted against the RMDs
for nonannuity assets. In cases that the contract value declines over time,
this benefit could even increase further as the annuity income may be much
larger than the RMD on the smaller remaining contract value. This can help to
lower the need to take distributions from the remainder of the IRA to cover
RMDs, which could prove useful in helping to manage sequence-of-returns risk.

However, there are complications related to this point
because the RMDs on a deferred annuity contract may not only be applied to the contract
value. RMDs may also be due on the present value of any living or death
benefits with the contract. Two simplifications provided about this are that
the actuarial value of these benefits can be ignored if they are worth less
than 20 percent of the contract value, and a standard return of premium death
benefit can be ignored for these calculations. These requirements can
complicate taxes because it is necessary to obtain estimates for the actuarial
present value of the annuity benefits in order to determine the total RMDs for
the annuity.

This taxation matter also speaks to the value of not placing
all retirement plan assets into a deferred annuity. One potential calamity
could relate to an optional death benefit rider that only paid a death benefit if
the contract value exceeds zero. If the contract value is close to zero, one
might wish to stop taking distributions, but the RMD required on that death
benefit could exceed the remaining contract value and require a complete
liquidation of the annuity if there were no other assets that could be used to
cover the RMD. Having other IRA assets can be an important way to manage tax
surprises related to this complex aspect of calculating RMDs for deferred
annuities.

Charitable Gift Annuities

For those with charitable inclinations, a charitable
gift annuity is another alternative. With charitable gift annuities, a
charitable organization receives the premium. In turn, the charity provides a
protected lifetime income. Charitable gift annuities will offer lower payout
rates than competitive commercial annuities (i.e. their money’s worth
measures will be lower) to better ensure that the average participant leaves
something for the charity.

The American Council of Gift Annuities
provides a table of suggested maximum annuity rates that charities should
offer with the goal of trying to preserve half of the gift as a charitable
contribution after making the required lifetime payments to the donor through
life expectancy. These tables are provided both for immediate and deferred
payments, as well as for single and joint lives. Charitable gift annuities
provide the opportunity to receive a charitable tax deduction for a portion
of the premium in the year that the premium is paid, which reflects an
estimate of the amount that will eventually be available for the charity
after lifetime payments are provided. The premium can also be paid with
appreciated stock, but long-term capital gains tax may then have to be paid
on income received through the annuity.

One planning idea related to this potentially
large tax deduction is that it could provide a further opportunity to do a
Roth conversion and generate offsetting taxable income in the same tax year.

Some charities may keep the premium on their
books. Charities could try to manage the risk of providing protected lifetime
income on their own. But charities do not necessarily have the toolset to
properly manage longevity and investment risk. A more sensible approach would
be for the charity to offload these risks to an insurance company that is
better able to manage the longevity and market risks related to managing a
pool of income annuity payouts. In this case, the charity would provide an
annuity on your behalf with the required amount of your premium, and then would
be able to book the rest of the amount as a charitable contribution, assuming
their offer is less competitive than a commercial annuity.

A final related point is that the protected
lifetime income is dependent on the financial health of the charity. If the
charity fails and does not have the capacity to make the promised payments,
there is no recourse for the donor.

Credit Risk for Annuities

Aside from general views that annuity fees are too high and
that the stock market can easily outperform anything that an annuity is able to
offer, the primary objection to annuities is that insurance companies may fail
to support their contractual payment obligations. This matter is worth
addressing. While the risk that guarantees cannot be fulfilled is not zero, I
think the concern tends to be overstated and there are steps retirees can take
to mitigate these risks. There are also differences to consider between
annuitized contracts and guaranteed lifetime withdrawal benefits for deferred
annuities.

First, this concern about insurer viability is often stated as
if conditions within financial markets are so bad that the 4 percent rule of
thumb fails to work, then surely insurance companies will be bankrupt in the
ensuing financial calamity. But sequence-of-returns risk means that a
particular cohort of retirees may find that the 4 percent rule is unsustainable
without an overall economic catastrophe. Financial markets may recover, but the
portfolios for those taking distributions will not get to enjoy the full
recovery on account of the increasing distribution demands from what is left in
the portfolio. As well, the 4 percent rule assumes an aggressive stock
allocation, while the general accounts of insurance companies hold little
stocks. Insurance companies mostly hold fixed-income assets to maturity and are
highly regulated to maintain appropriate backup reserves. Stock market volatility
will have little impact on their abilities to pay claims.

Financial calamity for insurance companies would instead
have to be triggered either by a widespread default on their bond holdings, by
efforts to invest more aggressively in riskier assets that circumvent
regulations, or by facing unanticipatedly large claims that exceed what their
assets can support. These outcomes are possible.

The first, though, would imply an economic catastrophe in
which not receiving annuity payments may be the last of one’s concerns. The
second would require regulators falling asleep at their jobs. As for the third,
a concern may be, what happens if cancer is cured and everyone starts living
longer than the insurance company expected? In this case, insurance companies would
see reduced death benefit claims on their life insurance business that would
help to offset the increasing claims on their annuity business. They may not be
able to fully manage this longevity surprise, but neither is a household
investor. Arguably an insurance company is better suited to handle this
systematic longevity risk.

Another avenue for the protection of income annuity owners and
owners of other fixed annuities are the state insurance guarantee associations
that guarantee annuity premiums up to certain levels defined for each state.
While these insurance funds do not have sufficient assets to support a
systematic collapse of multiple insurance companies, they are positioned to
stand behind guarantees on the rare occasion that an individual insurance
company falters.

The National Organization of Life and Health Insurance
Guarantee Association maintains a website (www.nolhga.com)
that provides details about the specific guarantees offered in each state. They
often range from between $100,000 and $300,000 of premium. A common strategy
for those seeking annuity amounts that exceed state guarantee limits is to
diversify across insurance companies and to not exceed the premium limit with any
one company. Nonetheless, relying on the state guarantee association is not an
alternative to choosing a well-managed company.

Another important point about state guarantee associations
is that they do not apply to optional income riders. The state guarantee
associations are for fixed annuities and provide protection for annuitized
contracts and for the contract value of deferred contracts. Variable annuities
are not covered, but the investment subaccounts are separately managed and are
protected from company failure in the same manner as mutual funds or ETFs are
not exposed to risks for the custodian of the assets. But the income riders are
not protected. With deferred annuities, the contract value could be recovered,
but there is no recourse to obtain guaranteed income through the benefit rider
if the insurer fails. This is a key consideration for considering how income
annuities provide an additional layer of protection over optional riders on
deferred annuities.

As such, credit ratings are also extremely important to
consider when choosing from among insurance companies offering income
annuities. It is not a good idea to blindly go with whichever company is
offering the highest monthly payout on a given premium, as that may be a lower-rated
company that could potentially run into trouble with meeting payments in the
future.

Several credit ratings agencies provide ratings on insurance
companies, with AM Best probably being the most well-known on the insurance
side. Others include Fitch, Standard and Poor’s, and Moody’s. They assess
insurance companies based on the riskiness of their investment holdings and
whether the company can be expected to successfully pay its liabilities
(annuity payments and other insurance claims) in a timely matter. Consider
sticking with larger insurance companies with long histories of paying claims
that also rank among the highest levels offered by the rating agencies.

Exhibit 9.3 provides the rating scales for several
well-known companies. These can be confusing to keep straight. Another measure
one may come across is the Comdex ranking, which aggregates the ratings of
various ratings agencies in order to provide an overall score between one and
100.

Exhibit 9.3

Credit Rating Scales for Insurance Companies

AM Best

S&P

Moody's

Category

Description

Category

Description

Category

Description

A++

Superior

AAA

Extremely Strong

Aaa

Exceptional

A+

Superior

A

Excellent

AA+

Very Strong

Aa1

Excellent

A-

Excellent

AA

Very Strong

Aa2

Excellent

AA-

Very Strong

Aa3

Excellent

B++

Good

A+

Strong

A1

Good

B+

Good

A

Strong

A2

Good

A-

Strong

A3

Good

B

Fair

BBB+

Good

Baa1

Adequate

B-

Fair

BBB

Good

Baa2

Adequate

BBB-

Good

Baa3

Adequate

C++

Marginal

BB

Marginal

C+

Marginal

C

Weak

B

Weak

C-

Weak

CCC

Very Weak

Ba1

Questionable

Ratings agencies provide credit ratings for insurance
companies based on assessments for the reliability that the insurance company
will be able to make good on its promised payments. These ratings can be used
as a tool to help assess the quality of an insurance company. A lower rated
company may offer a higher level of protected income, but the contract owner
would need to accept greater risk about whether the insurance company can make
good on its promises.

Annuity company failures are rare. The annuity industry on a
whole maintains a strong motivation to maintain consumer confidence in the
ability for insurers to provide the promised lifetime payments. In this regard,
it is highly likely that a large insurer will step in and support promised
payments for any small insurer that fails. Joe Tomlinson reviewed the history
of annuity provider failures in a 2012 Advisor Perspectives column, and he found
only a few cases where annuity owners ended up with less than they had been
promised after accounting for rescues by large insurers or state guarantees. In
1983, Baldwin-United, a piano company that decided to enter the insurance
business, declared bankruptcy, and was taken over by MetLife, but policyowners
eventually faced a court-ordered reduction in benefits. The Executive Life
Insurance Company of New York failed in 1991, and while it continued to pay
benefits until 2012, the company was liquidated at that time and owners with
contracts in excess of the state limits then faced losses. Past performance is
not a predictor of future performance, and so it is understandable to have
concerns about the credit risk for annuity providers. But it is important to
recognize that this concern can be overstated.

Fee-Only Advisors and Annuities

Historically, annuities have mostly been sold through
financial advisors who serve as intermediaries and receive a commission on
the sale, rather than being sold directly by the insurance company to the
consumer. Having insurance companies compensate the advisor through a
commission has created problems for financial advisors who only
accept fees from their clients rather than commissions for selling financial
products.

In recent years, the fee-only model for financial advice has
grown in popularity. It is often designed to charge a percentage of assets
under management or charge hourly fees or fixed fees for providing planning
services. Fee-only advisors have effectively won the public debate about this
type of compensation model being more aligned with serving consumer
interests. Commissions were argued to create a conflict of interest, as a
commission-based advisor need only to sell suitable financial products that
are not necessarily putting the consumer’s needs first.

While fee-only advisors can be aligned with client
interests during the accumulation phase by seeking to accumulate more assets
and grow the investment portfolio, the fee-only model does not necessarily
align with managing retirement risks during the distribution phase that
focuses on lifetime income rather than portfolio growth. Fee-only
financial advisors have been particularly slow to adopt the use of annuities.
Caution about annuities relates to their complexity and the confusion this
complexity can create among consumers, their built-in fees and surrender
charges for early distributions, and their commission-based compensation
model. This has left their clients more exposed to market volatility and
longevity risk when seeking to build retirement income plans.

Insurance companies are now creating annuities
that can fit into the toolbox of fee-only financial advisors in a much more
effective manner. It is now increasingly possible to treat the annuity assets
in the same manner as other investment options are treated on the platforms
used by fee-only advisors to consolidate and manage client assets. For
deferred variable and index annuities, the contract value is known, and
income annuities can be managed by accounting for the present value of their
remaining payments. This makes it possible for advisors to charge their fees
on the assets held inside the annuity in the same way as for other investment
assets.

For fee-only annuities, internal costs can
be reduced because advisors can charge their fees from outside the annuity.
The insurance company no longer needs to charge more from within the annuity
in order to collect fees to compensate the advisor. This can result in lower
mortality and expense charges on the annuity, and surrender charges can be
reduced or even eliminated. For variable annuities, lower internal expenses
can allow for more step-up opportunities and upside potential. A
fee-only index annuity can provide more to the options budget,
since advisor fees do not have to be supported internally. This can allow for
better parameters to provide the owner with more participation in the market
upside. Allowing fee-only advisors to also incorporate annuities in their
planning should help to increase their exposure to the public in the coming
years.

Final Thoughts and Best
Practices

As we near the end, we can review some key concepts and
highlights from the book. First, we consider characteristics that could make
annuity use more advantageous for the financial plan. The first is how the
retiree feels about using an aggressive stock allocation. The risk premium has
a better shot at competing with the extra spending supported through annuity
risk pooling. Bonds alone do not have an opportunity to compete with risk
pooling, making the case for annuities stronger for conservative or risk averse
retirees who are less comfortable holding stocks.

Another area in which some retirees may be conservative
relates to longevity risk aversion. Those who are more greatly concerned with
outliving their assets are better positioned to benefit from annuities because
their alternative is to spend even less from an investment portfolio in the
hope of sustaining it for a longer retirement horizon. Longevity risk aversion
reflects subjective views about life expectancy, but some individuals may also
objectively expect to live longer than the average member of the risk pool,
which also increases the value of an annuity. The spread between the spending
supported through an annuity and the spending supported from investments grows
with the length of the planning horizon and longevity risk aversion. Though
difficult to prove, there is a possibility that annuities help people to live
longer than otherwise because of the reduced stress from dealing with their
investments and market volatility.

With annuitization, it is no longer necessary to manage
investments, freeing up a lot of time and stress, and the worry about market
volatility and its impact on outliving wealth is minimized. Retirees no longer
need to worry about “safe” withdrawal rates and trying to figure out just how
much they can spend sustainably. Income protections, especially, benefit those
who are more prone to making behavioral mistakes with their investment
portfolio, who experience less self-control and may be tempted to overspend
from their investment portfolio, and those who are intimidated by investments. This
can especially apply to households with one member who is financially savvier
than the others. Remaining household members become more vulnerable if
something happens to the person who had been handling the family finances.
Setting up a strategy with protected income can be a way to subsequently
protect members of the household in this situation.

Retirees without children may have a stronger reason to
consider annuities as they are less able to create risk sharing within the
family. On occasion, children may offer to care for parents if assets deplete,
with the understanding that an inheritance will be provided from what is
otherwise left. However, this scenario creates the possibility of a reverse
legacy. Children may have to care for parents, and parents may not want to put
their children in that situation anyway. Nonetheless, if there are no children,
then this idea of a reverse legacy as a way to opt out of using an annuity is
not even an option.

Those who are pessimistic about financial markets can also become
paralyzed regarding spending from investments in retirement. The annuity can
provide a license to spend and enjoy because risk pooling will help to support
late-life spending.

Related to behavioral and cognitive issues, income protections
contribute the most when the purchaser maintains an openness and willingness to
treat the annuity as part of the bond allocation and use a higher stock
allocation with remaining investment assets. The idea is to draw from bonds to
purchase the annuity. Likewise, fixed index annuities that are linked to stock
indices will also be more effective for those who treat them as bond
alternatives rather than stock alternatives. Variable annuities gain an edge
for those who are willing to use a more aggressive asset allocation inside the
variable annuity because they are comfortable with the downside risk
protections for the annuity provided by the income guarantee provisions.

Annuities create more benefit when one would otherwise be
invested in bonds, or when one is willing to view the annuity as a bond and
invest more aggressively with the rest. Where annuity benefits are relatively weaker
is for those who are more comfortable with an aggressive asset allocation but
who have trouble with the big picture thinking on assets and allocate partly
from stocks into the annuity rather than just from bonds.

Annuities can also provide greater value to those with less
reliable income resources. Annuities can augment Social Security and other
company pensions to create a secure base of spending resources not exposed to
stock market volatility. Those with enough assets may find that earmarking a
portion to strengthen reliable income will increase risk capacity and improve
long-term outcomes.

If the payout rate on the annuity is higher than the
withdrawal rate from investments to meet a goal, then a partial annuity strategy
will allow for an even lower withdrawal rate from what is left in the
investments. This increases the success rate for the partial annuity strategy,
and it increases the retirement GRIP (guaranteed retirement income percentage),
which reduces the magnitude of shortfalls if investments do deplete because a
greater portion of spending is available from outside the investments. With
less earmarked to cover spending, true liquidity increases, sequence risk
decreases, and the potential for greater legacy in the long-term grows. As
well, for those with less flexibility for spending, the annuity can help to
avoid the need to reduce portfolio distributions in response to poor market
performance.

As for specific advice, it is important to take your time
with the decision about an annuity. Annuities are complex and this is a big
decision that can affect lifelong financial security. It is important to also
discuss the decision with family members to coordinate both with the spouse and
with any potential heirs. Work with someone who is familiar with the vast array
of available annuities and understands which work better for different
purposes, ages, and deferral periods. Only add optional living or death
benefits if you plan to use them. Do not make these decisions quickly or take them
lightly.

When comparing annuities for lifetime income, it is
essential to focus on the dollar amount of guaranteed withdrawals. The dollar
amount is what matters, and it is a complicated function of the interactions
between rollups, withdrawal rates, and the length of the deferral period. This
also helps to avoid thinking about the annuity strictly as an investment. The
purpose is to protect lifetime income, so it is important to focus directly on
what that lifetime income will be.

Try to view annuities and whole life insurance
as a replacement for bond holdings in the investment portfolio. For retirees
who view these actuarial bonds as a replacement for other fixed-income assets,
the partial insurance strategies can increase success rates, raise the
proportion of lifetime spending goals that can be covered, and improve legacy,
relative to an investments-only strategy. Partial annuity strategies also
provide more reliable income throughout retirement to help support spending goals
even in the event of bad market scenarios and portfolio depletion.

Partial annuity strategies mean not putting everything into
the annuity, and it is okay to diversify purchases between different companies
and even different types of annuities.

For other ideas about best practices, please see the
call-out box on what the National Association of Insurance Commissioners (NAIC)
suggests for consideration when determining if an annuity is a suitable tool
for the financial plan.

NAIC Suitability Requirements

The National Association of Insurance Commissioners (NAIC)
is a consortium of state insurance regulators that includes an advisory board
which creates a set of best practice model regulations that states can
consider and adopt to regulate insurance within their borders. States are not
required to adopt the model regulations, but most do, at least in a modified
form. It is worth considering their approach to annuity suitability, as it
can speak to issues relevant for consumers thinking about an annuity purchase.
Insurance commissioners want to know that agents are properly trained about
the annuities and that the annuity is suitable for their clients. The twelve
factors that they have outlined for determining the suitability of any
annuity recommendation include:

1. Age: The age of the annuity owner and annuitant are
both important considerations, with the important point being that older
individuals may experience cognitive decline or diminished capacity and be
less able to understand the annuity terms. Another concern is that the
surrender charges for the annuity extend beyond the owner’s remaining
lifetime.

2. Annual income: Annual income is particularly important
for annuities with flexible premiums in order to make sure that the owner
will have the resources to support future contributions. Single premium
annuities will also benefit from information about income in order to get a
better sense of the type of spending level support that will be needed.

3. Financial situation and needs, including the financial
resources used for funding of the annuity: It is important to always focus on
the big picture of retirement assets and liabilities and to think about the
change in the composition of these assets when using a portion of them to
purchase the annuity.

4. Financial experience: As the complexity of the annuity
grows, more financial experience is important to better clarify that the
owner can understand the terms of the annuity. With a variable annuity, the
owner must also be able to manage the asset allocation decisions for the
subaccounts.

5. Financial objectives: It is important to be clear about
how the annuity will work to meet a specific financial objective for the
household.

6. Intended use of the annuity: Related to the financial
objective, it is important to clearly understand how the annuity will be used
to meet a specific objective in the financial plan. Most often with
retirement, the use will be to generate longevity-protected spending power,
but other uses could include accumulating assets with downside protection,
obtaining tax deferral for assets, protecting assets from creditors, or
meeting a legacy goal.

7. Financial time horizon: It is important to recognize
that annuities are meant to serve as long-term tools, so the retiree time
horizon must be considered.

8. Existing assets, including investment and life
insurance holdings: The annuity will serve as a tool within a broader overall
plan and understanding how it fits into a plan means knowing about the other
resources available.

9. Liquidity needs: A key issue to consider is that there
must be enough remaining liquidity after the annuity purchase to avoid
experiencing surrender charges because the annuity assets are needed for
unanticipated expenses.

10. Liquid net worth: The liquid net worth is important to
consider with respect to ensuring that enough liquidity will remain after the
annuity purchase for unexpected needs.

11. Risk tolerance: Risk tolerance can be an important
factor in relation to the discussion about funding retirement spending
through bonds, a diversified portfolio, or an annuity. A lower risk tolerance
means less exposure to the risk premium to fund retirement, which will make
the case stronger for using risk pooling through an annuity to support more
spending than bonds.

12. Tax status: It is important to understand how the
annuity is taxed and whether its taxation will help improve the tax
characteristics of the overall financial plan.

Finally, it is important to understand how insurance
products work for retirement income. It can be complicated. I conclude with a
list of questions for which it is important to understand the answers for an
annuity product.

First, Exhibit 9.4 covers income annuities. This list is
relatively short. Exhibit 9.5 then covers questions for variable annuities, and
Exhibit 9.6 is for fixed index annuities. Some questions overlap, but others
are quite different or are not relevant for all types of annuities. These lists
are provided without further comment.

Exhibit 9.4

Questions to Ask About an Income Annuity

Income guaranteed amount

What is the minimum guaranteed
amount of lifetime income?

Guaranteed withdrawal rates

What is the guaranteed payout
rate? How does it vary by age and length of deferral period?

Other withdrawal features

Does the contract provide
liquidity to take nonguaranteed withdrawals? (Answering yes is uncommon)

Death benefit

What are the death benefit
provisions, such as cash refund, installment refund, or period certain
payments?

Insurance company credit
rating

What credit ratings has the
insurance company earned from the major credit rating agencies?

For deferred annuities, make sure you understand how the
annuity works with respect to its various features. This will help to assess
the potential upside and liquidity to be compared with an income annuity.
Exhibit 9.5 provides questions for variable annuities.

Exhibit 9.5

Questions to Ask About a Variable Annuity

Deferral Period

Rollup rate

Is the rollup rate simple or
compounded?

Other rollup features

How long will the rollup rate
be applied?

Step-up frequency

How frequently are step-up opportunities
provided?

Stacking

Do step-ups stack on top of
rollups?

Vesting frequency

How frequently are step-ups
and rollups vested into the benefit base?

Distribution Period

Income guaranteed amount

What is the minimum guaranteed
amount of lifetime income as determined by the interaction of rollup rates
and withdrawal rates after an assumed deferral period?

Guaranteed withdrawal rates

What are the guaranteed
withdrawal rates?

Do they depend on the age at first guaranteed withdrawal?

Or do they depend on age at contract issue and length of deferral period?

Adjustment for couples

Are withdrawal rates or fees
adjusted for couples relative to singles?

Other withdrawal features

Does the contract provide
liquidity to take nonguaranteed withdrawals?

Impact of nonlifetime
withdrawals

How does the amount of
guaranteed lifetime income adjust to nonguaranteed withdrawals (including
excess withdrawals beyond the guaranteed amount)?

Death benefit

What are the death benefit
provisions?

Risk Management Approach

Maximum allocation to risky
assets

What is the maximum allowed
allocation for risky assets?

Range of investment offerings

What are the fund choices for
the subaccount investments?

Other restraints on investment
allocation

Are there any other
requirements about using volatility-controlled funds or holding cash
positions?

Variable annuity and
subaccount fees

What are the ongoing mortality
and expense charges? What fees are applied to the investment options in the
subaccounts? Are these fees applied to the contract value, the benefit base,
or some other metric for the annuity?

Additional fees for guarantee
rider

What are the ongoing fees for
optional guaranteed living and death benefits? Are these fees applied to the
contract value, the benefit base, or some other metric for the annuity?

Fee adjustments

How much flexibility does the
insurance company maintain to adjust fees? What are the maximums?

Surrender charges

What surrender charge schedule
is applied to excess distributions in the early years of the contract?

Insurance company credit
rating

What credit ratings has the
insurance company earned from the major credit rating agencies?

Finally, Exhibit 9.6 provides questions for fixed index
annuities.

Exhibit 9.6

Questions to Ask About a Fixed Index Annuity

Deferral Period

Linked index

What financial market index is
used for crediting interest?

Downside protection

Is principal protection
provided? What is the worst-case interest to be credited? What is the
guaranteed minimum surrender value?

Crediting method

What crediting method is used
to determine upside participation?

Rollup rate

Is there a rollup rate? Is it
simple or compounded?

Other rollup features

How long will the rollup rate
be applied?

Step-up frequency

How frequently are step-up
opportunities provided?

Possibility for step-ups

Given the crediting method,
how likely are step-up opportunities?

Stacking

Do step-ups stack on top of rollups?

Vesting frequency

How frequently are step-ups
and rollups vested into the benefit base?

Distribution Period

Income guaranteed amount

What is the minimum guaranteed
amount of lifetime income as determined by the interaction of rollup rates and
withdrawal rates after an assumed deferral period?

Guaranteed withdrawal rates

What are the guaranteed
withdrawal rates? Do they depend on the age at first guaranteed withdrawal?
Or do they depend on age at contract issue and length of deferral period?

Adjustment for couples

Are withdrawal rates or fees
adjusted for couples relative to singles?

Other withdrawal features

Does the contract provide
liquidity to take nonguaranteed withdrawals?

Impact of nonlifetime
withdrawals

How does the amount of
guaranteed lifetime income adjust to nonguaranteed withdrawals (including
excess withdrawals beyond the guaranteed amount)?

Death benefit

What are the death benefit
provisions?

Risk Management Approach

Changes to crediting method

How much flexibility does the
insurance company maintain to adjust parameters with the crediting method at
each new term?

History of crediting method

Has the insurance company
demonstrated the ability to not adjust crediting method parameters in an
adverse direction at least during the surrender period?

Additional fees for guarantee
rider

What are the ongoing fees for
option guaranteed living and death benefits? Are these fees applied to the
contract value, the benefit base, or some other metric for the annuity?

Fee adjustments

How much flexibility does the
insurance company maintain to adjust rider fees? What are the maximums?

Surrender charges

What surrender charge schedule
is applied to excess distributions in the early years of the contract?

Insurance company credit
rating

What credit ratings has the
insurance company earned from the major credit rating agencies?

Retirees may wonder about which type of
annuity to use, and this depends on personal preferences. The variable annuity
maintains a contract value that can rise and fall with the markets, creating
more upside potential and downside risk than other annuities. The fixed index
annuity offers upside potential and liquidity, but generally less upside
potential than a variable annuity and less minimum guaranteed income than an
income annuity. Income annuities do not have liquidity, but they are the most
efficient way to secure a stream of protected lifetime income with the least
amount of assets. The analysis makes clear that including risk pooling as a
retirement income tool can help to lay a foundation for improved retirement
outcomes no matter which approach is chosen.

In conclusion, we must step away from the notion that either
investments or insurance alone will best serve retirees. More emphasis is
needed on different forms of insurance products and how they may behave as part
of an integrated retirement income plan. I hope this text has helped to expand
knowledge about the topic. Thank you for reading, and please check my website www.retirementresearcher.com
to stay up-to-date with the latest developments in the evolving field of
retirement income planning.

Further Reading

Chen, Peng, and Moshe A. Milevsky. 2003. “Merging Asset
Allocation and Longevity Insurance: An Optimal Perspective on Payout
Annuities.” Journal of Financial Planning. 16 (6): 64–72.

Haithcock, Stan G. 2014. The Annuity Stanifesto.
Ponte Vedra Beach, FL: AnnuityMan Publishing. [https://amzn.to/2N5mL7I]

Milevsky, Moshe A., and Alexandra C. Macqueen. 2015. Pensionize
Your Next Egg: How to Use Product Allocation to Create a Guaranteed Income for
Life (2nd Edition). Hoboken, NJ: Wiley. [https://amzn.to/2XqpRqO]

Olsen, John L., and Michael E. Kitces. 2014. The
Advisor’s Guide to Annuities, 4th Edition. Cincinnati: The National
Underwriter Company. [https://amzn.to/2IPFChG]

Pfau, Wade D. 2013. “A Broader Framework for Determining
an Efficient Frontier for Retirement Income.” Journal of Financial Planning.
26 (2): 44–51.

Tomlinson, Joe. 2012. “How Safe are Annuities?” Advisor
Perspectives (August 14).

Further
Resources

Other Books in the Retirement Researcher’s
Guide Series

How Much Can I Spend in Retirement?

Available from Amazon:

http://amzn.to/2xLgXGC

Reverse Mortgages (2nd Ed.)

Available from Amazon:

http://amzn.to/2GgCt7v

The American College of Financial Services—RICP®
Designation

The American College of Financial Services pioneered the
Retirement Income Certified Professional® (RICP®)
designation in late 2012. It is a three-course sequence providing comprehensive
coverage for the different schools of thought and philosophies about retirement
income planning. I became the RICP® curriculum director in early
2019 and am now responsible for incorporating the latest innovations in the
field and keeping the curriculum up to date. For those seeking to further study
about retirement income planning, the RICP® designation provides a
great opportunity (https://www.theamericancollege.edu/designations-degrees/RICP).

Glossary of
Acronyms

• AGI: Adjusted Gross Income

• CD: Certificate of Deposit

• CFA: Chartered Financial Analyst

• CFP: Certified Financial Planner

• DIA: Deferred Income Annuities

• FIA: Fixed Index Annuities

• FPA: Financial Planning Association

• GLWB: Guaranteed Living Withdrawal Benefit

• IRA: Individual Retirement Account

• IRS: Internal Revenue Service

• MPT: Modern Portfolio Theory

• MRT: Modern Retirement Theory

• QLAC: Qualified Longevity Annuity Contract

• RIA: Registered Investment Advisor

• RICP®: Retirement Income Certified Professional

• RMD: Required Minimum Distribution

• SPIA: Single Premium Immediate Annuities

• STRIPS: Separate Trading of Registered Interest and Principal
of Securities

• TIPS: Treasury Inflation-Protected Securities

• VA: Variable Annuities

About the Author

Wade D. Pfau, PhD, CFA, RICP is a professor of retirement income
and the director of the Retirement Income Certified Professional®
(RICP®) designation program at the American College of Financial
Services in King of Prussia, Pennsylvania. He is a codirector of the college’s
New York Life Center for Retirement Income. He also serves as a principal and
the director of retirement research for McLean Asset Management and chief
planning scientist at inStream Solutions.

He hosts the Retirement Researcher website as an educational
resource for individuals and financial advisors on topics related to retirement
income planning. He holds a doctorate in economics from Princeton University
and publishes frequently in a wide variety of academic and practitioner
research journals. His research has been discussed in outlets including the
print editions of the Economist, New York Times, Wall
Street Journal, Time, Kiplinger’s, and Money magazine.

Wade is a past selectee for the InvestmentNews Power 20 in
2013 and 40 Under 40 in 2014, the Investment Advisor 35 list for 2015 and 25
list for 2014, and Financial Planning magazine’s Influencer Awards. In
2016, he was chosen as one of the Icons and Innovators by InvestmentNews.
He is a two-time winner of the Journal of Financial Planning
Montgomery-Warschauer Editor’s Award, a two-time winner of the Academic Thought
Leadership Award from the Retirement Income Industry Association, and a Best Paper
Award winner in the Retirement category from the Academy of Financial Services.
Wade served for four years as a coeditor of the Journal of Personal Finance.

Wade is a contributor to Forbes, an Expert Panelist
for the Wall Street Journal, and a columnist for Advisor Perspectives.
He has spoken at the national conferences of organizations such as the CFA
Institute, Financial Planning Association, National Association of Personal
Financial Advisors, and Academy of Financial Services.

He is also author of two other books, Reverse Mortgages: How
to Use Reverse Mortgages to Secure Your Retirement and How Much Can I
Spend in Retirement: A Guide to Investment-Based Retirement Income Strategies.