Wednesday, September 19, 2012

Advisor Perspectives column for September: Systematic Withdrawals and Annuities

My September column at Advisor Perspectives is now available, "Your Clients' Toughest Retirement Decision: The Debate Between Systematic Withdrawals and Immediate Annuities." I attempt to present the case for each type of income strategy.

This column is generating some reader feedback suggesting that it is nuts to even consider immediate annuities now in the low interest rate environment. The reality is that now is a very expensive time to retire, and that any sort of retirement income tool/strategy will be hit by the low interest rates. I have not been persuaded that immediate annuities are hit harder, relatively speaking, than other strategies. Thus, I don't think that low interest rates alone are a reason to remove this tool from the list of possibilities.

As well, a very worthwhile read is Bob Seawright's "Five Good Questions for Moshe Milevsky"

13 comments:

  1. Wade,
    Yet another fine article. Thank you. Each of us has a unique (to us) situation, and in my case I think I have resolved the SPIA question to my satisfaction. But I am wondering now what you and the CFA community in general consider to be a reasonable long-term rate of return on a well balanced portfolio, after fees and inflation. Obviously, no guarantee, and high probability that the short-term return will not equal the average, so one must plan on weathering some difficult years. My personal plan is on being able to average 6% to 7% after inflation, with relatively low cost index fund investing. I'm still a little hazy on the specifics of which funds, but I have a little time to make up my mind. Right now, in my government TSP (401K) I'm invested 40% in US stocks (S&P500)20% in international stocks, and 40% in bonds and treasuries. I guess an equally good question for you is what do you consider a sufficiently diversified portfolio to contain, in general terms? Any feedback appreciated.
    Bob







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    1. Bob,

      I am not sure if there is any consensus about future returns.

      Laurence Siegel wrote a good column about a CFA Institute project on the equity premium and future returns. You can read it here:
      http://www.advisorperspectives.com/newsletters12/Jeremy_Siegel_Rob_Arnott_and_Other_Experts_Forecast_Equity_Returns.php

      I would say that 6% or 7% sounds too high for a portfolio return. Even historically, that would be for 100% stocks, and not a diversified portfolio. Also, as you are thinking about long term returns, you should use the compounded return rather than the arithmetic return, which is lower due to portfolio volatility. Personally, I use a 2% real arithmetic return for my own planning spreadsheet.

      Personally, I'd say that your portfolio is sufficiently diversified in terms of the asset class choices. I can't really comment on whether the asset allocation is right for your circumstances, but at least the asset class choices look fine. The only other thing I would consider adding is a small allocation to REITs.

      Best wishes.

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    2. Thanks, Wade, that was a fascinating link and article. And useful. I think I may be too "historically" oriented, with a "buy and hold for the long term" bias. The more I read and learn, the more I appreciate the good work you are doing. Thanks, again.

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    3. Hi! Bob,

      I agree with Wade's noting that there really is nothing approaching a "consensus" in the CFA community regarding forward returns.

      Having said that, Rob Arnott wrote very persuasively about forward returns in his most recent monthly Research Affiliates column entitled "The Glidepath Illusion." (You can find it at the Research Affiliates website.)

      In it, he suggests (with strong rationale) that investors would be wise to use forward equity returns of 5.4% (versus 8.3% historical) due to lower current dividend rates and the absence of an expanding multiples 'tailwind'. For bonds, he suggests a forward return of 1.9% (vs. 3.9% historical) due to lower starting yields and limited further capital gains.

      Interestingly, if you weight those returns for a traditional 60/40 portfolio, you come up with a 4% annual return expectation. Subtract 2% per year for inflation and you get to the 2% real return expectation Wade mentions in his reply to you above. (written before Rob's column was published)

      Stephen

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  2. Hi! Wade,

    The hits just keep on coming. . . thank you for continuing your fine work on retirement.

    A preliminary thought on the relative merits of SPIAs in a low-interest-rate environment:
    While I agree with you about this being a particularly expensive time to retire, I am struggling to agree with your premise that SPIAs are not harder hit than other strategies.

    Would not a strategy that locks in the present interest rate forever be hit harder than a strategy with more flexibility? SPIAs strike me as offering the same outcome as a laddered portfolio of high-grade bonds structured to immunize the investor's annual or quarterly income 'liability'. Thus, the income stream cake is baked the day that strategy is executed.

    Granted, if rates continue to decline or at least remain relatively steady, this is about as good as it would get. But would it not make more sense to build some flexibility into the portfolio such that a possible increase in rates at some point in retirement would provide the opportunity to improve one's income stream?

    Stephen Barnes, CFA, CFP(r)

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  3. Stephen,

    Thank you very much, and you are probably right. I'm still at the stage of thinking about how to set everything in motion at the retirement date. But using a bond ladder with the idea of potentially annuitizing later, or making staggered SPIA purchases over time, could both be potentially less hard hit strategies than the SPIA. I still need to do more work before I can model such strategies, as with them it is important to simulate interest rates, which is harder than simulating returns on a mutual fund of bonds.

    Thanks.

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  4. Another great article from you. Easy to read and explains things clearly. Thanks also for the link to the Milevsky interview. Also appreciate your comments and threads at bogleheads.

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  5. Hi! Wade,

    A client brought us an interesting example today. He is offered a retirement benefit from a former employer. For a limited time, this client (M56) can elect a lump sum, a single life annuity or one of two joint and survivor annuity options. If none of these options are elected, the client will have only annuity options at his normal retirement date (nine years from now).

    Here are the choices:
    Lump Sum: $142,757.53
    Single Life Annuity: $760.47/mo for life
    50% Joint/Survivor: $701.23/$350.62
    75% Joint/Survivor: $675.07/$506.30

    Were he to live to age 80, we calculate the "return" to the Life Annuity (vs. the lump sum) would be ~3.9% per year. Not a bad guaranteed return for the estimated 24 years an acutarial table says he is most likely to live. . . with an additional guarantee that he won't outlive it. On the other hand, he has to live at LEAST 15 years 8 months to receive a cumulative value equal to the lump sum.

    Considering that he would give up any flexibility with the funds whatsoever, any inflation protection whatsoever, and his survivors would have nothing after he passes. . . are any of these annuity choices prudent? I would really appreciate the ability to split this up and take a small annuity along with the balance in a lump sum, but that is not an option.

    I would greatly appreciate reading your thoughts on these kinds of real-world choices.

    thanks so much for your time!!
    Stephen

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    1. Stephen,

      Sorry, I've fallen a bit behind. I haven't dug into the numbers you provided too much. But how do those annuity payouts relate to what you could otherwise buy on the market for that lump sum amount? Are they a better deal than other market options? Because, another possibility would be to take the lump sum and then do the partial annuitization on your own, as you suggest you would prefer. Generally speaking, 56 does seem like a young age to annuitize. But I don't really know enough about the client's personal situation to suggest any more specific advice.

      Best wishes, Wade

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    2. Hi! Wade,

      No worries. I completely understand.

      With regard to the client, we have already provided an analysis of the (limited) options and our recommendation. I was merely curious to hear what your observations might be about the various options. Apologies for my lack of clarity - I certainly was not looking for specific advice.

      I agree with you that 56 is pretty young to be annuitizing even a portion of a nest egg. We have looked at individual annuity options but they are not competitive with the 'institutional' (group?) annuity options that are usually offered when these major corporations offer retirement packages.

      Also particular to this case, the individual has another retirement benefit available at normal retirement from a government pension. I anticipate that at full retirement, it might make sense to annuitize *that* benefit in part or in full, thus taking advantage of the favorable 'institutional' annuity rates and providing an income stream that cannot be outlived.

      Thank you for taking some time to discuss. I very much appreciate the work you are doing.

      best regards,
      Stephen Barnes, CFA, CFP®

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  6. Very interesting info Wade--thanks for sharing.

    The conversation @ issues related to inflation-adjusted SPIA shortcomings was useful.

    I would be interested in hearing more about your thoughts on the VA/GLWB option. Specifically, what factors do you think contribute to the less attractive location of the VA/GLWB option on the efficient frontier?

    Best,

    Tom Cochrane



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    1. Tom,

      Thanks. About VA/GLWBs, I think they are ultimately hampered by their fees, and the compounding impact of the rider over time. Joe Tomlinson called them "actuaries gone wild" because they try to bundle everything in one package: upside potential, downside protection, and liquidity. But I suspected, and confirmed to my satisfaction in the efficient frontier article, that those objectives can be met more efficiently by mixing stocks and SPIAs.

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