Over the past few days I’ve been getting
back into the programming spirit. This is all preliminary and subject to
further checks and refinements.
This evening I’ve been looking at how
partial annuitization impacts retirement outcomes. Borrowing on assumptions
developed by Joseph Tomlinson, I assume a 65-year old couple can purchase an
inflation-adjusted single-premium immediate annuity with a payout rate of
5.05%.
Update: I did say this was preliminary and subject to further checks. In the comments, Joe Tomlinson pointed out that I was misremembering about the 5.05% payout rate for a real SPIA. That is for a 65 year old male, not a 65 year old couple. Thus my analysis applies to a single male. For a 65 year old couple, 3.88% is the payout rate. I've changed the figure below to point out that it is for a 65 year old male. And I've also added a new corrected figure for the 65 year old couple. My descriptions below are about the male case. For the couple, the results are much less impressive. However, it is still vital to remember that "failure" does not mean the same thing when annuities are included. With systematic withdrawals, failure means your income falls to zero. With annuities, failure means that your income falls to the annuity amount. With 50% annuitization of assets, that would mean your income falls to
100 x .5 x 3.88 / 4 = 48.5% of your original spending level once your financial portfolio runs dry. For the couple, the advantages of annuities become less obvious, though I think this still reflects positively on them, especially if leaving a bequest is not an overly important consideration. Ultimately, to evaluate the tradeoffs for this couple, we may need to rely on the approach developed by Joe Tomlinson in his February 2012 JFP article. It accounts both for mortality rates and for how much relative importance the retiree puts on leaving a bequest. I'm also in the process of working on some other metrics to evaluate these decisions, though perhaps I should first do more careful checking before posting new material to avoid this sort of embarrassing backtracking :)
Update: I did say this was preliminary and subject to further checks. In the comments, Joe Tomlinson pointed out that I was misremembering about the 5.05% payout rate for a real SPIA. That is for a 65 year old male, not a 65 year old couple. Thus my analysis applies to a single male. For a 65 year old couple, 3.88% is the payout rate. I've changed the figure below to point out that it is for a 65 year old male. And I've also added a new corrected figure for the 65 year old couple. My descriptions below are about the male case. For the couple, the results are much less impressive. However, it is still vital to remember that "failure" does not mean the same thing when annuities are included. With systematic withdrawals, failure means your income falls to zero. With annuities, failure means that your income falls to the annuity amount. With 50% annuitization of assets, that would mean your income falls to
100 x .5 x 3.88 / 4 = 48.5% of your original spending level once your financial portfolio runs dry. For the couple, the advantages of annuities become less obvious, though I think this still reflects positively on them, especially if leaving a bequest is not an overly important consideration. Ultimately, to evaluate the tradeoffs for this couple, we may need to rely on the approach developed by Joe Tomlinson in his February 2012 JFP article. It accounts both for mortality rates and for how much relative importance the retiree puts on leaving a bequest. I'm also in the process of working on some other metrics to evaluate these decisions, though perhaps I should first do more careful checking before posting new material to avoid this sort of embarrassing backtracking :)
They want to spend at a constant
inflation-adjusted withdrawal amount representing 4% of their retirement date
assets (the normal 4% rule assumption).
Also, while I usually base Monte Carlo
simulations on historical averages, that especially isn’t fair for annuities. The annuity
payout rate is based on the low current bond yields, and so I adjust the
returns for stocks and bonds both downward by 1.52% so that real bond returns
are calibrated to 1% instead of the historical 2.52%. This maintains the same
historical equity premium, and I do not change either the standard deviations
or correlations. I explained this issue more completely in Lower Future Returns and Safe Withdrawal Rates.
I’m making a retirement income frontier
which shows the traditional failure rates for a 30-year retirement on the
x-axis, and the median real wealth remaining after 30 years on the y-axis. I show the results for asset allocations
between 0 and 100% stocks for two different strategies.
The blue curve represents traditional
drawdowns from a portfolio to obtain the desired spending without
annuitization. Because of the lower asset returns, failure rates are higher
than my figures usually show. Stock allocations above 40% have the lowest
failure rates, and these vary between about 20 and 30%. As for median remaining
wealth, higher stock allocations support higher expected bequests.
The cyan curve shows what happens when the
couple male annuitizes 50% of their wealth, purchasing an inflation-adjusted SPIA at
their retirement date. That 50% is arbitrary and is not a maximum allocation to
SPIAs or anything like that, I just wanted to see what happens in a basic
scenario. This couple then withdraws the necessary amount from their remaining
portfolio to top off the annuity and get their 4% spending power. With the
5.05% payout rate, this couple male is getting 2.5% of the 4% of spending from their
annuity, and the remaining 1.5% of their spending comes from their portfolio.
The cyan curve shows that partial
annuitization reduces failure rates across the board for all stock allocations. Even more than that, with partial annuitization, failure doesn't mean that income falls to zero. It just means that the portfolio is empty. You still have 62.5% (=2.5/4) of your original income amount from the SPIA even in the case of failure. Rethinking Safe Withdrawal Rates: The Meaning of Failure explains more about this issue.
I connected corresponding stock allocations with red dashed lines. The outcomes
for remaining wealth are more mixed. With annuitization, stock allocations
above about 50% would support lower bequests than the corresponding stock
allocation in the no annuitization case, while stock allocations below 50%
would support higher bequests.
But what is also rather important to note
is that for a risk averse couple male, partial annuitization lowers the failure
rates, which could make them more willing to use a more aggressive stock allocation
for their remaining portfolio. Essentially, the SPIA acts like a super-bond,
and so even 100% stocks with the remaining portfolio corresponds to something
closer to an overall 50/50 asset allocation. Consider a couple willing to hold
only 40% stocks if they don’t annuitize. With 40% stocks and partial
annuitization, they can obtain both a lower failure rate and a higher expected
bequest. And they could continue increasing their stock allocation to any level
up to 100% to get higher expected bequests while still keeping their failure
rates quite a bit lower than with the no annuitization case.
That, to me, suggests that partial
annuitization really does have the potential to help retirees obtain better
outcomes. I do have to acknowledge that this isn’t the full story. I assume a
rather long 30 year period, and annuities will look more attractive as the
period under investigation increases. When I wrote my somewhat negative column
on GLWBs last December, I suggested that partial annuitization may be a better
approach, and these preliminary results do suggest that a full investigation of
this issue is in order.
