This is a special guest post of an email exchange I had with Larry Frank, a retired Air Force Command Pilot and Contingency War Planner, and following that, almost two decades now in the financial planning profession as a Registered Investment Adviser and owner of his practice Better Financial Education in Roseville, CA. He blogs about retirement and many other financial planning topics at Blog.BetterFinancialEducation.
He focuses on how to develop plans for prudent and sustainable retirement income for the average middle class person to get them both to, and through, retirement. This starts with helping families determine how to maintain their standard of individual living which is specific and unique only to the them, i.e., no generic income replacement ratios.
Larry is the author of Wealth Odyssey and 5 peer reviewed research papers in the Journal of Financial Planning. He holds a BS cum laude in Physics from the University of Minnesota (how things work) and an MBA from the University of South Dakota (how money works). He is a CERTIFIED FINANCIAL PLANNERTM Practioner.
A list of his published research articles can be found at his website.
Larry wrote to me with comments about my efficient frontier article in the February Journal of Financial Planning. He makes an important point that in its current form, the efficient frontier is still static rather than dynamic as I have not built in ways to adjust away from the fixed lifestyle goal. Larry's research has focused on building more dynamic strategies for safe withdrawal rates which adjust for both age and portfolio experience. I haven't read his series of articles in the journal yet, but I did review a complementary version of the approach by his co-author David Blanchett with colleagues at Morningstar.
Larry describes himself as part of the probability-based school of thought rather than the safety-first school of thought. As we discussed it more, he wrote some rather provocative and thought-provoking comments about the role of annuities which I haven't seen expressed in such a way before. I thought his comments were interesting enough to warrant a guest post. In an earlier message he expressed concerns that insurance companies were not properly incorporating longevity improvements into their calculations (i.e. people will live longer than insurance companies expect, which could jeopardize annuity guarantees). I asked him what he thought about the idea that insurance companies could hedge this longevity risk by selling both annuities and life insurance. If people live longer than expected, annuity payments increase, but life insurance payouts decrease. Here is his response:
It seems to me Wade, that hedging is a short term strategy (5 years at best, with the majority only months) while the obligation to pay a benefit may last decades for an annuity. At the moment, immediate annuities are such a small percentage of assets that any blow ups can be almost absorbed by the insurance company. However, with the great push by legislatures and the insurance industry to “solve the retirement problem, ”the volume of assets may get so large that it becomes too big to fail. The promised payouts may exceed assets on such a large scale that it overwhelms both insurance companies and State guarantee associations. The solution doesn't match the problem here, where the real problem is people not saving enough in the first place, yet the “solution” doesn’t address that! Instead, the “solution” is to put more immediate annuities into 401ks, thus leading to a future increase in assets.
To big to fail? How would this happen? By the tendency to promise more out of the system than the system can sustain. Our last paper (JFP Dec 2012) opened my eyes to the fact that if the amount of assets shrinks, then the sustainable amount distributed has to shrink also (and vise versa). You can’t get more out than what the assets are capable of supporting. The tendency is to get too generous during good years (look at what happened to variable annuity benefits riders) and then it gets hard to take those back. Better to provide bonuses during good years rather then set up an income for life based on good years and ignoring the possibility for lean years.
Increased longevity should reduce annuity payouts because a set sum needs to support more years. So the payouts are based on longevity today, but while that retiree ages the longevity extends … thus, more is promised to be paid out than can be sustained. Ramp this up by many more retirees promised beneifts through their 401k's, and the total assets can’t sustain a longer living group. This effect combines with the above promises effect, and the system is not sustainable. The insurance industry made faulty assumptions about the VUL product in the late 90’s and faulty assumptions about VA riders in the 2000’s. Their track record based on “old” concepts suggests an insidious set up could take place … similar to the slow insidious forces that set up the mortgage industry … unless assumptions and models aren’t critically looked at.
When I talked with a number of professors at the Academy of Financial Services who are researching retirement, they say getting good data about current strategy, etc, for academic research is difficult because insurance companies tend to think of it as proprietary, or don’t want the academic scrutiny. So getting a good broad academic look at the topic is challenging.
A dynamic approach that adjusts payouts, like the dynamic model in our paper series, based on current asset levels provides an asset level that can be sustained into super centenarian ages. Income cannot be outlived if the supporting assets are properly managed as to sustainable payouts. However, the goal seems to be to promise a guarantee, which often ignores asset reality, and we could easily get into problems that pensions now have.