Wednesday, July 24, 2013

Decomposing SPIAs: Rising Equity Glidepaths vs. Mortality Credits

Michael Kitces and I have completed a research article together called, "The True Impact Of Immediate Annuities On Retirement Sustainability: A Total Wealth Perspective." That link will bring you to the complete research article at SSRN. Michael is also blogging about the article today. His post provides an excellent and detailed summary of the article. What I will try to do here is to provide a shorter and more intuitive explanation for what we are doing.

This article is about what happens when you partially annuitize your portfolio at retirement. We have known since the classic article called “Making Retirement Income Last a Lifetime," which was written by John Ameriks, Bob Veres, and Mark Warshawsky in 2001, that purchasing a SPIA with part of one's assets at retirement can actually reduce the failure rate for the portfolio, and possibly even allow for larger bequest after enough time passes for remaining assets to grow in value. This idea was also a big part of the article on the efficient frontier for retirement income which I published earlier this year, which showed that portfolios combining stocks and SPIAs could support the meeting of a spending goal more effectively while also leaving a bigger pool of liquid financial assets available for other purposes than portfolios of stocks and bonds held at differing fixed asset allocations.

What we do in this article is to take a more critical look at those sorts of conclusions by decomposing the impact of a SPIA into two different components. In building retirement income strategies, it is important to look at a household's entire balance sheet, which includes financial, social, and human capital. Not just financial assets. When someone annuitizes assets, the value of their financial portfolio drops, but for the purposes of understanding their retirement income strategy, we need to include the present value of their remaining SPIA payments on their balance sheet. Then we can look at their asset allocation from their entire balance sheet perspective. What percentage of their assets are in stocks, from the perspective of their total balance sheet and not just their financial assets?

When thinking about things in this way, what we can see is that one practical implication of a SPIA is that it ends up behaving like a bucket strategy in which the retiree disproportionately spends down their fixed income assets first, leaving their stocks alone to grow (more often than not), which results in an increasing in stock allocation over their retirement.

This brings us back to an issue I first discussed several years ago here at the blog, and it is something that Michael and I will explore more in subsequent research. As it turns out, having a rising stock allocation (a rising equity glidepath) during retirement can actually support lower failure rates and better retirement outcomes than any fixed stock allocations. Essentially, target date funds would have a declining equity glidepath over the accumulation phase (which they currently do) and then an increasing equity glidepath over the retirement phase (which they currently do not). The intuition for this is that you want to have the lowest stock allocation when you are most vulnerable, which tends to be at around your retirement date when you are the most exposed to sequence of returns risk. Here are four things that can happen to you in retirement:

-Good market returns throughout retirement: you are not in the worst-case scenario situation, your portfolio will continue to grow in spite of your withdrawals, and a rising equity glidepath would beat a fixed equity glidepath in terms of providing a greater legacy value for your portfolio

-Good market returns in the first half of retirement followed by bad market returns in the second half of retirement: as your portfolio continues to grow in the first part of retirement, the withdrawal rate needed to meet your lifestyle goal will continue to decline from its initial level in your retirement will be quite sustainable. These are also good outcomes, and the rising equity glidepath might not support as high a legacy in this case, this retirement will still be successful with either sort of glidepath

-Bad market returns in the first half of retirement followed by good market returns in the second half of retirement: this is the usual worst-case scenario for retirement. It's when the sequence of returns risk impacts your portfolio, causing a loss of portfolio value in the first part of retirement which is never able to recover as assets continue to be spent and the portfolio plummets toward zero. The 4% rule, the worst-case scenario in US history, comes from this type of situation. For a 30 year retirement, the halfway point for a 1966 retiree (worst-case in history) was 1981. Market conditions were quite awful in the first half of their retirement and quite good in the second half their retirement. In this situation, the rising equity glidepath helps. It makes you less vulnerable to sequence of returns risk in the first half for retirement and then helps to support higher withdrawals and greater legacy in the second half for retirement.

-Bad market returns for the entire retirement period: This is truly some terrible bad luck, and retirement outcomes are not going to look good no matter what happens. In this case, a fixed stock allocation would outperform the rising equity glidepath.

And so back to our story, in this article we compare three scenarios. First, we look at the outcomes from using a fixed 50/50 stock/bond allocation throughout retirement. Second, we look at partial annuitization, in which half of assets are used to purchase a SPIA at retirement, and the other half of assets are left in stocks. At retirement, the stock allocation as a percentage of total assets is 50%, but since half of the assets go into the SPIA, the stock allocation for the remaining financial assets is 100%. Since there is no ability to rebalance from SPIAs to stocks over retirement, the allocation to stocks as a percentage of total assets will usually increase over retirement. This figure shows the median allocation to stocks with this strategy as a percentage of total assets for both fixed SPIAs and inflation-adjusted SPIAs:

In the third scenario, we only use stocks and bonds, but in each time period for each simulation we rebalance the portfolio so that the stock allocation in this stock/bond portfolio matches the corresponding stock allocation as a percentage of total assets in the previous scenario when we had annuitized. The reason for doing this is very simple: it allows us to decompose the impact of partial annuitization into two components. We can now see the impact of annuitization that comes from the mortality credits (the idea that the annuity provider can make payments based on one's life expectancy, because those annuitants who die early subsidize payments to those annuitants who live long) as distinct from the impact of annuitization that comes from the implied rising equity glidepath. This is important, because the impact of annuitization that comes from the implied rising equity glidepath can be replicated without annuitizing, since one simply increases their stock allocation in their stock/bond portfolio over the retirement.

Here are the key takeaways for this analysis:

-SPIAs do indeed provide benefits to their owners, such as unparalleled longevity protection. However, it must be clear that one needs to live well past life expectancy before the unique benefits of SPIAs can be enjoyed. Earlier research gives too much credit to SPIAs by mixing in the impact of the rising equity glidepath through comparing it to a strategy with a fixed equity glidepath. This compares apples to oranges.

-Inflation-adjusted SPIAs do look a lot better than fixed SPIAs with this approach. They generally provide lower failure rates, and more of their benefits come from the mortality credits as they imply a less steep rising equity glidepath than with fixed SPIAs.

-Rising equity glidepath really do help to reduce failure rates at many different time horizons. In this regard, it is really a less risky strategy than a fixed stock allocation.

-Many retirees may be uncomfortable with rising equity glidepaths, and so we could say that a benefit of SPIAs is that they imply this rising equity glidepath without the person even realizing what is happening.