Smart guys question 4% SWR strategy

[cute fuzzy bunny]

Originally Posted by Notmuchlonger

Make sure Gabe doesn't do a crossover on you and bust up your ankles.

I aint that brittle.

[Texas Proud]

Originally Posted by cute fuzzy bunny

What are the odds of a financially cataclysmic event that permanently derails your financial plan at a time when you cant return to the workforce?

Yeah, I know. You're sitting there saying "But its NOT about averages, its about ME! What if I'M the guy who lives way too long!"

What if a rock fell out of the sky and hit you in the head. Sometimes theres bad luck. Insuring against slim chances "just in case" as protection against extraordinarily unlikely events is great as long as the cost isnt excessive.

As one of my old bosses said.... the chance of you being drafted and sent to Viet Nam was small.... but if you there being shot at... it was 100%...


You are correct that most people don't think about some of the higher probability problems... and overstate others....

If you plan correctly and are in the 90% to 95% 'success' rate... then I am sure you will be one who can make a mid course correction if something bad happens to the markets... and the chance of a 50% drop in a good balanced fund is just to small to even worry about...

Again... we could be like Japan or Brazil or even the Romans.... but I am betting not...

[cute fuzzy bunny]

I think that as an 18 year old in the vietnam era, your chances of being drafted and shot at in vietnam were far better than living past 90.

Just guessing but it might be fun to dig up the figures and do the math

[AdventuresAddict]

Hi, regarding the points that if the stock market is not doing well, how can insurance companies still stay afloat and continue to pay the annuity pay-outs, and why annuity pay-outs can be more than the 4% SWR even when insurers incur expenses and pay commissions:

I think most haven't considered the following two major factors:
1) That when calculating pay-out rates, insurers take into consideration the mortality risks that's working to their advantage.
2) That insurance companies are re-insured so their risks are diversified and absorbed by many strong backers.

The life fund in an annuity portfolio can afford to pay higher pay-outs to older annuitants than the 4% SWR because some annuitants do die prematurely, and their contribution to the life fund can then be retained ---partly or fully depending on the types of annuity bought--- to pay the other annuitants in the portfolio. So, an annuity is paying a rate that the insurer calculates that it can pay until an annuitant dies.

The SWR, on the other hand, is intended as a rate that can be theoretically withdrawn perpetually (but using a back test to calculate the sustainability of up to 30 or 40 years) from a balanced fund and yet does not deplete it.

So this explains why an annuity pay-out---especially for an older person whom the insurer calculates from its experience will live for less years to collect the promised monthly pay-outs---can be higher than the SWR of a balanced fund that is managed by oneself using ETF or pure stocks and bonds without incurring any agent commission, annual fund management fees, etc.

Now what about during financial crises when the stock market crashes and bond issuers default? Don't the insurers also invest in stocks and bonds? What makes them able to continue with the pay-outs even when the balanced fund we invest in to derive the SWR crash? That's the wonderful part about insurance, and why we buy insurance in the first place: insurance itself, for the insurance companies, which is called 'reinsurance'. The insurance companies themselves are insured by others. For the more highly rated insurers, they are properly re-insured so that in the event of a bankruptcy their reinsurers will step in to honor the pay-outs.

And, you may ask, why would these reinsurers want to reinsure? Then, again, it's the same reason why insurers want to insure us individual lives. They make a profit by insuring. When claims are not made from them, they collect the premium and make a profit. And, for this, they also agree to pay the claims when their insured insurance companies make a claim. It's the same when you pay the premium and don't make a claim from your insurance company: they make a profit. And, when you really need the money, because you were hospitalized, for example, you make a claim.

As such, an annuity from a reputable insurance company is certainly less risky than a portfolio of balanced funds consisting of stocks and bonds. In such a portfolio, the only theoretically risk-free investment portion should be the government bonds part. But since you can only hope to derive a 4% SWR by investing a large part in equities, the value of this portion is as good as the financial strength of the underlying assets held by the listed companies. If the value of these stocks drops to 50%, and you can't derive the same SWR (eg $40,000 per year based on a $1m balanced fund), there won't be any reinsurer to step in to top up the depreciated amount or to honor the $40,0000/y withdrawal. You assume all the risks yourself as an investor.

So are insurance companies and their annuity fool-proof? Well, they have an additional layer of shield as explained, unlike individually invested balanced funds to generate the SWR, but they are not 100% fool-proof. They may still not be able to honor the pay-outs if the reinsurers themselves also are unable to honor the reinsurance. That may happen if a financial crisis is prolonged.

[Independent]

Originally Posted by AdventuresAddict

Hi, regarding the points that if the stock market is not doing well, how can insurance companies still stay afloat and continue to pay the annuity pay-outs, and why annuity pay-outs can be more than the 4% SWR even when insurers incur expenses and pay commissions:

I think most haven't considered the following two major factors:
1) That when calculating pay-out rates, insurers take into consideration the mortality risks that's working to their advantage.
2) That insurance companies are re-insured so their risks are diversified and absorbed by many strong backers.
......

I can agree with your point 1 but not point 2.

Reinsurance generally relates to the insurance risks themselves (e.g. building damage due to hurricanes) not to the asset risks. An insurance company could buy credit insurance just like anyone else, but that's not "reinsurance" in their lingo. And, they aren't likely to use a lot of credit insurance because part of their business model involves capturing the spread on less-than-Treasury credit.

[brewer12345]

Originally Posted by Independent

I can agree with your point 1 but not point 2.

Reinsurance generally relates to the insurance risks themselves (e.g. building damage due to hurricanes) not to the asset risks. An insurance company could buy credit insurance just like anyone else, but that's not "reinsurance" in their lingo. And, they aren't likely to use a lot of credit insurance because part of their business model involves capturing the spread on less-than-Treasury credit.

Correct. Insurers do reinsure mortality risk on life insurance, but I am not aware of significant annuity block reinsurance. Those who reinsured VA secondary guarantees generally had cause to regret doing so, as did their reinsurers.

[cute fuzzy bunny]

Also, anyone under 60 who can get a 4%+ inflation adjusted SPIA with survivorship should email me the company name.

Since the SWR incorporates inflation adjustment and more often than not leaves an intact portfolio for a survivor to continue subsisting on, other comparisons arent apples to apples.

[AdventuresAddict]

Originally Posted by Independent

I can agree with your point 1 but not point 2.

Reinsurance generally relates to the insurance risks themselves (e.g. building damage due to hurricanes) not to the asset risks. An insurance company could buy credit insurance just like anyone else, but that's not "reinsurance" in their lingo. And, they aren't likely to use a lot of credit insurance because part of their business model involves capturing the spread on less-than-Treasury credit.

You might want to read up:

Transamerica Reinsurance - Annuity Reinsurance
Annuity Reinsurance


Annuity reinsurance helps companies who sell annuities to manage their risks and grow their business. With more than $25 billion of annuity account value in force and a dedicated team who on an average have more than 20 years experience in the industry, we are well positioned to provide flexible customized solutions to the industry. Our philosophy is to develop long-term relationships that result in partnerships where we are the solutions provider of choice.

A partial list of the types of solutions and services that we provide to our customers for fixed, variable and immediate annuities includes:

• Risk analysis of inforce and new business
• Capital and surplus management
• Earnings and earnings volatility management
• Deferred acquisition cost financing
• Market and interest rate risk management
• Actuarial and policyholder behavior risk management

Life/Annuity Reinsurance

Life/Annuity Reinsurance

While many companies today have accumulated books of business requiring large amounts of regulatory capital, very tight rules restrict their investment of this capital. The ACE Tempest Re Group enables life companies to leverage capital to enhance financial returns by providing customized reinsurance.

Through a variety of innovative reinsurance structures, we can help companies solve problems pertaining to earnings, capitalizations and aggregate enterprise risk. By combining an in-depth understanding of the underlying business with expertise in corporate finance, we structures highly customized solutions designed to solve complex problems.

[brewer12345]

Originally Posted by AdventuresAddict

You might want to read up:

Uhuh. But typically I see two forms of annuity reinsurance deals. One is where the reinsurer is effectively buying the block from the ceding company (and the ceding company is often in trouble or dead). The other is the type of deal described by the ACE Tempest quote: its either an accounting shenanigan or a way to lever up within the confines of insurance regulation, neither of which does much for the ultimate policyholder's security.

[Independent]

Originally Posted by AdventuresAddict

For the more highly rated insurers, they are properly re-insured so that in the event of a bankruptcy their reinsurers will step in to honor the pay-outs.

As such, an annuity from a reputable insurance company is certainly less risky than a portfolio of balanced funds consisting of stocks and bonds. In such a portfolio,

So are insurance companies and their annuity fool-proof? Well, they have an additional layer of shield as explained, unlike individually invested balanced funds .

For all I know, you're actually doing these deals today, and you know about some stuff that I would consider pretty "exotic". If you do, maybe you can share something about the structures.

The first statement I copied sounds like a credit guarantee. If the direct writer goes under, the reinsurer pays the policyowners directly. Is that what you intended? If so, how many of these have you seen? My thought is that reinsurance is always between the companies. The fact that the direct writer goes under does not trigger any additional payments from the reinsurer. Anything that's due because of the normal operations of the business is an asset of the direct company, and it goes through the normal work-out process.

The other two statements sound like an insurance company is somehow safer than some other company that's issuing a bond. I've always figured that a AA rating on claims-paying ability for an insurer is the equivalent of a AA rating on a bond. Very high quality, but not the best. The rating agency has already factored reinsurance arrangements into the rating, so reinsurance is not an add-on that makes the insurer AA plus something extra.

To me, a diversified portfolio of bonds, all AA rated, is "safer" than a single annuity from a single AA rated insurer. A truly risk-averse person buying an SPIA would want to spread the premium across a number of companies to gain some diversification, (but I've never looked to see how many companies are available with high ratings and good rates.)

[Jarhead*]

Originally Posted by cute fuzzy bunny

Uh oh. Is my surprise a Van's gift basket?

C-T is just pissed that his daughter moved in with a Republican.

I think I can do better than 90%.

I'm sure I'm better than Shaq at free throws. And I'm sure I'd do better as a movie actor.

Definitely couldnt guard him though

You're a good dad Fuzzy, so if you enjoy telling tall tails from time to time,

that's hunky-dory with me.

[AdventuresAddict]

Let me explain how reinsurance works using an illustration. A common form of reinsurance is the 'Proportional Reinsurance' arrangement. Suppose an insurer insures $1m, and chooses a PR of 50%, then $500K of the risk is transferred to an reinsurer. There are also various other arrangements, such as excess of loss. This limits the risk exposed by an insurer.

Now, what's the difference between two AA rated companies, one being an insurer and the other being an ordinary company? Theoretically they should be equally strong, but there is a fundamental difference here. It has to do with the level of regulation each has to satisfy. In other words, an AA-rated Construction Company is AA-rated during the last rating, but we have less assurance of what its financial strength can be after that, since there is little rules governing how its CFO can manage the fund. The company can enter into many debts and take foreign risks by entering into some contracts to develop some construction project, for example. A crazy trader may enter into futures trading and lose more money than the company has. All these may be done anytime, even though the company had never done these before. On the other hand, an insurer, by law, has to satisfy the regulatory authorities in terms of how its assets (eg life funds) are be allocated. It applies to insurance industry, but not most other industries.

You can argue that even with these laws governing the financial institutions, they may still not follow the law (eg Bank of England). But my argument is that, at least there is this law for insurers to follow, whereas there is none for most other industries (eg spa, hotels, construction, manufacturing, music.......). As such, the rating is only relevant as a historical reference. For insurance companies, it's the same: historical reference. But at least there is also the laws regulating this industry that is another layer of assurance.

Lastly, I don't recommend putting all your money with one insurer. As I suggested in the 'Insurerd or Uninsured Retirement Income' thread, I recommend allocating a portion of your nest egg to insurerd income streams from a portfolio of annuities to cover your survival needs +20% (eg providing annuity pay-outs of $2.4k/m), and the rest in a balanced fund to provide discretionary income (eg another $1 to 2k/m). Of the annuity portfolio, risks should be spread across a few insurers (eg 6, each providing around $400/m) across a few countries (eg 2 in US, 1 in UK, 2 in Switzerland, 1 in Singapore, etc) denominated in a few hard currencies (eg USD, GBP, CHF, SGD, Euro). In this way, you have a diversified basket of currencies to preserve the buying power of your annuity income. For example, over the past few decades, if you had bought a Swiss franc or Sing Dollar annuity, the buying power of your pay-outs would have been better preserved than if yours was a USD annuity, today. The USD had depreciated against SGD and CHF over these years due to the deficits of US, whereas these smaller, well-governed financial centers with sound fiscal policies have accumulated much surpluses and foreign reserves. If they continue to be run well (and it seems quite likely they will), their currencies should appreciate against the USD in the next few decades also, according to monetary economics theories. Of course, Euro and pounds had been strengthening also.

Then, regarding the uninsured income portion, you can use a balanced fund to invest it for better liquidity and for estate planning. You should observe the SWR rules in order to not overuse it and find it shrinking years later.

[samclem]

Multiple insurers, payouts spread across multiple insurers . . .this isn't going to be cheap. The argument about the importance/value of government oversight is not holding much sway with me now, maybe it will seem more convincing when we've forgotten about the value of fed oversight in the lead-up to the current mortgage crisis, the S&L fiasco, or the "quick-let's-do-it before-Monday" Fed collusion to help a single buyer acquire Bear Stearns--with funds guaranteed by me.

Re-insurers: Another level in the stack of cards. In a big market downturn affecting many primary insurers in the same way, will their guarantees hold?

Still, I guess these guaranteed income streams make sense for the right person. Somebody with tons of money who is very risk averse. Would it not be cheaper to just buy an island, establish an independent currency, and set up self-sustaining businesses to provide all the essentials?

[cute fuzzy bunny]

And then insure the living crap out of it!

[Independent]

In this post:

Originally Posted by AdventuresAddict

Now what about during financial crises when the stock market crashes and bond issuers default? Don't the insurers also invest in stocks and bonds? What makes them able to continue with the pay-outs even when the balanced fund we invest in to derive the SWR crash? That's the wonderful part about insurance, and why we buy insurance in the first place: insurance itself, for the insurance companies, which is called 'reinsurance'. The insurance companies themselves are insured by others. For the more highly rated insurers, they are properly re-insured so that in the event of a bankruptcy their reinsurers will step in to honor the pay-outs.

And, you may ask, why would these reinsurers want to reinsure? Then, again, it's the same reason why insurers want to insure us individual lives. They make a profit by insuring. When claims are not made from them, they collect the premium and make a profit. And, for this, they also agree to pay the claims when their insured insurance companies make a claim. It's the same when you pay the premium and don't make a claim from your insurance company: they make a profit. And, when you really need the money, because you were hospitalized, for example, you make a claim.

As such, an annuity from a reputable insurance company is certainly less risky than a portfolio of balanced funds consisting of stocks and bonds. In such a portfolio, the only theoretically risk-free investment portion should be the government bonds part. But since you can only hope to derive a 4% SWR by investing a large part in equities, the value of this portion is as good as the financial strength of the underlying assets held by the listed companies. If the value of these stocks drops to 50%, and you can't derive the same SWR (eg $40,000 per year based on a $1m balanced fund), there won't be any reinsurer to step in to top up the depreciated amount or to honor the $40,0000/y withdrawal. You assume all the risks yourself as an investor.

So are insurance companies and their annuity fool-proof? Well, they have an additional layer of shield as explained, unlike individually invested balanced funds to generate the SWR, but they are not 100% fool-proof. They may still not be able to honor the pay-outs if the reinsurers themselves also are unable to honor the reinsurance. That may happen if a financial crisis is prolonged.

you are claiming that reinsurance gives insurance companies some special ability to meet their obligations even in the face of "financial crisis" and "bond defaults" that regular bond issuers don't have.

I disagreed. Other than posting a sales piece from TransRe, you haven't responded to my point that reinsurance is just one more asset that rating companies consider when they rate insurance companies.

I see that in your last post you shifted from "reinsurance makes insurance companies special" to "statutory regulation makes insurance companies special". I'm taking that as an indication that you realized that reinsurance doesn't provide insurers any unique ability to weather general economic downturns.

I'm glad to see that you recommend diversifying the annuities across multiple companies. I'm disappointed that you didn't mention the possiblity of using US CPI-linked annuities for people who plan live in the US.

(I think brewer did a good job in post #118 of talking about insurance company safety, including statutory regulation. I won't try to add anything to that.)

[brewer12345]

Originally Posted by AdventuresAddict

Let me explain how reinsurance works using an illustration. A common form of reinsurance is the 'Proportional Reinsurance' arrangement. Suppose an insurer insures $1m, and chooses a PR of 50%, then $500K of the risk is transferred to an reinsurer. There are also various other arrangements, such as excess of loss. This limits the risk exposed by an insurer.

<schnip>

Don't pee on my head and tell me it is raining.

Generally speaking, the insured only has recourse to the insurer, not to the reinsurer. So if the insurer goes tits up, the reinsuurance arrangement is likely to be cold comfort to the policyholder. As a matter of fact, if the insurer is in trouble, the reinsurer is likely to take whatever actions they can to protect themselves, which may not be ultimately beneficial to the policyholder.

And as for regulation, riddle me this: where are most of the big reinsurers domiciled? Beruda, Ireland, etc. All places with extremely light regulation. Not exactly something that would bring a lot of comfort to the policyholder, I imagine.

I have seen plenty of well reinsured companies get themselves in to very deep doodoo. So lets just drop the suggestion that reinsurance is some sort of boon to the policyholder.

[AdventuresAddict]

Originally Posted by Independent

In this post:



you are claiming that reinsurance gives insurance companies some special ability to meet their obligations even in the face of "financial crisis" and "bond defaults" that regular bond issuers don't have.

I disagreed. Other than posting a sales piece from TransRe, you haven't responded to my point that reinsurance is just one more asset that rating companies consider when they rate insurance companies.

I see that you are still obsessed with rating. As I said, it's a historical reference, and neither is rating as reliable as we hoped it is. As the subprime crisis reveals, some CDOs rated highly sank.

In retirement planning, which is what we are discussing about, the certainty of one getting his retirement income for as long as he lives is the primary concern here. And, by commenting that having some annuities to insure one's ability to have a survival income level throughout retirement, instead of putting everything into a balanced portfolio of bonds and stocks, I am making a comparison. To be specific, it's a comparison of:

(A) Solely bonds and stocks vs (B) Annuities plus bonds and stocks.

Do note that I am not even comparing the yield or estate for your children. I am talking about:
1) Retirement income;
2) that is sustainable for as long as one lives through his retirement
3) for survival
4) which is more (relatively) certain

And in this relative comparison, it's apparent that if part of (B) :
1) must meet more financial regulations imposed by insurance regulators in terms of how the assets are to be invested; and
2) has an additional layer of risk protection by insurance

whereas (A) (the stocks and bonds of the companies in the majority of industries that do not have the above 2 restrictions) has none of the above (2) protection,

it is relatively more certain to be able to meet the above 4 criteria of retirement income planning.

Please note that I had never suggested things like:
Insurance companies can never fail to honor their obligations (even though they are regulated and reinsured, and even though they are located in relatively safe financial centers like Switzerland and Singapore).

I hope I'd explained myself clearly.

I see that in your last post you shifted from "reinsurance makes insurance companies special" to "statutory regulation makes insurance companies special". I'm taking that as an indication that you realized that reinsurance doesn't provide insurers any unique ability to weather general economic downturns.

Again, it's a relative comparison. I had acknowledged that government bonds are theoretically risk-free (including the CPI-linked ones which I shall touch on later). But the risk-free return is relatively low, so for a balanced fund used to generate the 4% SWR, only a limited amount can be allocated to this risk-free base, so that a higher return may be expected. So this would mean including bonds from corporates (eg BB or higher rated companies), plus stocks of a variety of companies including Big-cap, small-cap, US, emerging markets, commodities, etc (eg as suggested by authors of books on early retirement, which form a balanced portfolio).

Now, having explained the frame of reference we are using, it's quite easy to explain my point about relative certainty of sustainable survival income (CSSI):

If you were to compare (A) balanced portfolio mentioned above without the 2 layers of assurance for insurers and (B) a portfolio of annuities with the 2 layers of assurance, it's clear that (B) meets the criteria of CSSI better.

Now, but I had not stopped at this point. I am suggesting only to invest what you need to survive---what you cannot risk losing because you'd die without it---on this Insured Income Stream, simply because even smart guys question the 4% SWR. So, can we take chances for this amount of money? Not too much. So, Insured Income stream consisting of a portfolio of annuities diversified across different major currencies, financial centers and strong insurance companies is a better option than the pure (and questionable) SWR portfolio for the above explained reasons using comparisons. But it's still not risk-free, because only government bonds such as the CPI linked can be theoretically risk-free. And, I am going to move on to your next point to explain why, despite the fact that such an annuities portfolio is not 100% risk-free, I'd still choose it rather than CP linked bonds. This is my personal opinion.

I'm glad to see that you recommend diversifying the annuities across multiple companies. I'm disappointed that you didn't mention the possiblity of using US CPI-linked annuities for people who plan live in the US.

(I think brewer did a good job in post #118 of talking about insurance company safety, including statutory regulation. I won't try to add anything to that.)

Yes, CPI linked bonds would be good to counter inflation. But the problems, in my opinion, have to do with:
1) The USD denomination (I am not aware if Swiss, British, Singaporean, Norwegian, Canadian, Australian, etc governments also issue inflation-linked bonds. I am aware of US government-issued ones though. Maybe those who know could tell us also.)
2) less returns especially for older people who can get much more payouts from annuities.

So, if we were to compare using (a) only CPI-linked bonds vs (b) annuities portfolio, then (a) has only 1 major advantage, and that is it being risk-free. But (b) has 2 advantages: (1) opportunities to diversify across currencies ; (2) higher payouts. The advantages of (a) over (b), in my opinion, can be compensated by these 2 factors and the fact that by using the diversification method as described, the risk of all the 6 insurers being made bankrupt in our lifetime is minimal. I'd need much more money if I wanted to use the risk-free CPI bonds to provide the CSSI , and in my case I intend to live outside US, and I do expect the USD to depreciate in the long term due to its deficits, so a USD-denominated CPI linked bond may not be ideal in my case.

[AdventuresAddict]

Originally Posted by brewer12345

Don't pee on my head and tell me it is raining.

Generally speaking, the insured only has recourse to the insurer, not to the reinsurer. So if the insurer goes tits up, the reinsuurance arrangement is likely to be cold comfort to the policyholder. As a matter of fact, if the insurer is in trouble, the reinsurer is likely to take whatever actions they can to protect themselves, which may not be ultimately beneficial to the policyholder.

And as for regulation, riddle me this: where are most of the big reinsurers domiciled? Beruda, Ireland, etc. All places with extremely light regulation. Not exactly something that would bring a lot of comfort to the policyholder, I imagine.

I have seen plenty of well reinsured companies get themselves in to very deep doodoo. So lets just drop the suggestion that reinsurance is some sort of boon to the policyholder.

As I had explained, it's a comparison. In the case of financial difficulties, the insurers may still claim from the reinsurers, whereas most other private companies do not have this additional layer of protection.