Smart guys question 4% SWR strategy

[cjking]

Suppose I'm comfortable with an income that increases as fast as the CPI. In that case, doesn't your strategy reduce to buying an SPIA on the day I retire, and skipping over the "4% SWR" phase?

Yes, if that income is sufficient. I assume most people are investing in risky assets because they need to generate more income than an annuity would yield.

 

[samclem]

Yes, if that income is sufficient. I assume most people are investing in risky assets because they need to generate more income than an annuity would yield.

It's not so much "need" as "want."

My guess is that if the folks on this board found that their nest egg would buy them an annuity that would meet their living expenses, most people still wouldn't use all their money to buy one. The risk/benefit just doesn't support buying them (because the costs are so high) in most cases. Exception: Some people with no or very small pensions choose to buy an annuity big enough to meet their basic monthly expenses. This is typically viewed as insurance--not something that will make money for us, we realize it is a bad investment and we are likely to lose money on average, but the personal utility of that small income stream, if everything else goes to hell, is viewed as worth the cost.

 

[73ss454]

I don't claim to know much about annuities except they have high expenses. So if they have high expenses why would we want one?

Every investment book we read says that no one can beat the market and that's why many of us index to get our fair share of what's happening. So why would we pay an ins. co. 3 to 4% if they can't beat the market any better than any person or investment house. I really don't think any ins.co. is taking a risk by signing us up for annuities so to me there's something wrong with using them.

I'm going to take my chances and stick with my portfolio without any help from an ins. co. at 3 or 4%. If we can only take out 3 to 4% from our portfolios how can we afford to give another 3 to 4% to an ins. co.

I gotta be missing something with annuities but that's OK I'll just roll the dice without them.

 

[Independent]

Yes, if that income is sufficient. I assume most people are investing in risky assets because they need to generate more income than an annuity would yield.

Like samclem said, there's a difference between "need" and "want". It seems to me that if you need more income than the annuity will produce, then you can't afford to retire. If you retire anyway and invest in "risky" assets, and spend more money than the annuity would have provided, then you're taking some chance of not having enough money to meet your needs.

The problem with such an esoteric scheme is that the kind of people who join it are likely to be particularly long-lived, so I might get better value if I join the herd in a more conventional annuity.

If you're talking about a "conventional SPIA", that individuals purchase for themselves, then the buyers are already "particularly long-lived".

 

[ESRBob]

Something has always bugged me about annuities-- maybe someone here can set me straight.

We buy one in order to have a failsafe backup 'insurance' plan where a certain amount of income is guaranteed come h&$# or high water. In other words, if markets really tank and most of our other investments tank with it, we'll at least have this annuity to live off.

But if markets really tank, then why would the insurance company fare any better than the rest of us? And so, why would they be more able to continue meeting their annuity commitments than you and I can support a SWR from the money they have taken from us and invested in the markets? They may fare worse because they've been dipping into it for fees all those years.

It could be something like the bond insurance or credit swap insurance that all these big institutions were buying to make all those mortgage backed securities "AAA". It works fine until you actually need it. I know there are regulations, and state regulators and fail-safes and yada yada, but they are invested in the same markets as everyone else, so what can they do but come back to you and say 'oops'?

Anybody knowledgeable on what safeguards might actually ensure annuity-holders long run income?

 

[cute fuzzy bunny]

About all you can reliably say is that aside from the insurers who have gone bankrupt over the years, they generally kept paying...even during the great depression.

They do have some mighty deep pockets. Just look at the fancy buildings full of fancy furniture, paid for by people who primarily died on time and left the insurance company a nice inheritance.

I guess my question is that if you've lived your life to the point where the best option to leave YOUR inheritance to is an insurance company, maybe between now and your scheduled demise you oughta find something or somebody you care about a little bit more.

Even if its only yourself.

 

[ERD50]

Something has always bugged me about annuities-- maybe someone here can set me straight.
...

But if markets really tank, then why would the insurance company fare any better than the rest of us? And so, why would they be more able to continue meeting their annuity commitments than you and I can support a SWR from the money they have taken from us and invested in the markets? They may fare worse because they've been dipping into it for fees all those years.

....

Anybody knowledgeable on what safeguards might actually ensure annuity-holders long run income?

Your observations seem correct. But they are not accounting for one factor:

My personal SWR has to meet my personal life expectancy. There is a 50% chance for that to be greater than the median life expectancy for people my age.

The life insurance company only needs to be funded for the median life expectancy.

I'm not saying that makes annuities a good deal (I have not purchased any), one needs to run the numbers for themselves. But it could explain how they could 'work'.

So, if I know that I will only reach the median age, I'm sure that the annuity will be a bad deal because of the costs. But if I'm trying to protect myself in case I live out on the edge of the bell curve, an annuity could help with that.

No different than fire insurance on your house. You don't expect to get your money back, but you pay in case you need it.

But I won't seriously run the numbers until I'm older - I don't want to take the additional years of risk of the credit-worthiness of the provider.

-ERD50

 

[FinanceDude]

Something has always bugged me about annuities-- maybe someone here can set me straight.

We buy one in order to have a failsafe backup 'insurance' plan where a certain amount of income is guaranteed come h&$# or high water. In other words, if markets really tank and most of our other investments tank with it, we'll at least have this annuity to live off.

In theory, that is the premise...........

But if markets really tank, then why would the insurance company fare any better than the rest of us? And so, why would they be more able to continue meeting their annuity commitments than you and I can support a SWR from the money they have taken from us and invested in the markets? They may fare worse because they've been dipping into it for fees all those years.

Well, there's been crappy markets plenty of times, yet folks die every year, and companies like Hancock and Hartford and other somehow find the money to pay the death claims, whether their investment experience was good or not. AllState and American Family took a BIG HIT with all the hurricanes in Florida a couple years, back, but they paid the claims, right?

It could be something like the bond insurance or credit swap insurance that all these big institutions were buying to make all those mortgage backed securities "AAA". It works fine until you actually need it. I know there are regulations, and state regulators and fail-safes and yada yada, but they are invested in the same markets as everyone else, so what can they do but come back to you and say 'oops'?

Anybody knowledgeable on what safeguards might actually ensure annuity-holders long run income?

Well there's not much, except the long history of the insurer and their record of paying their claims. They need to keep reasonable loss reserves in cas they have an unusual year (actuarily). The NAIC regulates them. Other insurers step in much like other banks do if theings go haywire. However, there's no "Fed" guaranteeing things.

Brewer would day a lot of insurers are accidents waiting to happen, and he's probably right. However, one of the reasons a VA with income stream guarantees is so expensive is the cost of the "promise".

You guys and gals out there with pensions, private or otherwise, you do realize there is a HIGH cost of giving you guaranteed income for life, right? Your employer, whether private, public, or governmental has to PAY to make those promises come true, right? Same theory in essence here, someone has to pay, and in the case of the VA, that someone is you............

Vanguard and Fido can price them cheaper than the others because they're not compensating an agent to sell them. However, I doubt I'll ever see Vanguard sell a living benefit VA, because they would have to charge 75-100bp for the "promise", even if noone is compensated by the sale.............

 

[retire@40]

Something has always bugged me about annuities-- maybe someone here can set me straight...But if markets really tank, then why would the insurance company fare any better than the rest of us? And so, why would they be more able to continue meeting their annuity commitments than you and I can support a SWR from the money they have taken from us and invested in the markets? They may fare worse because they've been dipping into it for fees all those years...Anybody knowledgeable on what safeguards might actually ensure annuity-holders long run income?

When people go into a casino and place bets, what makes them so sure they will get paid? What if everyone wins at the same time? Can it happen? They know it probably will not.

Essentially you are making a similar bet with the insurance companies. You are betting you will get at least the same in cash outflow than what you put in. They are betting you will not. They are usually right.

 

[FinanceDude]

Essentially you are making a similar bet with the insurance companies. You are betting you will get at least the same in cash outflow than what you put in. They are betting you will not. They are usually right.

What you are stating is the premise that traditional life insurance, fixed annuities, and SPIAs are based on.

VAs are based on the same premise in theory, but if the market performs well, you could get more money out of it than the insurer would "like"...........

 

[retire@40]

What you are stating is the premise that traditional life insurance, fixed annuities, and SPIAs are based on.

VAs are based on the same premise in theory, but if the market performs well, you could get more money out of it than the insurer would "like"...........

Sure that happens on occasion, but there are enough losing bets to cover a big win once in a while.

 

[Independent]

Something has always bugged me about annuities-- maybe someone here can set me straight.

We buy one in order to have a failsafe backup 'insurance' plan where a certain amount of income is guaranteed come h&$# or high water. In other words, if markets really tank and most of our other investments tank with it, we'll at least have this annuity to live off.

But if markets really tank, then why would the insurance company fare any better than the rest of us? And so, why would they be more able to continue meeting their annuity commitments than you and I can support a SWR from the money they have taken from us and invested in the markets? They may fare worse because they've been dipping into it for fees all those years.

It could be something like the bond insurance or credit swap insurance that all these big institutions were buying to make all those mortgage backed securities "AAA". It works fine until you actually need it. I know there are regulations, and state regulators and fail-safes and yada yada, but they are invested in the same markets as everyone else, so what can they do but come back to you and say 'oops'?

Anybody knowledgeable on what safeguards might actually ensure annuity-holders long run income?

Wow, four responses already. I'll try to add something....

I think you need to distinguish between two risks. (A) that your investments will do horribly, and (B) that you will live a lot longer than the "average" person.

It's easy for me to see why an insurance company can send you money if (B) happens. They can pool this type of risk. The longer-lived people get to spend the money that the shorter-lived people lost. The way I look at it, this is the only "pro" when you're evaluating annuities vs. traditional investments.

But your question seems to be entirely about (A). Yes, insurers are subject to the same market whims that you are.

In the case of variable annuities they simply pass the risk through to you. So this is like asking whether mutual funds can protect you from the market - they can't and they don't claim they can.

In the case of fixed annuities, they are putting a layer of their capital between you and the worst effects of the (bond) market. This is like having an uninsured savings account with a bank. The bank's capital should protect you against "normal" swings in the market, but even the bank can be swamped if things get too bad. The value of the insurer's guarantee is always debatable. It involves all the elements of normal credit analysis, plus something for the risk of underpricing (B).

 

[OAG]

Aren't issuers of Annuity Contracts required to have "reserves" and don't they engage in "reinsurance contracts" to cover and spread the risk? I do not have any annuities except the two the Government gave me but may consider one in the near futures (SPIA only).

 

[cute fuzzy bunny]

Isnt it really a lot simpler than all the hand waving?

You've got two risks. The one where you might live longer than average, and the one where your investments might end before you do.

If you have good asset allocation and the planning tools using backward looking data say you'd have survived anything, then you're looking at the odds of a worse-than-the-great-depression event vs the odds of your living 10-15+ years beyond expectations.

I know the odds of the average person outliving their lifespan. Slim and gets slimmer.

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.

Irrevocably committing a large portion of your principal in order to receive a fee reduced payment forever seems a bit excessive.

Of course, there are other ways to solve this problem by simply reducing your spending risk rather than trying to mitigate your investing and longevity risk.

Pay off your house, pay off your cars, keep your risky money in an account you wont touch for some time, keep a flexible budget that lets you skinny it down to almost nothing in hard times, and if you get to 85 or 90 and the money pot starts emptying out, sell that house or reverse mortgage it for a nice income stream for the rest of your life.

Nice part about that plan is you keep control of your assets, you can drop all of it into target retirement/lifestrategy/managed payout funds to eliminate the horrors of managing investments in your 80's and 90's, and when you're gone theres something for your heirs, friends, charities or maybe just someone you want to give a nice little surprise to!

 

[Jarhead*]

Isnt it really a lot simpler than all the hand waving?

Nice part about that plan is you keep control of your assets, you can drop all of it into target retirement/lifestrategy/managed payout funds to eliminate the horrors of managing investments in your 80's and 90's, and when you're gone theres something for your heirs, friends, charities or maybe just someone you want to give a nice little surprise to!

CFB: Agree. (I don't belong to the "Cutthroat" idea, that it's mine, all mine!)

In fact, you're under consideration for a surprise.

But only if you admit that you can make 90% of your shots from the half-court line is from an over-active imagination.

 

[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

 

[cute fuzzy bunny]

By the way, heres my court.

Gabe's been doing some dunking.

 

[brewer12345]

Something has always bugged me about annuities-- maybe someone here can set me straight.

We buy one in order to have a failsafe backup 'insurance' plan where a certain amount of income is guaranteed come h&$# or high water. In other words, if markets really tank and most of our other investments tank with it, we'll at least have this annuity to live off.

But if markets really tank, then why would the insurance company fare any better than the rest of us? And so, why would they be more able to continue meeting their annuity commitments than you and I can support a SWR from the money they have taken from us and invested in the markets? They may fare worse because they've been dipping into it for fees all those years.

It could be something like the bond insurance or credit swap insurance that all these big institutions were buying to make all those mortgage backed securities "AAA". It works fine until you actually need it. I know there are regulations, and state regulators and fail-safes and yada yada, but they are invested in the same markets as everyone else, so what can they do but come back to you and say 'oops'?

Anybody knowledgeable on what safeguards might actually ensure annuity-holders long run income?

There are a number of safeguards that exist for the protection of insureds. First, insurers in the US have t o submit to quite extensive regulation. This ranges from what they are allowed to invest in, to how much extra capital they are required to have, to the type, form, pricing and features of the products they are allowed to sell. Regulation varies considerably by state in terms of how aggressive the regulator is, as each state has its own insurance regulators and insurers are primarily regulated by the state in which they are domiciled. But the general rules of the game are pretty similar from state to state.

Second, insurers of any size are under the thumb of the rating agencies. Whatever failings the agencies have on their MBS ratings, the fundamental analysts at all the agencies are generally pretty sharp and are given wide ranging access to management and non-public information. They cannot see everything and can be lied to successfully, but the agencies serve as a second set of watchdogs. The insurers generally toe the line marked by the agencies because this is one of the few industries in which companies can (and have) been put out of business simply by being downgraded.

Third, the rules by which insurers play require them to invest relatively conservatively (90+% investment grade fixed income of some sort), do tight duration matching, use derivatives sparingly/conservatively, and maintain a pile of their own capital on top of the assets that back the promises they make. In addition to all the rules, the better run insurers all have management teams that understand that there is no Fed to bail them out like the banks have, so they had better be careful.

Fourth, if we are talking about some kind of variable product (VA, VUL, etc.), the assets that underlie the product are held in what is known as the "separate account." This is a separate, segregated pool of assets that the insurer and its creditors do not have a legal claim on (similar to a mutual fund). While the separate account is shown as part of the insurer's balance sheet, it is really a segregated trust that has little to do with the "general account" (what you wold really think of as their balance sheet, with equity, debt, etc. on it).

Fifth, (and this is the weakest protection) every state has a state guaranty fund that is supposed to cover any policyholder claims that cannot be met by the assets of a failed insurer. The guaranty funds are funded via assessments on the other insurers operating in that state. I do not put much stock in these.

So there are a lot of things that mitigate credit exposure for policyholders. Having said that, the industry has its (relative) idiots and (relative) cowboys , so if anyone buys an insurance product it is wise to buy from the bigger, higher rated companies that have been around for a long time, and pick a mutual if you can. I would be hesitant to take significant exposure to an insurer rated lower than Aa3/AA-/A+ (Moody's, S&P, AM Best, respectively), as there is often a big difference between AA and A rated companies.

If anyone is thinking about buying something from an insurer and isn't sure about their credit, ask me via PM and I will attempt to express an opinion (which will be worth what you paid for it).

 

[Notmuchlonger]

By the way, heres my court.

Gabe's been doing some dunking.

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

 

[ERD50]

Isnt it really a lot simpler than all the hand waving?

.... the odds of your living 10-15+ years beyond expectations.

I know the odds of the average person outliving their lifespan. Slim and gets slimmer.

No need to hand-wave. We have actuary tables:

https://personal.vanguard.com/us/planningeducation/retirement/PEdRetPicLongRetireContent.jsp

The average life expectancy of a 55 YO Male is 27 years, to AGE 82.

One out of eight (12%) will live 10 years beyond that, to age 92. Only 3% will live 15 years beyond that, to age 97.

Insuring against slim chances "just in case" as protection against extraordinarily unlikely events is great as long as the cost isnt excessive.

I don't put a 1 in 8 chance in the 'extraordinary' category. But one certainly needs to look at the costs.

I have not played with any annuity quotes yet, but are some of us missing something? If you have a spouse, you will want a 'last to die' type
coverage, right? W/o an annuity, whatever portfolio that is left would be available for a spouse. But with an annuity, that money would be gone at the death of the covered one.

So, if you look at a quote and you have a spouse, you want to the 'last to die' type coverage, and the pay-out will be less (unless your spouse is a much older than you, and a 3-pack a day, sky jumping, active bomb-squad member).

-ERD50

 

[cute fuzzy bunny]

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

I aint that brittle.

 

[Texas Proud]

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]

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.