Smart guys question 4% SWR strategy

[brewer12345]

In previous posts you have listed the (few) companies you consider to be long term safe. I recall that AIG was specifically NOT on your list, but has your list changed?

Correct, they were specifically not on my list. They are, in fact, one of the last insurers I would choose to do business with.

List hasn't changed. You ideally want to buy life and annuity products from a large, highly rated company that has a long track record. I also have a strong preference for mutual companies, as they do not have the sometimes perverse incentives that investor-owned companies have.

So IMO top shelf would be Northwestern Mutual, MassMutual, New York Life, Guardian, USAA and TIAA-CREF. A solid second tier would include companies like Pacific Life, Penn Mutual, Met Life, and some others.

 

[ESRBob]

Wasn't AIG the firm the Vanguard used for their inflation-adjusted annuities?
Yeah, just checked -- it is AIG. This I guess is exactly what I've been concerned about -- I am sure Vanguard checked out the field 5 years ago or whenever they started these things and picked from the strongest firms they could find. Then some 'stuff' starts happening in a firm and the next thing you know you've got potential issues. When you're making a 50-year bet on a company's solvency, the importance of even small deterioration can become magnified.

 

[REWahoo]

Yep. From the Vanguard website: "The Vanguard Lifetime Income Program annuity is a single-premium immediate annuity issued by AIG Life Insurance Company"

Another educational opportunity for those seeking a 'no-risk, guaranteed lifetime income'.

 

[Nords]

7% sounds roughly right to me. I consider putting 1/2 my money into a 6% SWR with COLA and jump at 8%. I'd stick to 50% because even though I don't have kids I do look forward to giving away a lot when I am 80 or so.

Regardless of the rating of the insurer, I'd need to fully understand their business model before springing for an annuity, and the higher the promised payout percentage, the more skeptical I'd become.

Before anyone gets too excited by the idea of buying a "safe" annuity, remember that these guys were an unassailable AAA from all the agencies a couple years ago:

I was wondering how many annuity contracts would be affected by losing $3/share...

 

[Texas Proud]

Wasn't AIG the firm the Vanguard used for their inflation-adjusted annuities?
Yeah, just checked -- it is AIG. This I guess is exactly what I've been concerned about -- I am sure Vanguard checked out the field 5 years ago or whenever they started these things and picked from the strongest firms they could find. Then some 'stuff' starts happening in a firm and the next thing you know you've got potential issues. When you're making a 50-year bet on a company's solvency, the importance of even small deterioration can become magnified.

The question is... what would you rather 'trust'... someone with the strength of AIG who can absorb a huge loss (and possible more) and can go out and get new capital or someone who already would have closed up shop...

Look at Citi... IIRC they have acquired $45 billion in new capital.... now they are looking at selling $500 billion of assets to strengthen their balance sheet and improve their future profit potential...

Now... it is not as 'safe' as holding your own CDs and such... but then you have taken on all the risks that you were hoping to sell to someone else... an annuity is just selling the risk of living to long to someone else....

 

[cute fuzzy bunny]

an annuity is just selling the risk of living to long to someone else....

For a price. And hoping they can manage the risk 20-40 years from now better than you could.

 

[samclem]

I wonder . . .
Could the risk of outliving assets be handled in a much lower-cost fashion? Observation 1: We have new peer-to-peer lending, facilitated by the Internet, that allows people to borrow money directly from others (sometimes many others). These functions were formerly performed by banks or more costly brokered means.

Observation 2: The primary function of an annuity, for most people, is a means to avoid running out of money. It s not a means of obtaining better investment results, exceptionally good tax treatment, etc.

Okay, so why not build a cheap means to gather and bundle risk. Example:
People could join the year 2045 risk pool trust. To join, each has to buy into a specified type of investment (Zero-coupon govt bond? TIPS? CD with a very long maturity? ) co-owned by the individual and the trust, plus pay a small fee (to cover the admin costs of running the trust). When 2045 comes around, all bonds are cashed and distributed among the survivors. Each individual gets a proportional share depending on how much he/she invested. In the intervening years (from now until 2045):
-- As individuals die, the trust becomes the sole owner of the investments (it is part of the contract, the ownership doesn't pass to the heirs)
-- If the trust goes out of business, the individual investments revert to the individual co-owners.

To assure an income stream, an individual would need to buy a laddered set of these contracts going out for as long as the person might live. Still, $$ put in for each of the later years (beyond normal life expectancy) would only need to be very small because of the big impact of long-term compounding and the large additions to the pot from members of your cohort who kicked the bucket early. A few thousand bucks invested now would go a long way in 45 years as a result of these two mechanisms.

This would be lower risk and higher payout than an annuity because:
- Safer: As an individual you are part owner of the investment instruments. If the Trust goes out of business, you' still own the underlying instrument.
- Cheaper: No skyscrapers, no dividends to shareholders, no fees after the buy-in. All run on the internet, no agents, etc. No monthly checks to send out: When the maturity date comes, the securities are liquidated and everyone still standing gets their money.

- Or, maybe this is being done already.
- Or, maybe this is not being done because it is actually a phantom insurance company and would need to be regulated.
- Or, maybe the transfer of ownership from the individual to the trust if the person dies early is not legal.

If legal and not being done already, I hereby cede all rights to the Samclem Retirement Lottery Trust Construct (C) to the Early Retirement Forum.

 

[Texas Proud]

For a price. And hoping they can manage the risk 20-40 years from now better than you could.

Correct... you did sell it to them for a price...

And i would say that for the vast majority... then can handle it better than they could...

 

[Texas Proud]

Samclem....

Heck, why get in a 'pool' Unless you are hoping for a lot of them to die before you and 'make' a lot of money...

And what if for some reason every one lived? Would you still have enough money?

As I said (and CFB agreed... for a fee)... you are selling your risks to someone else... some charge you a lot, some not as much... but you are paying a company to pay you a stream of money for YOUR life... a fixed amount (or one with inflation adjustments)... not contingent on enough people having to die to get enough... the risks you got rid of were market risks, interest rate risks, living past your money risk. There are not a lot of ways you can construct your own without keeping some of these risks... (did you not see the news magazine where this guy thinks he knows how to 'slow' aging and we will be able to live to 150 If this does happen... an annuity would look pretty nice)

The question is 'is it worth the price' for the risk you take on... that the company will be able to pay you for the rest of your life...

Most people here answer 'NO'... that is fine...

 

[samclem]

Heck, why get in a 'pool' Unless you are hoping for a lot of them to die before you and 'make' a lot of money...

For the same reason people buy annuities. You aren't hoping to outguess the underwriters and "make a lot of money," you are just hoping to insure against the unlikely but possible instance of outliving yours. I don't think any (sensible) person buys an annuity believing he'll receive returns, on average, larger than he would have made in the market.

And what if for some reason every one lived? Would you still have enough money? . . . (did you not see the news magazine where this guy thinks he knows how to 'slow' aging and we will be able to live to 150 If this does happen... an annuity would look pretty nice)

Does anyone believe insurance companies would have enough assets to cover the instance of their entire risk pool living 50 years longer than they predicted? No way. So, something bad would happen. At least in the risk-pool scheme the failure mode is graceful--you can see that people aren't dying at the forecast rate well in advance and take steps to cut back on your expenses, etc. You'll still get something every year when the payouts begin, it just won't be as much as you'd anticipated. Contrast this with the very large individual uncertainty when MegaCorp insurance goes bust (after they've held on as long as possible by liquidating assets, going to riskier and riskier investments, etc) and then the lawyers get their share. I'd be much more comfortable as the partial owner of an identifiable investment instrument.

 

[ERD50]

I wonder . . .
Could the risk of outliving assets be handled in a much lower-cost fashion?
....

Okay, so why not build a cheap means to gather and bundle risk.

....
- Or, maybe this is not being done because it is actually a phantom insurance company and would need to be regulated.

If legal and not being done already, I hereby cede all rights to the Samclem Retirement Lottery Trust Construct (C) to the Early Retirement Forum.

samclem, I am glad you brought this up. Here is a fascinating (IMO) podcast on the subject and its history. I heard it a while back, and tyour comment reminded me to share it with this group. While the title refers to Carbon Credit financing, it is largely about the history of finance, and discusses this and other remarkable concepts. I think many here will find it interesting. It is long, 90 minutes with Q/A, but here are some highlights:

Yale Business & Management

~ 10 minutes: Finance = Time Machine. A loan makes future money appear now.

~ 27 min - The 'invention' of checks, bonds - Marco Polo had 'traveler's checks' in China.

33 M - Perpetual Bonds from the Holland Water Boards are still paying interest today from the 1600's! (Never defaulted, but they did need to cut the promised interest rate).

38 M - 'Tontines' from the 1700's - these are the pooled annuities you describe.

51 M - some 'trivia' of Ben Franklin developing anti-counterfeit techniques for bonds, using a marbled background and cutting the bond in half, so the holder and the issuer had matching halves.

55 M - discuss a 'basket of goods' measure of inflation on a bond. The bond could be paid in a combination of wheat, meat, etc, - the pictures of those commodities were on the bond.

And my favorite - @ 59 min; They talk more about these pooled annuities, and the issuers didn't really have the data to figure life expectancies, so they didn't. Buyers soon figured out that they would buy the annuity in the name of their child. But this still left you with a risk based on a single person. So pools were created by organizations, made up of 6-8 year old girls (past the risk of many childhood diseases, had to be smallpox survivors, girls were ineligible for war drafts, etc).

There was also mention that the traditional multi-generation household provided the financial 'smoothing' that many of us seek today - mortgages in our youth, annuities and pensions in old age. Pooling several generations is another solution.

Also, some of these early bonds/annuities included an annual lottery - some earned 5%, but paid out 4% and the lottery winner got the group's 1%. Is this really an AA construction of low and high risk investments?

and some background info:

Q2 Fall 2007: What is a long life worth?

Tontine - Wikipedia, the free encyclopedia

-ERD50

 

[brewer12345]

Sam, sounds like a tontine. This has been done in the past, although I don't know if it is legal in the US. If not, no doubt you could do it in Bermuda or somewhere similar. In the US, you might well run afoul of insurance regulation.

But what you are describing is basically what TIAA was set up to be for teachers.

 

[samclem]

Brewer, ERD50: Thanks. Yep, it looks like what I decribed is a variant of a tontine, though without the "last [-]man[/-] old lady standing gets everything" aspect of the earlier (infamous) tontines. There would be some incentive for foul play, particularly as the number of participants dwindled in later years, so it might be best to keep the entire list of participants a secret, and even to administer the subscription list in three or four sections so that no one person would know all the names--at least until payout day.

I do think it might provide the same protection as an annuity at lower cost and greater safety.

 

[brewer12345]

Brewer, ERD50: Thanks. Yep, it looks like what I decribed is a variant of a tontine, though without the "last [-]man[/-] old lady standing gets everything" aspect of the earlier (infamous) tontines. There would be some incentive for foul play, particularly as the number of participants dwindled in later years, so it might be best to keep the entire list of participants a secret, and even to administer the subscription list in three or four sections so that no one person would know all the names--at least until payout day.

I do think it might provide the same protection as an annuity at lower cost and greater safety.

Honestly, it sounds very, very similar to an insurance company without the regulation and the safety of extra capital. I suspect that the insurance regulators would be inclined to see it that way.

 

[Nords]

Honestly, it sounds very, very similar to an insurance company without the regulation and the safety of extra capital. I suspect that the insurance regulators would be inclined to see it that way.

Even more reason to keep it secret-- once the regulators learn about it, they'll leak it to the insurance companies...

 

[Independent]

sam, imagine doing the same thing with life inusurance. We get a group of people of about the same age. (You need to pass a health exam to get in.) We agree that anytime one of us dies during the next ten years, each of the other people in the pool will send $1,000 to the deceased's spouse.

To avoid cheating, you want some way of knowing exactly who is in the pool, and exactly who died, and exactly who is keeping up with their $1,000 payments. If you want smoother and more predictable results, you want to get a bigger pool. (A bigger pool means you have a bunch of $10 payments instead of a few $1,000 payments.) But that means the pool is too big to run with volunteers, you'll need a paid staff. You'll also want someone to do some marketing. And probably a lawyer to defend the pool in case of lawsuits. Then you need some way of making sure your paid staff isn't stealing from the pool....

I expect that if we could do enough research on "assessment societies" we'd discover that a reasonable number of "insurance companies" started this way. In today's world, the regulators will discover you before you get big enough to be viable.

OTOH, I'm often thought that I'd like a chance to set up something that has a similar sales story to your tontines, but somewhat different mechanics. I'd like to see if just changing the way we describe payout VA's would change the way people perceive them.

 

[ESRBob]

Sam,
I like your idea, but what about the 6-year-old-girl phenomenon? That people buy these things in the name of their kids who are past the childhood diseases stage, but otherwise are going to live a really long time. I guess that is OK, too, if everybody is doing it? Otherwise it does penalize the older participant.

 

[cjking]

I wonder . . .
Could the risk of outliving assets be handled in a much lower-cost fashion? Observation 1: We have new peer-to-peer lending, facilitated by the Internet, that allows people to borrow money directly from others (sometimes many others). These functions were formerly performed by banks or more costly brokered means.

Observation 2: The primary function of an annuity, for most people, is a means to avoid running out of money. It s not a means of obtaining better investment results, exceptionally good tax treatment, etc.

Okay, so why not build a cheap means to gather and bundle risk. Example:
People could join the year 2045 risk pool trust. To join, each has to buy into a specified type of investment (Zero-coupon govt bond? TIPS? CD with a very long maturity? ) co-owned by the individual and the trust, plus pay a small fee (to cover the admin costs of running the trust). When 2045 comes around, all bonds are cashed and distributed among the survivors. Each individual gets a proportional share depending on how much he/she invested. In the intervening years (from now until 2045):
-- As individuals die, the trust becomes the sole owner of the investments (it is part of the contract, the ownership doesn't pass to the heirs)
-- If the trust goes out of business, the individual investments revert to the individual co-owners.

To assure an income stream, an individual would need to buy a laddered set of these contracts going out for as long as the person might live. Still, $$ put in for each of the later years (beyond normal life expectancy) would only need to be very small because of the big impact of long-term compounding and the large additions to the pot from members of your cohort who kicked the bucket early. A few thousand bucks invested now would go a long way in 45 years as a result of these two mechanisms.

This would be lower risk and higher payout than an annuity because:
- Safer: As an individual you are part owner of the investment instruments. If the Trust goes out of business, you' still own the underlying instrument.
- Cheaper: No skyscrapers, no dividends to shareholders, no fees after the buy-in. All run on the internet, no agents, etc. No monthly checks to send out: When the maturity date comes, the securities are liquidated and everyone still standing gets their money.

- Or, maybe this is being done already.
- Or, maybe this is not being done because it is actually a phantom insurance company and would need to be regulated.
- Or, maybe the transfer of ownership from the individual to the trust if the person dies early is not legal.

If legal and not being done already, I hereby cede all rights to the Samclem Retirement Lottery Trust Construct (C) to the Early Retirement Forum.

In the UK there are a couple of annuity schemes where the insurance company is essentially just an administrator taking a fixed fee.

You buy an annuity by transferring assets in. You (or you advisor) can continue to manage those assets. In one scheme there is a choice of about 10 funds, in another there is a much wider choice, you can even have a stockbroker account and hold stocks directly.

You have control of what your money is invested in. I think the insurance company going bust can't affect you - they are just administrators of the scheme, the money in it does not belong to them. (I assume the assets are owned by a trust of which the insurance company is a trustee, but I may be wrong.)

The insurance company tells you how much you can extract each year. There are government regulations that specify the minimum and maximum income you can take. These regulations take into account your life-expectancy and are designed to ensure you never run out of money. As an extra safeguard, if you run your capital down (through bad or unlucky investing) to something like half of what it should be you then can be forced to switch to a conventional annuity.

The annuity aspect works (I think) like this. On any given day, you will actually either contribute nothing to the mortality pool (if you survive) or everything (if you die.) Your notional contribution is probability of death on that day multiplied by your closing balance. Suppose someone else has died that day, and their assets are to be redistributed to everyone else. Your share of the assets will be the fraction your notional contribution is of the sum total of all annuitants notional contributions. (I'll just elaborate to address a point someone made: a 90 year old with 100K of assets will receive far more of the pool than a six-year-old with the same balance. The 90 year old is notionally contributing far more, because of the higher probablity of death.)

If I remember correctly, Prudential UK charge about 0.75% (of assets) per annum for running a scheme like this.

 

[ESRBob]

Got it... that explains how to cover the 6-year-old girl problem. It is normalized for the age of the person in whose name it is taken out (and on whose life it is designed to pay). Interesting scheme. The .75 is steep considering you're also paying fund managers for the actual investing part, but it's nice to know something is out there.

 

[Independent]

In the UK there are a couple of annuity schemes where the insurance company is essentially just an administrator taking a fixed fee.

.....
The insurance company tells you how much you can extract each year. There are government regulations that specify the minimum and maximum income you can take. These regulations take into account your life-expectancy and are designed to ensure you never run out of money. As an extra safeguard, if you run your capital down (through bad or unlucky investing) to something like half of what it should be you then can be forced to switch to a conventional annuity.

The annuity aspect works (I think) like this. On any given day, you will actually either contribute nothing to the mortality pool (if you survive) or everything (if you die.) Your notional contribution is probability of death on that day multiplied by your closing balance. Suppose someone else has died that day, and their assets are to be redistributed to everyone else. Your share of the assets will be the fraction your notional contribution is of the sum total of all annuitants notional contributions. (I'll just elaborate to address a point someone made: a 90 year old with 100K of assets will receive far more of the pool than a six-year-old with the same balance. The 90 year old is notionally contributing far more, because of the higher probablity of death.)

If I remember correctly, Prudential UK charge about 0.75% (of assets) per annum for running a scheme like this.

As I mentioned above, I've thought that this format could be more marketable than our current VAs. The reason is that it's transparent enough to explain the mis-understanding regarding "the insurance company keeps your money".

I found the Prudential UK site, but didn't see this on their list of annuities. I'm probably looking in the wrong place. Do you have a source?

 

[cjking]

Flexible Lifetime Annuity - Prudential UK

However hard information about the charges is very hard to track down. I was looking a couple of hours ago and couldn't find it. I have a feeling that last time I looked I worked out that if you went through a discount broker (who decline all the commission that would usually go to a financial adviser) you could get the charges down somewhere in the region of 0.5% to 0.6%, inclusive of fund management charges.

 

[Independent]

Flexible Lifetime Annuity - Prudential UK

However hard information about the charges is very hard to track down. I was looking a couple of hours ago and couldn't find it. I have a feeling that last time I looked I worked out that if you went through a discount broker (who decline all the commission that would usually go to a financial adviser) you could get the charges down somewhere in the region of 0.5% to 0.6%, inclusive of fund management charges.

Thanks for the link. I followed it and eventually got to this brochure http://www.pru.co.uk/content/acrobat/ANNKF0093_07_2004.pdf
Page 9 describes "lifetime bonuses" (not a bad name from a marketer's perspective). I think your explanation is clearer. Maybe they were trying real hard to avoid a word like "mortality". I can see some complexities with using this concept for joint annuities and for a certain period, which they seem to have worked out.

This product has so many moving parts that the "lifetime bonuses" get lost in the machinery. I think I would try to take out some of the flexibility and focus on the bonus feature.

 

[cjking]

In describing how it worked I think I may have been conflating half-remembered details from more than one company - and possibly also inserted a little "plausible reconstruction" of how I logically deduce these products do work, as opposed to how they describe themselves. Along those lines, although the products could be constructed as trusts in the way I describe, on second thoughts I doubt they actually are. I think (though I haven't checked) that the regulatory framework guarantees customers won't lose if an insurance company goes bust. In any case, that doesn't seem to be a risk that people here regard as worth worrying about. I suppose the important thing is that a scheme could be constructed in the way I describe, if any US company wanted to do it.

When I was trying to understand how this type of annuity could work, one thing I noticed after looking at mortality tables, is that if you make it to your late 80's/early 90's, there's a very long period when your life expectancy stays at about four years. Or to put it another way, for several years you have about a 25% probability of dieing each year, given that you've made it that far. That means that you should earn a fair return of 25% a year on your remaining capital in mortality bonuses alone. (This is in a hypothetical product that works as described indefinitely, I think the small print of the Prudential product switches you into something more conventional when you hit 90.) (Edit: actually that's a 33% return. Four customers with equal capital, one dies, the other three get a mortality bonus of one third.)

The other company who had a similar product was "Merchant Investors" however the last time I looked their product information was no longer available on the web. (The product was still available though.) I may have got the term "mortality bonuses" from them. They were the ones who, in addition to giving you access to managed funds, gave you an option of having a stock-broker account within your annuity. (For an extra annual charge, of course.)

A company called GE Life (I think they were Canadian-owned) used to offer a product that I think was structured along similar lines, but for drawing down home equity. In effect you would "buy" an annuity by transferring ownership of your home into the scheme, retaining the right to live there for life. In return you would get an income for life. The income could be linked to various funds, including a fund that owned all the homes transferred in. The homes would be revalued every three years, and as the value went up (or down) your annuity income would change accordingly. I thought this was a very innovative product, however I don't think it's available any more. (One unnecessary weakness in this scheme was that if you moved out of your home, maybe because you needed a care in an institution, you didn't get any compensation for vacating your home early. You could move home while within the scheme though. I can't remember the details of how differences in value between the new and original homes were accomodated.)

(For anyone dropping in on the middle of this thread who hasn't realised this yet, these are all companies and products in the UK. I mention them because the products are very interesting and I don't see any reason why US companies shouldn't start offering something similar.)

 

[Independent]

I think the 33% bonus would be paid on a very small account balance (at least if the investment returns and mortality bonuses up till then had followed the original assumptions). So the big bonus rate times the small balance results in a dollar bonus that's modest.

If I were doing this, it would be an add-on to a mutual fund, and would be marketed primarily with the fund name, not the insurance company name. Kind of like Vanguard doesn't highlight AIG. That increases the perceived distance from traditional annuities, even though it would be filed as a variable annuity.

I would calculate a table of maximum withdrawal percents at issue. Each month the owner gets the max percent for that month times the balance for that month. The percents are set up so that at some assumed investment return, and some assumed mortality credit rate, the monthly payout is level. This seems simpler than the Prudential structure, though it results in more monthly variation in payouts.