Wade Pfau- How are annuities better (different) from bonds?

[urn2bfree]

http://www.advisorperspectives.com/...d-funds-don-t-belong-in-retirement-portfolios

In this recent piece by Annuity Fan/Salesman Wade Pfau, he shows how annuities lead to a better outcome for retirees than if they try to manage their saving using only bonds and stocks. Now I am not smart enough to even understand the math and a lot of the "hand-waving" that he seems to do, but the skeptic in me can't help smelling a rat.

There are a lot of smart people on here so I hope somebody can explain it better, or shoot it down better than I can.

He clearly positions an annuity as something like a bond. And he even states that the annuity company is investing in bonds. Seems very similar to a bond fund, except I get "guarantees" on my interest rate. He sees that as a plus...I see that as a huge cost. That guarantee is bought by paying off the salesmen and all these middle men. How can it be cheaper to have all these layers put between me and my money?

If my bond funds values go down, I can still get some of my principle back, but with annuity, my principle is gone for good.

Also the scenario of bad outcome for the bond fund investor does not make sense in light of asset allocation and rebalancing. If I invest in bond funds, I get the income. If bond fund prices fall, my bond funds allocation falls. If I need more income, I probably am selling stocks which now likely comprise a higher part of my asset allocation than they did before my bonds fell...now I am not selling bond funds at a low I am buying these new cheaper bond funds. I am also putting my money into funds WHICH are paying higher interest rates now.

Is it just my lack of understanding how this works or is Pfau trying to hard to sell his annuities?


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[soupcxan]

I stopped reading when I got to this chart. What a joke. This guy is a pioneer in the emerging field of pseudo-finance.

 

[dallas27]

I stopped reading when I got to this chart. What a joke. This guy is a pioneer in the emerging field of pseudo-finance.

Agreed, does anyone understand that graph enough to explain it? I mean, I get it, but it lacks any relative values and yet was made by a guy who strives for "mathematical optimization"

 

[fritz]

As I recently replied on another post regarding Wade Pfau on this forum -

I seem to recall an old saying (might not be exactly right) - "Always remember who's telling (selling) you"...

Kind of like Vegas - all those magnificent huge Casinos are built on the belief that you're going to win.

 

[Animorph]

I believe the graph in post #2 is just saying that you can spend more safely with an annuity. He's talking a single payment immediate annuity or deferred income version, which are not terrible choices. The portfolio, or bonds, can run out or not generate enough income in time. The annuity is guaranteed income for life, and about the only way to "safely" spend your last dime before you die. An SPIA's cost is determined by a pooled "average" lifespan, so if you live extra long, you get extra value. With portfolio withdrawals you have to allow for the possibility of an extra long lifetime, reducing your income from what you could have spent if you knew you would live to the average lifespan. And most likely leaving some of your portfolio to your estate instead of spending it all.

I suspect that Dr. Pfau is not including real-world fees in his annuity costs. He is an academic after all, not an annuity salesman. I haven't seen fees and annuity lifetime adjustments discussed in his papers. To that extent he may be somewhat optimistic. But I think he's got some good ideas here.

A few of us on this forum have discussed our "Plan B" (or higher) of buying an SPIA if our portfolio value drops to the point where our retirement is in danger but we can still afford an SPIA that covers our expenses. That ensures no portfolio remainder for the estate, but also that you will have sufficient income for as long as you live. It's a good way to safely maximize your income while you are living. I probably won't be buying any annuities before then (other than Social Security at age 70), but I'm not a bond guy either.

 

[fritz]

This is where Wade Pfau works

The American College

The American College is a non-profit educational institution with the highest level of academic accreditation dedicated to leadership in innovative training and development for financial services professionals.

The College is distinguished by resources of the highest quality, innovation in program delivery and design, and results that create sustainable advantages for our customers.

Serving as a valued business partner to banks, brokerage firms, insurance companies and others since 1927, The American College has assembled a faculty of the foremost thought leaders in the industry to help companies and their employees succeed.

Could see a bias for annuities...

 

[Independent]

On another thread, I complain about Wade Pfau promoting whole life insurance. So, I'm not necessarily a supporter of his ideas.

But, I can certainly see a use for an SPIA. After all, I'm deferring SS, and that's equivalent to buying an SPIA from the gov't.

SPIAs are a type of longevity insurance. Many people here don't need that type of insurance because they have enough money that they have no real fear of running out before they die. Others don't want to plan to run out of money the day they die, because they are concerned (whether or not they are willing to admit it) that they might run up very big long term care expenses. They want a reasonably liquid lump sum available late in life to cover those expenses. If they die without needing LTC, they are happy with their heirs inheriting the savings.

I think Pfau would be clearer if he said "If you think a bond ladder, that expires YY years from now, has a place in your retirement portfolio, then an income annuity might well provide a better fit."

I can see where some people want the bond mutual funds because they want both income and liquidity and assets at the end of life. For people who don't want those things, the SPIA may be more efficient.

 

[pb4uski]

Agreed, Dr. Pfau's credibility has slipped much in my eyes over the years.

SPIAs could be good if one lives long (or at least long enough). The issues I have with them are 1) I could die the day after I buy (though I guess that could be solved with a minimum payout that my heirs at least recover the premium) and 2) if I do live long and "win" the benefits are severely eroded by inflation.

If inflation adjusted annuities were more widely available from financially stable insurers I might be more interested. As it is though, between SS and my small pensions when we are 70 about 85% of our living expenses will be covered, so I don't have much appetite for filling the remaining 15% with a SPIA.

 

[gcgang]

Agreed,

...1) I could die the day after I buy (though I guess that could be solved with a minimum payout that my heirs at least recover the premium) and 2) if I do live long and "win" the benefits are severely eroded by inflation.

If inflation adjusted annuities were more widely available from financially stable insurers I might be more interested. As it is though, between SS and my small pensions when we are 70 about 85% of our living expenses will be covered, so I don't have much appetite for filling the remaining 15% with a SPIA.

I agree. Dying right after you buy something sucks. I suppose dying anytime sucks, but that's a discussion for another thread.

Inflation adjusted annuities are out there, but the few I checked on had such a reduced beginning payout and such a convoluted method of determining the inflation factor (insurance language in general), I lost interest.

But the earlier poster who assumed he'd just rebalance into bonds from stocks if bonds go down is ignoring the possibility that their stocks can go down a lot more, and at the same time, as their bonds. That's where the idea of a guaranteed income makes sense. Reduced risk, perhaps sacrificing returns, with the immediate annuity, I think, is Pfau's point, especially for those who don't have pensions or significant other sources of recurring income.


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[ziggy29]

Not a fan of annuities at all, though in a more favorable interest rate environment I think an SPIA can make some sense in some situations. And in general I would usually treat the SPIA more like a purchased pension than a bond assuming similar survivor income options and complete loss of principal when both annuitant and spouse expire.

That all said, these are probably more bond-like than stock-like or cash-like. But they aren't bonds.

 

[Gill]

Who do SPIA's always invoke such a heated discussion? I, for one, am a great believer in them and have invested a significant sum in 12 different contracts. If I die before recovering my premium, all well and good. I'll will have enjoyed a guaranteed income that I never could have generated in any other way.
Bruce

 

[clifp]

Who do SPIA's always invoke such a heated discussion? I, for one, am a great believer in them and have invested a significant sum in 12 different contracts. If I die before recovering my premium, all well and good. I'll will have enjoyed a guaranteed income that I never could have generated in any other way.
Bruce

Most of the people board are ok with other people buying SPIA. I fall into into maybe I'll buy one when I'm older and interest rates go up. Even at 55 they aren't a great match for me a $1,000,000 annuity buys me $57,800 worth of income which sounds pretty good but with no inflation protection.
If I had retired when my dad did in 1979 1/2 way through my retirement I'm only getting $28K. Even retiring when I did at 2000 1/2 through my retirement income would have dropped to $41K.

However, the big problem the forum has with annuities is much less to do with the product and hell of a lot more the people who sell them. Annuity salesman and insurance company have well deserve and well documented reputation for loading most annuities with a dozen rider clause, which add several percent of fees to the typical one.

In short I have no problem with people buying SPIA from a low cost provider like Annuity, a big problem from being sold one from your typical Ameriprise or Allianz salesman.

 

[soupcxan]

Who do SPIA's always invoke such a heated discussion?

Nothing wrong with a SPIA as long as you know what you're buying - insurance to cover the risk that you live too long. This risk has a cost, which the insurance company is charging you, plus their marketing expenses, plus a profit margin. Also, the SPIA has credit risk.

The problem is when salesmen say SPIAs are unequivocally better than keeping that money in your portfolio. There is no free lunch.

 

[bmcgonig]

My expenses in retirement are budgeted as 50k/yr non-discretionary and 20 to 30k discretionary (30k until age 80 and 20k thereafter). At 70, when I intend to take SS I will get about 38k. I have considered covering the other 12k of the non-dis expenses with an SPIA. Then as Pfau says in the article I can become more aggressive with the rest, if I choose. It's a sleep at night insurance policy. I never want to worry in a market crash like 2008 and wonder "what if the fed can't pull us out this time". But that's just my insecurity/personality.

When I looked into these at Vanguard, and other places, they just charge a load of about 2%. I.e., if you spend 100k on an annuity, you send them a check for 102k. There are no other hidden "fees" no more than any product you buy. Whet you see is truly what you get.


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[Gill]

When I looked into these at Vanguard, and other places, they just charge a load of about 2%. I.e., if you spend 100k on an annuity, you send them a check for 102k. There are no other hidden "fees" no more than any product you buy. Whet you see is truly what you get.

This is just plain wrong. What you see is what you get. You do not send them an extra 2%. They are simply disclosing their fee which is lower than any competitor. When you pay a $100,000 premium and it says you will receive $8,000 a year that's what you pay and that's what you get.
Bruce

 

[bmcgonig]

This is just plain wrong. What you see is what you get. You do not send them an extra 2%. They are simply disclosing their fee which is lower than any competitor. When you pay a $100,000 premium and it says you will receive $8,000 a year that's what you pay and that's what you get.

Bruce

Well actually the quote I got was for 100k, but only 98k was invested, the other 2k was a fee. I turned that around in my head so that I would send them ~ 102k so that the entire 100k was invested. So not wrong, really. I think if you read the rest of my post we agree in principle. Like I also said, what you see is what you get.


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[Gill]

If you sent them $102,000 you would be investing $99,960.
Bruce


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[bmcgonig]

I guess you missed the "~"




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[mathjak107]

pfau is a researcher he sells nothing.

the expenses with an spia are built in already to the draw rate . it is like buying a cd . if you like the draw rate that is your deal.

today a 65 year old can have almost a 6% draw.

while the annuity has no roi for many many years when used with your own investing it does not need one .

it allows you to take a higher amount of your own money out then you can safely take from cash and bonds since the annuity has dead body's and no sequence risk to allow for .

you would drain your cash and bond buckets down to zero over x-amount of years having to liquidate more equity's sooner.


the higher cash flow of the spia not only never decreases as your own cash and bonds will but if rates rise as they will you will need to sell more and more off in bonds as their value falls just to produce the same level of income .

as far as his use of life insurance , it is a far better deal not to buy a joint annuity with a spouse is what he said. you are better off taking the difference between a single annuity instead of a joint annuity and buy life insurance instead.

the life insurance is tax free , the annuity is not .

sure , if you are a skilled investor and the market gods and sequence of risk gods smile on you , you can come out a head on your own . but under average conditions the insurance / investing will always provide a higher initial income and a pretty good chance of a bigger pile at the end

 

[urn2bfree]

it allows you to take a higher amount of your own money out then you can safely take from cash and bonds since the annuity has dead body's and no sequence risk to allow for .

This is as the best answer I have yet seen...not entirely satisfactory, but closer to convincing me. My main question was that if I have $1M in bonds, why should I give it over to an insurance company, pay them a fee and a sales commission and allow them to take the remaining money and invest it in bonds to pay me money, when I can just invest in bonds myself.

The reasons I remain skeptical of paying the middle man to take the sequence of returns risk is that a bad sequence of returns CAN wipe out insurance companies, too. Also as Pfau's buddy and some time co-author, Michael Kitces, recently pointed out, bond fund holders of shorter duration bonds can be just fine even in the supposedly terrible forthcoming rising-rate environment,

https://www.kitces.com/blog/how-bon...ve-help-defend-against-rising-interest-rates/

so the boogie man of an economic storm wiping out my money before I die just seems either unlikelier or at least a similar threat to the annuity companies as it is to me.

Maybe I have enough to self-insure.



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[mathjak107]

the answer is you can't invest in the diversification the insurer can to pay that higher draw rate.

they have dead body's to invest in , lots of them , you do not.

those who die pay for those who live .

in either case your money in bonds and cash will be gone.

at 1% on cash and 3% on bonds trying to duplicate that level of cash flow to hold off selling equity's would be tough .

you would have a balance of zero in cash and bonds if you delayed refilling x-amount of years down the road so whether you spend those portions to zero or you give it to the insurer in either case you don't have it any more .

however the guaranteed draw from the insurer will form a base requiring less equity selling .

you will not have that on your own .

the danger now is if rates rise you will need to liquidate bonds at a loss to keep up that cash flow or else sell more equity's to compensate .

the real difference is bonds and cash have an roi up front that eventually hits zero as you spend it .

the annuity has zero roi up front since basically it is your own money given back to you at a higher cash flow then you can take , then once you get it all back the annuity roi begins and gets higher and higer as you live.

but that isn't the magic , the magic that usually has an spia/ equity's beat bonds/cash /equity's is the fact not so much powder has to be kept dry for sequence and market risk and the higher cash flow allows less frequent or less selling of equity's leaving them to grow longer .


cd's have the same commission over time as the spia does , like the cd the fees are in the rate .

in fact hold a bond fund for a few decades and see what even low cost ones add up to , where as with annuity products like an spia that is all figured in to the rate . i bet vanguard total bond over 25-30 years comes pretty close if not more than the expenses on the spia .

 

[Dash man]

pfau is a researcher he sells nothing.

I thought this was pretty funny. Researchers are constantly selling their ideas, data, and results (with skewed data in many cases). When looking at research it's good to know where they got their funding to understand their perspective. Statistics can be skewed to present any result the client wants, especially if it means another grant or contract to support the client's product.

 

[Totoro]

I thought this was pretty funny. Researchers are constantly selling their ideas, data, and results (with skewed data in many cases). When looking at research it's good to know where they got their funding to understand their perspective. Statistics can be skewed to present any result the client wants, especially if it means another grant or contract to support the client's product.

Former researcher here.

As far as I know public funding does not determine outcomes, but it does influence what gets investigated.

Frequently it ends up being a game: You repackage what you want to research or already are researching into the "fad of the grant year".

For example in ICT, suddenly distributed computing becomes "cloud computing", and wireless low power networks becomes "the internet of things". Grant bodies are happy, research institution merrily goes on doing what they already were doing.

I have never seen anyone steering or adjusting results though because it went against the (perceived) agenda (political or otherwise) of the granting entity.

No idea how that transfers to private funding - but we all remember tobacco funded research 'proving' no link with lung cancer. So in that case we all could rightfully be suspicious.

 

[fritz]

I thought this was pretty funny. Researchers are constantly selling their ideas, data, and results (with skewed data in many cases). When looking at research it's good to know where they got their funding to understand their perspective. Statistics can be skewed to present any result the client wants, especially if it means another grant or contract to support the client's product.

I recall attending a meeting (when I was still working) where a consultant (trainer) was providing us with insight as to what he was going to teach our distribution channels. Some were company held and others were independent. It was mostly about improving one's bottom line through streamlining and working the areas where money could be saved. Since we were (in a round-about-way) acting as a middleman, buying in bulk and redistributing (for profit) to our distribution network - working one's vendors successfully, which is a significant area for improvement/savings to add to one's bottom line was not addressed. So yes - information may be skewed to be favorable to the one who pays you.

 

[Independent]

as far as his use of life insurance , it is a far better deal not to buy a joint annuity with a spouse is what he said. you are better off taking the difference between a single annuity instead of a joint annuity and buy life insurance instead.

the life insurance is tax free , the annuity is not .

sure , if you are a skilled investor and the market gods and sequence of risk gods smile on you , you can come out a head on your own . but under average conditions the insurance / investing will always provide a higher initial income and a pretty good chance of a bigger pile at the end

This is off topic for this thread. But, I guess I'm the one who introduced it so I should make some comment.

I agree with what you said about SPIAs vs. bonds.

However, I don't buy Pfau's claim that whole life insurance plus a single life SPIA beats term life plus a joint life SPIA.

There was a thread on his article in the Bogleheads forum. He joined in and corrected some simple communication problems. However, he did not address all the substance. On Saturday, May 16 he wrote
"On Monday, I'll make charts for this 0% fee case." He did not come back to that thread. I'll assume the numbers didn't work out like he expected.