Milevsky: What Does Retirement Really Cost ?

[chinaco]

Nice article. He provides a simple illustration for comparison.

Of course Milevsky is a fan of annuities. But I think some die-hard mutual fund investors may find it interesting too.

If there is one question that has captured the wallets and imaginations of baby-boomers contemplating retirement, it must be: Do I have enough … or will I live longer than my money?
Although I have spent a large part of my professional career pondering a myriad of financial matters, I must say that this particular vexing question — with all the complications of health care, income taxes and financial markets — might be one of those riddles wrapped in enigmas, to which it is impossible to provide a fully satisfying answer.
Unfortunately, a growing number of the retirement planning “tools and philosophies’’ that are widely used to answer these questions often give misleading results. More problematically, they then generate a false sense of security that you indeed do have enough, when in fact you don’t.

What Does Retirement Really Cost?

 

[youbet]

Well, that was a total waste of time.

4.5 pages directed at (1) a "safe" 100% fixed portfolio is an expensive way of financing retirement and (2) sensationalizing the risks of investing in a diversified portfolio with plenty of details of what can go wrong when non-fixed investments are involved. Then a quick paragraph on the solution: Buy an annuity!

The only details of how annuities work and why they are better are summed up in this subjective statement:

the annuity price is actually a market signal of what retirement really costs. And, it is the cheapest and safest way to convert a nest egg into a lifetime of secure income. Market prices convey information and the cost of a life annuity is a hard-drive full of intelligence.

BTW, I understand annuities (well, most of 'em) and see a place for them in some situations. But this article gives zero information on annuities and is simply a "knock the competition" ploy with the solution being to buy an annuity without an explanation why.

Yuuuuck..... I'm glad I was sitting here drinking coffee anyway because otherwise I'd be calling the authorities and complaining about "theft of time."

 

[Coolius]

Just a thinly disguised effort to push annuities upon a fearful and uninformed audience.

After some DD and studying of this subject in the past, I am finding that a well chosen portfolio of solid dividend paying blue chips, supplemented by Preferred Shares and Investment Grade corporate bonds, working together in a laddered structure, is the best for me.

And absolutely no fees except for the buying/selling brokerage commission.

 

[GregLee]

But I think some die-hard mutual fund investors may find it interesting too.

As a die-hard mutual fund investor, I found it interesting enough to read through, but not at all persuasive. There are these two fundamental problems: (1) Milevsky pretends to offer certainty, but you can't do that -- life is inherently risky.

(2) He offers qualitative solutions to quantitative problems -- e.g., on the last page, he says: "In sum, assuming a more aggressive rate of return — or planning to some arbitrary age — and then claiming that retirement has suddenly become “cheaper” is a dangerous fallacy that will end up costing many retirees quite dearly." But I need to know how many. If it's a very small number, it's rational to assume an aggressive rate of return, in my view. It doesn't make sense to reject a retirement plan just because it has some risk of failure, no matter how small.

 

[rescueme]

...is the best for me.

Agreed - however, it may not be the best for everybody.

All options should be considered and none thrown out as "imperfect". It all depends on your life, your situation...

 

[youbet]

All options should be considered and none thrown out as "imperfect". It all depends on your life, your situation...

That's a concept that annunity salespeople should keep in mind.........

They seem intent that everybody needs an annuity. And, of course, that they need a generous commission from everybody.

"Remember, a well researched, conservative, diversified FIRE portfolio may lead to homelessness, starvation, misery and a slow agonizing death for yourself and those you love. So, step right up and buy an annuity now!"

 

[Chuckanut]

I think the jump from a 1.5% inflation adjusted rate of return to a 6% rate is a large one. How about assmuming a 3% rate and seeing how things compare?

 

[Chuckanut]

I wonder..... Is there any guarantee that those annuity payments will be made in the event the insurance company falls on hard times? Who guarantees the company that pays the annuity?

 

[chinaco]

Ever heard of confirmation bias?

I said up front... Milevsky is a fan of annuities. He often recommends low risk solutions for retirees... especially if they can't afford to take much risk.

But, that was not the reason I posted the link.... it was his example.

I think a couple of you overlooked the value of that article.... At least what I thought was valuable.

Many people do not know how to begin to frame the problem of longevity risk much less the solution. I thought he did a pretty good job of describing how to think about longevity risk and quantify the cost of retirement.

 

[Coolius]

Agreed - however, it may not be the best for everybody.

All options should be considered and none thrown out as "imperfect". It all depends on your life, your situation...

+1. Absolutely, that's why I made sure to include the phrase that it works for me. Others might not like it at all. It may totally crash & burn for some.

Annuity salespeople tend to think in a one-size-fits-all situation, so everyone needs an annuity, no matter what their age, health, wealth, locale, hobbies, extravagance, frugality, mobility, passion, and longevity is.......

 

[youbet]

Ever heard of confirmation bias?

I said up front... Milevsky is a fan of annuities. He often recommends low risk solutions for retirees... especially if they can't afford to take much risk.

But, that was not the reason I posted the link.... it was his example.

I think a couple of you overlooked the value of that article.... At least what I thought was valuable.

Many people do not know how to begin to frame the problem of longevity risk much less the solution. I thought he did a pretty good job of describing how to think about longevity risk and quantify the cost of retirement.

I think the reader had to dig pretty hard to get much information about logevity risk out of the article. It was mostly a sensationalistic look at the horrors of trying to manage your own FIRE portfolio and pointing to the obvious safe, cheap and effortless solution of buying an annuity.

If the author wanted to explain longevity risk, he should have done so in a straight forward manner and given examples of solutions.

All he said was that an 100% fixed (he mentioned long term TIPS yielding 1.5%) portfolio is the only safe way to structure a retirement portfolio and that requires more initial capital than an annuity. (I agree) He also said you could add some diversity such as equities to reduce capital requirements but that introduces horrible risk. Then he points to inflation adjusted annuities as the answer.

That's not much of an explanation of longevity risk.

I'm sure I'm coming across as being extremely critical of the article (I am) and broad brush anti-annuity (I'm not). I'm just totally fed up with the tidal wave of sales pitches for annuities that give so little information about how they actually work. When a sales pitch focuses on the negatives of the competition instead of the positives of the product it's pitching, I'm always pessimistic.

 

[W2R]

I think a couple of you overlooked the value of that article.... At least what I thought was valuable.

Many people do not know how to begin to frame the problem of longevity risk much less the solution. I thought he did a pretty good job of describing how to think about longevity risk and quantify the cost of retirement.

Thanks for the link. All of us (especially females) need to consider longevity risk. I thought he had an interesting outlook on it.

 

[haha]

I'm sure I'm coming across as being extremely critical of the article (I am) and broad brush anti-annuity (I'm not). I'm just totally fed up with the tidal wave of sales pitches for annuities that give so little information about how they actually work.

We have had 25 years of very powerful hype for stock, mutual fund, and stock/bond investing for retirement and in retirement. This continues unabated, it is in fact more powerful than earlier. So maybe a little publicity for another approach is not a bad idea?

To your second point, surely stocks and bonds and especially mutual funds are far more difficult to understand adequately than fixed annuities. What's to understand? A bunch of people put money into a pot. Some gets skimmed off the top. The rest gets conservatively invested and minus expenses is used to a pay out a contractual monthly amount to the annuity holders who are still alive. In effect, it is applying a liquidating strategy that most of us consciously or unconsciously use in our retirement funding plans, except the annuity applies it to a group, not an individual. Hence a person's payout has three sources-investment returns, liquidation over his estimated lifetime of the corpus, and money left in the pot by early decedents. Also, unlike the individual strategy, short of failure of the insurance company, the payment cannot stop, no matter how long an annuitant might live

To understand it more technically, there are insurance industry texts to help.

Ha

 

[youbet]

haha,

I have no problem with "a little publicity for another approach." I just feel that some of the annuity salespeople go over the top. BTW, I think some so-called "financial planners" do the same regarding portfolio management. I recently received a solicitation from Financial Engines wanting to manage my 401k for $4k/yr! Choke! We have eight fund choices (all low cost category indexes) and they want to charge me $4k annually to allocate my money between them..... I don't think so...... Similarly, if and when I ever purchase an annuity, it won't be from a slick salesguy who tries to scare me with the dangers of portfolio self-management and stories of how my family will suffer a horrible end if I don't turn my life savings over to him to annuitize.

Your explanation of the workings of a fixed annuity is very good and similar to my own understanding. I believe that inflation adjusted fixed annuities can serve a worthwhile purpose. I especially like SS in this regard. My problem comes when aggressive, commissioned salespeople convince folks that "special features" of their company's annuity will give them returns far in excess of market returns. These returns are usually delivered in complicated ways that baffle me and I doubt that they ever manifest themselves in the way the annuity owner believes they will. Or when the salesperson makes a conservative, typcial by historical standards and well researched self-managed FIRE portfolio sound like a guarantee of future impoverishment and something that will take 101% of you time to manage.

Returning to the article...... To the author's credit, he only mentions inflation adjusted fixed annuities. That's a reasonable product. But he spends approximately 80% of the article emphasizing the negatives of non-annuity investing such as:

You'll hire an advisor and pay him/her hefty fees
Only 100% fixed portfolios are safe and 100% fixed portfolios cost more (require more capital) than an inflation adjusted annuity for the same cash flow
Non 100% fixed portfolios are very risky
If you aim your WR and AA for a specific time period, say 30 yrs, you need to promptly die after that date since you'll surely be out of money
And so on and so forth.

He could have left out the heavy sales pitch and explained annuities as you did and why/how they provide longevity protection, at what cost and the various pros and cons.

 

[pb4uski]

I wonder..... Is there any guarantee that those annuity payments will be made in the event the insurance company falls on hard times? Who guarantees the company that pays the annuity?

Actually there is, sort of. In the event an insurer goes into receivership, state insurance regulators step in and take control of the insurer, and if the insurer's assets are insufficient to pay benefits, state guaranty funds would typically make up the difference.

The state guaranty funds are replenished based on future assessments made against the solvent insurers.

While I'm not a big fan of annuities for a number of reasons, the fact is that they are relatively safe given the regulation of the insurance industry and the backstop of the state guarantee funds. Perhaps a small notch below an FDIC insured CD.

 

[MasterBlaster]

We have had 25 years of very powerful hype for stock, mutual fund, and stock/bond investing for retirement and in retirement. This continues unabated, it is in fact more powerful than earlier. So maybe a little publicity for another approach is not a bad idea?

To your second point, surely stocks and bonds and especially mutual funds are far more difficult to understand adequately than fixed annuities. What's to understand? A bunch of people put money into a pot. Some gets skimmed off the top. The rest gets conservatively invested and minus expenses is used to a pay out a contractual monthly amount to the annuity holders who are still alive. In effect, it is applying a liquidating strategy that most of us consciously or unconsciously use in our retirement funding plans, except the annuity applies it to a group, not an individual. Hence a person's payout has three sources-investment returns, liquidation over his estimated lifetime of the corpus, and money left in the pot by early decedents. Also, unlike the individual strategy, short of failure of the insurance company, the payment cannot stop, no matter how long an annuitant might live

To understand it more technically, there are insurance industry texts to help.

Ha

I concur...

What many here are ignoring is the cost to them of providing for their own longevity risk. That way-big stash they need hold back to avoid any chance of a dog-food old age lifestyle will probably never be spent. Yet they need hold it nonetheless - Just in case they live a long time.

And since they don't want much market risk they hold a good part of it in bonds that pay...at best close to inflation-...at worst way less than inflation in real terms especially after taxes are paid.

To me the beauty of an annuity - paid for with a portion of the nestegg, along with whatever Social Security provides, is it will deliver a baseline standard of living. With those two income streams, the level of longevity risk goes way way down. The other issue is that the cost of the annuity need only be to some median age of the pool (plus the insurance fees). So the cost of an anuuity could be less, perhaps way less, than providing your own longevity stash.

The leftover nestegg then provides all the extra discretionary income. This remaining nestegg can then be both invested and spent down more agressively than someone who is providing for their own longevity.

I am convinced that this may be the good way to provide long-life security and have lots of income - When you really need it.

 

[traineeinvestor]

While annuities may have their place in retirement planning (and I wished I could actually find someone offering them on reasonable terms out here), they are of limited use for early retirees due to the extended expected duration. If you FIRE early enough, annuities will be too expensive to consider. Almost by definition, if you can afford to retire at an age when annuities are too expensive to be viable, then you should have enough to see you through retirement without them - buying an annuity may give you some added diversification and/or reduce the time spent managing your portfolio, but I would have meaningful doubts about an annuity actually improving the viability of your financial plan.

The other reservation I have is that if we see a pick up in inflation it will be easier to protect youself with a portfolio of bonds/equities/cash/real estate than a fixed annuity.

Also important for some (not all) of us, without the annuity I can leave something for my [-]children [/-]cat.

 

[GregLee]

So the cost of an anuuity could be less, perhaps way less, than providing your own longevity stash.

Yes, it could be way less. But will it actually be way less? What sales and service fees is the insurance company skimming off, and what future interest rates is it assuming in pricing the annuities? What will future interest rates actually be? (I think they'll be considerably higher.) How can we make a comparison without having estimates of these quantities, which Milevsky doesn't discuss?

 

[youbet]

I concur...

What many here are ignoring is the cost to them of providing for their own longevity risk. That way-big stash they need hold back to avoid any chance of a dog-food old age lifestyle will probably never be spent. Yet they need hold it nonetheless - Just in case they live a long time.

And since they don't want much market risk they hold a good part of it in bonds that pay...at best close to inflation-...at worst way less than inflation in real terms especially after taxes are paid.

To me the beauty of an annuity - paid for with a portion of the nestegg, along with whatever Social Security provides, is it will deliver a baseline standard of living. With those two income streams, the level of longevity risk goes way way down. The other issue is that the cost of the annuity need only be to some median age of the pool (plus the insurance fees). So the cost of an anuuity could be less, perhaps way less, than providing your own longevity stash.

The leftover nestegg then provides all the extra discretionary income. This remaining nestegg can then be both invested and spent down more agressively than someone who is providing for their own longevity.

I am convinced that this may be the good way to provide long-life security and have lots of income - When you really need it.

When I run the numbers, the portion of my FIRE portfolio that I would have to spend for an annuity of sufficient size to provide adequate (by my standards) longevity insurance is significant. Whether I use non-inflation compensated annuity examples (but 1.5X in size to overcome, say, 30 yrs of inflation) or, as the author suggests, inflation compensated annuity examples, the expense is significant.

Without considering inflation, a relatively minor portion of my FIRE portfolio would do it. But when you figure in 50% (or more) inflation, it gets quite pricey. Or alternately, if you choose a inflation compensated annuity, those are darn pricey these days.

Could you give some examples of the numbers you're using? The tone of your post suggests that the "portion" of your FIRE portfolio you think you need to put into an annuity paying enough in real terms in 30 years to provide longevity insurance is not large.

If, for example, you wanted $55k retirement income and were getting that from $20k SS and $35k FIRE portfolio WR (3.5% WR from a $1M portfolio), how much of that $1M would you divert to a fixed annuity? Would that annuity be inflation compensated or not?

Thanks.


Edit: An addition question if you don't mind. You mention that retirees hold funds in fixed investments to provide for longevity insurance if they don't have annuities. At first I thought that I'm an exception to that. My AA is approximately 50/50 5.4 years into RE (age 64). I have no special stash set aside for longevity insurance. Are you saying that if I had a significant annuity, that I could/would change the AA of my remaining portfolio to something significantly more aggressive such as 90/10 or even 100% equities?

 

[chinaco]

I think the reader had to dig pretty hard to get much information about logevity risk out of the article. ...

That is possible. Of course... it is always relative to the eye of the beholder.

It could be that you saw his preference for solving the problem a certain way and just shut down or it could be because of your background you do not see it.

What I see... is a basic model for analysis of some independent variables that are non-determinant yet their outcomes have an affect on the overall problem at hand. Look at his table and read his explanation (with an open mind). Look at the risk (both stated and implied).

That basic model could be extended a little to do further analysis about someone's situation to better understand the issues and help them make certain decisions.

As for an annuity... even if you intend to self-insure your longevity... you still need to provide an income stream (annuity that is DIY funded) for a non-determinant term (longevity risk) and probably have some assumed range of returns (implied investment oriented risk).

Look at it... think about it!

 

[obgyn65]

Hello traineeinvestor - like you I wished I could someone offering good annuity terms. A few weeks ago I got the documentation I asked from the Immediate Annuities - Instant Annuity Quote Calculator. website with different quotes and advice. The information looks quite good. Please let me know if you find other companies with reasonable terms.

While annuities may have their place in retirement planning (and I wished I could actually find someone offering them on reasonable terms out here), they are of limited use for early retirees due to the extended expected duration.

 

[rescueme]

...I would have meaningful doubts about an annuity actually improving the viability of your financial plan.

Well in one case (ours) it is.

Retiring many years before claiming the "superior annuity" (AKA SS), it removes the need to consider claiming before it makes most financial (not emotional) sense, and allows us to execute an option for married folks.

Will the long term results of a fixed rate SPIA (fixed, rather than inflation adjusted, to maximize early payments) mean less in the future, due to inflation? Sure. But then that's when our respective (inflation adjusted) respective SS's kick in. The continuing SPIA payments after that time, till our end of days will be a bit of "whipped cream" on our income "sundae".

For us, it made sense. Using a retirement income calculator (such as FIDO's RIP) confirmed our feelings on this technique, using different scenerios to forecast multiple "what if's".

Just our story...

 

[portart]

retirement question

How much can you expect to spend a month from retirement with an annuity of 50k a month and a portfolio of 2.4 million. Not expecting to take SS for four more years.

 

[REWahoo]

How much can you expect to spend a month from retirement with an annuity of 50k a month and a portfolio of 2.4 million. Not expecting to take SS for four more years.

With an annuity of 50k per month, I could spend a lot. I'd have to work at it, but I'd figure out a way.

 

[Nords]

Wow, guys, I've rarely disagreed with so many of the comments here.

You all remember Milevsky from the 1990s, right? The university professor who trashed an entire annuity industry by pointing out that their products overpromised, underdelivered, and egregiously overcharged? He made most of his professional reputation back then by writing peer-reviewed research studies that beat the crap out of the insurance companies and their deliberately confusing marketing.

Take a look at his "Are You a Stock or a Bond?" book. Near the back he says that annuities used to suck but that SPIAs have gotten better. (He leaves the implicit assumption that the other types of annuities still suck.) He goes on to say that unless you're (1) in a profession with no reason to ever retire or (2) already receiving a very good inflation-adjusted pension with substantial expectation that it'll pay out for the rest of your life, then annuities have their place in everyone's portfolio. Like Social Security, it provides a safety net against longevity and the 1%-5% of FIRECalc's scenarios that we so blithely explain away.

I'd say that annuities definitely have a huge role in early retirement by providing a cheap bare-bones standard of living that will keep you going until the market (or rental real estate or selling blood plasma or even getting a job) helps your portfolio recover.

Look at Otar's retirement calculator-- if you get a red light then he recommends annuitizing the entire portfolio.

Milevsky doesn't advocate annuitizing an entire portfolio-- only part of it. He doesn't really even advocate using financial advisers, either-- only if you're trying to sort out wealth-transfer issues.

Alas, the real dilemma is what fraction of your nest egg you really want to allocate to actual retirement — and eventually convert into some sort of life annuity — and what fraction should be allocated to the kids, the grandkids and beyond, perhaps using life insurance and other estate transfer tools. That is a personal decision that has less to do with expected returns and probabilities and everything to do with personal preferences. Extracting this information from clients in a consistent manner is precisely where advisors can really add value.

I think Milevsky's one of the good guys. The man's book was certainly worth reading. I'd agree that this article's layout is crappy (I hate multi-page websites where you can't get it all on one long scrolling screen) but the article's worth thinking about the next time you're ready to tweak an assumption.