longevity insurance

[ats5g]

I posted this on another conversation, but thought it may be a good topic for its own discussion:

Milevsky and Chen wrote an interesting article Merging Asset Allocation and Longevity Insurance: An Optimal Perspective on Payout Annuities..

- Alec

 

[haha]

Excellent article ATS. I am personally too addicted to the investment game to be interested in annuities at this time. But it may change when I am older. I wonder what the cost structure of these variable payouts annuities is?

These annuities might be a good sales product, if going back to work seems in the cards. The natural market is older retired people, so one's age should possibly even be a help in reaching out to potential customers. It sounds like these annuities would actually help very many people at least for part of their assets.
Mikey

 

[eytonxav]

Alec, I enjoyed this article. When I took the buyout (lump sum pension) from my company last November, I had talked to a planner that was espousing a mix of annunities and mutual funds. Given the good advice from this board regarding the high costs of these products, and the fact that timing (at least for an immediate annuity is not good right now), I decided to go with the traditional approach. However, I had planned to revisit the annuity aspect in another 5 years (when interest rates are hopefully higher) when I turn 60 and had been wondering what portional of the portfolio might make sense to allocate. Market volatility and longevity are both factors that I have been concerned about mitigating to some extent. At age sixty I had been thinking about taking 25-30% of my portfolio and getting an immediate annuity, but based on this paper, perhaps it would be wise to utilize a 60/40 split fixed to variable annuity. That said, I still wonder about the costs of these products versus the risk protection that you receive by using such products.

Doug

 

[newellcr]

Folks,

I had a hard time following this paper. It didn't help that the graphs were microscopic. What did you take away from reading it?

Thanks,

Chris

 

[Michael]

With regard to the costs associated with inflation adjusted annuities, it is my understanding that they operate by putting TIPS in their portfolios to cover inflation. A younger investor could self annuitize at lower cost by placing a portion of his IRA directly into TIPS, and annually withdrawing part of it.

For older investors, the survivorship benefit of annuities may outweigh the cost advantage of the direct approach. The insurance company pools together the assets of all who buy an annuity, and give the balance of the money of those who die early to the retirees who survive the longest. This has the effect of allowing older retirees who buy an annuity to get a larger annual return from the annuity than they could safely withdraw from a TIPS fund. This is in contrast to younger retirees who would get more from self annuitizing because of the lower expenses of directly owning TIPS.

A person would have to run the numbers for his own individual situation to see which approach gives the optimal outcome.

 

[eytonxav]

Mike, Currently I have approximately 5% of my portfolio in TIPS index/fund; so are you suggesting that at my age (55), I could essentially self insure by increasing my % of tips, maybe up to 25% to diminish market volatility, while providing an inflation longevity hedge?

Thx,

Doug

 

[ats5g]

Doug,

When I took the buyout (lump sum pension) from my company last November, I had talked to a planner that was espousing a mix of annunities and mutual funds. Given the good advice from this board regarding the high costs of these products, and the fact that timing (at least for an immediate annuity is not good right now), I decided to go with the traditional approach. However, I had planned to revisit the annuity aspect in another 5 years (when interest rates are hopefully higher) when I turn 60 and had been wondering what portional of the portfolio might make sense to allocate.

I think that was a good plan. Papers like Milevsky's are mainly talking about Variable and Fixed Payout (or Immediate) Annuities. I think the planner you talked to was espousing Variable Accumulation (or Deferred) Annuities (which are just Mutual Funds inside an insurance wrapper with higher expenses).

As MikeSchoeren noted, the survivorship benefit (when annuitizing) is greater for older people than younger people. So, it may make sense for younger retirees to wait until...oh, I don't know age 65(?) or so before they annuitize some of their assets. Remember that annuitizing does incur costs (mortality & expense and admin costs), so the benefits when we're younger may not outweigh the costs. Of course, there are qualifiers (as there always are).

Check out figure 4 of the aforementioned article.

Figure 4 provides a graphical illustration of the trade-off between the desire for bequest and liquidity needs and existing pension income.

If I already have fixed or cola'd pension and SS income, I already have some longevity insurance (depending on the $$ amounts of the pension/SS as compared with my spending needs), and thus may not want to annuitize some or any of my other assets. If I want to leave a lot of money to heirs or I want my assets very liquid, then I wouldn't want to annuitize most of my assets.

I wouldn't necessarily consider TIPS as longevity hedges (or insurance) as much inflation hegdges (or insurance). Since retirees without a lot of COLA'd guaranteed income are at serious inflation risks, TIPS are an excellent asset to hedge this risk. Retirees have "real" liabilities (e.g. "real" future spending needs) as opposed to nominal liabilities (as insurance companies have). TIPS are a way to better immunize these future real liabilities (than longer nominal bonds) b/c they take away the inflation risk.

Note that the Treasury is considering coming out with 20-year TIPS, in addition to the already existing 10-year TIPS.

Here's the working paper version of Merging Asset Allocation and Longevity Insurance, which has more readable versions of the tables.

Also, for anyone who is interested, here are some more papers (which I think are a little easier to read - and provide some more backround) on the subject of annuitization.

How to Completely Avoid Outliving Your Money - by Moshe Milevsky. Targets Canadian audience, but still applicable to U.S. investors (easier read).

The (Mostly) Pros and (Few) Cons of Lifetime Payout Annuities - by Thomas Walsh.

Annuities and Inflation - by Thomas Walsh

- Alec

 

[eytonxav]

Alec, Thank you. I am always impressed with the advice, explanations and references that you provide!! If you don't mind sharing, could you give us a summary of how you have your portfolio structured, as I'm sure it would be educational to many of us.

Thx,

Doug

 

[ats5g]

As I mentioned in Toejam's background query, I'm 28, married, 2 year old son, no house yet (maybe latter this year, or early next).

Our portfolio is split b/w two 401(k)'s, my old job (currently unemployed) and wife's.

15% - G fund (Fed Gov't TSP's stable value fund)
15% - Pimco Total Return Instl (PTTRX)
25% - I fund (Fed Gov't TSP's MSCI EAFE Index)
10% - Vanguard REIT (VGSIX)
15% - S&P 500 Index (SVSPX)
15% - S&P 600 Index (DISSX)
5% - Dogde and Cox Stock (DODGX)

Not as diversified as I'd like it (no EM, no TIPS), but we're not making enough to be able to contribute to Roth's yet, so that's about as good as I can get it. Perhaps my new job will have better 401(k) choices.

I got interested in researching all this annuity payout stuff b/c my dad has all of his retirement w/ TIAA-CREF. I felt that the literature from their website was lacking in adequate explanations about how to set up retirement income. A TC retiree directed me to their Research Institute Website and to Milevsky's webiste.

- Alec

 

[Michael]

Doug,
The advice I would give would be to take your time and thoroughly investigate all of your options before making a commitment. TIPS funds can be volatile as real interest rates change, and immediate annuities are a commitment that you cannot change at a later date. There is also the option to buy TIPS directly from the treasury at no cost, which is even cheaper than Vanguard's fund. I don't know you or your situation well enough to even guess at how to best construct a portfolio for you. I don't know if TIPS, annuities, or something else entirely is best for your individual situation.

 

[eytonxav]

Alec, Your obviously a very bright young man and I commend you for looking out for your Dad and taking positive investment steps at a young age. Hopefully you will be in a position to ER yourself one of these days.

Mike, your certainly right about taking time to flush this out. I thought it might be a good hedge in case my wife and I live longer than expected and to also provide some cash flow in the event the portfolio takes a dump. I don't relish the thought of having to liquidate in a down market to pay expenses. Also don't know what SS will look like in another 7 years when I become eligible or whether my wife's traditional pension from ATT will be there in another 15 years. What intrigued me with this paper was the coupling a variable annuity with an immediate fixed annuity, and other non-annuitized investments.

Currently my portfolio is about 40% equity/60% fixed income investments. The fixed portion contains CMOs, Corp Notes, Step Coupons, CDs, TIPS and REITS/Preferred stocks, with some laddering out 7 years, although the FI portion is really oriented more towards a short term play (3-4 years).

I wish it was possible for me to be positioned so I didn't have to worry so much about market downturns, but I do get hung up in this daily watching of the ups and downs and it does cause me some lost sleep at times.

Thx guys,

Doug

 

[wzd]

Folks,

I had a hard time following this paper. It didn't help that the graphs were microscopic. What did you take away from reading it?

Thanks,

Chris

Quite frankly, I thought it was a bunch of BS. That is primarily because it used an axis of 'risk aversion' as key in the charts. Risk adversion or risk tolerance is more of a financial advisors game than any real measure, IMHO.

Wayne

 

[newellcr]

Alec,

If you have access to the G-fund, why would you pursue TIPS? The G-fund is a sweetheart deal. It gives a longer term yield with a very short term to alleviate rate risk. Just curious why you feel the need to add TIPS for diversification. The G-fund gives you the cake and let's you eat it too.

Wayne,

I've looked at it a couple of times now. Did the authors get rewarded for the page count or content? My guess is page count, but if they were really smart they would have made the graphs bigger to take up more page space.

Cheers to all,

Chris

 

[ats5g]

Chris,

I totally agree that the G fund is one of the best deals around. It virtually has no interest rate risk, but it does have inflation risk. TIPS would hedge this risk, and should provide added diversification. Now since I'm very early in my earnings years, my future income should be inflation adjusted (well hopefully), and I may not want to add TIPS now. Also, TIPS aren't as good of a deal as they were when they were yielding 3-4% real. And since I may be buying a house soon, I might pray for inflation to inflate away my fixed mortgage costs.

Unfortunately, relative risk aversion is the only real way (I think) for us to build how different people feel about risk and reward into portfolio selection models. And no one knows how to measure it properly. I sure wish I knew what mine was.

There's also an interesting thing about risk averion. When there have been studies done about measuring people's levels of risk aversion, the outcomes are usually levels b/w 1-7 (very risk tolerant to very risk averse). However, when we look at the historical risk premium on stocks, this seems to indicate levels of risk aversion around 10-12. There appears to be a chasm here. Or at least that's what I've read (and probably butchered). Or perhaps people are just lying to please the researchers.

- Alec

 

[newellcr]

Alec,

WRT the G-fund, there is inflation protection there in the form of the rate being set each month. The rate is set based on inflation rates and a negotiated core rate, which is loosely based on longer term rates. So the inflation protection piece is there depending on your point of view. I believe that the latest G-fund interest rate is about 4.5%. How does that compare to the latest TIPS offerings? I don't follow TIPS because they don't hold much benefit for me in my current situation.

Kind Regards,

Chris

 

[wzd]

Chris,

Unfortunately, relative risk aversion is the only real way (I think) for us to build how different people feel about risk and reward into portfolio selection models. And no one knows how to measure it properly. I sure wish I knew what mine was.

Risk aversion is often used by planners (and programs) via a 20 question quiz. Finding investments that are risk appropriate for someone is not done very well by those that use these simplistic tools.

Risk aversion is most appropriate for determining what type of investments are inappropriate because the investor is likely to bail out at the worst time. The 'correct risk' is a mixture of the risk needed to achieve the desired returns vs the downside of not reaching the goals.

Wayne

 

[ats5g]

Chris,

D'oh. Now I see. Can we say that the G fund will have a slightly positive correlation with inflation? Or, as inflation rises, the return (yield) on the G fud will rise as well.

Thanks,

Alec

 

[newellcr]

Alec,

Yes, as inflation rises we will see a rise in the G fund rate. It is difficult to say there is a direct correlation, so you could easily argue that doesn't have inflation protection. The G-fund rate isn't tied directly to one of the benchmark bonds. It is just an agreement between the TSP and the Treasury that benefits both. The treasury has access to a massive pot of money as needed without a particular term that simply rolls over from month to month and the TSP participants have a good yielding "bond" fund that has nearly no rate risk. This is oversimplified, but reasonably accurate.

Cheers,

Chris