What makes annuities work? More stocks!

[Focus]

Very interesting findings from new research. Here's the gist from this Nerd's Eye View blog post:

In fact, as the results show, the majority of the benefits commonly attributed to partial annuitization are actually just the indirect result of a bucket strategy that produces a rising equity glidepath. While SPIAs do still provide superior results for very long-lived retirees, it truly takes extreme longevity - i.e., married couples living beyond age 100 - before the contribution from mortality credits actually outweighs the benefits of just using a strategy that liquidates more fixed income in the early years and allows equity exposure to rise. Accordingly, the bottom line is that for retirees who truly want to hedge extreme longevity, the benefits of SPIAs remain unmatched, but for most retirees who will not live that long the reality is that SPIAs not only fail to provide benefits, but they can actually produce results inferior to just replicating the rising equity glidepath without annuitizing at all!

Highlights mine.

 

[Huston55]

I read the same article, and found it thought provoking. I like the discussion regarding how using SPIAs is akin to a bucket strategy to mitigate the risk of poor returns in early retirement.

I've also added the link to Pfau's blog on this joint paper. It contains some insightful observations and questions in the comments section.

Retirement Researcher Blog: Decomposing SPIAs: Rising Equity Glidepaths vs. Mortality Credits

 

[Onward]

Very interesting article, particular for its redesign of the optimal glide path.

This surprising effect - that the best approach to retirees may be to increase their equity exposure over time - is certainly one that deserves further study. Though it isn't entirely surprising; if the greatest risk to a retiree is a series of ongoing mediocre market returns throughout the first half of retirement, then it makes a lot of sense that income sustainability will be better if the retiree continues increases the weighting to stocks as they get cheaper. Notably, if stocks are in a bull market and going up, the rising equity exposure increases the impact on the retiree of a future bear market, but if stocks are in a bull market, then there was no danger to a 4% withdrawal rate in the first place....

 

[Huston55]

Very interesting article, particular for its redesign of the optimal glide path.

Yep, the "increasing equities" approach is a new twist, for me anyway; makes me think about decumulation in a different way - which is a good thing. It's always good to challenge what you think you know.

Below are some of the questions an 'increasing equities as you age' approach generates. I think questions #3 & 4 are particularly important.


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AnonymousJuly 26, 2013 at 10:15 AM
This is an interesting and provocative article. Thanks for the deep thinking, Wade!

Some thoughts/reactions:

1. In your paper, you assume a perhaps unrealistic overall real return of 1.54% for inflation-adjusted SPIA's, although the top of the yield curve for 30-year TIPS is currently 1.35% and the yield for 10-year TIPS is around 0.40%. Similarly, your assumption of a 4.49% nominal return for fixed SPIA's is very high in relation to today's available SPIAs, where even a 4% internal rate of return is hard to find.

2. If you are going to value the annuity income stream from a SPIA portfolio in terms of the present value of the remaining lifetime income, are you also willing to incorporate the Social Security income stream into your analysis? If so, how might that alter your conclusions?

3. You portray the early years of retirement as ones where there is an elevated sequence-of-returns risk and the latter years as ones where an increasing proportion of assets in stocks is appropriate. However, suffering a large loss from a stock-heavy portfolio in very old age could be one that cannot be recovered from -- just around the time that expensive health events become more likely. I question the wisdom of encouraging a stock-heavy portfolio in very old age unless leaving a bequest is the main objective.

4. There are psychological and behavioral elements that could use attention. For instance, people often buy SPIAs for peace of mind-- so they are not so psychologically captive to volatile markets. How do you put a value on sleeping well at night, worrying less about returns and accumulations, and avoiding regret about investment decisions? Given that the pain of losing a certain $ amount tends to greatly exceed the joy of an equal $ gain, I submit that encouraging a larger proportion of volatile investments (i.e., stocks) as one ages may be a catalyst for unhealthy emotions, especially if a person is unlikely to live long enough to recover from a large market drop.

5. Is there a place in your analysis for individuals who wish to hold no equities at all -- and perhaps only bonds? This would be useful for people who have more assets than they need to retire on and deliberately choose to dial back on volatility or risk with their investments.
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[mathjak107]

I think the bottom line is that while we all have that what if i lose it when i am old in our heads it really rarely if ever happened in 111 30 year retirement time frames to anyone .

The flip side is there is tons of data and studies that show being to conservative has failed more times than anything else.

Kind of ironic i think.