In my
last column, I provided an analysis of the income guarantees from a life-only, immediate annuity versus the likelihood of running out of money if you kept your retirement savings invested in the markets. I received a lot of comments on that column, and I thought I'd respond to several of them.
One solution. Several people commented that I couldn't be much of an adviser if I only recommended one solution, which was to stay invested in the stock and bond markets. Well, in the last paragraph of the column I stated that some people might elect to do a little of both, and that each client needs to weigh the risks and rewards of both strategies. I may not be a big fan of annuitization, but I recognize it may fit for some people and clearly indicated that in the column.
Distribution rate. Some people felt that it was unrealistic to recommend a 6.17% withdrawal rate on an investment portfolio. First, I did not recommend a 6.17% withdrawal. I compared the income stream from the annuity, which was 6.17% on the principal balance used to purchase the annuity, to a portfolio withdrawal rate of 6.17%. Second, the distribution rate used for the investment portfolio was non-inflation-adjusted because the income stream from the annuity was not adjusted for inflation. Thus, for those commentators concerned that only a 4% withdrawal rate is considered safe, they misread the illustration. The 4% withdrawal rate applies if you are adjusting distributions for inflation. If you run historical distribution simulations using a 6.17% non-inflation-adjusted distribution, you'll find success rates similar to what I cited in the article.
Buy and hold. Others felt I was misguided as a buy-and-hold adviser who only espouses modern portfolio theory. First, the example had nothing to do with modern portfolio theory. I simply analyzed the actual historical cycles, not simulations based on my assumptions about asset class correlations. Second, buy-and-hold is common sense. Moreover, when you buy an annuity and give your money to the insurance company, the insurer basically implements a buy-and-hold strategy with a balanced portfolio that includes stocks and bonds as part of the investment strategy.
Insurance. Several people used the example of buying insurance on your house as a justification for buying an immediate annuity. They stated that there is a low risk of your house burning down, but you still buy insurance. Well, if you want insurance on your stock portfolio, you could consider buying a long-term put on the stock market. The put arguably gives you a truer price for insuring against declines. You pay the premium for the put, but get to keep ownership of your portfolio, just like you get to keep ownership of your house when you buy an insurance policy on it. If you had to give away your house to get insurance, I don't think many people would do it. But you can if you want.
Sequencing of returns. Some felt that I didn't understand the sequencing-of-return risk in retirement distribution planning. Well, I can assure you that I do, and I have the spreadsheets to prove it. I've re-created every 30-year cycle since 1926 and can look inside every cycle to see why portfolios failed and why they succeeded. When you do that, you recognize that the biggest risk is getting hit with a severe bear market in the first few years of retirement. And if you recognize the sequencing risk, then you can plan for it by creating distribution strategies to deal with bear markets. This allows investors to keep their life savings but still get through a bad bear market if it hits early in their retirements. Then, when markets are better, the investor has the opportunity to participate in those returns. Moreover, sequencing of returns also illustrates that most cycles are good. So while we need to plan for the worst, we should reasonably expect that most years will be good and thus most investors will have a pretty successful retirement.
Insurance protections. One commentator felt I did not understand the regulatory protections governing insurance carriers and the protection from insurance guarantee associations. Well, I do, so let me address each of those.
First, the regulatory protections clearly have limits. The collapse or near-failure of a number of major financial services firms (including insurers) last year should serve as a warning sign of the rogue risks in the financial-services sector. Regulators can't and don't identify all systemic risks, so you may want to tell your clients about that. Given a different chairman of the Federal Reserve, a different Treasury secretary or a different Congress, we might have been looking at a totally different outcome for some of our biggest insurers.
Consequently, you must factor in some probability of default over a 30-year cycle. As I mentioned in the column, it clearly isn't zero. So I put it at 1% to 2% for any one company. The bottom line is that nobody knows, but in my home state of Colorado, the website for the Life and Health Insurance Protection Association lists about 50 insurers that have become insolvent since 1991.
Second, while the insurance guarantee associations are a very important safety net in the event of a failure, they have dollar limits. Many annuity guarantees are limited to $100,000, so larger annuities often wouldn't be covered.
And by the way, below is an excerpt from the Q&A section of the Ohio Life & Health Insurance Guarantee Association website:
Q: Why hasn't my agent or company told me more about the Guaranty Association?
A: When the Legislature created the Guaranty Association, it was concerned that someone buying insurance might be led to believe that the company's financial condition is irrelevant, since its policies are protected by the Guaranty Association. Because this protection is limited and, in some cases, there is no protection at all, the Legislature prohibited agents and companies from advertising about the Guaranty Association. The existence of the Guaranty Association, therefore, is not and should not be a substitute for your prudent selection of an insurance company that is well-managed and financially stable.
Summary. The purpose of my column was to analyze the costs and benefits associated with purchasing an immediate annuity versus continuing to invest in the markets. Moreover, I was not analyzing or making any assessment of other insurance strategies. The annuitization topic is much deeper than what can be covered in a typical column, but I put forth a basic framework for analyzing the numbers that I think helps to inform the debate. I understand others don't feel that way, and I continue to welcome your comments and suggestions.
