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Retirement Issues, Concerns & Concept Retirement Income Comparisons

Surveys & Reports

GAO 401(k) Report Favors Annuities (1/14) 
Retirement Confidence Survey (5/13)   
AARP Study Shows More Consumers Want Annuities (7/12)
5.3M Mutual Fund Owners Shouldn’t (6/12)

More Retirees Taking GLWB Income Than Expected (7/11)

Retirees: An 85% Bank Pay Cut (10/10)

Retirement Income Comparisons 
GLWB: The Realistic Answer (3/13)
GLWBs: Stacking vs Roll-up (2/13)
The Secret Weapon: GLWB Instead Of DIA (1/13)
GLWBs Are Even More Attractive In Low Yield Times (12/10)

GLWB Costs Generally Up, But In Different Ways (6/10)
GLWB: Can An Index Annuity Be Competitive With A VA? (6/10)

GLWB Morass (5/09)
Guaranty Funds and GLWBs (5/09)
Increasing Death Benefit Riders (3/09)
GLWBs & Other Choices (7/07) 

Does A VA With A GLWB Make Fixed Annuities Obsolete? (5/07)

Issues Concerns & Concepts 

6 Reasons Why You Should Use An Annuity Instead Of Managed Assets (9/14)
A 2.5% Wall Street Withdrawal Rate Means Annuities Essential (3/13)

A Longer Holding Period Does Not Affect The Size Of The Loss (8/13)
Aging & Financial Decisions (3/16)

Annuities As The Black Swan Killer (11/09) 
Annuities For Efficient Retirement Income (9/12)
Annuities In 401(k) Plans (11/13
Annuity Protection From CROPS Failure (8/12)
Bell Curves + Monte Carlo = Risky Retirement Income (6/09)

The Bond Door Cracked (7/13
Coping With The Full Market Monte (1/08)

FIAs Both Transfer & Hedge Retirement Risk (11/13) 
GLWBs: Beating Breakeven Bias (2/15)
GLWB: Opportunity Cost versus Emotional One (12/16)

GLWB Rate Wins Over Safe Rate (3/13)

GLWB: The Realistic Answer (3/13)
The Immediate Annuity Puzzle (3/10)
Immediate Annuity Ruled Not An Asset Under Medicaid (12/10)
Index Annuities Are The New Normal (2/10)
Index Annuities Instead Of Bonds (12/06)
Investors Still Selling Low (and now they are buying high) (6/14) 
Making Retirement Real (8/16)

Myopic Planners & Immediate Annuities (9/10)

The New Financial Pyramid (7/10)
The Old Financial Pyramid (7/10)
Retirees: An 85% Bank Pay Cut (10/10)
Retiree Short-sightedness Works Against SPIAs & LTC Insurance (10/13)
The Retirement Equation: Solve For “I” (4/12)
Retirement Roulette Or Guaranteed Lifetime Withdrawal Benefits (2/10)
Retirement Ruin(ed) (5/16)

Social Security: Are Men Mean Or Stupid?
Target Payout Funds & Synthetic Annuities (3/09)
Volatility & Losses Aren’t The Same (6/10)

Wall Street’s FIA Alternatives (8/11)
Wall Street’s Retirement Income
Plan (10/08) 
Web Savvy Retirees Not Told About Benefits Of Annuities (6/10)
Why Swapping A Pension Plan For A 401(k) Seldom Works (12/12)
2008 Reverberations (9/11)


GLWB: Opportunity Cost versus Emotional One (12/16)   
This year my wife and I each bought a fixed index annuity with a guaranteed lifetime withdrawal benefit rider. The reason why is we wanted an extra $12,000 in steady annual income available beginning in 5 years. My overriding goal was maximum income with certainty – that there would be $12,000 available regardless of how poorly the annuity's indexed interest performed. I was also insensitive to fees. For the primary goal – certainty of maximum income in five years – I picked the top income producing GLWBs from two highly financially rated carriers. I am comfortable that I chose the proper GLWBs, but was a GLWB the proper choice for guaranteed income?  

The alternative annuity choice to generate guaranteed income in five years was a deferred income annuity (DIA). The reason we did not chose a DIA was because we wanted access to the annuity cash value in case of emergency (even though we know that the GLWB withdrawals will cause the cash value to steadily decline – unless there really is a Santa Claus). However, I wanted to know how much more it cost us to buy that access and used to get DIA quotes.  
A GLWB should cost more than a DIA because of the access to cash value for myself and my heirs. The single benefit GLWB cost 106% of what the cheapest DIA would have cost to produce the same income. Thus, the cost of having access to the cash amounted to a 6% penalty. However, for my joint GLWB annuity the premium was 98% of what the cheapest DIA (no death benefit) premium would have been. The overall "penalty" for choosing the two GLWBs over DIAs to get the same income guarantee was paying 2% more premium (adding any type of period certain guarantees made even the single benefit DIA more expensive than the GLWB).  

To get the same guaranteed income it cost 6% more to buy the first GLWB instead of the cheapest DIA, but the second GLWB cost 2% less premium than the DIA to get the same income.  

What is the maximum premium "penalty" one should pay to have access to GLWB cash values when a DIA could produce the same income? I don't know. Frankly, I don't think you can create a hard and fast rule that says "if the GLWB costs $X more than the DIA don't do it" because having access to cash is an emotional decision as well as a financial one.  

An opportunity cost is what is given up by selecting one choice over another. What is the opportunity cost of buying the GLWB? The opportunity cost of not buying the DIA here would appear to be 2% – because the GLWB annuity premium cost 2% more to produce the same $12,000 a year – but if we die before the cash value runs out then it is the DIA that has the much higher opportunity cost. Thus, we need to make some assumptions to try to determine realistic opportunity costs. The first is we'll use life expectancy as the number of years the income is received: Life expectancy of an age 67 individual is 18 years (United States Life Tables, 2008). Second is we'll use a 2% return. Third is we'll deduct the actual average GLWB fee of 1% from the annuity cash value. What this means is assuming the annuity is earning 2% interest, less 1% for the rider fee, leaving 1% net interest credited.  

Based on these assumptions the annuity cash value is used up in 16 years, but since it is lifetime income the $12,000/year continues. Therefore, choosing the DIA creates an opportunity cost for the first 16 years, but no opportunity cost for the 17th year and beyond when both DIA and GLWB have zero cash value, but continue to pay the $12,000.  

I assumed a gross return rate of 2% on the annuity. Let's assume we could also earn 2% over time in bank saving accounts, short-term government bonds or fixed rate annuities. Where is the opportunity cost if we assume $12,000 a year withdrawals for 18 years (life expectancy)? $164,000 growing at 2% becomes $181,069 in five years. If we continue to earn 2% and take out $12,000/year the remaining balance in 18 years is $1663, thus, at life expectancy, the GLWB imposed the opportunity cost – and the cost is much if death occurs earlier – but the cost flips to the other side after age 85 because the GLWB continues to pay $12,000 but the safe money is all gone.  

As the chart shows there is a significant GLWB opportunity cost for early death, which is not surprising, since one is paying a 1% a year longevity insurance premium.  

Is Guaranteed Annuity Income Worth It?
Arguments against selecting a DIA, GLWB or immediate annuity are that interest rates are at historic lows (buying a lifetime income today means locking in today's factors), and that it doesn't take much of a return to enable a non-guaranteed return to also pay an income that lasts a lifetime. Both are valid arguments. From a probabilistic perspective it doesn't make sense to pay to safeguard current GLWB income guarantees. However, for me it's mostly about peace of mind. We gladly gave up a portion of our retirement assets to ensure we have an extra $12000 a year coming in. And for us the GLWB was the proper choice because it gives us the flexibility to take the remaining cash value if we want to – and that was worth the "penalty" cost of not buying the DIA.        

Making Retirement Real (8/16)
Psychological distance is how near or far something non-physical feels to us. Feelings and experiences perceived as near are thought of as more concrete and real than those things that one senses are far away. A person is more likely to take action on something that feels real and "now" rather than abstract. A problem with abstraction is it can be difficult to get worked up enough to do something. We know the long-term effects of smoking, eating poorly and not exercising are bad, but many don't take necessary action today because the lack of action shows minimal consequences today. This abstraction is also a problem with retirement planning. Most of us know we need to do something about retirement, but the idea of needing to create an income that doesn't come from a paycheck is foreign.

Wall Street has worsened the abstraction of retirement.
Before 1980 the retirement planning was to get a company pension; a steady income that lasted your lifetime. Since Wall Street can't do that, they changed retirement planning from getting an income into building a pile of assets – and thus changed the concept of retirement income from the practical to the theoretical. And since Wall Street can't even tell you how large a pile of assets you need (they keep moving the finish line) they fell back on the one metric left – the size of the return. Thus, retirement planning became all about the return number.

Over a decade ago
annuities created something called a guaranteed lifetime withdrawals benefit (GLWB). The GLWB did away with the main perceived problem with immediate annuities – that of the insurer keeping the money if the buyer died too early – by letting the buyer keep control of the remaining principal. The GLWB also guaranteed to increase the income if receipt was  delayed. Unfortunately, most carriers expressed this guaranteed growth as a “roll-up rate”, and so most agents sold annuities with GLWBs based on the size of the roll-up number. The reason for selling the roll-up rate (or now the stacking rate) is it is a concrete number. The problems with it are not only can investments show a higher number, but the roll-up number itself is an abstraction because it’s not a return. In addition, it doesn’t motivate consumers since it still leaves retirement in the abstract. Because of this, agents are leaving tens of thousands of dollars on the table because they are presenting GLWBs wrong. Here are two ways to do it better.

Back To The Future
Make the future real. Ask the consumer to imagine it's the first day of retirement. There are no more paychecks coming in. What expenses do you need to cover? Let's make a list. Where is the income coming from? We can estimate Social Security using calculators, so how are you going to produce the rest of the income you show you need? What is a “safe rate” to spend down the investment assets? What return assumptions are you making to build that pile of assets that needs to last your lifetime?   Let’s look at this from a different perspective. You’re dead. How is your widow going to maintain her independence? Will she need to move in with her daughter-in-law? What will she wish you had done today?  Would she have hoped you created a stable, lifetime income for the two of you?   The consumer is transported to retirement time and starts to feel the anxiety and concerns associated with retirement  – and these are about having enough real income, not about hypothetical returns. Talking about real income translates into coming up with a real income number and then working backwards with the GLWB factors to determine the size of the premium needed today. Retirement and the need for the annuity purchase today becomes concrete.

The Future Becomes Today
This is simpler. The consumer picks the future date when the income will begin. You know the amount of premium, so the roll-up rate and payout factors are used to determine the GLWB income –  as in, “your $100,000 will produce $10,000 a year when you retire.” Even though this is a future income, since it is expressed as a dollar amount it feels very real and it is compared against the initial premium. Because it is a future value in a present value world, it compares very favorably and is very concrete.   Retirement is an abstract concept. Presenting GLWBs correctly makes it real and creates sales.

Retirement Ruin(ed) (5/16)
A recent article by Professor Moshe Milevsky does a great job of illustrating the fascination that many advisors and some in the media have with the concept of retirement ruin, even though they  often don't have the "mathyness" to understand what they are looking at.  

As used, retirement ruin means running out of retirement income before one is dead. In the investment world it has come to be defined as odds that a pile of assets will not produce a given percentage of income for a certain number of years. In practice, the advisor will enter details about the consumer's assets, withdrawal percentage and number of years the income is needed into a software program, and the program will spit out an answer showing the probability that the assets will last. The advisor then says something like "There is a 90% probability of receiving this percentage payout for the next 30 years."  

This concept seems to be a hot topic for many advisors. I've read blogs where comments get quite heated over whether a 75% probability is acceptable or must it be over 90%. I've seen articles rank asset allocation portfolios from best to worse, based only on their retirement ruin probability, even though the difference between “ruins” may be only a few percent. And yet, it is readily apparent that many of these relying on the probabilities produced by the model have given little thought to whether the underlying assumptions are accurate or can even be supported. Here are three main problems with retirement ruin odds calculations:  

1) Beware the standard deviation. 
Let's say that Portfolio A and Portfolio B each have a 90% probability of being able to pay out an income for 30 years. Based on only that fact we should be indifferent to using either one, if our goal is a 90% probability of getting 30 years worth of income. However, let's say the worst case scenario for Portfolio A is the income lasts 28 years and the worst case scenario for Portfolio B is the income lasts 16 years. Are you still indifferent?   A large standard deviation (or a lopsided deviation where there's a bunch of short year run-outs) means if you are not one of the probability winners, that the number of years short of 30 years when you run out of money could be huge. However, I almost never see the range of possible outcomes of the suggested portfolios discussed nor a comparison of how big a miss in years a specific portfolio composition could produce.  

2) Too few data points.
A Martian landing in Duluth on the first day of June and leaving after Labor Day would have over 100 data points for Twin Ports weather. The conclusion you would reach from looking at only the data points is the average temperature in Duluth is 71 degrees and it never gets below 55 degrees.  

Milevsky says that in an experiment years ago it took thousands upon thousands of dice rolls to figure out that a die is more likely to get a 5 or 6 than any other number because the holes bored into the dice shift the center of gravity – in other words, based on limited data it was assumed the odds were one way, but when much more data was included the actual odds were found to be completely different. Many in academia and especially on Wall Street act as if their extremely limited number of data points, representing less than a century of modern financial market history, shows all of the possible outcomes in the financial markets.    

3) Beware Soothsayers & Prophets
  When it comes to computer predictions of retirement ruin, seldom has GIGO (garbage in-garbage out) seemed more appropriate. Addressing these financial engineers, Milesky states "Your black box is subliminally forecasting how interest rates, stock prices, inflation, and mortality will evolve over the next 50 years and how they will co-vary with each other. Can you justify these assumptions to your clients? Do you even know these assumptions?"   I'm unaware of any investment algorithms made in the 1990s that had predicted even a 1% probability of a three-year bear market followed by a 50% market crash within the same decade. I'm unaware of any model from a decade ago that assumed an extended period of near zero T-bill rates.   

Annuities Are Not Perfect but....
If you buy an annuity guaranteeing a lifetime income you are protected from retirement ruin...unless the insurance company making the guarantee fails. Although infrequent, annuity carriers have failed in the past. In addition, if the future is a decades long period of near zero bond returns and spiking longevity some of today's carrier may not be able to make good on their guarantee. An annuity may not protect one from retirement ruin. However, there are actual safeguards here that don't apply to those fantasy retirement ruin portfolio models.  

One safeguard is carrier financial strength is dynamically watched over and regulated by state insurance departments. A long period of low bond yields and rising longevity will be like watching the approach of a very slow moving train. The regulators have sufficient time to switch the train to a different track.  

If the consumer mentions their advisor says a managed portfolio will give them a 90% chance of not outliving their money, ask the consumer, “What assumptions did the advisor make? What is the standard deviation of the success rate? Did the advisor tell you the past predicts the future, because that’s the only way he could calculate probabilities? Ask your advisor to explain what Bayesian statistics are without Googling it on his tablet.”   

Guaranty associations providing a minimum level of coverage in case of carrier failure are another safeguard. There are two concerns here. The first is the treatment of guaranteed withdrawal benefits. All state guaranty associations protect a specific amount of annuity cash value; some refer to the present value of annuity benefits. The guaranty associations need to define guaranteed withdrawal benefits by their income value and not their cash value. The second concern is that covered annuity owners are made whole by assessing solvent life and annuity carriers over time. If several annuity carriers go belly-up it could be years before an annuity owner would get their covered payments.  

The reality is getting a life income from an annuity does not give you 100% protection from retirement ruin because we can't predict the future, but the annuity comes a whole lot closer to 100% than anything else out there (and you don't need a degree in mathyness to understand that).    

Moshe Milevsk. March/April 2016. It’s Time to Retire Ruin (Probabilities). Financial Analysts Journal. p.8-12  

Aging & Financial Decisions (3/16)
A recently published 4000 person study concluded that while aging generally has a negative effect on making decisions, the decline in the ability to make optimal economic decisions is a "distinct phenomenon" from other forms of age related cognitive decline. This might mean that our ability to make economic decisions declines sooner than our ability to make other types of decisions.  

When it comes to making decisions the working memory, also known as fluid intelligence, is called upon because it holds the different bits of new information you need to process. Both the amount of new information you can hold and the speed at which you can process it begin to decline about when you enter adulthood. The reason we can still function at age 40 is, as we age, we also pick up knowledge, also known as crystallized intelligence, which means we don't need as much new information. The end result is the quality of our decisions improves until sometime in our sixties or seventies – depending on the individual – when the quality declines.

A new study says that our ability to make financial decisions declines differently than our ability to make other decisions, and perhaps at a quicker pace. This news follows an article in the last issue of Index Compendium that reported on a different study saying that seniors generally made good decisions regarding retirement and that their decisions were often better than juniors. Although the results of the two studies seem to be contradictory, that is not necessarily so, because what it may mean is financial decision-making follows a different path of decline than other cognitive processes and not that the person is unable to make good decisions.  

Even though cognitive functions declines this doesn't mean a 75 year old automatically makes worse decisions than a 25 year old, but it means the 75 year old may not make the optimal decision they might have made at age 55, however the decision may still be good enough.        

What this new study does is question the belief held up to now that the mental or cognitive decline was the same across the decision spectrum. In other words, we thought that whether the older person was trying to decide which hotel to stay at, which car to lease or which annuity to buy, their decision making resources would operate at the same level for these different  decisions, but this new study suggests that may not be true.  

If this study is correct what do we do? One reaction may be for regulations to limit the economic choices of the aged or the government to make the choices for the aged. Another might be to encourage the use of financial solutions that do not require ongoing decision-making – such as using life income annuities rather than managing withdrawals from a portfolio. However, until we know whether this specific decline is happening and why, there can't be any solutions, because we haven't identified the nature of the decline or tested different remedies to combat or minimize its effects.  

While we’re waiting for the results of additional  research, we can still practice the key elements that allow all of us to make better decisions:

* Allow sufficient time for the new information to be processed
* Minimize distractions
* Probe for understanding by asking the decider to tell you what you just told them (and not simply asking “do you understand”)
* And don’t force the decisions when they are tired.  

Aging does not mean bad decisions, but it does require more effort to make good ones.  

Kariv, S. & D. Silverman. 2015. “Sources of Lower Financial Decision-making Ability at Older Ages.” University of Michigan Retirement Research Center Working Paper, WP 2015-335.      

GLWBs: Beating Breakeven Bias (2/15)  
  A large number of people evaluate a stream of income not by its discounted net present value, but by how long it takes them to "breakeven", meaning getting back in income an amount equal to what they put in. If they doubt they will breakeven they almost never buy the income stream. This has been a major, if not the major factor, that has limited life contingent income annuity sales and serves as a limiter on deferred income annuity sales growth. A fixed index annuity with a guaranteed lifetime withdrawal benefit avoids this problem because if the annuityowner dies early, the remaining annuity cash value is paid out. Given the prevalence of this breakeven bias, perhaps showing GLWB income in a different way would help more consumers in making a favorable decision.  

The chart below assumes a $100,000 premium is placed at age 55 and withdrawals begin at age 65. The income payout is 5% and it grows at a compounded 6.05% (roll-up) for ten years. This translates into a guaranteed income starting at age 65 of $9,000 a year for life. Based on the income, the chart shows that by age 77 the annuityowner has received more in income than the original premium. So far, this is the same value proposition that annuitization products use. The problem with annuitization products is many potential buyers think they won't make it to age 77 (even though the actuarial tables show roughly three-quarters do). The good news is by using a GLWB the annuity owner always breaks even or better when you consider the cash value.  

We're going to further assume that the original premium grows at a net rate (after GLWB rider fees) of 4%. What becomes clear is the FIA with GLWB does away with break-even bias since the annuityowner always at least breaks even (This chart ignores surrender charges, but by the time income begins the vast majority of FIAs would be out of their penalty period). Indeed, by age 77 when a traditional annuitization product would have broken-even the GLWB annuityowner has not only received over 100% of his or her original premium as income, but if the policy were cashed in they'd get back an additional 100% of their premium – more than double the premium back in cash and income. If the  annuityowner lives eventually the cash value runs out, but the income continues (that's why one buys the GLWB in the first place). Presented in this manner, the FIA with GLWB is a winning argument against breakeven bias because the annuityowner always "beats" the insurance company.    

6 Reasons Why You Should Use An Annuity Instead Of Managed Assets (9/14)   
There has been much written on the effects of dementia on senior decision making, but dementia is only one factor (albeit a powerful one). The reality is as we get older it requires more effort to make good decisions because of our failing ability to rapidly process large amounts of data in our brains – a decline in our fluid intelligence. This does not mean that age in and of itself says a person cannot make good decisions, but it means that the focus and concentration required to do so may not be available due to issues of health or general stamina, even if the person is not cognitively impaired.  

Due to this inevitable decline several studies have suggested that the use of annuities with life income benefits to generate retirement income makes sense because it eliminates the need for much of the future decision making regarding retirement assets. A paper* published this summer by Professor Lawrence Frolik at the University of Pittsburgh explores this topic in depth. Aggregating what has been written previously about the issue, along with some specifics mentioned in this new paper, effectively creates a list of reasons to explain to a retiree why they should buy an annuity with a life income using at least a portion of their retirement assets.  

Why You Should Buy An Annuity With Life Income Instead Of Managing Assets  

1. Because you don't have a pension
Unless the retiree worked for a government entity the odds are very strong the only predictable source of income they have is Social Security. Even if they worked for a company with a defined benefit plan they may have taken the cash instead of a pension. Unless the Social Security check is covering all of the retiree's essential costs there is merit in getting an annuity life income (especially a joint life annuity for when Social Security income dips after the spouse dies).  

2. Managed Asset Withdrawals are a Hope not a Guarantee
Wall Street uses retirement models to determine how much money can be withdrawn each year, but these are models, not reality, which is why the suggested "safe" withdrawal rate – safe meaning the odds are favorable that the money will last until the retiree dies – has varied from 2% to 5% since the turn of the millennium. If the model is wrong and the retiree runs out of money no financial advisor, target date fund or asset manager will say "oops, I was wrong, but tell ya what, I'll continue to pay you out of my own pocket." It's not going to happen.  

3. Diminished Physical Capabilities
Even if your mental faculties are as sharp as ever your physical parts may not be. As we age our hearing, eyesight and general stamina declines. Professor Frolik makes the point that you may not be able to read those IRA reports due to macular degeneration and hearing loss may mean you mishear important news your financial advisor is sharing. Finally, an octogenarian or nonagenarian may simply not have the endurance to actively monitor investments on a regular basis.  

4. Chronic Health Issues
As we age we are more likely to have ongoing health problems. The pills and therapies that treat the illness often leave the person still in pain, disoriented and/or fatigued and thus less likely to devote time to managing their retirement assets. As the paper puts it, the 80 year old going for dialysis treatment three days a week will probably not be spending the rest of the week worrying that her portfolio is overloaded with equities.  

5. Mental Impairment
The Plassman studies** found that for seniors in their 70s 1 in 5 had some cognitive impairment and that figure rose to 1 in 2 for seniors in their 80s and 3 in 4 for seniors in their 90s. Cognitive impairment includes both those with dementia and those where thinking is only slightly impaired. If we tighten this to only include those with dementia – which includes Alzheimer's – the results are  1 in 20 for the 70s age group, 1 in 4 for the 80s and 1 in 3 for the 90s. The reality is a significant portion of the people that begin retirement actively managing their money will at some point be unable to competently do so, at least at times. Put bluntly, the reason for using an annuity is there is much less loss if the retiree succeeds in wiring their monthly annuity check to a Nigerian bank account than if they wired their entire IRA.  

6. Guardianships & Powers of Attorney Have Limits
Something I faced years ago was my mother in the early stages of dementia which necessitated giving my brother power of attorney over her affairs, but due to her diminished capacity it was questionable whether she had the legal capacity to sign the power of attorney. We had her sign anyway, found agreeable witnesses, and crossed our fingers it wouldn't be challenged. We were lucky, it never was. Still, it was a heavy burden that my brother assumed, even though our mother's assets were few.  

The guardian or agent has a fiduciary duty to do what is best for the retiree. However, even if they don't steal from the kitty or intentionally misuse their power what are their qualifications as an asset decumulation expert? Will they manage the assets to produce the maximum income prudent with reasonable risk? Will they try for riskier investments and lose the asset? Or will they put all the money into three month Treasury Bills to try to protect the principal, but generate too little a return so that the retiree still winds up impoverished in the future?  

There is also the choice of the guardian/agent. The paper mentions the age 70 man naming his age 69 wife as agent and becoming incapacitated at age 85, but by then the wife is 84 and experiencing her own problems. An acceptable agent now may be less than ideal when needed; even a well intended guardian can make mistakes. Selecting an annuity with lifetime income before a guardian is needed helps prevent a future problem.  

The Answer Is An Annuity With Guaranteed Life Income
Previous Index Compendium articles have discussed recent studies that found using part of the retirement assets to buy an annuity producing a guaranteed life income vastly improved the odds that the total income will last a lifetime, but although some financial advisors seem to have a difficult time accepting this, the use or non-use of an annuity is not a financial choice, it is primarily a behavioral one. On the advisor side a combination of two cognitive biases – overconfidence and hyper-optimism – work against recommending an annuity. In short, the advisor is confident that they can beat both the return expectations of the insurance company and the laws of probability in managing the retiree's assets. On the retiree side the biases of risk aversion,  availability and mental accounting often get in the way of buying an immediate annuity, because the retiree feels they will die too early and get cheated. However, the use of a fixed index annuity with a GWLB overcomes most of the retiree's biases.  

To wrap up why an annuity with a guaranteed life income makes sense I'll quote three few lines from Professor Frolik's conclusion, "The assumption that retirees can successfully manage their IRAs during their declining years is a folly... It is time to admit that what most retirees need is a stream of income. Our nation’s retirees need and deserve the security of having a check arrive every month that does not depend upon their skill at managing an IRA during their declining years."    

* Frolik, Lawrence. 2014. Rethinking ERISA’s Promise of Income Security in a World of 401(k) Plans. University of Pittsburgh School of Law. Working Paper 2014-26.  

** Marrion, Jack. 2012. Addressing The Challenges Created By Cognitive Changes In Seniors. Advantage Compendium.  

Investors Still Selling Low (and now they are buying high) (6/14)
The chart below is a classic illustration of how investors buy high and sell low. What it shows is the period from the summer of 1996 through the summer of 2003. The gray line is the S&P 500 – if you pick a gray box and look down and to the right it will tell you around, say, June 2001 the S&P 500 closed around 1250. The black line is a 3 month rolling average of net equity mutual fund purchases and sales, or inflows –  if the black line is above zero investors are buying and it it’s below zero investors are selling.

What the chart shows is as the late 1990s bull market soared that investors kept buying. Indeed, purchases hit their peak just as the bull market cycle was peaking. And investors kept buying as the S&P 500 dropped from 1500 to 1300 to 1100 and didn’t start selling in earnest until the index dropped below 900, which happened to be the bottom of the bear market. This is the type of behavior that creates the results shown in the Dalbar studies where actual mutual fund investor returns are far lower over long periods of time than if the investor had simply bought a diversified portfolio of funds and left them alone.

The millennium bear market was not the longest bear market since the Great Depression –  the 1980-82 bear was two days longer; nor did the recovery take the longest – the 1973-1974 bear market took three months longer to regain its past high point, but it was the deepest. It took over seven years for the stock market to come back. The millennium bear market made investors more skittish going forward as the chart below shows.   By 2007 we were completing the fourth year of a bull market, but as 2007 ended investors became nervous. They weren’t selling much, but they weren’t buying much either; the irrational exuberance this time around was more tempered. However, they hadn’t lost their penchant for selling low. The majority of the selling in the market crash of 08 took place after the index slipped below 1000 and generally continued as the index topped 1400. As in times past, the majority of investors were selling during the bull market days with the greatest gains. When has the strongest and most sustained buying happened? Since the index went over 1700. It wasn’t until the bull market was nearing its fifth anniversary and the index was up 150% that the typical investor began buying in earnest. For the last several months these investors have been strong buyers of equity mutual funds.


 As June begins the bull market has been around 64 months making it the third longest one in the last half century. The S&P 500 is up 179% from its low and the Nasdaq is up 234%. I don’t know how much longer the bull market will continue. The 1990s one lasted over nine years and produced far greater gains. For all I know we are at the early stages of a new phenomena where the market never goes down, but there are a couple of things that make me nervous.  

The Advisor Confidence Index ( which takes the temperature of financial advisor attitudes finds they remain strongly optimistic about the markets and economy....just as they were in late 2007.  But more disturbing is the confidence of the small investor who have decided that now is the time to invest.  I don’t offer investment advice nor do I have a crystal ball, but I do look at behavior. The past behavior of the average investor is they almost always buy high and sell low. I’ve seen nothing recently that alters this view.    

Annuities in 401(k) Plans (11/13)
It's been almost a year since LSW announced their first-in-the-industry 401(k) index annuity. I believe this will be a huge market for FIAs, but it will be a steep learning curve for plan providers. The original idea behind 401(k) plans was that the worker got to create their own retirement pension instead of the company providing one. Over the last 30 years this keystone was lost. Today 9 out of 10 plan sponsors view 401(k)s as saving plans while less than 1 in 10 remember that the purpose of these "savings plans" was to generate a lifetime income. The result: sponsors are trying to figure out ways to make the investments last rather than working to create the lifetime pension the concept was based upon.

44% of employees want an annuity option in their plan. Why aren't plans offering them? Slightly over half say it is because annuities will be too complex to administer and roughly the same percentage are concerned about their fiduciary liability. And 44% says they don't think the employees will select an annuity option. The most encouraging news is while over half of plan sponsors last year did not want to consider an annuity option roughly three-quarters do this year; I suspect this is mainly due to the Treasury saying they like annuities.

The concern about fiduciary risk may be overblown. I've read articles saying that plan sponsors are concerned they could be liable under ERISA if the carrier they select for the annuity goes out of business in 20 years and fails to meet their  obligation, but neither ERISA nor the legal     requirements of being a fiduciary require one to predict the future. A plan sponsor has no more liability resulting from the future performance of an annuity than they would from the future     returns of a mutual fund. However, the plan sponsor does need to show they've been prudent in creating and following a selection process   today. This would include setting minimum standards of current carrier financial strength and looking at enough carriers to say that the one(s) selected had competitive fees/payouts.

MetLife, Retirement Income Practices Study: Perspectives of Plan Sponsors and Recordkeepers for Qualified Plans, 2012

Comments on Reichling & Smetters’ Optimal Annuitization Paper (8/13)
Released at the end of June, what I feared would happen with their report is happening, which means the annuity community needs to have sound bites ready to counter the false information.

The Study Spin
You kind of knew where this was heading when the first article about the study was titled  Annuity Puzzle Solved: Don’t Buy Them. The study did not conclude that people shouldn’t buy annuities. The study concluded that most people should not buy immediate annuities or annuitize, which most people don’t do anyway. That first article appeared in an smartadvisor blog and was an interview with one of the authors, Kent Smetters. The first question was “So who should and who shouldn’t be buying annuities? What Smetters should have done was correct the reporter and said “This paper isn’t about all annuities, this study is about when life contingent immediate annuity buying or annuitization is optimal...but he didn’t. He does make the point that he is talking about annuitization, but the damage is done in the headline because the memory you walk away with is “Study says don’t buy [any type of] annuities.

What The Report Does Say
This part gets a little deep because their paper is a little deep. The study is a mathematical response to Menahem Yaari’s 1965 paper on annuitization that concludes, unlike Yaari’s paper, that most people should not buy a life-contingent immediate annuity (or annuitize). What the study does is revise, and I would say mathematically rebut, the conclusion of the 1965 study by Yaari titled Uncertain Lifetime, Life Insurance, and the Theory of the Consumer. Yaari concluded that 100% of people will annuitize all of their wealth unless they have a bequest need. The reality is only 0.5% to 2% (depending on the study) ever annuitize and even though there are have been articles written about the surge of life immediate annuities, the reality is it hasn’t happened. In 1996 sales of life-contingent annuities were roughly $3 billion (Advantage Compendium); in 2011 they were $4.2 billion (Beacon Research) and this was during a period that witnessed total annuity sales soar to over $200 billion a year. Consumers have self-selected to not buy immediate annuities for years for both financial and behavioral reasons.

The new idea introduced here is that negative health shocks cause the value of a life-contingent annuity income to drop. It is like this: You annuitize an existing fixed annuity or buy a life immediate annuity because you think you are going to live for 30 more years. Next month you have a stroke or severe heart attack causing your life expectancy to drop. In fact, you might even require long term care. It is a good bet that you are not going to be around for 30 years, so the value of the income from the annuity is less than it was. And you might even be forced to sell it at a loss if you need the money for a nursing home (and may react in a less than rational manner ). The loss in the annuity value more than offsets the mortality credit (the extra income life annuities pay based on the fact that some annuitants do die early and the carrier uses that money to increase the average annual payout to all).

If you have a large enough net worth you will not have to sell the annuity if you get a shock and the loss of annuity value will not be as a big a concern. Thus, the study also concludes that annuitizing does not make sense if you have a small net worth because you may need that money to cover the cost of the negative shock.

When you consider that over 60% of those over age 65 have a net worth under $250,000 – 36% under $100,000 [U.S. Census, 2011] – and that a sizeable portion are not in good health, an argument can be made that these people should not annuitize. However, in the real world, you would be hard pressed to find someone to advise a person with only, say, $50,000 (and no bequest need) to put it all into a life immediate annuity, but that’s what Yaari said would happen. and it is what the new study says should not happen.

Shorting Annuities & Negative Annuitization
The study also talks about negative annuitization and shorting annuities, but this does not mean that annuitization is bad; it means the opposite of annuitizing which is buying life insurance. Buying a life annuity and buying a life insurance policy are opposite events because death ends the payout on one and starts the payout on the other. If paying a lump sum and getting an income is positive, than paying an income (to the carrier in the form of premiums) and getting back a lump sum at death is negative (it is the reverse).

The study concludes that most working people should have negative annuitization, but this does not mean they should not buy annuities, it means they should buy more life insurance. Indeed, Reichling & Smetters conclude that young people should own life insurance, even if they don’t have dependents. The two key points to keep in mind is that this is an academic paper that has created some new algebra and the terms it uses are academic ones, which can have different meanings than the real world (such as “negative” for “opposite”). It also uses primarily a rational expectations model, which, like the expected utility model, requires “economic man” or woman to make all financial decisions rationally to maximize expected utility (minimize risk-maximize gain). The study’s message is also very broad in context.

Financial Behavior
I’ve written about the annuitization puzzle several times. The behavioral economic point I and others have raised is there isn’t a puzzle. People that could financially benefit from annuitized income mainly don’t buy life-contingent immediate annuities or annuitize because they feel they’ll die early (a framing issue); it is presented as a stand-alone purchase instead of as a part of a comprehensive retirement solution (a framing issue); and they feel the odds are stacked against them because the insurer would never let them win (a trust issue). Effectively, the unvoiced perception is buying a life-contingent immediate annuity increases the risk of loss because the buyer won’t get the full benefit.

Reichling & Smetters also said most people won’t annuitize, but they approached it from a math angle, by concluding the valuation risk of the immediate annuity is too high therefore the greater the risk aversion the more the likelihood of annuitization is reduced. Their risk aversion measurement is directly opposite the behavioral effect that higher risk-aversion correlates with greater annuity buying, but it isn’t inconsistent with rational-expectation theory because of the way they’ve staged this, which is buying an annuity decreases the ultimate financial reward. What they concluded was that the more risk-averse the person was, the less likely they were to buy an immediate annuity because they would be afraid they wouldn’t get the full annuity benefit. Essentially, Reichling & Smetters came up with a mathematical reason for a behavior, but we both say most people won’t buy life immediate annuities due to risk aversion.

The Study Spin II
Sadly, I believe this study will be used by those that don’t like annuities, and were never going to use annuities, to justify their existing bias of not offering annuities. The good news for us is the study never slaps down deferred annuities. It even builds a strong case for GLWBs.

Guaranteed Lifetime Withdrawal Benefits
You don’t have the financial behavioral problems with GLWBs that you have with immediate annuities because the buyer does not give up control of the asset. The GLWB gets a lifetime income, but also has the remaining cash value of the annuity in case there is a health shock. Indeed, many GLWBs offer substantially increased payouts if there is a health shock and the person needs long-term nursing or hospital care.

Not only do FIAs with GLWBs provide the capital for unexpected health shocks, but many are designed to increase the payout if a health shock occurs. Although not directly stated, I  believe the study supports the use of GLWBs and strongly implies they are a better solution than deferred income annuities (DIAs) for those nearing retirement.

On a dollars & cents basis the question might be “Does the GLWB with its average 0.90% annual fee remain competitive with the bonds/bond funds Reichling & Smetters use in their models?” Reichling & Smetters never addressed this. Based on my modeling of index annuities, fixed index annuities may very well beat bond and bond fund returns. From a purely financial basis the GWLB could very well be optimal to the binary paradigm created by the study. However, the main reason for buying a life-contingent immediate annuity, a DIA or a deferred annuity with a GLWB is peace of mind and that is something that can’t be modeled.

In Summary
The study itself is not bad for FIAs, in fact, it makes a strong case for them. However, the study will be spun by FIAphobes into an anti-annuity story and you’ll need to be prepared.

Retirement Confidence Survey (5/13)  

When I Plan To Retire 1991 2013 69% of current workers say they will work during retirement, but 47% of those currently retired were forced to do so before their planned date
Plan to retire before age 60 19% 9%
Plan to retire Ages 60-64 31% 14%
How Much Do I Think I Will Need To Retire? ">Men ">Women   How Much Do I Have? (not counting home)  All Workers Age 55+
Under $250,000 28% 32%   Under $25,000  57% 43%
$250,000 to $499,999  19% 22%   $25,000-$99,999 19% 17%
$500,000 to $999,999 22% 21%   $100,000—$249,999 12% 18%
Over $1 million 22% 15%   $250,000 + 12% 24%
Don’t Know  5% 8%   49% say they are not confident they will have enough money to live comfortably throughout retirement  - dramatically up from 29% saying this in 2007
Sources Of Retirement Income   1974 2010 The retirement myth repeated by the financial world is that back in the good old days before 401(k) plans that pensions provided a much higher source of income than they do today. Not true. In 1974 pension produced 14¢ out of each dollar of income, in 2010 it was 20¢.
Social Security   42% 40%
Pension 14% 20%  
Income from Assets 18% 12%  
Working 21% 27% Source: Employee Benefit Research Institute and Mathew  Greenwald & Associates, Inc.,2013 Retirement Confidence Survey  
Other 5% 2%

New SOA Report On Retirement Is Required Reading 3/13

An exceptional study published this year by the Society of Actuaries (SOA) takes a panoptic look at retirement from a variety of concerns and metrics to calculate the assets required. I strongly encourage all agents to go the SOA website and download the complete report. Some Key Points: 

  • Many of the next generation of retirees are facing a big drop in their standard of living when they retire. 

I reached a similar conclusion after doing research on trailing-edge boomers (born between 1955 and 1964). People hitting their early fifties are in worse shape than current retirees and older boomers. 

  • Half of retirees have less than $100,000 in   financial assets (excluding home)
  • To handle longevity risk with a 5% failure rate the assets needed are approximately $686,000 (excluding home) for those that made $60,000 the year before retirement.
  • The most effective way to increase the odds that you will have adequate retirement income is by delaying retirement.
  • Annuitization helps to meet income needs after other assets are gone, but must be balanced against having an adequate emergency fund. “[Annuitization] is not feasible for lower income individuals and those with low financial assets. It is most likely to benefit the middle and upper income retiree with more assets.
  • Shock events (prolonged poor returns due to stock market downturns or low interest rates, long term care needs, death of a spouse) can derail retirement.

The study also finds that the most middle market retirees cannot afford to purchase an immediate annuity to guard against longevity risk and an LTC policy and hedges against poor investment returns and life insurance for remaining spouse. The study has a significant omission in that they ignore fixed annuities with guaranteed living benefits (GLBs). Although it says there are combination products it completes ignore the reality that there are fixed annuities with riders available today that guard against longevity risk, provide additional income if hospitalization or a nursing home stay is required, protect principal against market loss while still making assets available in case of emergency, and can provide a death benefit. The innovative financial products the study says are needed are already here.

Perhaps the reason for the omission is because it would be nearly impossible to quantify the amount of remaining asset in the annuity at time of death, or the fact that not all annuities with GLBs offer all or two of these different benefits.

The study finds that buying an immediate annuity (or annuitization) always reduces the odds of having financial wealth at death. Part of this makes intuitive sense – after all, you’re converting part of your cash into an income stream leaving you with less cash. However, a second reason for the conclusion is they assume historic returns on investment assets – which were much higher in the past, and current rate returns on the annuities – which were much lower now. They basically tell the reader to disregard this part of the study saying “we do not feel that any strong conclusions can be made regarding the efficacy of annuitization strategies based on these results.” Frankly, I’m not sure how I would have handled this point either. My view is that future stock market returns will not be nearly as high as those used in most financial models and that immediate annuity rates will be higher in a few years from today’s levels. However, I might have lowered my investment return assumptions and shown an additional chart. 

Overall, it is an excellent study and a prime educational tool. The agent can use it with consumers to point out the shock events that need to be taken care of and it provides a third party view that speaks of retirement risks and what can be done.  

AARP Study Shows More Consumers Want Annuities (7/12)
Recently AARP Public Policy Institute released “Older Americans’ Ambivalence Towards Annuities” which highlighted the result of a 2010 survey on retirees and workers (ages 50 to 75 and still working). I strongly recommend downloading and studying both the results and the responses to the questions.

The study found that 30% of workers with a 401(k) type plan intended to choose an annuity. This is higher than many expected since the dollar amount of life-contingent immediate annuity sales has remained essentially flat over the last 17 years (if you remove period certain sales leaving only life-contingent annuity sales you find the sales in 2010-2011 are just about where they were in 1995-1996. The study has far reaching implications for agents and the industry. Here’s my take:

Retirees Like Their Annuity Income
Retirees that were already receiving an annuity income from their defined benefit plan were asked – If you could get part lump sum and part pension annuity income would you do it? – 85% said no with 52% saying hell no. Even 68% of the workers scheduled to receive an annuity

income at retirement said they were unlikely or unwilling to swap the annuity pension for a mix of cash and pension. Retirees understand the value of an income guaranteed for life.

Workers Prefer Income Over Cash in Plans...
The understanding with a defined benefit plan is you will receive an annuity income, but a defined contribution plan creates a pot of money to be used for a do-it-yourself approach to retirement. Only 11% of workers said they would take their 401(k) as a lump sum. Over 31% said they would use it to buy a life annuity and 24% said they would take out regular payments not guaranteed to last a lifetime (25% said they didn’t know what they would do).

Workers and retirees were also asked if their 401(k) plan allowed/had allowed them to take part of the balance as a lump-sum payment and the remaining part as monthly payments guaranteed to last for the rest of their life, how much of their balance would they choose/had chosen to convert to a life annuity?  22% of both groups said they’d use most of their money to buy an immediate annuity and 55% said they’d spend half of their money to buy an immediate annuity.

This is news! Up until the crash of 2008 very few new retirees chose to convert 401(k) plan cash into an immediate annuity and now roughly one third are saying, “I want to buy an immediate annuity” and they’ll spend half or more of their cash to do so.

The other aspect is roughly a quarter said they wanted to take out regular payments and another quarter were clueless about what to do. What Wall Street and the media have been pushing for years is that there is only one solution to retirement – take out 4% a year from your professionally managed account and cross your fingers. Since that has been a lousy plan for the last decade both Wall Street and the media are finally admitting that maybe annuities aren’t terrible (it makes me wonder whether consumers are changing their attitudes towards annuities because the media is less negative, or did Wall Street and the media change their message because consumers told them they didn’t believe the old 4% story).

Agents that build the brand of annuity income expert – not the broader brands of annuity expert or retirement expert – should attract a growing group of prospects. There will be a strong temptation for consumers to simply purchase the immediate annuity with the highest payout factor, but retirees need to be educated on understanding how to interpret the financial strength of the carrier and be aware of the different payout options. Agents as annuity income experts can provide this education.

But This May Not Be True If It’s Their IRA
When it comes to decisions about pension and 401(k) plans both workers and retirees seem very receptive to using life annuities, but when it comes to the person’s IRA you get different answers. The survey asked workers how likely they would be to convert their IRA into a life annuity. The example they used was taking $50,000  to buy an immediate annuity income of $335 a month. Only 5% said they were very likely to do this and 32% said they were somewhat likely (however only 17% said they were not at all likely to convert to an annuity).
These results might be because many of these workers have a pension plan and an IRA, so they are already getting a life annuity income. Or it might be that workers have a different mental picture of how their IRAs will be used in retirement – perhaps they are thinking that the 401(k) is for income and the IRA is for emergency cash. Even so, more than 1 in 3 workers said they would consider buying an annuity with their IRA cash.

Why They Will Or Won’t Buy An Annuity
Workers and retirees said it was very or somewhat important in retirement to obtain a dependable monthly income (93%). This correlates with other answers where they believed that immediate annuities would give them more annual income than living off dividends and interest, greater peace of mind, help them manage their budget better, remain independent longer and avoid stock market risk. However, 86% of workers and retirees said it was very or somewhat important in retirement to preserve your principal, and this is largely explains why they said they wouldn’t buy an annuity.

The major reasons for not buying an immediate annuity are the ones always heard...I want cash around for emergencies...I may die early...the insurance company has rigged the deck...I don’t want to lose control. Past articles in Index Compendium have talked about the annuity puzzle and why more people don’t annuitize or buy an immediate annuity. However, the elephant in the annuity room that the study completely ignored was the use of guaranteed lifetime withdrawal benefits.

The Survey Flaw: GLWBs Completely Ignored
The first variable annuity with a GLWB was introduced in 2003, the first fixed annuity to offer one came out in 2006, and yet although the annual sales of deferred annuities with GLWB riders is more than 20 times greater than immediate annuity sales the researchers completely
ignored this. The reality is a GLWB eliminates most of the objections associated with reasons given for not buying an annuity.

The trade-off is the guaranteed income from a GLWB is less than a life only payout factor. It would have been interesting if the participants had been asked, “Would you be interested wherein you receive an income guaranteed for life that is higher than you’d get from dividends or interest, gives you access to cash for emergencies, and leaves you in complete control?”

Educating Workers
When it came to retirees most said they were familiar with annuities and how they work, but for workers 3 in 10 said they were not too familiar with annuities and 2 in 10 were not familiar with annuities at all! The annuity industry faces an education problem because half of their prospective market doesn’t know an annuity can be the solution.

Part of the reason for the ignorance is roughly two-thirds of workers and half of retirees are do-it-yourself retirement income experts; they don’t have an advisor. While this means that most workers and retirees haven’t had an advisor tell them over and over again that annuities are bad, the problem is well over half of these consumers aren’t trying to educate themselves. They don’t attend seminars or classes on retirement planning (79%), don’t use the internet to learn about financial choices (83%), and don’t read magazine articles or books on the subject (55%). The workers and retirees need an agent’s help, but it will be tough to get them to realize it. This lack of education is why when workers were asked how they were going to generate retirement income from their assets roughly half said they didn’t have a clue.

To Sum Up
There is a stronger demand for lifetime income from annuities than previously believed. Even with the baggage immediate annuities carry – you have to sell the asset to get the income – you still have 3 out of 10 people that say they would buy one. One big point I take away from this is if more consumers were aware of how GLWBs really worked they would buy them. The other big point is a great deal of education needs to be done conveying the benefits of annuities.

5.3M Mutual Fund Owners Shouldn’t (6/12)
The new
ICI Research Report contains extensive demographics about mutual fund owners, but one area of the report that surveyed mutual fund owners I found particularly interesting. 13% of the people that own mutual funds stated they are “unwilling to take any risk” and 10% will accept below-average gain for below-average risk. What this means is there are 5.3 million  mutual fund investors essentially saying they shouldn’t be in the mutual funds they own.

So, assuming there are $200 billion in in-force index annuities and guessing at the average size of an FIA sale, this means roughly 3 million people own index annuities. Thus, if FIAs could capture roughly half of these self-admitted risk-averse MF investors, in-force index annuities could increase to $400 billion thus doubling sales for years to come. Another interesting risk point is the largest groups unwilling to take any risk are the young (born after 1977) with 19% saying no to risk, and the retired (born before 1945) at 21%. While intuitively it makes sense that retirees don’t want to risk what they have, the young people have little to risk and yet they don’t want to risk. These are people that have come of age during the financial miasma of the 21st century and it appears this period has led to the same type of generational scarring that the Great Depression caused on the Silent and GI generations. 

When you add on those that would settle for a below average return in exchange for below-average risk the percentage increase to 27% of the young and 37% of the old (the percentage of the middle groups saying they are very risk averse are 15% for those born 1965-1976 and 20% for those born 1946-1964. The result of all this risk aversion should be a strong demand for annuity products now and in the future due to the guarantees desired by the young and the old.

Schrass, Daniel, and Michael Bogdan. 2012. “Profile of Mutual Fund Shareholders, 2011.” ICI Research Report (February).

More Retirees Taking GLWB Income Than Expected (7/11)
Milliman's new Guaranteed Living Benefits survey of leading variable annuity (VA) carriers released last month found that more annuityowners are using lifetime benefit withdrawal benefits. Here’s what they found and what it means.

1. Lapses Are Lower Than Expected
Almost every VA carrier says lapses have been lower than expected, with 1 in 5 carriers underestimating lapse rates by over 20%. Lower lapses means more people are using the benefit which increases the likelihood that the carrier might someday have to pay the annuityowner some of the insurer’s money. A continuing higher than expected lapse rate means the carrier didn’t charge enough for the benefit; a continuing much, much higher than expected lapse rate could mean the carrier doesn’t have the money to pay the benefits.

2. Withdrawals Go Up When Age Goes Up
Overall, roughly a quarter (23%) of eligible VA GLWB buyers are taking withdrawals. The percentage of annuityowners taking withdrawals increases by age: 17% of those in their 60’s took withdrawals, 34% of annuityowners in their 70;s and 42% of those in their 80’s.

3. Withdrawals Go Up When Investment Value Goes Down
Withdrawals increase when the VA is “in-the-money” meaning that the income account value was higher than the actual cash value (this is actually out-of-the-money for the carrier because the cash withdrawal represents a higher percentage of the cash account value). The overall median was that 13% of annuityowners were taking withdrawals when the income account and cash value amount were the same, but that 25% took withdrawals when the income account value exceeded the cash value by more than 20%, and that 54% took withdrawals when the income account value exceeded the cash value by more than 50%. Sales of VAs resulting from annuity exchanges were 24% in the first half of 2010, significantly below the 40% level on 2007, due to existing VAs being in-the-money on their GLWBs.

The way income growth guarantees are structured index annuities will almost certainty be in-the-money with their income values exceeding their cash values. I predicted this would decrease index annuity sales from annuity exchanges, and this is indicated by the results being seen in the VA world. However, the differences in market risk between the two types of annuities means the withdrawal response from index annuity owners should be more measured.

Explanation: A VA owner permitted to take 5% withdrawals could begin with $100,000 in VA cash value and income account value. If, 5 years later, the cash value was down by 50% the VA cash would be worth $50,000, but the owner could still withdraw $5,000 a year through the GLWB, because the 5% withdrawal is based on the original $100,000 income account value and not actual investment value. A VA GLWB owner with a big loss might view taking withdrawals as a way to get 10% returns ($5000 payouts on the remaining $50,000) especially if the VA owner is pessimistic that the VA investments will ever recoup their losses. Essentially, the structure of a VA GLWB means it is most likely to be utilized at the worse possible time for the carrier – when the annuityowner is more likely to withdraw and use up all of their money and start using the carrier’s money.

On the other hand, let’s look at an index annuity where the income account is guaranteed to grow at 10% simple interest, and make the same assumptions. Due to the guaranteed growth the annuityowner could withdraw $7,500 a year after 5 years ($150,000 times 5%). If the index was flat or had fallen the cash value might still only be $100,000, however, the FIA owner does not have a loss. Furthermore, the FIA owner knows if a withdrawal is not taken the guaranteed withdrawal amount will be higher next year and, at worse, the $100,000 will still be there. If the annuityowner takes a withdrawal they know they will create a loss – taking the cash value below $100,000, but if they wait the worse that can happen is they could withdraw even more next year and the cash value could go up.

An in-the-money GLWB on a VA is pressuring the annuityowner to take withdrawals before “things get worse” to recoup the loss. An in-the-money index annuity GLWB is the normal state of affairs that pressures the annuityowner to not take withdrawals because “things can only get better.” It’s an entirely different mindset and one that works in favor of the index annuity carrier.

4. 69% OF VA Buyers Buy A GLWB
GLWBs are the most popular lifetime benefit with 95% of variable annuities offering it and 69% of VA buyers selecting it. GLWBs changed why people buy deferred annuities.

A Longer Holding Period Does Not Affect The Size Of The Loss (8/13)  
In one part of his well-written book with the long title, The 7 Most Important Equations for Your Retirement: The Fascinating People and Ideas Behind Planning Your Retirement Income, Moshe Milevsky says we should look at not only the probability of the loss, but the pain caused by it. I'd like to talk about this topic giving full credit to Milevsky for the idea, but using a slightly different context.

What Wall Street Says
The mantra from Wall Street is that yes, the stock market is risky, but the risk goes down over time. As proof of this viewpoint one could look at the monthly S&P 500 closes from January 1951 through July 2013 and calculate the ups and downs:

  One Month One Year Five Years Ten Years
# of Periods 750 739 691 631
# of Up Periods 443 534 554 570
# of Down Periods 307 205 137 61
Average Period Loss -3.2% -11.8% -11.3% -13,8%
Average Period Gain 3.3% 16.1% 60.2% 128.0%
Biggest Period Loss -21.8% -44.8% -35.8% -40.6%
Biggest Period Gain 16.3% 52.9% 219.9% 370.5%

Wall Street says that the stock market is less risky with longer time horizons – there is more risk in a one month holding period than a ten year period they would say – but they are talking about the number of losing periods and not the pain of the loss. It is true that the number of losing periods decline as the length of the holding period increases. As shown, 41% of monthly holding periods would have shown losses versus 28% of one year periods and only 10% of ten year periods resulted in losses. However, this does not reflect the pain of incurring the loss.

The biggest one year loss was 44.8% meaning the $100,000 placed in the S&P 500 index was worth $55,200 one year later. The biggest ten year loss was 40.6% turning $100,000 into $59,400. It may be reassuring for the advisor to tell the client the odds of incurring that $40,000 loss were much slimmer than if it had been a one year holding period, but it still doesn't resolve the fact that the client that invested $100,000 at age 55 now is age 65, has only $59,400 and has run out of time.

These were one time events. Only for 1 one year period and only for 1 ten year period did the S&P 500 drop over 40%. However, the age 55 investor that lost 40% in one year has nine more years or chances to "get it right"; the age 55 investor that lost 40% over ten years has no chances left. The pain of the 40% ten year period loss is much greater than the pain of the 40% one year period loss.

A final point on this is over the last 20 years Wall Street has hired dozens of brilliant mathematicians and statisticians that have created incredibly complex algorithms and computer models, many good advisors spend hours using Monte Carlo simulation software, both do so in an effort to minimize losses. And yet, we just concluded the worst decade for investment returns since the Great Depression.

If the past predicts the future – and Wall Street believes it does – it still means that the average period loss of a losing period is 12% to 14% whether the period is one, five or ten years and that the possibility of a large loss does not go away as the length of the holding period increases. For a client that does not want to incur losses a vehicle with zero chances of losing principal over any holding period may be a much better solution.

The Bond Door Cracked (7/13)
You might pitch your tent by a canyon river below a dam because the steam provides a little more water than you’d get from a well, but you have to realize that if the dam breaks you could get swept away. Although the bond dam didn’t break in June, it did develop cracks.

Cognitively, investors knew that interest rates would eventually go up – the Federal Reserve has said repeatedly in the past that they won’t keep rates artificially low forever – and most are aware that the value of an issued bond falls when yields on new bonds increase. In spite of this investors moved $91 billion into bond mutual funds in the first 5 months of the year. I think this is largely due to fact that these investors were still scared of equities and bank account yields stink (and it doesn’t help that Wall Street and the media won’t stop telling investors that the financial world only consists of stocks and bonds). However, with FRB Chairman Ben Bernanke first hinting and then saying the Fed’s bond buying might be cut back as early as this fall, the mood changed. In the first three weeks of June $23 billion were taken out of bond funds.

However, the bond dam didn’t collapse, it only cracked a bit, and your tent wasn’t swept away, but it might be partly in the water. I compared changes in the net asset value from 31 May to 29 June of nine Vanguard bond exchange traded funds (ETFs) and mutual funds. All had lost value with five losing between 1.5% and 1.8% and four losing between 3.1% and 5.0%1. However, these losses are minor and won’t inspire the phrase “Black Bond June” anytime soon. I would not be surprised if bond values rally in the near-term and these small losses are reversed. But this should be a wakeup call for small investors because it is a harbinger of the future.

 Bond funds researched lost 1.5% to 5% of their value in June

 The period from 1945 to 1981 saw bond rates rise from an average of 2.80% to 16.40%. I don’t think we’re heading for double digit bond yields, but even a period of modestly increasing rates results in major losses of principal. As an example, corporate bonds issued in the late 1940s when rate were around 3% were worth roughly 80 cents on the dollar in the late 1950s when rates averaged 4%2. Unless you have the ability to manage and adjust your portfolio, aided by fresh money coming in that allows you to buy higher yielding bonds over time, might it not be more prudent to select an interest based instrument wherein your principal and credited interest are protected from this loss of value? A fixed index annuity provides the opportunity to stay competitive in a rising rate world and won’t get washed away.

1. Vanguard N.A.V. change 31 May to 29 June: VBTLX -1.84%, VBMFX  -1.84%, VBILX -3.08%, VFITX -1.74%, VBLTX -4.94%,  VGIT -1.49%, BLV -3.99%, VGLT -3.45%, BND -1.65%.  Not a solicitation to buy or sell, for educational purposes only.

2. Federal Reserve Board; Van Caspel. 1983. The Power Of Money Dynamics. p.313

A 2.5% Wall Street Withdrawal Rate Means Annuities Essential (3/13)
Building on previous research, a new paper
1 concludes that the 4% Rule touted by Wall Street as the “safe” percentage one could withdraw from their investments and not outlive their money does not work in today’s low yield times. Indeed, even under the optimal stock/bond allocation a 4% withdrawal rate – adjusted for inflation – fails 40% of the time when looking at a 30 year retirement period. What if interest rates head back up? Even if the low bond yields that have existed for the last few years abate and
interest rates return to higher historic levels in five years – and the researchers do not see this as likely – the failure rate is still 18%.

What withdrawal rate is sustainable? You need to get withdrawals down to 2.5% a year to get the failure rate over 30 years down to 10%; to get a “95% confidence level” you need withdrawal rates at 2.2%. When you consider that an age 65 couple can easily find an annuity with a guaranteed lifetime withdrawal benefit (GLWB) of 4% or 4½% or a joint-life immediate annuity payout of 5.6% it appears that it would violate an advisor’s fiduciary responsibility if they didn’t recommend a life income annuity solution for a client entering retirement. But even though using life income annuity solutions may double the initial income (see page 8) and remove longevity risk when compared with the Wall Street approach an annuity is not right for every situation.

When IAs, DIAs, GLWBs Are Required
There are reasons to not put a portion of your assets into an annuity guaranteeing a lifetime income: 1) based on family or personal history you have a justifiable belief that you won’t live that long – a lifetime income doesn’t mean much if you’re going to die next Tuesday; 2) you need the money for an emergency fund or other future cash needs; 3) you have bequest desires; and 4) Social Security and pension provide enough income to cover the essentials.

Reasons Not To Use Life Annuity

  • You won’t live that long time 

  • You need money for an emergency fund or future cash needs 

  • You have bequest desires  

  • Social Security & pension provide enough income.

What this means is an annuity is not for everyone. However, to flip this, if 5) there’s not real evidence to suggest you’ll die early; 6) you feel you have sufficient assets for cash needs; 7) you don’t have bequest needs or you have provided for those needs with life insurance; and 8) your Social Security and pension represents less than half of the income you’ll need in retirement, then I don’t know how you justify not putting at least a portion of assets into an annuity with a lifetime benefit – especially if a younger spouse is involved.

Reasons To Use Life Annuity

  • There’s no evidence to suggest you’ll die early

  • You have sufficient cash reserves;

  • You don’t have bequest needs

  • Social Security & pension represents less than half of the income

Annuities Not Usually CPIed
Although it is possible to get an immediate annuity that is indexed to the Consumer Price Index (CPIed), and a very few GLWBs offer an increasing income option, the reality is life annuity income is rarely designed to increase with inflation, but this may not be a big factor. First, Social Security income is inflation-hedged. Second, not all of the retirement assets are placed in an annuity and these can be allocated to inflation friendly assets (indeed, since annuity income is guaranteed one can be more aggressive with the spare investable assets). Third, when you contrast the guaranteed non-CPIed annuity payout with the low inflation-adjusted “safe Wall Street withdrawal rate” there isn’t a contest.

A typical joint payout percentage at age 65 with a GLWB is 4%. If you use the Wall Street 2.5% “safe rate” (accepting a 10% failure rate) and assume 3% inflation the payout from the Wall Street model doesn’t catch up with the GLWB until age 81. If your age 65 payout rate is 4.5% the “safe” model doesn’t catch up until age 85. If your age 65 payout rate is 5% the “safe” model doesn’t catch up until age 89. You’ve enjoyed a much higher quality of life for your first 16 to 24 years of retirement from the GLWB. It could also be pointed out that the GLWB gives you considerably more money to spend on travel and lifestyle during the early years when your health and mobility are most likely to allow you to do so (and roughly half of the couples will die before the catch-up point).

If a higher payout is needed then an immediate annuity is the answer. A quick look at today shows a couple, age 65, can get a joint lifetime payout of 5.6% - the inflation-adjusted safe model doesn’t catch up until age 93 (and at that point is only two years away from the Wall Street model’s end. Again, whether the income is from a GLWB, life contingent immediate annuity (IA) or deferred income annuity (DIA) the annuity is not the only asset when an annuity is used. The retiree has other assets, including Social Security, that work to offset inflation. The conclusion that one is better off not buying inflation-adjusting life annuity solutions has been endorsed in other studies2.

A Monte Carlo model isn’t the real world; a life income annuity solution is

For Many, Annuities Are Essential
Assuming the client meets the parameters previously mentioned the use of a guaranteed life income annuity solution is in the client’s bes financial interest. One can argue that a certain investment allocation “model” may do a better job, but all models – whether written on a napkin or created by countless stochastic gyrations – are works of fiction. A financial model is a hypothesis or theory that is made to represent the real world, but it isn’t the real world. A guaranteed lifetime income annuity is reality. For those situations where the annuity fits, the responsibility of the advisor is help manage the credit risk of the annuity and this can be done by using carriers with strong financials and utilizing multiple annuity issuers.

1. Finke, Pfau & Blanchett. January 15, 2013. The 4% Rule is Not Safe in a Low-Yield World.

2. Wade D. Pfau. Feb 2013.  A broader framework for determining an efficient frontier for retirement income. Journal of Financial Planning.

GLWB: The Realistic Answer (3/13)
An article published last month1 looks at trying to produce a 4% income for a 65 year old couple assuming that 10% of the time the money runs out early (a 10% failure rate). What is found is a combination of stocks & immediate annuities is far more effective that combinations of stocks & bonds. His conclusion is worth noting, the evidence suggests that optimal product allocations consist of stocks and fixed SPIAs, and clients need not bother with bonds, inflation-adjusted SPIAs, or VA/GLWBs.”

The reason for using non-CPIed immediate annuities is because the non-inflation ones provide such a higher initial payout that it could take over 20 years for the inflation-indexed annuity to catch up; this additional money could be invested and used to self-insure inflation risk which is the point previously made. I also completely agree that life income annuities should be used instead of bonds, but I disagree that the evidence means you should ignore GLWBs and the reason why is because consumers haven’t done and won’t do what is suggested.

Actual Behavior Trumps Math Models 
If a conclusive study came out tomorrow that guaranteed we could live to age 100 in good health if we immediately started eating only brussels sprouts and rotting fish very few people would adopt the new diet even if they agreed that the study was true. Since 1965 academic studies have time and again proved that annuitization/life inc
ome is the optimal solution for most retirees, but the results show only a very small percentage of retirees will voluntarily sell or convert an asset to buy an annuity income – we refuse to transform from millionaire to pensionaire. We know the math; we simply won’t do it. However, GLWBs don’t create the same behavioral objections because the asset remains under the control of the retiree. Are GLWBs a better solution than immediate annuities in providing a lifetime income? No, but they are a life annuity solution that the client will actually use.

1 Wade D. Pfau. Feb 2013.  A broader framework for determining an efficient frontier for retirement income. Journal of Financial Planning

GLWB Rate Wins Over Safe Rate (3/13)
Although index annuity GLWB initial payouts could increase after withdrawals begin it is unlikely under most scenarios (unless the GLWB is one of the very few with an automatic increase feature). By contrast, the Wall Street “safe rate” approach assumes one increases withdrawals to keep pace with inflation. However, due to the significantly higher GLWB payouts at the start over the now suggested 2½% safe rate it takes many years before the Wall Street income surpasses the GLWB income. If we assume 3% inflation and withdrawals beginning at age 65 it takes Wall Street until age 85 to pass an initial 4.5% GLWB payout and age 89 to pass a 5% one. If we begin withdrawals at age 70 the retiree is in their 90s before Wall Street catches up. The reality is the GLWB offers the most income when the retiree still has the health and mobility to enjoy what it can buy. If the retiree is concerned about future income they can always take a part of the high GLWB payout and invest it in an inflation hedge as additional longevity insurance.

Why Swapping A Pension Plan For A 401(k) Seldom Works (12/12)
The belief that most workers back in the ‘70s and early ‘80s retired with a company pension has almost become an urban legend, but even then fewer than half of all workers were covered by any type of employer retirement plan. However, workers in the private sector today are even less likely to get a company pension. Of workers in their fifties 21% will get a pension at retirement. If they’re in their forties the covered percentage drops to 15% and only 12% of thirty-somethings are in line to get a pension. Each of these categories is down 20% or more when compared with pension-eligible workers in 1989 (CRR, 12-13).>If a private sector employer offers a retirement plan it is almost certain to be a defined contribution plan wherein the employee saves – possibly matched to some extent by the employer. The original idea was that 401(k) plans would give workers greater flexibility in their retirement with a “portable plan” that they could use to create their own pension. In a perfect world here’s how that would work out.

On Paper It All Works
Pat is retiring at the end of this year at age 66 and in that final year of employment earned $75,000. Let’s assume that Pat received a 3% raise every year and has contributed 6% (with employer match) of that annual salary since 1976 (pretending there were 401(k) plans in 1976). Let’s also assume Pat invested 100% in some S&P 500 index fund with zero expenses. Over that 35 year period those annual contributions would have grown at a rate of 9.7% and result in a 401(k) balance today of $592,265. Conventional wisdom says we’ll need 80% our pre-retirement income so Pat will need $60,000 in retirement. The annual Social Security Benefit is $20,352. Pat could use some or all of the 401(k) to buy an immediate annuity. I got a quote of a $37,200 life income based on a $592,254 premium. Added to the Social Security that gets Pat’s income to $57,552, which is pretty close. Indeed, if Pat could have retired a few years ago when interest rates were higher her annuity income would have been over $40,000 meaning her total retirement income would have exceeded $60,000. Isn’t a 401(k) wonderful!


Reality Often Upsets Paper Plans
Pat is in a far better position than most because we’re assuming Pat was never unemployed and thus kept contributing year after year, Pat never had family financial demands requiring money to be withdrawn from the plan, Pat also contributed a percent more than the average worker to the 401(k), received steady raises, and, most importantly, this assumes that Pat never futzed with the allocation and kept it always invested in the index fund and reinvested those dividends.

As an example of futzing, say that the 1981 and 1990 years when the stock market was down caused Pat to move the money to the money market account – just for the following year – and then Pat returned to investing in the index. By second guessing for only two years Pat’s balance drops by a hundred thousand dollars down to $491,000.  What if Pat was a might spooked when her 401(k) balance dropped to $323,000 at the end of 2008 and moved the money to the money market fund for the next three years? Instead of having $592,265 in 20span style="mso-spacerun: yes; language: EN">  Pat strayed from the original investment plan only three times in 35 years and wound up with 40% less at retirement.

This also assumes Pat uses the money to buy a pension replacement: an immediate annuity. However, until very recently Wall Street advisors almost never suggested using annuities in retirement and instead suggested withdrawing a percentage of the 401(k), usually 4%. In a perfect world Pat had $592,265 and 4% of $592,265 is $23,691. When that is added to Social Security Pat has a retirement income of $44,043 – or $16,000 short of what is needed in retirement. Of course, if Pat futzed and only has $350,000 the 4% withdrawal income drops to $14,000 and the total income becomes $34,352. Pat now has only half of what is needed to enjoy a comfortable retirement.

DALBAR studies compare how investments perform on paper with the returns of actual investors in those same investments. What they consistently show is that real life investors do not act like the investment models say they should, which is why investor returns are a third of what the actual market generates. Put simply, in real life people buy high and sell low because of cognitive biases that affect our decision-making. To maximize the performance of a 401(k) invested in the stock market an individual must often make decisions that are contrary to what he or she wants to do. They must not sell when the market drops (r

A 401(k) was intended to give workers a portable retirement plan so they wouldn’t be “locked-in” to an employer’s defined benefit (pension) plan. On paper one could show if you took the money that was being spent on the pension, gave it to the worker, and the worker invested the money in the same manner as the pension plan does, that the worker would have the money to buy a similar pension at retirement, but with greater freedom and flexibility. However, because of decision-making biases the vast majority of workers did not do this. Fixed annuities can do a better job of providing for retirement because they don’t trigger most of these self-defeating biases. As of now there is only one index annuity designed for the 401(k) market, but there will be many in the years to come and the index annuities will allow workers to have better retirement.

Annuities For Efficient Retirement Income (9/12)
The Wall Street solution for retirement income is a static one. Use some variation of 100 minus your age to determine the percentage of equities in your portfolio and take out 4% a year (or less) adjusted for inflation. There are a few problems with this approach. A major one is it is a static solution to a fluid problem. Since the market waxes and wanes in different ways this may be the completely right strategy for one period and the completely wrong one for another. The reality is, based on the past, it is far too low a payout for most periods – meaning the retiree will die with most of their retirement assets intact, and too high for a few periods – meaning the retiree will run out of money before death.

Even a 3.3% payout leaves a 1 in 10 chance of outliving your money

Wall Street has ways to address this static solution. One way is using the required minimum distribution approach (RMD) where you take generic life expectancy tables and simply divide the investment amount by the number of years until average life expectancy is reached – so if life expectancy is 25 years you’d withdraw 4% a year. The problem is life expectancy is when half the people your age are dead, so even if you keep adjusting it as you get older there is still a significant chance you could still be alive after your “life expectancy.” Another way is to adjust the distributions every few years based on an agreed upon probability of failure (you accept that you might run out of money before the end of a certain period of time). As an example, you retire at age 65, put 40% into equities, and assume you will drop dead at age 100. You then withdraw 4.1% a year knowing that, based on the past, there’s a 1 in 4 chance the money will run out early. At age 70 you increase the withdrawal to 4.5%, because now there are fewer years to go to hit age 100, at age 75 you’d increase the withdrawal to 5.1%, and so on – all the while accepting a 25% chance you’ll run out of money early.1

Morningstar recently unveiled a new tool to compare different retirement withdrawal methods called a withdrawal efficiency rate (WER). It assumes the retiree has perfect information and then computes the efficiency of different payouts and percentages of equities in the portfolio. It appears to be a good tool, but it also illustrates the remaining problems with the Wall Street approach. In all of these equity-based scenarios the retiree must agree to the risk that they will run out of money before they die. Even placing as little as 20% in equities and keeping initial withdrawals at 3.3% still creates a 1 in 10 chance that a centenarian will outlive his or her money.

The Morningstar study uses “Monte Carlo simulations, to determine the optimal withdrawal strategies” and thus, unintentionally, shows both the hubris of Wall Street and the flaw in every investment-only based approach, which is assuming the past will repeat – but it doesn’t always do that. Bond yields are a prime example. The long-term trend over the last 2 centuries has been declining bond yields. If you had created Monte Carlo simulations in 1901 using data from the entire 19th century your simulations would have severely overestimated bond yields in the 20th century. Monte Carlo simulations done now are based on a belief that the stock market patterns and ranges of the past 20, 30, 50, 100 years will continue in the future and there’s no reason to believe they will. All of this modeling is no more than financial astrology.

On the other hand, annuities, whether life contingent immediate annuities or deferred annuities with guaranteed lifetime payouts, offer a retirement income tool that does not rely on the past repeating, does not rely on an optimal mix in an investment portfolio, does not require the individual to predict the date of their own death, and, therefore, does not result in a probability of loss. This is not saying that a retiree needs only these annuities to ensure a happy and less anxious retirement, but I am strongly saying that a retirement plan that does not include annuities is an inefficient retirement plan.

1. Blanchett, Kowara & Chen. 2012. Optimal Withdrawal Strategy for Retirement Income Portfolios. Morningstar Associates, p. 10

Annuity Protection From CROPS Failure (8/12)>
A traditional or classical approach to retirement income planning involves creating and managing a diverse portfolio of equities and bonds. Money is then withdrawn from this portfolio during retirement. The goal is to produce an income that aids in covering retirement expenses and lasts as long as the retiree lives. There are problems associated with the traditional approach. One problem is that inflation may cause those expenses to increase as the Cost of living in retirement goes up. Another is the Rate of return earned on that portfolio may be insufficient to provide an income. A third factor is one may not die on schedule and thus Outlive their money if withdrawals are exceeding gains. Fourthly, the amount of the withdrawal is not guaranteed so the Payout percentage may fluctuate depending upon the return earned (especially if our game of life goes into extra innings).  Finally there is perhaps the most insidious element because it is often not considered at all, and that is the effect of the Sequence of returns on the portfolio (the order in which returns happen).

The EBY (Early Bad Year) Effect means that a bear market occurring at the start of retirement may result in insufficient funds later on because the retiree is unable to recover from the early drop in portfolio value. Anyone of these five elements can derail the retirement goal and every one of the retirement income plans that use only the traditional approach to retirement are at risk from these elements. However, if you sow your income field with annuities you can avoid failure of your retirement CROPS.

CROPS may not be a great acronym, but the message it tries to convey is important – the use of life contingent immediate annuities or deferred annuities offering guaranteed lifetime withdrawal benefits (GLWBs) can prevent the problems that may occur when using the traditional approach. Starting at the tail end, the sequen ce in which the returns occur is immaterial because the main risk with the sequence of returns is longevity risk – lasting longer than your money – and both annuity solutions eliminate this longevity risk. The payout percentage is guaranteed and won’t be reduced. You can’t outlive the payments. The rate of return earned on the underlying assets is largely immaterial because the longevity return risk has been transferred from the retiree to the annuity carrier. In reality, all of these retirement income risks have been transferred from the retiree to the annuity carrier. That is the reason one uses a life contingent immediate annuity or a deferred annuity with a GLWB. The final risk – increases in the cost of living – usually is retained by the retiree. There are immediate annuities and GLWBs available that do transfer away all or part of the inflation risk too, but there is a significant reduction in the payment. However, this is why annuities are only a part of the retirement solution. Using only the traditional approach exposes your retirement field to the risk of the elements. Using annuities can protect the retirement income seeds sown from CROPS failure.

The Retirement Equation: Solve For “I” (4/12)

The autumn 2009 Advantage Compendium said that the retirement stool that Wall Street sits upon has three broken legs. The first leg uses an age based equity asset allocation plan, the most common of which uses some variation of 100 minus your age equaling the percentage of stock investments in your portfolio. The second leg assumes a safe withdrawal rate whereby the person will not run out of money before they die, the safe rate used to be 5% in the ‘90s, became 4% in the ‘00s and now many advisors suggest a 3% withdrawal rate to try to ensure that money lasts. The third leg says to use an income replacement rate, usually 70% to 80% of their pre-retirement income to begin retirement. The paper said that the reason this was a broken stool was because it used ineffective and inefficient generalizations that relied on the past to repeat.

A fundamental problem with Wall Street’s approach is that it incorrectly states the math problem. The problem for most retirees is they want enough income to last as long as they live. The retirement solution is solve for “I” (income). However, Wall Street solves for “A” (assets). Assets are not income, so Wall Street needs to complicate the problem by adding another step where the assets are converted into income. This can work, but most of the variables in this asset-to-income algebra formula cannot be determined.

We can’t know exactly how much income we will need in the future. Due to known unknowns such as the rate of inflation or need for nursing care, and unknown unknowns no retirement product or algorithm can provide for our precise income needs. However, even if the needed
yearly income could be determined, we would need to know how long it would be needed for – when we’re going to die. In addition, we need to know the return that will generate that income. The Wall Street approach cannot solve for ho long the income will be needed, it cannot guarantee the return to generate that income, so therefore the solution it currently uses is to create an asset pile that is so large that it lasts in most situations, assuming that future returns follow the same patterns as historical returns.

Under most scenarios the Wall Street solution will result in most of the retirement assets passing to beneficiaries because the retiree didn’t spend all the income they were entitled to. However, because the past doesn’t always predict the future there will be times when even the statistically cautious approach doesn’t work. An article by Lavonne Kuykendall in the 26 March issue of InvestmentNews tells the tale of the Hoaglunds, now ages 75 & 74, that retired in the late ‘90s. They based their retirement spending on their Wall Street advisor’s estimate of 6% to 8% annual returns – a forecast that must have seemed quite conservative when compared against the long-term double digit average return of the stock market over the century. However, two years after they retired the Hoaglunds were hit by the millennium bear market. The result, they sold their Florida home, sold the second car and an evening out meant “a hot dog dinner at the local Costco.” They also met with a new advisor in 2008 and bought an immediate annuity. The annuity is to cover their basic expenses with the remainder of their assets invested in a conservative portfolio for additional income. The Hoaglunds say that having ironclad income security outweighs the lure of taking on risk to gain a little more yield.

Annuities solve for “I”. With an annuity you know both the income and how long it will last (until it is no longer needed). This can be accomplished through life contingent immediate annuities or by guaranteed lifetime withdrawal benefits. This permits the retiree to cover their basic expenses (perhaps buying an annuity with an increasing payout to help with the unknowns).The point of the Advantage Compendium paper was that agents could help people like the Hoaglunds by showing how annuities could provide the income  to cover essential expenses leaving remaining assets to provide additional income. It’s time to replace the broken stool model with a solid annuity foundation.

2008 Reverberations (9/11)
In the fall of 2008 I wrote that the new financial crisis would cause a behavioral shift in consumer attitudes, saying “consumers have been hurt but many don’t realize how badly yet.” I went on to say that the crash of 2008 was a generation killer with the damage to investor’s psyches so severe that we could spend the next decade in a singsong market that works hard to compete with bank returns. The damage has been tallied. A Wharton Study1 released last month says the 2008 market crash “wiped out a quarter of U.S. household net worth” with a severe impact on Baby Boomers, so much so that repercussions will be felt for a long time in the stock market and general economy. Lifetime incomes will be up to 4% lower than projected before the crash causing people to continue working past retirement age, or returning to work part time after retirement. 

Three times in the last decade the investment world has terrorized the small investor by throwing calamities at him that were not predicted by advisor models. Wall Street has failed the small investor. Banks kept money safe throughout these times, but today rates are so low as to be meaningless. By default, annuities may be the best place for the typical Baby Boomer to be. In 2008 I said that annuity carriers and producers would need to concentrate on marketing the guarantee story. This has occurred as lifetime withdrawal rider usage has increased as well as more money being allocated to fixed accounts. People have become more conservative and are saving more; the negative side is because they are not spending as much this recovery has been very modest and with so much cash floating around interest rates will remain low. However, even in a low interest world the index annuity remains viable because it resets its interest calculation in the sing-song world of the stock market, meaning even if an annuityowner only sees positive years half of the time the interest earned may still be much more than the fulltime performance of other safe money places.

1. Maurer, R., Mitchell, O., & Warshawsky, M. 2 Aug 2011 Retirement security and the financial and economic crisis: An overview. PRC WP2011-08. Pension Research Council  

Wall Street’s FIA Alternatives
The risk-reward proposition of an index annuity may be looked at from opposite ends. From a saver’s perspective it provides a no-market-risk to principal vehicle with a higher potential return than other no-market-risk to principal vehicles such as CDs. From an investor’s perspective it typically provides a lower potential return than an investment vehicle like mutual funds, but offers a no-market-risk to principal benefit that the investment vehicle can’t. The first index annuities were promoted as a way to get stock market-like returns without market risk to principal; the transition to marketing them as a safe money place with greater interest potential occurred as early participation rates and caps fell, and registered reps became uninterested in index annuities. The rep that initially sold an index annuity with a 100% participation rate guaranteed for 5 years, or one that locked in interest gains each year subject to a 16% cap, quit selling them when the participation rate fell to 90% and the cap dropped to 14% because the ‘90s bull market would last forever.

During the millennium bear market a decade ago interest in index annuities resurfaced on Wall Street. However, the consensus in 2002 was to either wait until good times returned, or if you were a VA provider, to examine other ways to offer lower risk options, and I believe guaranteed withdrawal benefits were one of the outcomes.The Crash of 2008 reminded Wall Street of the well publicized growth of index annuity sales, and the use of VA guaranteed withdrawal benefits, causing them to again look at the safer side of the street. The result has been the creation of a variety of investments designed to lessen the risk of investing. The following is a brief look at some of the more visible products.

Index Certificates of Deposit These CDs are FDIC insured and principal is returned upon reaching a typical maturity of 3 to 10 years. All of the early ones, and most of the current ones, use a term end point crediting structure where gains are not credited until the end of the multi-year period. Index CD sales were poor largely for the same reason that sales of term end point design index annuities declined, which is that consumers prefer annual reset methods that lock in gains. For emphasis, only $300 million of the term-end-point designed Index Powered® CD was sold over 8 years, even though a hundred banks were marketing it.

Current credit methods include: term end point where final interest is a percentage of total equity or commodity index gain; quarterly averaging where the ending index value each quarter is noted, added together, and then divided by the number of quarters over multiple years to get an averaged end point to compute gain over the term; quarterly cap forward where several years of quarterly gains (up to a cap) and quarterly equity index or commodity losses (not subject to a cap) are added together; summed individual cap gain/cap loss takes the individual components of the index, adds together each gain up to 10% and the index, adds together each gain up to 10% and each loss down to 20%, and then sums the component returns; and inflation indexed that credits the rate of inflation plus an additional yield, subject to a cap, on an annual basis. Commissions currently run 2%-3%. Key competitive points:

Taxes are owed on phantom growth – even though the interest is not usually paid out until maturity the bank must issue a Form 1099 each year showing the “might have” interest earned. Due to their design there could be a situation where the owner paid taxes on several years of phantom interest income only to have much lower actual interest paid out. I’m not sure how you would treat this on your tax return.

Liquidity is not guaranteed – some banks will redeem the CD before maturity, but no guarantees and the value is typically the market value. There may or may not be a secondary market.

Crediting methods are usually very complicated – index annuities justly get accused for having some atrociously complicated and misleading crediting methods; some index CDs make these annuities look as simple as first grade arithmetic by comparison.

Index-Linked Notes
Many types of interest bearing index-linked notes have been developed. Some are fixed, most are floating, and a few are fixed and floating. The notes may give you a percentage of the index gain over a period of years, or the gain may be computed more often and capped. The note may use a multiplier meaning the amount of index change is multiplied by a set number and then the multiplied return credited. The index link might be the S&P 500, Dow, the price of gold, inflation, a basket of currencies, or changes in the spread between the constant maturity rate (CMT) of 2 and 10 year Treasuries.

If the notes are held to maturity the principal value is returned, or maybe not. Some notes do agree to pay the principal amount upon maturity, others give you the market value, and still others offer a type of partial insurance where they’ll return 100% of the principal if the loss isn’t too bad.  Depending upon the note some may be redeemed for the principal value on issue anniversaries, some may be redeemed early only if the issuer feels like it, and some may not be able to be redeemed at all. There may or may not be a secondary market. Key competitive points:

Taxes may be owed on phantom growthdepending on the structure of the note a Form 1099 could be issued though no interest or gain was paid out to the consumer.

Liquidity is not guaranteed – Some issuers will redeem the note before maturity, but no guarantees and the value is typically the market value. There may not be a secondary market.

There’s no FDIC or Guaranty Fund – the note is backed by the financial strength of the issuer.

Even though the upside is typically capped the downside may not be – this applies more to devices such as accelerated return notes and not at all to most fixed and floating interest notes. The principal protection offered on some is if the closing value is down, say, 20% or less at maturity, then the issuer will give you back 100% of your principal. However, if the loss is greater the issuer will still only cover up to 20% of the loss. So, if the closing market value was 50% of the initial value you’d get the 50% market value plus 20% from the issuer for a total of 70%, meaning you’re still down 30%.

Step-Up Notes
With this low interest rate environment these are getting a bit of play. They promise to pay a fixed yield that increases after a predetermined period of time. For example, the note may pay 2.5% for the first five years and then increase the yield by 1% thereafter until maturity in 7 to 15 years.  Key competitive points:

Not insured or guaranteed – the issuer must be around at maturity.

Issuer can pay off early – the ones I’ve seen are all callable with the issuer able to simply give you back your principal at their option.

Liquidity is not guaranteed – some issuers will redeem the note before maturity, but it is not guaranteed and the value is the market value, and there may not be a secondary market at all.

Alternative Mutual Funds
In the first six months of 2011 Lipper says over 440 new mutual funds launched and many of these were alternative mutual funds. Since the “alternative” label can be used on just about anything, what I’m talking about funds that are designed to lose less in bear markets, although I don’t think they would use that wording. Here are three approaches:

Long/Short Equity: This strategy uses long and short positions in common and preferred stocks. They actively look for stocks they think will go up and buy them (go long) and also look for stocks they think will go down that they don’t own and sell them (short). This leveraged position is designed for capital gains; however, over the last 3 years the average fund in this segment lost 0.2%.

Market Neutral Equity: This strategy is designed to exploit equity market inefficiencies, which involves being simultaneously invested in long and short matched equity portfolios generally of the same size, usually in the same market and attempts to achieve capital appreciation. The average total return over the last 3 years for this market segment was 0.4%.

Income Replacement Funds: Possibly in reaction to GLWBs Fidelity began offering an Income Replacement Fund Series in 2007. These managed payout funds used the lifecycle stock/bond allocation approach and are designed to offer a level payout until the end of a future date you select. In 2008 Vanguard added payout funds to their mix. The income from these payout funds is not guaranteed. In early 2009 Vanguard dropped their payouts by 16% and Fidelity cut some payouts 20% to 33%. However, things are looking up. For example, the current payout on the Fidelity Income Replacement 2042 Fund of 4.94% is supposed to be 5.01% next year. Key competitive points:

Nothing is guaranteed – the consumer is fully exposed to both market risk and longevity risk. The income replacement concept already failed – the whole idea is to provide an income payout that won’t go down. In the crash of 2008 many payouts were cut.

Do-It-Yourself FIA 
This tried and failed choice says avoid index
annuity “fees” and buy a bond, an option, and do it yourself. As I wrote earlier this year, following this advice over the last several years would have resulted in effective participation rates of less than 20%. Key competitive points:

The advice creates a term end point design – all of the articles I’ve read that suggest do-it-yourself create a term end point design that doesn’t lock in gains for 5 years or longer, but well over 90% of consumers have consistently bought annual reset designs. The advice creates a solution that people won’t use.

A consumer can’t create a good annual reset – a consumer could buy a one year CD or Treasury and put the remaining money in a one year LEAP (Long Term Equity AnticiPation) option but the costs are too high to make it competitive with an index annuity. Even with a million dollars the consumer is still paying retail markup wherein the insurance company is buying wholesale.  

Wall Street Alternatives Aren’t
Wall Street’s whole mindset is on managing risk and what these alternatives are generally designed to do is reduce the risk of investing. On the other hand, index annuities transfer risk away from the consumer and are designed to increase the return on savings. These are two different worlds. The good news for the index annuity world is Wall Street has not figured this out yet.

Immediate Annuity Ruled Not An Asset Under Medicaid (12/10)
In February 2010 a husband had been receiving skilled nursing home care. Although his assets were less than $1600 his wife’s assets were $340,000. The Connecticut Dept of Social Services said the wife would have to spend her assets down to $180,735 for the husband to qualify for Medicaid. The wife then spent $166,220 to buy a life-only immediate annuity, furnished the State with a letter from the insurer that the annuity was unassignable and could not be cashed in, and applied for Medicaid on the husband. The State suggested she sell her immediate annuity to Peachtree Financial and when she refused the State denied Medicaid benefits for the husband. The wife then sued the state in District Court for summary judgment.

The Medicare Catastrophic Coverage Act (MCCA) says a non-institutionalized spouse can receive Medicaid for their significant other while keeping a community spouse resource allowance (CSRA). The figure in this case, adjusted for inflation, meant the wife could keep $180,735 in assets and the husband would qualify for Medicaid. The act also says income cannot be a factor in this calculation. What this case boils down to whether the fact that you can sell an immediate annuity to a third party and convert the income to cash makes the immediate annuity income an asset for Medicaid purposes.

The District Court said a related court case (James v Richman, 547 F.3d 214. 3rd Cir 208) found that an unassignable annuity income stream could not be treated as an asset and said they reached the same conclusion. The insurance company issued a letter saying the immediate annuity was unassignable and therefore not an asset. However the District Court went further saying “Even if Mrs. Lope’s income stream were assignable...It would be incongruent with the principles of the MCCA to permit a state to characterize even an assignable income stream as an asset.” On 11 August 2010 the court ruled the wife could keep the immediate annuity income, the husband would get Medicaid, and the wife could go after the state to repay her attorney fees. U.S. District Court, CT. 3:10-cv-00307-JCH

Retirees: An 85% Bank Pay Cut (and an annuity opportunity) (10/10)  
In 2007 the average rate on a one year certificate of deposit was 3.70%. At the close of September 2010 it was 0.58%. A retiree with $200,000 in bank CDs might have received $617 a month in CD interest in 2007. Today, that same amount produces $97 a month. When you combine an 85% drop in interest income, with investment portfolios confronted with sharp losses from the last bear market, an argument can be made that retirees have not seen a retirement income environment this severe since the days in the Great Depression before Social Security benefits began.  

In a typical economic recovery interest rates move higher as the demand for money increases. As this is happening the short-term interest rates move up more quickly than long-term rates. The yields on CDs and money market accounts funded by short-term lending tend to increase more rapidly than yields on annuities funded by longer term bonds. The usual result is poor fixed annuity sales during this rising interest rate period. This has been true in every cycle over the last 20 years, but it may not be this time. This time around annuity rates should be increasing faster than bank rates. If today was simply a case of banks maximizing profits, knowing that consumers will put up with low rates due to a lack other opportunities, that would be one thing as soon as competition heats up, rates would go up but this time may be different due to changes in margins and fees.

A Decade Of Fat Cats  
Banks largely live off the margins between what they pay out in interest and what they take in, plus the fees they collect on bank activities. The
net interest margin enjoyed by banks was roughly 4.2% to 4.5% in the ‘90s. By 2008 this margin slid to 3.3%. Banks were making lower profits between money lent and borrowed. However, from 1991 through 2004 the return on assets banks were making increased from 0.54% to 1.41%. Why were returns increasing in a time of decreasing margins? The reason is banks had discovered how to implement a wide array of new fees that ramped up their income. The end result is from roughly 1998 until 2008 bank income was getting increasingly fatter and customer yields were getting subsidized by the
explosion in fee income. And then...

Lower Fees & Margins  
We entered a severe recession that drove interest rate margins even lower. By the end of 2008 margins had decreased to 3.1%. Banks reacted by drastically cutting the rates they were paying depositors and margins crept back up. By summer 2010 margins were 3.8%, which would have allowed banks to increase CD rates paid, except bank regulators in the previous year reined in many of the more abusive (and profitable) fees banks were charging on bank accounts and credit cards and this severely cut into fee income. In addition, there are still many bad real estate loans on the books and regulators are requiring banks to set aside higher reserves just in case of default.  

Even though bank margins had increased to 3.8% by the summer of 2010, bank return on assets had dropped to  0.57% the same level it was two years ago at the depths of the crisis. The reality is today it is a difficult time to be a banker, or a saver at a bank.

Looking Forward  
As this recovery strengthens the cost of borrowing will go up, and the risk of loan defaults will go down, freeing up bank reserves. However, banks still don’t have their fee income back and returns on assets should continue to be weak. Banks have a few options. They could cut executive compensation from the record levels enjoyed over the last ten years, they could tell investors that bank earnings will suffer and to invest their money in other stocks, or they could continue to
increase their net margin by keeping the interest paid to savers at record low yields – I’m betting on the last option. What this means is 2011 could be a period where bank CD yields rise much more slowly than bond-backed annuity interest rates. Annuity carriers may be able to maintain a 2% advantage over CD rates or possibly increase it. All of this is simply my opinion, but I believe 2011 should be strong for both fixed rate and fixed index annuity sales.

Myopic Planners & Immediate Annuities (9/10)   
A recent article in Financial Planning [Paul, Menchaca. Annuities from bust to boom. August 2010] shows faulty logic to justify not using an immediate annuity. A planner quoted in the article correctly points out that future inflation can be a concern with annuitization saying that if one buys an immediate annuity at age 65, and inflation averages 3%, the after-inflation income would be cut by 45% by age 85. I agree; inflation is a concern in retirement, but he dismisses inflation-adjusting annuities because the initial payouts are lower than if they don’t adjust for inflation. So what’s his answer? The planner’s solution is Wall Street’s old tried-and-flawed stated withdrawal percentage method, “the odds are great that a well-diversified retirement portfolio will deliver you a 4% distribution rate” states the planner.

If the disease in retirement is running out of money the annuity cures the disease 
while the Wall Street approach continues to treat it as a chronic illness without a cure

There are two problems with this. The first is the “odds are great ” reality of all stated withdrawal percentage plans in that there exists a real world probability that the plan will fail, the assets will be spent to zero, and the income will stop before death. If the disease in retirement is running out of money the annuity cures the disease while the Wall Street approach continues to treat it as a chronic illness without a cure. The second problem is not using the same basis for comparison. These planners are saying if you have $100,000 in a securities portfolio at age 65 you can take out $4000 a year initially, and assuming the future financial world goes according to their plan, and inflation average 3%, the plan would (hopefully) produce the $7224 needed at age 85 to keep you even with inflation.

However, today you could buy an immediate annuity for under $75,000 that would produce $4000 today and produce $7224 at age 85 assuming the same inflation rate. No “odds” “hopes” or “guesses” simply a guaranteed inflation-adjusting income for life. If you don’t think inflation will be a factor I priced a straight life contingent annuity for a 65 year old and the premium came in around $55,000 for a man or woman to receive $4000 a year. These immediate annuity solutions solve the stated problem – running out of money before death.

Solving for longevity risk and creating an estate are two separate and distinct problems

At this point what I usually hear from myopic planners is that the immediate annuity cost decreases the size of the estate – but that’s not the problem they said they were trying to solve. The annuity solution solves the longevity problem and leaves money leftover to create an estate (the remaining $25,000 could be used for a single premium life policy, or the $45,000 could be invested to produce additional income if inflation is a future factor and build a potential estate).

Left unsaid is that an annuity with a GLWB may well do a better job of solving these problems than any Wall Street solution

But the real problem is all of Wall Street’s solutions ignore the way people actually act in retirement. The reality for retirees is not all expenses are treated as equally important and retirees adjust what they spend based on what they receive. When income goes up they spend more and when income goes down they spend less, but the essential expenses always need to be covered. Providing the income needed for retirement essentials is the role for annuities – both immediate ones and deferred annuities with lifetime withdrawal benefits – because this enables remaining assets to be more aggressively invested since withdrawals from these other assets can be reduced in bad market times. Showing consumers how to use the annuity cure is the role of behavioral retirement planning.

The Old Financial Pyramid (7/10)
You’ve all seen the old Wall Street financial pyramid. The broad bottom level usually held things such as bonds, the middle levels contained diversified portfolios of equity mutual funds, and the top had assets like real estate or gold or tech stocks. It was a pyramid based on risk and it was supposed to show that you should put most of your assets in lower risk investments and less in high risk ones when planning for retirement. The size of the pyramid steps were often adjusted by age so the lowest ones were fattest for seniors and thinnest for juniors. The problem is the pyramid doesn’t work well for retirement planning in the new normal financial world.

The pyramid did okay in limiting exposure to perceived high risk assets – real estate and gold are excellent examples of the potential gains and losses of high risk exposure – but it has occasionally failed over the years on the low risk side. The reason the Wall Street pyramid fails is because...

Old Pyramid Confuses Low Risk & No-Risk 

“the fund industry may finally have found its Holy Grail: mutual funds that offer shareholders a steady stream of income that will last well into their sunset years” (Comments on Target Date Mutual Funds, Crain, 8 October 2007)

Three investments touted as super-low risk a few years ago were mortgage backed bonds, auction rate securities and target date funds. However, more than 90% of mortgage backed securities rated “AAA” when issued in 2006 and 2007 are now rated as junk bonds (CFO, June 2010), many states sued B/Ds for selling auction rate securities as “short-term & liquid” when they turned out to be illiquid (IC, November 2008) and the SEC proposed new disclosure rules for target-date funds because some funds lost an average of 25% of their value in 2008 (AP, June 2010). The problem is Wall Street’s pyramid treats an asset with low probability of loss the same as one with no probability of loss. A money market account has zero probability of market loss; the same cannot be said for a money market fund, and yet the pyramid treats them as having equal risk. The new normal market is redefining what low risk means in retirement planning.

Old Pyramid Treats Finance As Science In the middle ages scholars spent their lives “proving” the Aristotle and Ptolemy theory that the sun revolved around the earth. Indeed, so much time and money was invested that the chief regulators of the day, the Catholic Church, protected this conventional wisdom by saying it was heresy to even dispute this view, even though the theory had trouble explaining why planets seemed to move backwards at times. However, eventually it was proved this theory wasn’t science, but merely an opinion that was couched in scientific terms and protected by the establishment.

Although denied in principle, Wall Street’s pyramid is based on an investment theory that the past predicts the future, and because of this one can create math formulas that tell us how an asset will perform. The problem is finance isn’t science because the future is unknown and can’t be mathematically predicted, largely due to the fact that humans get in the way and act unpredictably. Time and again this is demonstrated as Wall Street goes from one crisis to another by following their formulas, but because Wall Street has so much invested in maintaining the prediction illusion the regulators of today continue to support the Wall Street view of retirement planning and will even harass those proffering alternative theories of the financial universe.

 Old Pyramid Ignores Fixed Annuities
Where are fixed annuities in the pyramid? Wall Street doesn’t make fixed annuities so they ignore them, as do the financial writers that get all of their information from lower Manhattan. The good news for consumers today is due to the damage done by following Wall Street’s advice for the last decade that the concept of annuities is now being discussed, but Wall Street has problems with annuities.

If you take, say, $250,000 out of a portfolio to provide a retirement income today guaranteed to last for the life of the client – an immediate annuity – how do you keep making money off the client from these dollars? Granted, an immediate annuity may pay a 3% to 4% upfront commission, but that one-time income pales when you consider the 1% a year forever fee income you could charge from managing that money. Of course one answer is you shouldn’t be paid for managing money after you are no longer managing it, but Wall Street folks often don’t seem to like this answer. One solution is to have the carrier pay the advisor a commission each year, but that reduces the consumer’s income.

What about deferred annuities? Deferred annuities often aren’t considered because of ego. Many advisors have told me they can do better than the insurance company. In truth they may. Index annuities have competed well since they were introduced, but there is less than 15 years of actual returns to compare. However, every time an advisor has argued they would do better they have shown me either a long-term hypothetical example – here’s how I could have performed, or very short-term real performance – I beat the annuity last year. When I ask to see real results from real clients over time the advisors often switch the subject by saying deferred annuities are illiquid so returns really don’t matter.

But Annuities Are Liquid
The liquidity argument is specious. Advisors say that deferred annuities aren’t liquid because they have surrender charges, but fees and illiquidity are not the same thing. If you sell a stock you get your money, net of the commission charged to sell the stock. If I assess a 5% annuity surrender charge and give someone back 95% of their

account value they still get their money, net of fees. I submit that if a consumer was offered the choice between Asset One that on any given day gave them liquidity with a predetermined maximum liquidity cost (and even surrender charges with MVAs have maximum costs) or Asset Two where the maximum cost is unknown and could be as much as 100% of their investment, that the consumer would say Asset One is more liquid. A final point sometimes raised is that the annuity carrier usually has the ability to delay payment in times of crisis (it was a Great Depression thing). However, several securities have also been rendered illiquid – the auction rate securities already mentioned, some thinly traded REITs, and the entire stock market following 9-11.  

And Tax Deferral Isn’t An Add-On
Annuity tax deferral is either ignored or treated as a negative by Wall Street. If the money is nonqualified the argument is tax deferral results in ordinary income and not lower taxed capital gains. Although this has some validity with variable annuities (but many aspects often tilt the scales in favor of tax deferral) the argument doesn’t make sense with fixed annuities. Fixed annuities produce interest, interest, whether from a bank or annuity is always taxed as ordinary income. If an annuity is inside a qualified plan the argument is made that you have wasted the annuity tax deferral. This would only be a waste if there was a distinct charge for it. Neither the insurance company nor consumer incurs any additional expense because of the annuity tax deferral, the deferral is a result of the tax code and not an option the consumer is paying for.  

Old Pyramid Assumes Rational Investors  
The final problem is the biggest, and that is Wall Street’s assumption that people make all financial decisions as if they are little computers possessing perfect information. It shouldn’t come as a surprise that people do not make completely rational decisions with their money and therefore violate the rules of the pyramid. In reality what this often means is consumers move too much money to the high-risk level when the market is soaring and keep too much in the bottom level after the market has bottomed and is moving up, and consumers also confuse no-risk and low-risk. It also means the real world financial decisions made by consumers do not reflect computer-created formulas of the old pyramid. Consumers do not put all their money in a pile and then divide up the money into least risky, risky, and most risky levels. Instead money is divvied up based on what the money is designed to do, and this is why a new pyramid is needed.

The New Financial Pyramid (7/10)
We tend to think of retirement in terms of dollars of investable assets because this is how Wall Street has trained the media to teach us about retirement. Since Wall Street hasn’t been able to guarantee a lifetime income, or guarantee growth of the assets to produce this income, they instead use retirement planning “rules of thumb” and since there is still a significant risk that the assets can disappear before the retiree does their rules of thumb tend to require a very large pool of assets (and Wall Street’s compensation is largely asset based, so it is in their best interests to keep the asset pool needed as large as possible). This is the old pyramid. We need to retrain consumers to think of the new retirement pyramid.

The new pyramid is based on an awareness of Behavioral Retirement Theory that I have written about previously (Advantage Compendium, Fall 2009). What it says is consumers are not simply conservative or moderate or aggressive when it comes to risk, but instead our aversion to risk depends on the context we are using. Consumers divide up financial decisions into different sub-accounts with each having its own level of acceptable risk, and risk is defined as failing to provide the money needed in the sub-account. Our risk tolerance and the returns we will accept are the sum total of these sub-accounts.

It’s Income Not Assets
Most retirees do not need a million dollars; they need the income that the million dollars can produce. Granted, there are people whose main goal is producing the maximum estate possible and will starve to do it, but the demographics and surveys show the main retirement goal is to not outlive your money. What this means is people should be thinking of how much retirement income they need.

Wall Street says count on using 80% of your working income in retirement. Why 80%? There is reasoning behind the ratio, but the real answer to why 80% is why not. With the Wall Street pyramid the income is simply a factor in getting the final answer which is total assets required.

The new financial pyramid believes getting the needed retirement income is the reason you save for retirement, so the consumer needs to figure out what they’ll need by creating a retirement budget. Creating the budget accomplishes two things. The first is it provides real numbers about real expenses so that real planning can begin. The second accomplishment is it makes the concept of retirement tangible. 


During your working years retirement is an abstract thing that happens in the future and we tend to think of retirement assets as game pieces. However, when you sit down and put on paper that you’ll need $8,000 for housing, $7,000 for utilities, $5,000 for uncovered medical expenses and such retirement becomes very real. Instead of treating it as a game you become focused on the reality of retirement, which means thinking about the source of the income and can I count on it.

Essential Income
The retirement budget is usually a bit of a wish list because it is designed to maintain the working lifestyle in retirement, but you also need to determine which expenses are essential because this is the income that needs to be protected. The budget may be $50,000, but if pushed the $4,000 January vacation can be eliminated next year as well as the weekly dinner out. Maybe, if you had to, you could get by on $36,000, and since Social Security provides $24,000 this means your essential income from your retirement assets is not $26,000 but $12,000. Guaranteeing that $12,000 is the primary level of the pyramid. What if the couple has an age 70 retirement goal and is age 65 today. If you could find an annuity growing the income benefit at 7.5% a year a premium of $167,175 today guarantees the $12,000 is there in 5 years with a joint payout of 5%.

Other Levels  
What kills the Wall Street plan is treating low risk assets as no risk assets, and taking money out when the value of the assets is going down. With the new financial pyramid there is no market risk on the essential assets and withdrawals do not need to be taken from the high risk assets in bad years. Issuer risk on the essential assets is mitigated by using multiple carriers and the existence of state guarantee funds.  

The additional income level is used to create income above the essential income. This could be done with additional index annuities, laddered multi-year guaranteed annuities or traditional fixed rate annuities. The top level is designed for bequest needs. This could be a charitable annuity or index universal life. The key point here is all of the retirement needs can be met with fixed products not requiring securities registration because only annuity income and life insurance products are used. However, the new financial pyramid approach readily lends itself to securities sales. The essential income is always provided by an annuity, but the additional income and bequests can be met through investments if desired. The new pyramid encourages securities advisors to use annuities in retirement planning, but operates on a non-securities basis as well.  

A Comparison
The Wall Street pyramid usually assumes a very low 4% withdrawal rate because taking withdrawals in bear markets tends to deplete portfolios. The new pyramid uses annuities to cover the essential income so the investment assets would only be tapped when their value is not falling. This would permit a withdrawal of 5% or 6% on investment assets increasing the likelihood  that  that the investment assets will be able to provide inflation adjusting income until death.
Wall Street’s definition of “low risk” doesn’t work in the new normal. Essential income needs to be protected from both market risk and longevity risk. Immediate annuities and fixed annuity GLWBs guarantee the primary level of the new financial pyramid.

Volatility & Losses Aren’t The Same (6/10)
I’m spending more time talking with financial advisors this year and most of them are telling me they are looking at ways to reduce the volatility of returns. When I hear this I ask them “So what you’re saying is your client is earning maybe 8% or 10% and you’re trying to reduce the possibility of them earning 30% or 40%?” And every advisor so far has told me no, more gains would be okay, what they mean is reducing downside volatility. Which really means what they’re really trying to do is avoid losses which has nothing to do with volatility.

In the past I have personally used option strategies that were based on market volatility. With these strategies I made money when the market went up or down, the key to my profits or losses was how much volatility there was and not whether it was positive or negative. Doing things such as option straddles are pure plays in volatility. However, many advisors seem to use the word volatility as a synonym for loss. Instead of telling a client they could lose money they couch it by talking about the downward volatility of an investment. There are two surefire ways to avoid both losses and downward volatility. Buy a fixed rate or index annuity.


Web Savvy Retirees Not Told About Benefits Of Annuities (6/10)
Recent studies have looked at web sites that provide retirement income calculators and shown they are biased against annuities. In a recent study only three of 25 retirement calculator web sites ever mentioned immediate annuities as a part of the retirement income solution. An additional three never proposed an annuity solution but at least provided information about annuities in general. Amazingly, half of the retirement income calculators provided by annuity carriers do not mention annuities as a retirement solution.

I gave many of the calculators a shot. I said I was 65, retiring at 66, had $370,000, and wanted $30,000 a year. The amount was based on a life quote I received at Kiplinger asked if I wanted to use conservative stock market returns of 6% a year or would I rather assume 10% returns to base my retirement upon, but didn’t mention an annuity option. When I plugged my assets and desired income numbers into the MSN and Bloomberg calculators both simply said I’d be broke by age 79. 

AARP’s calculator did ask what size estate I desired at death, but even though I entered zero it still said I was short $269,423 to make it from age 66 to age 100, never mentioning I could buy an immediate annuity, altho it did talk about annuities in another section. Finra’s calculator doesn’t mention annuities either, but it does talk about them elsewhere on their “Smart Investing” consumer pages. However, it warns consumers that immediate annuities have “potentially high management and insurance costs.” In any event you may not want an immediate annuity anyway because, according to FINRA, a fixed annuity “exposes you to inflation risk” and a variable one “carries the risk that your payments could shrink.” The study’s conclusion “retirement planning programs available online seem to direct retirees toward phased withdrawal, which could well expose many people needlessly to longevity risk”.

John A. Turner. 2010. Why Don’t People Annuitize? The Role of Advice Provided by Retirement Planning Software. Pension Research Council Working Paper. WP2010-07

The Immediate Annuity Puzzle (Why more people don’t buy immediate annuities) (3/10)

1) The existence of immediate annuity substitutes

2) The bequest motive

3) The need to face unexpectedly large expenditures (medical care, nursing)

4) Adverse selection increases costs

5) Refusing to face ones own mortality

6) The lack of understanding of the true properties of annuities

7) The lack of trust in insurance companies

8) Insurance company policy loads & pricing transparency

9) Using family to cover financial hardships

10) Social Security and private pensions

11) Believe equities provide higher returns

12) Belief individual/advisor can do a better job of money management than the insurer

13) Smell-of-death and annui-cide

14) Behavioral portfolio theory (goal based, give me hope and banish fear)

15) Framing and money illusion (ignoring time value of money)

16) Aversion to loss

17) Aversion to regret 

18) Aversion to dipping into capital

19) Too much focus on fear, too little on hope)

20) Advisor not considering immediate annuities due to loss of ongoing fees

22) Advisor not considering immediate annuities because the commission is too low

22) Advisor not considering immediate annuities due to bounded rationality

23) The retirement puzzle is presented from a capital perspective and not an income perspective

24) Poor framing

Retirement Roulette Or Guaranteed Lifetime Withdrawal Benefits (2/10)
Each line of the chart below represents a 70 year old with $100,000 that began withdrawing $6,000 a year. The blue line began withdrawals 1 January 2000, the pink line began in 2001, the yellow in 2002, and so on. The right side of the chart shows how much each has left in their account on 1 January 2010 based on movements of the S&P 500. The final column states the return they would need to earn each year from today forward to be able to continue to withdraw $6,000 a year until age 100. If you retired a year ago you are now age 71, your account is worth $116,043, and if you earn 2.94% a year you can keep taking $6,000 for 29 more years. But if you retired in 2000 you’re now 80 with $19,258 left. You’d need to earn 31.02% to make it to 100...unless you’d bought a GLWB annuity.

Return Needed To last Until 100














Index Annuities Are The New Normal (2/10)
The average reported S&P 500 index annuity return beat the real S&P 500 return in 63% of actual five-year periods. Index annuity detractors often retort those bad periods were exceptions, because when you take into account the good ones, and add on reinvested dividends, you more than make up for the bad times because “everyone knows” mutual funds perform much better than index annuities. However, if you had invested $10,000 at the beginning of every five year period – a total of $80,000 in each since 1997 – the index annuities would have grown to $104,991 and the S&P 500 index with reinvested dividends would have been worth approximately $103,574.1

What if the investment markets of the last decade are not an aberration, but represent the new normal investing environment? If these times are the new normal then index annuities are the clear winners.

The detractors typically use two “normal” periods to support their position. The first big period usually starts in the mid 1920s and ends at the millennium. It results in those 12% return numbers cited by folks like Ibbotson. The second period used is the more recent 20 or 25 years that include returns for the ‘80s and ‘90s; the average annual stock market return for those two decades was 17.6% 2.The detractors then apply today’s index annuity participation rates to these periods and say “see, in normal times mutual funds heartily beat index annuities”. However, I submit those periods (to say nothing of the participation rates assumed) are also not representative of normalcy.

If you could have invested $10,000 in the U.S. stock market on New Year’s Day 1980 your account balance on 1 January 2000 would have been $253,766! However, if you had done this from 1970 to 1990 your balance would have been $87,486, and starting in 1960 and ending in 1980 your $10,000 would have grown to $36,905. Some people use Ibbotson’s 12% return as representative of a normal stock market, but even using their 80 year timeframe as “normal” 96.8% of the 20 year returns will be less than the 1980-2000 period. And if you use the first 80 years of the century instead of the last 80 years as normal, the likelihood of not getting a 1980-2000 style return is 99.99%. 

What is normal?
Professor Siegel of Wharton looked at periods beginning after World War II and found the average annual stock market return for the next six decades, including reinvested dividends, was 6.83%
3. If you could find an annual reset index annuity that averaged a 50% participation rate for the same period your annualized return would have been 7.13% without reinvested dividends. In my modeling of the Great Depression, if  you could have purchased an index annuity each month beginning in August 1929 with only a 30% participation rate your average annual index annuity return would have been 6.4%. All of this during a decade where the stock market ended 65% lower than where it began and blue chip stock market investors lost a lot of money. The ten years following 1972 resemble the decade after 1999 in stock market movement. In this earlier era the S&P 500 finished 3.8% higher than where it began, but an index annuity annual reset approach would credit interest based on a total period gain of 124%. Frankly, I don’t know if the next 10 or 20 years will be like the last, but it appears extremely unlikely that the 1980-2000 period returns that occurred only once in the last 200 years should be used as “normal” times 4.

What about retirement income?

Many investment hypothetical comparisons begin in 1974. It’s not a coincidence, 1974 was the bottom of the worst bear market since the Great Depression  and if you’re trying to show how high something is, it will look even taller when you’re sitting in a hole. From 1974 through 1999 the S&P 500 grew at an annualized rate of 13% before reinvested dividends. A person retiring in this period could have easily withdrawn 6% a year from this portfolio without ever running out of money. But what if you retired earlier or later?   

I calculated how long money lasted if you withdrew 6%  each year, earned S&P 500 returns, and retired in 1960, 1961, 1962 and so on. In every case the money did run out, and in over a third of the cases the money ran out in less than 20 years. I could have picked a lower withdrawal amount, but 6% is the percentage most consumers intuitively select when asked what they think is a safe withdrawal percentage in retirement. In addition, many index annuities offer a guaranteed 6% lifetime withdrawal rate as early as age 70. This was for the years preceding the great bull period of the 20th century. 

One of the things that the table highlights is how greatly one year can affect the long-term. If you began withdrawals in 1962 or 1964 your money lasted 21 years, but if you began in 1963 your money lasted 31 years. The reasons are gaining one good year and avoiding one bad, because if you missed 1962 you avoided a 12% drop, but if you missed 1963 you didn’t get a 19% gain.It’s a similar story in this century. A person beginning withdrawals in 2003 only needs to earn 4% from now on for their money to last until age 100, but begin a year earlier or later and 8% to 11% is needed. An even more vivid example is the person that began withdrawals in January 2009 needs to average 8.4% to keep taking the original 6% out; but if they could have delayed until this January earning even a 3% return hereafter means an income until 2040.

Avoiding losses is key
The 1980s had eight years in a row wherein the S&P 500 ended higher. With the exception of a 1% dip in 1994, the 1990s were gain after gain. So far the patterns of this century look a lot more like the historical stock market than those decades and that supports an annual or biennial reset. If the next stock market era resembles the broader strokes of the past two centuries it will have frequent peaks and valleys. This type of market is distressing enough when one is building for retirement, but it can be devastating if you are already retired and spending it down. An index annuity, especially with lifetime benefit features, is ideal for benefiting from what may be the new normal stock market pattern.  

If You Retire In You Ran Out Of Money In Years Money Lasts
1960 1984 24
1961 1990 29
1962 1983 21
1963 1994 31
1964 1985 21
1965 1983 18
1966 1983 17
1967 1992 25
1968 1985 17
1969 1985 16
1970 1994 24
1971 2005 35
1972 1997 25
1973 1991 18

 1. The index annuity returns are actual policy returns for 5-years periods generally beginning and ending at or around 30 September. The $103,574 index return assumes reinvested dividends of 1.72%, which was the S&P 500 dividend average yield from 1997 though 2009

2. Bogle, John, 2003. The Policy Portfolio in an Era of Subdued Returns. Bogle Financial Center.

3. Siegel, Jeremy (1992) The Equity Premium: Stock and Bond Returns Since 1802, Financial Analysts Journal; 48, 1; pg 28

4. Schwert, G. William. 1990. Indexes of U.S. Stock Prices from 1802 to 1987. The Journal of Business. 63, 3; 399

Annuities As The Black Swan Killer (11/09) 
Nassim Nicholas Taleb has written about Black Swans, which are unpredictable events causing a massive impact. For many the stock market crash of 2008 was a black swan. It caused people to doubt the mantra that diversification across correlating equity classes will protect you from risk and a 4% withdrawal rate will keep you from running out of money. The problem is often Wall Street’s idea of diversification is to invest in blue chips stocks such as General Motors and Lehman Brothers, and mortgage derivative bonds, and a 4% withdrawal strategy becomes an 8% depletion rate when ones portfolio loses half its value.

Annuities As The Black Swan Protector  
The intended purpose of retirement savings is to produce retirement income and this is what annuities do. If one puts retirement assets into a diversified portfolio of immediate annuities and deferred annuities with strong guaranteed lifetime withdrawal benefits this income is protected from future stock market black swans. What about a desire to leave a bequest? Since our income is now protected by annuities the remaining money can be invested in more speculative higher risk-higher potential investments.  

The Wall Street retirement plan says withdraw 4% or less of your investment assets each year. Their hope is that the past will repeat and your chances of running out of money at this low withdrawal rate will be slim. However, if Wall Street followers truly believe the past will repeat what they are doing is positioning the retiree to lose over 80% of the time because too little money will be taken out during the lifetime. The reason for rigging the table so the investor cannot fully enjoy their retirement income – which is supposedly the reason all the money was invested in the first place – is that even without a Black Swan occurring Wall Street knows there is a hole in the table that could swallow the retiree. But Wall Street is not trying to help the retiree avoid the hole, instead they are trying to ensure the fall won’t completely kill them.  

Wall Street often has investors risking a dollar to potentially make another penny. If your dollars are protected by annuities then your pennies can be invested in high risk proposals where the likelihood of losing the penny is high, but the potential payoff is also great – it doesn’t matter if you lose 99 pennies if the last penny returns a thousand fold. What if all the pennies are lost? You still have your annuity dollars.  

Protecting Against The Black Swan Of Death  
That death will occur is a certainty, it is the timing that is unpredictable, and this is why we buy life insurance. Life insurance can also be used to provide the certainty of a bequest.In October I was able to find an immediate annuity that would pay an age 65 man $77,000 a year for life in exchange for $1 million – a considerably higher income than the $40,000 income many Wall Street models suggest. What about leaving a bequest? I was able to find a list of a half dozen carriers that would provide a $1 million death benefit for a lifetime guaranteed premium of $27,000. Even after paying for the insurance there remains $50,000 in income.  

What about inflation? The immediate annuity payout I chose does not increase. However, there are many things that can be done. At 3% inflation the $40,000 from Wall Street does not catch up with the $50,000 annuity income for 8 years giving the retiree flexibility to determine whether to take the maximum income in a given year or save it for the future. Or the bequest could be reduced. Leaving a death benefit of $750,000 instead increases cash flow to $57,000 meaning you can either save some of the extra early income to offset inflation in later years, or use it to gamble on those high risk ventures that might pay off big. Wall Street refuses to acknowledge the possibility of black swans because it means all of their retirement models are ultimately flawed. Using annuities and life insurance guard against those market loss black swans than can ruin a retirement, but still leaves money for the retiree to possibly hit a bequest home run.

Bell Curves + Monte Carlo = Risky Retirement Income (6/09)  
I believe the main problems Wall Street’s retirement income plan (R.I.P.) has are these:

  • We can’t predict the future, but Wall Street acts on the belief they can

  • Wall Street assumes just because something is unlikely to happen means it won’t happen

  • Wall Street believes managing risk is the same thing as transferring risk

Three culprits contributed to the recent loss of billions of dollars in retirement savings. Here’s what they are and why this happened:

 Bell Curve  Today is unique because what happens today isn’t exactly like what happened yesterday and what happens tomorrow won’t be identical to today. However, there are similarities in what does and does not happen and this data can be recorded and patterns detected.

Suppose you were furnished with this weather history. Over the last 59 years the wind speed averages 9 miles per hour. The month with the highest average wind speed is April at 10 and July and August have the lowest average wind speeds of 8 miles per hour. If you recorded the average hourly wind speed for the last 59 years the wind speed chart would look similar to a bell. Based on this chart, if you were an analyst planning a sailing trip you might say the odds were 98% that winds would be between 1 and 33 m.p.h. and plan accordingly. And you’d probably be right, unless tomorrow is 24 August 1992 because this is the chart for Miami and Hurricane Andrew will hit today with 150 m.p.h. winds.

Monte Carlo Modeling uses past data but reports it in a different way. Instead of saying “98% of the time wind speed was between 1 and 33 m.p.h. the modeling creates possible futures and then reports how confident they are of their prediction. The often cited Monte Carlo model might say they are “90% confident that wind speed will be between 3 and 30 m.p.h. The “confidence” is based on their assumptions being correct and that future data will follow the patterns of the past. In general the modeling works because tomorrow often is similar to today. The problem is when the assumptions are wrong or when one confuses low probability with no probability. The Miami area has seen fifteen Category 3 hurricanes or better and yet some people still refuse to evacuate when the warnings sound.

The same probability realities apply to Wall Street, but because human emotions are involved the unpredictability on Wall Street is much greater than it is when merely forecasting hurricanes. A bell curve may show that 99% of past annual returns have been between  +20% and -20%, but that doesn’t mean that losses can’t be worse, and a “99% confidence level” often means you are 99% confident that you’ll reach the wrong conclusion because your assumptions are flawed. Closing the barn door late, even The Wall Street Journal finally admitted that Monte Carlo modeling has problems.

Concept Of Risk Management Proper risk management does not mean producing zero losses, it means accurately identifying the risk of loss and determining how much risk to take. As a personal story, my qualified plan is invested in the stock market and was down 30% by March. This was not an example of poor risk management because prior to the drop I understood the market can fall dramatically on occasion, therefore I ensured I had other resources available and sufficient time available to recover from a severe drop. However, the media is full of stories of people that apparently thought managed risk of loss meant zero risk of loss.

Wall Street offered auction rate securities (ARS) as short-term investments with liquidity, but as a consent decree with the Missouri Securities Department pointed out “although the ARS market had, in fact, functioned for more than twenty years with virtually no auction failures, ARS are actually long-term instruments subject to a complex auction process that, upon failure, can lead to illiquidity and lower interest rates”. Seeing the new sales generated by insurance company lifetime payout products mutual fund folks like Fidelity and Vanguard came out with their own lifetime payout products. But alas, since these mutual fund payouts were not insurance company products a retiree owning the Fidelity payout fund saw their income fall 16% earlier this year, and Vanguard payout fund owners saw cuts of 20% to 33%.

The securities world is selling the concept that risk is manageable and if you get smarter analysts (and better regulators) that they can essentially manage the risk down to zero. The problem is Wall Street can never be a zero risk place because the risk is not transferred – it remains with the investor, and the times Wall Street has gotten in the most hot water is when they don’t correct the misperceptions that certain offerings are really low risk and not zero risk.

R.I.P.  And therein lays the unfixable flaws in Wall Street’s retirement income plan. You can create very sophisticated statistical models to plan every possible outcome, but your models are counting on probabilities of the past to repeat in some fashion, and your financial models will never be science as long as people are involved in making the investment decisions. Ultimately any model is probably not any better over the long term in predicting extreme events than throwing darts. Wall Street does a good job of predicting risk adjusted returns when the world follows their models, which the world does most of the time, but a poor job in eliminating risk of loss because their job is managing risk and not transferring it, and that is where fixed annuities come in.

leptokurtosis (fat tails)

A normal distribution of data looks similar to the bell curve I created and it leads some Wall Street types to believe that low risk basically means zero risk. To try to fix this misperception some analysts are presenting the data in different ways that make the bell flatter and make low risk scenarios more visible. The statistical slang for showing the data this way is “fat tails” because a normal distribution curve has very thin ends or tails. The academic term for this is leptokurtosis which is literally translated as “skinny bulges” (I don’t speak Greek, I looked it up).


What does this mean for investors? Not a damn thing! So, unless you are taking a statistics class if someone uses the term fat tails or leptokurtosis in conversation, you are probably dealing with a poseur that doesn’t have a clue what they are doing, but is trying to sound like they do.

Target Payout Funds & Synthetic Annuities (3/09)
It was inevitable that the mutual fund industry would look at the potential revenues from offering life income benefits. One approach taken by Fidelity in 2007 was to offer the Fidelity Income Replacement Fund Series. These managed payout funds used the lifecycle stock/bond allocation approach and are designed to offer a level payout throughout retirement. In 2008 Vanguard added payout funds to their mix. But the income from these payout funds is not guaranteed. 

Payout Mutual Fund Payments Plummet

In early 2009 Vanguard dropped their payouts by 16% and Fidelity cut some payouts 20% to 33% prompting Robert Frey of Professional Management Company to say, “These funds are dogs, the chance of running out of money before you run out of time is very high” (Investment News; Feb 2). A new outgrowth of the annuity GLWB concept was reached in 2008 when guaranteed payout benefits were added to mutual funds and managed money accounts. On 13 March 2008 Lockwood Capital Management Inc. introduced Guaranteed Retirement Income Solutions (GRIS) with a GLWB underwritten by PHL Variable Insurance Company that guaranteed a lifetime payout of 5% for an annual fee of 1.25% (1.45% - Jt) plus 0.5% management fees on three model portfolios. Allstate used a group annuity to offer the Allstate Guaranteed Lifetime Income annuity certificate with their Allstate Clear Target mutual funds.; fees are 0.85% for the Basic Guarantee; 1.00% for the Guaranteed Lifetime and 1.25% for the Enhanced Lifetime Certificate. Genworth/AssetMark have built a similar themed annuity life guarantee wrap around managed accounts with cost of 0.85% to 1.25% ; the guaranteed payout is 5%. Allianz/Envestnet are working on a 5% withdrawal using three portfolio asset allocation models with a fee of 1.20%, and Merrill Lynch with Transamerica has developed three portfolios with respective charges of Conservative (0.50%), Moderate (0.65%), and Moderate Growth (0.95%) and a maximum fee of 1.45%; guaranteed withdrawals are age based. The securities industry will be devoting more resources to creating better guaranteed securities.

Wall Street’s Retirement Income Plan (R.I.P)  (10/08)
An oft proposed Wall Street retirement income plan (R.I.P) uses two rules of thumb. The first rule is an age-based asset allocation formula that says 100 minus your age should equal the percentage of stocks in your portfolio. So, a 60 year old would have 40% stocks and 60% bonds/cash and a 30 year old would have 70% stocks and 30% bonds/cash. The idea behind this is that stocks are more volatile than bonds and have greater risk of loss over the short term; therefore as you get older you should shift more money into less volatile bonds. The second rule of thumb is using a safe withdrawal rate. In the ‘80s and ‘90s it was commonly said that one could withdraw 5% from their portfolio forever, increased for inflation, and never run out of money. These two rules were used by many retirement planners to advise folks how to allocate and receive their retirement funds.

In 2001 a trio of planners tested these rules1. They took actual past market performance and then mixed up the yearly returns to randomly create thousands of different possible financial patterns to show how different mixes of stocks, bonds, and cash would perform if the past parameters repeated. Instead of using a 5% safe withdrawal rate they were even more conservative and used 4½%, adjusted for inflation. What they found was if you put 40% into stocks and the rest into bonds and stocks you ran out of money 24% of the time after 30 years and 41% of the time after 35 years. What that means is if a 60 year old followed the 100 - age = % of stocks rule of thumb they would have run out of money by age 90 a quarter of the time and by age 95 two fifths of the time. Even after using a more conservative 4½% safe withdrawal rate there was a one on four chance the retiree patient would die on the table.

Wall Street’s rules of thumb saw you broke by age 90 a quarter of the time  

This is a serious issue. An argument can be made if a quarter or more of your patients could die from using your medicine they may need a different drug. How did Wall Street react when informed of this problem? They kept the drug and changed the dosage. Now, instead of suggesting 5% as a safe withdrawal rate, whereby your money would last until you die, the rate most often touted is 4%. Some have gone as far as suggesting you should only withdraw 3% from your retirement assets to lower the risk of outliving your money (and if you withdrew nothing I am sure your money would last even longer). But the problem was not solved because the problem is the two rules of thumb do not work well.

Wall Street’s R.I.P – the retiree wants so the children can waste

The problem with using these two rules is two things can happen. The first is even at a lower “safe rate” you can still run out of money before you die – taking out 4% or even 3% does not eliminate the risk of running out of money it simply reduces it. The bigger problem, and what is much more likely to happen, is the retiree will live their retirement in penury only to leave their beneficiaries with a mountain of cash – the retiree will want so the children can waste. I am not the only one that thinks this way. William Sharpe, a developer of the Capital Asset Pricing Model and the Sharpe Ratio for risk analysis, a man that had a huge role in making possible our modern financial tools, said about the two retirement rules of thumb that “Either the spending or the investment rule can be a part of an efficient strategy, but together they create either large surpluses or result in a failed spending plan2.” The bottom line is Wall Street’s long suggested retirement income plan does not work well.

Driving Via The Rear View Mirror
Altho the inflation-adjusted annual returns of stocks has been around 6% for long periods within the last two centuries the same cannot be said for bonds. The inflation-adjusted return on government bonds was 5.1% from 1802 to 1870 but averaged 0.5% annually when calculated over most of the 20
th century3. A key problem with the Wall Street models is they all assume the next century will perform like the last, or to be more specific, the next 30 years will be within the parameters of market moves over the last 80 years. I believe that this is a questionable assumption.

This chart shows the simple average annual “after-inflation” gain or loss of the Dow Jones Industrial Average for 600 thirty year periods beginning in 1928. What I did was calculate the annual gain or loss for each year of the subsequent 30 year period, subtract the rate of inflation for each year, add the inflation-adjusted 30 numbers together, divide by 30 and get an average simple annual gain or loss (movement for 9/28 to 9/29 + 9/29 to 9/30 +....9/57 to 9/58: all divided by 30) and then did it again and again (10/28 to 10/29 + 10/29 to 10/30 +....10/57 to 10/58: all divided by 30). The idea was to see what the average DJIA inflation-adjusted annual gain or loss would have been for, say, the 30 years following a retirement in October 1928, November 1928, all the way up to retiring in October 1978.

Long-term stock market averages do not predict short-term returns  

What I found was there were extreme differences between periods. If you had retired in June 1932 the average net Dow gain was 8.75% a year for the next 30 years, but if you retired in June 1955 the net Dow showed an annual simple loss after inflation when calculated annually until June 1985. In general if you retired in the 1950s or early 1960s the average net Dow gain over the next 30 years was very low - 0% to 2%, primarily due to the lousy ‘70s stock market and the inflation of the ‘70s and early ‘80s. It is important to note that these numbers do not include reinvested dividends. Dividends would have added 2%, 4% or even more to the average annual change, depending on the period. It should also be noted that these are simple and not compound results. Gains are not added back in and losses are not deducted. You cannot use this chart to say “you would have earned an x% return if you had bought the Dow stocks in October 1946.”  

The point of this chart is to show that even tho the long-term stock market return has been around 6% after inflation for the last 200 years you can't rely on that number for planning a 30 year retirement. Even if past performance predicts the future – something every prospectus says does not happen – a retiree cannot be sure which past will repeat. The bigger problem is even tho the required mantra is that the past does not predict the future most of these Wall Street models depend on the past repeating in some fashion, because if the past truly does not predict the future – as they are all required to say – their models are essentially useless. The financial climate has changed, financial tools have changed, and global demographics have changed. It may be true that beyond recognizing there are economic cycles, that the accuracy of all Wall Street retirement models are no better than throwing darts at a retirement allocation dartboard.  

It comes down to this. If you ask Wall Street “Can you guarantee your client an income for life?”  
Their answer is “We can’t.” Only insurance provides a guaranteed retirement solution.

An Insured Retirement  
The same uncertain future faces owners of annuities and life insurance contracts, but the consumer has an intermediary, a regulated insurance company, whose job is to protect them from uncertainty. The importance of this regulation was apparent in the recent problems affecting AIG. The SEC regulated parent company received a bailout, but the state-regulated insurance subsidiaries of AIG were solvent and did not need a September bailout. As the NAIC stated “The federal bailout of the non-insurance portions of AIG does not negatively change the solvency strength of its insurance subsidiaries. The key distinction here is that AIG’s insurance subsidiaries did not cause this crisis – rather, they will play a critical role in the solution4.” Annuities and life insurance offer insurance against life’s uncertainties and provide a real alternative to Wall Street’s R.I.P.  

Preserving Income, Hope & Freedom   
The solution I created uses optimal combinations of immediate annuities, fixed annuities with GLWBs and longevity insurance to preserve not only income, but also the flexibility to adapt the solution to the retiree’s changing needs, whether those needs are increased income or a desire for a greater bequest. The insurance world can create a secure retirement alternative to Wall Street by using a holistic approach that guarantees a retirement income baseline that is not damaged by underperforming stock markets, but guarantees an income for as long as a retiree and the spouse live.  

1. Ameriks, Veres, Warshawsky. 2001. Making retirement income last a lifetime. Journal of Financial Planning. 14;12:66  

2. William F. Sharpe, Jason S. Scott, and John G. Watson. 2007. Efficient Retirement Financial Strategies. Pension Research Council Working Paper Series. 

3. Jeremy Siegel. 1992. The Equity Premium: Stock and Bond Returns Since 1802. Financial Analysts Journal. 48; 1:28  


Social Security: Are Men Mean Or Stupid? (the study says stupid)   (9/08)    
Most married men begin receiving Social Security at age 62 or 63. Because benefits increase the longer they are delayed it can be argued that it makes sense to delay claiming Social Security until at least the full benefit age. However, due to a man’s shorter life expectancy it works out to a pretty near thing overall whether the men receives lower payments for more years or higher payments for fewer years. The problem is the early retirement may severely impact the wife.

A man retiring today at 62 may get 75% of their full benefit, but due to life expectancy that 75% beginning at age 62 actuarially approximates the cash of getting 100% at age 66. However, usually when the husband dies the wife is still alive and she receives the survivor Social Security benefit that is based on the husband’s benefit. If the husband claimed early benefits and only received 75% of the full share the surviving spouse is also penalized for many more years due to a longer life expectancy. The husband’s decision to claim the benefit 3 or 4 years early may severely impact the widow’s income for many more years after the husband dies.

Social Security Benefits


Starting in 2009 the full retirement age for the next 11 years is 66 (Born 1943-1954)

Reduced Benefits Wage Earner Spouse    
Age 62 75.0% 35.0%    
Age 63 80.0% 37.5%    
Age 64 86.7% 41.7%    
Age 65 93.3% 45.8%    
Age 66 100.0% 50.0%    
Monthly Retirement Income Wage Earner (Widow/Widower)
Retire @ Age 62 Age 63 Age 64 Age 65 Age 66
$20,000 575 (268) 617 (289) 675 (325) 735 (361) 795 (398)
$30,000 708 (330) 761 (357) 835 (402) 910 (447) 987 (494)
$40,000 841 (392) 905 (424) 995 (479) 1086 (533) 1180 (590)
$50,000 973 (454) 1049 (492) 1154 (555) 1261 (619) 371 (686)

Claiming early benefits can be justified if the couple needs the money, but the study found the man often did not need the income, but was simply filing for Social Security because that is what one does when one retires. The question the study raised was did men that did not need to claim benefits file early because they were unaware of the consequences or because they wanted to act like a cad towards their wife. The study concluded that when a man claimed early benefits he was simply ignorant of the possible results, and not intentionally being a jerk. The study also shows how little the typical person understands about Social Security as they enter retirement and the need for coordinating Social Security planning with other retirement planning.

Sass, Steven, W. Sun, A. Webb. 2007. Why do married men claim Social Security benefits early? Ignorance or caddishness? Center for Retirement Research. CRR WP 2007-17.

Coping With The Full Market Monte (1/08)
It can be argued that the stock market has averaged a 10% annual return over the long-term. If that 10% average holds true in the future one might assume that taking out 6% a year would give you plenty of buffer for down times and your money would last forever. After all, earning 10% and spending 6% means you are leaving 4% to grow and compound. Unfortunately, averaging 10% does not mean earning 10% each year and therein lies the problem. If you have a ten year period that looks like this chart the annualized average return is 10%. If you put $100,000 in, and left it alone, ten years later you’d have $260,000. However, if you began withdrawing $6,000 a year in the first year – a 6% spending rate – you run out of money. The obvious reason is the combination of withdrawals and dramatic market drops in years one and two put you so far down that you never recover.

If you look at the 25 years from 1981 to 2006 the S&P 500 averaged 10% a year and not only could you have maintained your 6% income but you’d have a balance of roughly $4 for every $1 you started with. However, if you look at the 25 years from 1973 to 1998 the S&P 500 also averaged 10% a year, but you ran out of money in 1992. If you play with more periods you find that you were okay if you started withdrawals in 1970 or 1971, but if you began withdrawals in 1968 or 1969 you also ran out of money before the 25 years were up.

Maybe to be safe we should only take out 5% a year. Well, that works most of the time, but what about inflation? In 1973 you could have bought a new Ford Mustang Coupe for $2,760, by 1997 a bare-bones new Mustang retailed for $15,355 (source: To simply maintain our living standard the withdrawals should probably increase at the rate of inflation. But this mean that our nest egg that allowed for 5% withdrawals initially would need to support 7% withdrawals in a dozen years simply to keep pace with 3% inflation (and then even our previously safe starting years of 1970 and 1971 also run out of money when the withdrawals are adjusted for inflation). How about if we cut the initial withdrawal rate to 4% or even 3% and adjust it for inflation? Well, that works better, but there are still are no guarantees that we will not run out of money.  

Therein lays the retirement income problem. You can wind up taking out too little – making retirement a bitter, penny-pinching experience, but leaving buckets of money for your heirs, or you might spend too much and wind up needing to live with those heirs. One obvious solution is to buy a life-only immediate annuity. If you do not have a bequest need then the logical answer is to maximize your income and eliminate the potential of losing it. Indeed, the last time I checked an age 66 man could get a 6% income for life, indexed for inflation, and never outlive his money. You could provide a couple an income for as long as either lived. The problem is most people do not seem to be able to cope with the psychological problem of losing the asset when it is converted into an immediate annuity.  

Misunderstanding Statistics  
Too many investment folks run future retirement scenarios based on the past and then say with a great deal of certainty that their retirement target plan gives you an 80% probability that your money will last at least 30 years. The problem is 100% of the people that retired in 1973 and took out an inflation-adjusted 5% a year ran out of money early, but 0% of the people that retired in 1975 and took out an inflation-adjusted 5% a year ran out of money. All retirement models – whether they are as simple as subtracting ones age from 100 or as cumbersome as creating Monte Carlo simulations – are based on the assumption that there is a pattern to financial markets that allows us to predict future events. There are cycles that do seem to follow a pattern; the millennium bear market was predicted (at least by some) by seeing the market excesses of the late ‘90s and remembering that every time the phrase “this time it’s different” is used a bear market follows. However, almost no one predicted the decade long market shock that began in 1973 when OPEC raised the price of a barrel of oil tenfold. Retirement models cannot predict the unpredictable and so the unpredictable is ignored.  

Another problem with these retirement probabilities is assuming people will act like computers when a future crisis occurs. However, people act normally and thus react emotionally to events, which mean computer-like decisions may not be made in times of stress. Instead of building your retirement life around a 4% withdrawal retirement plan that ignores the twin realities that the future is unknown and retirees are not computers, I believe it makes more sense to develop contingency plans to give you a guide to follow if certain things do happen.  

Try Not To Retire In A Down Period  
It is New Years Day 2001, the year you planned to retire, but the market has dropped over 10% in the last six months. Perhaps we should delay retirement and wait and see. Using the S&P 500 as a proxy for the market, if we had $100,000 and took out an inflation-adjusted $4,000 a year beginning in 2001 we only had $74,108 left by the end of 2006 (and it got down to $60,000 before the 2003 bull market kicked in). But if we had delayed retirement for two years we’d be sitting with $138,000 today.
The market today is off 7% from its previous high. If it continues downward and you are thinking about retiring this year, think again. Or, if you recently retired perhaps you should consider doing some part-time work that will help keep your hands out of the retirement cookie jar until the market turns.  

Try To Spend Less In A Down Period  
The retirement math models all assume that withdrawal amounts increase each year, but that may not reflect reality. I have listened to hundreds of retirees over the past score of years and in general I have found they try to match their outgo to their income. If the retirees’ bank CD is paying 5% this year instead of 4% they spend the extra 1%. If the mutual fund dividend gets cut from $600 to $400 a year then $200 less is spent at home. If the income reflects what is happening to the principal I have seen retirees adjust to the income, and a few years of taking a little less may put a detoured retirement engine back on track (using the previous example if you had retired in 2001 and spent 3% in 2002 and 2003 instead of 4% you would have had $80,000 by 2006 instead of $74,000). Is everyone able to postpone retirement, work at a part-time job, or tighten their belt to get thru market downturns? Of course not, but many retirees can react to these challenges, and by reacting as people instead of computer models the retirees can help maintain their retirement funds.

Put 10% to 15% In A Safe Place  
Beginning with $100,000 at the end of 1972, if you withdrew an inflation-adjusted $4500 from the S&P 500 starting in 1973 you ran out of money in 1993. However, if you put $90,000 in the S&P 500, placed the remaining $10,000 in a no-market-risk vehicle to produce the $4,500 withdrawals until it was used up, and then started taking inflation-adjusted $4,500 withdrawals from what was left of the original $90,000 in the S&P 500, you did not run out of money in 1993. It appears putting 10% to 15% of the retirement money into no market risk vehicles, and withdrawing this money during market downturns instead of tapping into the invested assets, helps our money survive longer.  

Magical GLWB  
The Guaranteed Lifetime Withdrawal Benefit available on many annuities gives us income for life and control of the asset. The main disadvantage is the payout is not indexed to inflation. However, most annuity GLWBs have reset or step-up provisions that allow for increased income if the benefit base increases. In addition, while most financial plans would suggest a 4% withdrawal starting point for a 70 year old the typical fixed annuity GLWB would pay out 6%. At 3% inflation the retiree would be age 85 before the financial plan income exceeded the GLWB income (and that assumes no increases in the GLWB benefit base and all of the excess GLWB income is spent on enjoying retirement and not reinvested).  

And You Can Always Buy An Income Annuity  
Using our 2001 retirement example we would have had $74,000 remaining at the end of 2006. Adjusted for inflation we would now be withdrawing $4,776 a year or an equivalent of 6.45% of the remaining principal. If we no longer want to perform a full market monte and be totally exposed to market risk, we could buy an inflation-adjusting life payout immediate annuity. The last time I checked $74,000 would produce $5,000 annually that increases as inflation increases.  

Historically, withdrawing 5% or 6% each year from your retirement nest egg would have worked most of the time. Unfortunately, when this failed it often failed badly leaving folks with remaining years and no remaining cash. The financial advisors have tried to address this problem by solving for the worst possible case. What this means is the typical financial advisor’s 4% solution locks consumers into a retirement spent in deprivation by building a withdrawal strategy using a long-shot doom scenario, meaning the most likely result will be that the retiree’s kids will have a lifelong party on their graves, and sadly, even the advisor’s worse case solution will fail to protect the retiree in all situations.  

Instead of using a rigid plan that forces retirees to base their lives on the possible occurrence of an unlikely event, it makes more sense to base their lives on what is likely to happen, but have contingency plans or guides to follow if the unlikely event occurs. This contingency plan could include delaying retirement or reducing withdrawals if the market goes down 10% in the preceding year, putting 10% to 15% of the retirement money in a no-market-risk instrument that is accessed when the stock market drops, or buying a life income annuity if retirement assets drop to a specified level. Another excellent solution to the whole not-outliving-your-money problem is to place the money in annuities with GLWB benefits. Altho there are costs, and the income is not perfectly indexed to inflation, the GLWB gives consumers potential asset and income growth, and control of the asset. For retirees concerned about outliving their cash the best advice may be to ignore the retirement statistical probabilities and take the retirement GLWB sure thing.

Index Annuities Instead Of Bonds (12/06)  
The average long-term U.S. stock market return over the last 200 years has been 6.8%. Indeed, a look at 50 year plus periods since 1802 finds returns of between 6.6% and 7.0% consistently over the two centuries. By contrast, bond returns have been on a long-term decline averaging 4.8% in the 19th century and only 2.3% when calculated over most of the 20th. Even though the falling interest rate periods of the last 25 years generated annualized bond returns of over 8% from 1982-2004, a longer look covering 1946-2004 produces an annualized bond return of 1.4% versus the 6.8% of the stock market.  

The story gets worse for bonds. If you look at 10 year holding periods from 1870 onward stocks beat bonds 83% of the time. For 20 year periods stocks were a winner for 95% of the scores and for 30 year periods stocks KO’d bonds for every period occurring since Ulysses S. Grant was president. Historical results appear to make nonsense of that “100 minus your age” heuristic when it comes to determining the percentage of bonds in the portfolio because a 100% stock portfolio would appear to be the better choice for most people if they have at least a 10 year horizon, and certainly optimum if they have a 20 year or greater timeframe. Unfortunately, consumers seem to behave as if long-term horizons have the same risk as short-term ones. Studies by Benartzi & Thaler find that people tend to base their willingness to accept risk of loss not on the time horizon of their investment period but on the length of the evaluation period used. Say two consumers look at and adjust their investment portfolio once a year, but Consumer A plans to spend his money in twelve months while Consumer B won’t use the money until 30 years from now. Even if both consumers were fully aware of the stock and bond return histories mentioned previously both consumers would allocate their portfolios the same way – with a strong emphasis in bonds – because their evaluation periods are on 12 month cycles, even though this near-sighted view is costing Consumer B a considerable loss in potential returns.  

This short-term approach to long-term horizons has been found to be true for both part-time investors and professional pension managers (because pension managers must show short-term results they also tend to be too risk averse to maximize long-term returns). The problem is an irrational fixation on the possibility of ending the next year with a loss even though over the long haul the effect of a loss in any given year is minimal; the result is too much money is kept in lower returning bonds. A possible solution is to use an alternative to bonds that offers a potential for higher returns without the risk of loss that is prompting this behavior. This alternative would be an index annuity.  

Index annuities using annual reset methodologies may be used as the bond alternative in a portfolio. The annuity’s protection of principal and credited interest from market loss should satisfy the risk aversion need perceived in bonds while the linking of credited interest to the movements of a stock index could result in higher returns than bonds would provide.  

Annualized Returns   Annual Reset Method with Participation Rate of  
Holding Period U.S. Stock Market Long-Term Bonds 60% 50% 40%
1946-1965 10.02% -1.19% 7.34% 6.12% 4.89%
1966-1981 -0.36% -4.17% 5.40% 4.50% 3.60%
1982-2004 9.47% 8.01% 8.37% 6.97% 5.58%
1946-2004 6.83% 1.44% 7.13% 5.94% 4.75%

  Participation rate applied to S&P 500 without reinvested dividends. S&P 500 does not endorse any index annuity. Information from sources believed accurate but is not warranted and is intended to be educational and is not investment advice.

Example: The graph compares the annualized returns of long-term bonds with an annual reset approach to the S&P 500 over different periods. The annual reset method credits 60%, 50% or 40% of any index gains for the calendar year and treats years with losses as years of zero gains. The annual reset calculations do not include reinvested dividends.  

What is discovered, with the exception of the extremely bond favorable 1982-2004 period, is that an annual reset approach to the S&P 500 index produced returns that were considerably higher than bond returns. Even at a 40% participation rate the annual reset method produced index-linked returns that averaged almost 5% higher than bonds. Although the annual reset styled returns were generally lower than stock market returns they were still 3.3% to 9.6% higher than bond returns for the periods. Even during the period where bonds and stocks posted losses the annual reset approach generated positive returns. I believe a strong argument can be made that an index annuity with an annual reset structure may well outperform bonds, and because it is a fixed annuity that protects both principal and interest earned from market loss that the index annuity will quell consumer risk aversion fears. It is possible that the index annuity could result in more money placed on the stock side of the equation because the consumer feels there is even less risk of loss with index annuities than there is with bonds.  

There are a few points to keep in mind. Index annuities have been around only ten years and although my research shows they have generally been competitive with bond vehicles over various 5 year periods they have a short track record. And, of course, the past is no guarantee of the future. Jeremy Siegel of the Wharton School forecasts a low inflationary future in which stock returns are 5.5% to 6% and bond  returns are 3.5%. The degree that an index annuity participates in an index is dependent on the interest rate climate, and the low bond rates predicted in this future would lessen the money available to provide the index participation.

The stock market has produced significantly higher returns than bonds over the last 200 years and may very well continue to do so, but irrational fears of loss get in the way and make consumers too risk averse so that they put too much in bonds and hurt potential returns. Index annuities remove the element of market loss from the decision and provide the possibility for greater returns than bonds may give. Index annuities are a viable alternative to bonds.  

S. Benartzi & R. Thaler (1995); Myopic loss aversion and the equity premium puzzle, The Quarterly Journal of Economics, February, pg. 73-92  

N. Siebenmorgen & M. Weber (2004), The Influence of Different Investment Horizons on Risk Behavior, The Journal of Behavioral Finance; 5, 2; pg. 75–90  

Siegel, Jeremy (1992) The Equity Premium: Stock and Bond Returns Since 1802, Financial Analysts Journal; 48, 1; pg 28.  

Siegel, Jeremy (2005); Perspectives on the Equity Risk Premium, Financial Analysts Journal; 61, 6; pg 62



Copyright 1998-2016 Jack Marrion, Advantage Compendium Ltd., McKinney TX (314) 255-6531.  All information is for illustrative purposes only, does not provide investment or tax advice. No index sponsors, promotes, or makes any representation regarding any index product. Information is from sources believed accurate but is not warranted. Advantage Compendium neither markets nor endorses any financial product.