Retirees Should Plan for a Long Retirement Longevity risk is the possibility that a person will outlive his or her retirement savings. Chances are, people are going to live longer than they think. While living longer is a good thing, it can pose some challenging financial issues in retirement. Longevity risk is perhaps one of the biggest risks that investors will face as they enter retirement. Accounting for longevity risk in retirement planning is more important than ever because people today are living significantly longer than prior generations, due to advances in medicine, diet, and technology. This risk is compounded by medical and health-care expenses that are rising considerably faster than the rate of inflation. Most people underestimate how long they are likely to live. Too often, people base their financial planning upon their life expectancy, which is the average age at which someone is expected to die. In the United States, the median life expectancy of a 65-year-old man and woman is 85 and 88, respectively. What people do not always realize is that this is the median. Half of the population will live longer, often much longer than their life expectancy. The image above illustrates the probabilities of a 65-year-old living to various ages. For example, there is 25% chance that a 65-year-old man will live to age 91, a 65-year-old woman to age 93, or at least one spouse of a 65-year-old couple to age 96. Retirees should plan for a long retirement, perhaps as long as 30 years. If retirees’ financial plans assume they live only to the median life expectancy, they run a greater risk of depleting their retirement savings. There are a couple additional reasons to use conservative mortality assumptions. First, the fact that your clients are working with a financial advisor means that their expected mortality is likely to be older than the population at large due to better health-care, nutrition, etc. Second, consider the downside risk—you would rather be conservative and have money left over than have your clients run out of money before they die. Source: Annuity 2000 Mortality Tables—Transactions, Society of Actuaries, 1995–1996 Reports.
Personal Savings Expected to Play a Larger Role in Retirement The sources from which current workers expect to receive their income during retirement differ from the sources from which current retirees actually receive their income. The graphs illustrate that while only 47% of current retirees utilize their personal savings for retirement income, 70% of current workers anticipate personal savings to play a role during retirement. 75% of workers expect to receive retirement income from an employer-sponsored retirement savings plan, while only 40% of those already retired actually receive income from such a source. A whopping 92% of retirees say they derive some of their income from Social Security, as opposed to 81% of current workers who expect to rely on this source. Traditionally, Social Security and company pension plans were primarily depended on to fund an individual’s retirement. As the retirement income gap grows larger, however, the current belief is that these established retirement income sources will no longer play as prominent a role. Personal savings are expected to play a much larger role funding future retirements. Source: Employee Benefit Research Institute, 2009 Retirement Confidence Survey, April 2009.
Potential Shortfall: The Risk of High Withdrawal Rates If you plan on withdrawing from your retirement savings for a long period of time, it is important to examine the effect various withdrawal rates may have on a portfolio. Several factors need to be examined when determining an investor’s withdrawal rate. The answer may depend upon the portfolio mix, how long an investor expects to withdraw from the portfolio, and the investor’s risk aversion and consumption patterns. This image looks at a hypothetical 50% stock/50% bond portfolio and the effect various inflation-adjusted withdrawal rates have on the end value of the portfolio over a long payout period. The hypothetical portfolio has an initial starting value of $500,000. It is assumed that a person retires on Dec. 31, 1972, and withdraws an inflation-adjusted percentage of the initial portfolio wealth ($500,000) each year beginning in 1973. As illustrated, the higher the withdrawal rate, the greater the chance of potential shortfall. The lower the rate, the less likely you are to outlive your portfolio. Therefore, early retirees who anticipate long payout periods may want to consider assuming lower withdrawal rates. Government bonds are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. About the data Stocks in this example are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Bonds are represented by the five-year U.S. government bond and inflation by the Consumer Price Index. An investment cannot be made directly in an index. Each monthly withdrawal is adjusted for inflation. Each portfolio is rebalanced monthly. Assumes reinvestment of income and no transaction costs or taxes.
What is an Immediate Payout Annuity? Immediate payout annuities are insurance products that retirees can use to provide income in retirement. An immediate annuity is typically intended to provide income for the life of the annuitant. It can offer protection against outliving your assets. In exchange for the insurance company’s guarantee of income for life, an annuity can be purchased with a lump-sum amount or with portfolio assets that are rolled over from another source, such as a 401(k). Annuitants can decide how the payments from the annuity are determined. In a fixed annuity, the income payments are set at a fixed amount and are not adjusted for inflation. This provides for consistency and the confidence that each payment is the same. A variable annuity, in contrast, offers the annuitant the ability to receive payments that are pegged to a basket of either equity or fixed-income securities. This makes the payment stream variable and offers the annuitant the chance for higher payments than with a fixed annuity. It is possible that income payments could also fall below those of fixed annuities, so annuitants must consider their ability to handle volatility in their income stream when purchasing a variable annuity. Regardless of the type of annuity chosen, the insurance company guarantees that some level of income will always be available for the life of the annuitant or some other specified period. This guarantee is based on the claims-paying ability of the insurance company that issued the annuity product.
Inflation Affects Immediate Fixed Annuity Payments While an immediate payout fixed annuity provides a consistent and steady income stream, the purchasing power of each payment can be reduced by inflation. The image above illustrates a hypothetical payment stream from an immediate fixed annuity. With an initial premium, or purchase amount, of $1 million the annual income payments for a 65-year-old male in Illinois would be $75,804. The annual payments before inflation are represented by the straight line. People who enjoy the security of a steady and predictable stream of income may find a fixed annuity appealing. The drawback of a fixed annuity becomes evident over time. Since the payments are the same year after year, purchasing power is eroded as the annuitant gets older. The second, curved line in the image represents the same payment stream after a hypothetical 3.1% inflation rate is factored in. The annuity income guarantee is based on the claims-paying ability of the insurance company that issued the annuity product. About the data The example assumes a male, age 65, living in Illinois, and a $1 million premium payment. A quote for fixed annuity payments given these assumptions was obtained from immediateannuities.com. The after-inflation results were calculated by Morningstar using the 1926–2009 annual inflation average of 3.1% from the Consumer Price Index.
Sample Allocations With and Without Immediate Payout Annuities The appropriate mix of annuitized and non-annuitized assets is determined by a number of factors: age, risk tolerance, how worried an investor is about outliving their money, the desire to leave an estate, and the fees and expenses of the products they choose. The image illustrates six sample portfolios (three traditional, three annuitized) by risk type, for a male retiree with a moderate desire to leave an estate. These sample portfolio allocations will be used in many of the following illustrations. It is important to note that the asset allocation of equity and fixed investments at each risk level remains comparable between the traditional and annuitized portfolios. The difference between the portfolios is the type of product used to implement the asset allocation strategy. The allocations presented herein are intended for illustrative purposes only and do not represent any investment advice. These portfolios are based on the patented Ibbotson optimal allocation methodology with annuitization.
Interpreting Confidence Levels in Simulation Confidence levels are a statistical measure that indicate a probability value and are expressed as a percentage. Interpreting confidence levels can often be difficult. The table provided is intended to help interpret confidence levels that are commonly displayed in illustrations of simulated market performance. In the context of simulating wealth and income in retirement, a 50% confidence level means there is a 50% chance of exceeding the illustrated result and a 50% chance of falling short. This is also considered the median result. A 75% confidence level means there is a 75% chance of exceeding the illustrated result and a 25% chance of falling short. This confidence level takes more downside scenarios into account than the 50% level. A 90% confidence level means there is a 90% chance of exceeding the illustrated result and a 10% chance of falling short. Results shown under these conditions include a significant exposure to expected downside risk. Unexpected events that are out of an individual’s control are a significant concern for today’s retirees. Prudent retirement planning often means preparing for the worst. For this reason, it is much safer to plan for poor market conditions associated with the 75% or 90% confidence levels.
Immediate Annuities Can Provide Income For Life Using only systematic withdrawals from traditional investments could lead to a high likelihood that an investor may run out of funds too early. The image shows that at a 90% confidence level a 60% stock/40% bond portfolio becomes unable to meet income goals beyond age 87. This is a considerable concern, given there is a 50% chance that a man will live to 85 and a 25% chance that he will live to 91. An alternative portfolio in which 27% of the portfolio is annuitized improves the probability of an investor meeting income goals over long-term horizons. Even if the non-annuitized assets are depleted, the annuities will continue to provide some level of income no matter how long an investor lives. An immediate payout annuity is typically intended to provide income for life. In an immediate fixed annuity (IFA), the income payments are set at a fixed amount. In contrast, immediate variable annuity payments (IVA) fluctuate in value depending on the underlying investments held and, therefore, annuitants must consider their ability to handle volatility in their income stream when purchasing a variable annuity. An initial portfolio of $1 million was assumed for a single male at age 65 with an annual income need of $50,000 after inflation. The initial $9,288 payment for the IVA is based on a Society of Actuaries formula and incorporates an Assumed Investment Return (AIR) of 3%, mortality, expense and administrative charges of 1.20%, annual investment expenses of 0.88% and 0.74% for stock and bond mutual funds, respectively, and mortality tables from the Society of Actuaries. Subsequent IVA payments are determined as follows: (1+return)(1–fees)/(1+AIR)*previous payment. If the market return net of fees is higher (lower) than the AIR, then the IVA payment will be more (less) than the previous payment. The fees applied to the IVA modeled do not reflect fees for additional features or riders often available for this type of product, or surrender charges that may apply upon distribution. The annual IFA payout quote was $9,828 for a 65-year-old male living in Illinois in Dec. 2009, from www.immediateannuities.com. The image was created using Monte Carlo parametric simulation that estimates the range of possible outcomes based on a set of assumptions including arithmetic mean (return), standard deviation (risk), and correlation for a set of asset classes. The inputs used are historical 1926–2009 figures. The risk and return of each asset class, cross-correlation, and annual average inflation over this time period follow. Stocks: risk 20.5%, return 11.8%; Bonds: risk 9.6%, return 5.8%; Correlation 0.03; Inflation: return 3.1%. Other investments not considered may have characteristics similar or superior to those being analyzed. The simulation is run 5,000 times, to give 5,000 possible 35-year scenarios. A 90% confidence level indicates that there is a 90% chance of the outcome being as shown or better. Higher confidence levels are chosen in order to view tougher market conditions. A limitation of the simulation model is that it assumes a constant inflation-adjusted rate of withdrawal, which may not be representative of actual retirement income needs. This type of simulation also assumes that the distribution of returns is normal. Should actual returns not follow this pattern, results may vary. Government bonds are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while returns and principal invested in stocks are not guaranteed. Variable annuities are subject to certain insurance-related fees and charges that are not associated with other investments. About the data Stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general, bonds by the 20-year U.S. government bond, inflation by the CPI, and expense charges from Morningstar. Data assumes reinvestment of income and does not account for taxes or transaction costs.
Immediate Annuities May Lessen Income Gap Purchasing an immediate annuity may lessen the potential income shortfall an investor could experience in a long retirement. The table illustrates at a 90% confidence level the percent of annual target retirement income an investor may meet for both traditional and annuitized portfolios assuming a 5% withdrawal rate. Regardless of the portfolio, in a short retirement horizon, both are able to fully fund retirement income needs. In longer retirement horizons, however, adding annuities can potentially provide a benefit. While the annuities do not fully meet the desired income, they can provide some level of income throughout an investor’s lifetime. In this case, annuities were able to meet roughly 20% of the retirees needs by age 90 compared to no income (0%) for the traditional portfolio. Initial payments for immediate payout variable annuity allocations are based on a formula from the Society of Actuaries and incorporate an Assumed Investment Return (AIR) of 3%, mortality, expense, and administrative charges of 1.20%, annual investment expenses of 0.88% and 0.74% for stock and bond mutual funds, respectively, and mortality tables from the Society of Actuaries. Subsequent variable annuity payments are determined by: (1+return)(1–fees)/(1+AIR)*previous payment. If the market return net of fees is higher (lower) than the AIR, then the variable annuity payment will be more (less) than the previous payment. The fees for the immediate variable annuity modeled herein do not reflect fees for additional riders often available for this type of product, or surrender charges that may apply upon distribution. Annual fixed annuity payout for each portfolio was quoted for a 65-year-old male living in Illinois in December 2009, from www.immediateannuities.com. The image was created using Monte Carlo parametric simulation that estimates the range of possible outcomes based on a set of assumptions including arithmetic mean (return), standard deviation (risk), and correlation for a set of asset classes. The inputs used are historical 1926–2009 figures. The risk and return of each asset class, cross-correlation, and annual average inflation over this time period follow. Stocks: risk 20.5%, return 11.8%; Bonds: risk 9.6%, return 5.8%; Correlation 0.03; Inflation: return 3.1%. Other investments not considered may have characteristics similar or superior to those being analyzed. The simulation is run 5,000 times, to give 5,000 possible 35-year scenarios. A limitation of the simulation model is that it assumes a constant inflation-adjusted rate of withdrawal, which may not be representative of actual retirement income needs. This type of simulation also assumes that the distribution of returns is normal. Should actual returns not follow this pattern, results may vary. Government bonds are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while returns and principal invested in stocks are not guaranteed. Variable annuities are subject to certain insurance-related fees and charges that are not associated with other investments. About the data Stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Bonds are represented by the 20-year U.S. government bond, inflation by the Consumer Price Index, and expense data from Morningstar. The data assumes reinvestment of income and does not account for taxes or transaction costs.
Assessing Suitability of Immediate Annuities in an Asset Allocation In order to assess the suitability of immediate annuities in an asset allocation, a number of factors need to be evaluated. These factors include: age, subjective survival or perception of health, irreversibility or apprehension about turning over money to purchase an annuity, bequest or desire to leave an estate, consumption preference, fees, wealth, and sources of guaranteed income. As investors age, immediate payout annuities in an asset allocation tend to become more suitable. This is because payments from a payout annuity are tied to the annuitant’s survival. The money that was put into annuities by those who have passed away is then spread among the pool of surviving annuitants. This idea is often referred to as mortality credit. Subjective survival probability addresses an investor’s perception of their health and fear of outliving their money. For example, if an investor thinks they will live only to their life expectancy, then they believe they are of average health. Some may have a history of long life in their families and believe their chance of living past the average life expectancy is high. The greater the risk of outliving money, the greater the suitability of including annuities in retirement. If a person is very apprehensive about turning over a lump sum or their portfolio to annuitize because of the permanence of the decision, then it becomes less suitable for that individual to have a significant portion of annuities in their asset allocation. Once the decision to annuitize has been made, it cannot be changed or reversed. Bequest is the desire to leave an estate to heirs. As the amount an investor wants to leave increases, the appropriateness of immediate payout annuities declines. This is because, with an insurance product, the investor is exchanging their wealth for a guaranteed income stream that does not pass to heirs. Conversely, if an investor has a preference to consume their wealth in retirement and leave little or no estate, annuities may be a way to provide guaranteed income to support consumption. The higher the fees associated with an annuity product, the less appropriate it becomes, because fees reduce returns. This is particularly important on immediate variable payout annuities, because income payments are based on market returns. Investors with significant portfolio wealth are less likely to need income guarantees, as the chance of not having the money to meet their income needs in retirement lessens as wealth increases. Also, those who already have sources of guaranteed income, such as Social Security and pensions, are less likely to need additional sources of guaranteed income to supplement income from their portfolios. Factors described are from patented methodology assigned to Ibbotson Associates. Source: Peng, Chen and Milevsky, Moshe A., “Merging Asset Allocation and Longevity Insurance: An Optimal Perspective on Payout Annuities?,” Journal of Financial Planning, June 2003.
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