Today, one of the hottest topics in financial planning research is retirement portfolio sustainability. Put simply, the question boils down to: "Will a retirement nest egg last a lifetime?"
Sustainability is usually defined as the probability that a portfolio will generate the required income (referred to as the withdrawal rate) for the rest of the retiree's life. Not surprising, running out of money too soon is generally referred to as "retirement ruin." Retirement adds some new risks, which have an impact on this analysis: Longevity risk (the possibility of living longer than average) and sequencing risk, the risk of suffering a number of consecutive downturns in the market early in the distribution phase of a portfolio.
It's easy for a financial advisor to think that academic research has little impact on his or her practice. However, researchers are testing some of the strategies that advisors are using -- and maybe to your surprise -- they are agreeing with many of them. In this article, we will cover some of those findings that have an impact on your planning with clients.
The last three years have seen a flurry of interest in the questions such as, "How much can I withdraw from my portfolio?" and "What should I invest in during retirement?" Clients who spend conservatively (too little) may unnecessarily deny themselves from enjoying the fruits of their careers. Clients who spend too aggressively may find themselves in catastrophic failure. And while the academic crystal ball has not found a magic withdrawal rate or portfolio composition, three studies have shed light into the relationship between withdrawals, investment options and retirement success. Specifically, much of this literature focuses on how annuitization strategies affect sustainability.
For example, Lemoine, Cordell and Gustafson (2010) tested five traditional retirement solutions searching for which one protected retirees most effectively from outliving their money. The models tested applied a uniform withdrawal rate and compared a portfolio entirely made up of equity and bond mutual funds was contrasted with a number of other portfolios that included along with the mutual funds, deferred annuities with lifetime benefits or immediate annuity options. The authors demonstrated that utilizing equity-based investments during the client's accumulation phase (while working) and at retirement using a portion of proceeds to purchase an immediate annuity generated the lowest chance of portfolio failure.
Financial planners and insurance agents are not alone in studying the need for securing retirement cash flows. The Jounal of Accountancy recently published a quantitative article by Marcus, Janken, & Hovey (2009) that reinforces the importance of a obtaining a secured income stream during retirement. The study found that fixed income investments and immediate annuities help hedge portfolio failure risk. Also, they demonstrated that longevity risk is significantly increased when retirees face steep equity losses at the inception of retirement. As advisors realized in 2008, clients invested heavily in equities may be in a situation of re-evaluating goals. Those clients who had secured a portion of their assets did not suffer the same level of portfolio stress.
Horneff, W., Maurer, R., & Stamos, M. (2008) added to the discussion of ideal portfolio composition with a strategy of gradually annuitizing retirement portfolios over time. One practical application that resulted from the study was the general recommendation that older workers should consider purchasing an incrementally larger portion of annuity assets as they approach retirement. This laddered approach to annuitization provides liquidity through non-annuitized assets and protects against interest rate risk. Annuity contracts that have low minimum purchase thresholds may be the solution to middle market retirees securing assets.
Pang and Warshawsky (2009) compared different withdrawal strategies including systematic withdrawals from mutual funds, a fixed immediate life annuity, a variable immediate life annuity, a variable deferred annuity plus guaranteed minimum withdrawal benefits, and a mix of mutual funds and a number of life annuities gradually purchased over time. Interestingly, they found that none of the strategies clearly dominated the others. Maybe the most important part of their work was identifying that a client's goals are critical to choosing the appropriate withdrawal strategy. More specifically, they found that the alternatives offer a tradeoff between wealth accumulation and income security concerns.
For example, the mutual fund portfolio offers the possibility of the greatest growth, but because of portfolio volatility, the largest risk of an income shortfall. On the other side, the immediate life annuities offered the largest income stream at the price of wealth accumulation. The variable annuity plus guaranteed minimum withdrawal benefits, as well as the mix of mutual funds and immediate annuities purchased over time did a better job of balancing both wealth accumulation and income security concerns.
Xiong, Idzorek, and Chen (2010) focused specifically on optimizing the portfolio mix between traditional investments and variable deferred annuities with guaranteed minimum lifetime withdrawal benefits. They found certain factors were relevant in determining the appropriate mix. They found that clients with low risk tolerance and longer subjective life expectancies should have a larger portion of their assets invested in annuities.
On the other hand, annuities should play a smaller role for those with a shorter the life expectancy, (due to the individual's age or subjective life expectancy), as well as for those individuals with a great deal of wealth compared to their income needs, or other sources of guaranteed income that will cover expenses, such as annuity payouts from a company-sponsored defined benefit retirement plan.
Researchers have found other benefits of deferred variable annuities with living benefit riders. Milevsky and Kyrychenko (2007) have demonstrated that the existence of a living benefit rider in a deferred annuity makes retirees much more comfortable investing in equities than those who buy annuities without one. Much of sustainability research has concluded that success requires that the retiree have a high percentage of equities in the retirement portfolio. For example, Spitzer and Singh (2007) found that 75% of the portfolio should be in equities.
So what does this research mean for your practice? First, it is clear that your clients have some difficult choices. For one, the research demonstrates that there is a tradeoff here between income security and wealth accumulation -- and many clients are not going to like making that choice. No one model is the perfect solution for every objective, and each client has to struggle with what they value most. It is interesting that the solutions that offer balance between these goals include using deferred annuities with guaranteed living benefits or laddering immediate annuities over the retirement period.
Another issue is that during the pre-retirement period, your risk-adverse clients typically elect a higher exposure to fixed income investments. Using this same strategy during retirement increases the risk of portfolio failure, as research has shown the importance of equity investments in the retirement portfolio. The risk-adverse client needs to learn there is a paradigm shift -- and the biggest risk becomes running out of money. This risk can be managed with immediate annuities or deferred annuities with guaranteed living benefits -- which also allow the client to feel more comfortable with their equity investments.
Third -- besides considering an individual's objectives and risk tolerance -- the right solution also has to consider the client's specific circumstances. Factors such as life expectancy, other sources of lifetime income, and the amount of wealth compared to income needs all have been shown to influence the appropriate mix of retirement assets.
The complexity of this story leads to the importance of a knowledgeable advisor helping his or her clients through these difficult decisions. Educating clients, helping them clarify their goals and objectives and offering solutions is what you do best!
David A. Littell, JD, ChFC, CFP, holds the Joseph E. Boettner Chair in Research and is a Professor of Taxation at The American College. In this position, Professor Littell is responsible for the course and textbook development associated with several courses including: "326 Planning for Retirement Needs" and "Financial Decisions for Retirement." He also serves as the coordinator for the Chartered Advisor for Senior Living (CASL) designation program.
Craig W. Lemoine, CFP, is an Assistant Professor of Financial Planning at The American College. As a former Senior Planning Manager, financial advisor, team manager, and adjunct faculty member, Professor Lemoine brings a blend of expertise in financial theory, software planning tools, and practical business experience to The College. He also provides community outreach as a guest speaker, representing The College at various events. For more information about either author, visit www.TheAmericanCollege.edu.
Appendix:
Horneff, W., Maurer, R., & Stamos, M. (2008). "Optimal Gradual Annuitization: Quantifying the Costs of Switching to Annuities." Journal of Risk & Insurance, 75(4), 1019-1038.
Lemoine, C., Cordell, D., & Gustafson, W. (2010). "Achieving Sustainable Retirement Withdrawals: A Combined Equity and Annuity Approach." Journal of Financial Planning, 23(1), 40-47
Marcus, R., Janken, G., & Hovey, J. (2009). "Annuities and the Other Side of the Retirement Savings Coin." Journal of Accountancy, 207(1), 36-39.
Milevsky, M. and V. Kyrychenko. (2007) "Asset Allocation Within Variable Annuities: The Impact of Guarantees." Pension Research Council Working Paper.
Pang, G., & Warshawsky, M. (2009). "Comparing Strategies for Retirement Wealth Management: Mutual Funds and Annuities." Journal of Financial Planning, 22(8), 36-47.
Spitzer, J. and S. Singh. (2007) "Is Rebalancing a Portfolio During Retirement Necessary?" Journal of Financial Planning, 20(6), 46-56.
Xiong, J., Idzorek, T., & Peng, C. (2010). Allocation to Deferred Variable Annuities with GMWB for Life. Journal of Financial Planning, 23(2), 42-50.
