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Annuities Allow For Higher Yields- Moshe Milevsky In The News Again

For once, the Wall Street journal has published an article that I agree with on the topic of annuities!

For years I’ve cringed as their “Buy and Hold Stocks and Bonds” tunnel vision routinely ignored or bashed annuities.

But today brings a good article that I agree with, advocating to create a guaranteed income floor  that will allow  you to take more risks elsewhere to chase higher yield (if you are so inclined).

It’s exactly the strategy I advocate with clients on this and our other websites.

Because it’s so unusual for the Journal, I’m going to quote it entirely below.  It appeared Here first.

Moshe Milevsky, one of our favorite writers on the guaranteed income landscape, features prominently as well.

For those concerned they might outlive their assets, annuities can provide a guaranteed income stream.

But for those who go this route, a big question remains: How should your annuities affect the rest of the portfolio?

 

In general, investing professionals say that putting part of one’s nest egg in annuities can open the door to taking on more stock-market risk, which in turn offers the possibility for more portfolio growth.

Matt Grove, a vice president at New York Life Insurance Co., who heads the company’s annuity business, says owning annuities can allow investors to increase their risk exposure in part because annuities are so different from conventional securities. For instance, there are types of annuities that provide a set monthly check for life and that are completely independent of the ups and downs of the stock market, he says. And mixing uncorrelated assets is a key strategy in managing portfolio risk, whether you are talking about annuities or simply diverse types of securities.

Brett Wollam, senior vice president at Fidelity Investments’ life-insurance unit, suggests retirees use income annuities along with Social Security and pensions to fund their essential expenses. When there are several sources of guaranteed income, retirees can invest more in products with growth potential than they might have otherwise, he says.

“Typically, investors are too conservatively invested” in retirement, Mr. Wollam says.

What’s Your Tolerance?
Fidelity Investments Life Insurance Co. sales manager Robert Cummings gives an example of a 60-year-old couple who changed a portfolio that was invested largely in cash to one with a 45% allocation to two annuities and a 28% allocation to equities. The couple weren’t knowledgeable about the stock market, but they knew longevity ran in their families and were concerned about inflation, says Mr. Cummings. “Both factors speak to the need for growth because of the time horizon they are planning for,” Mr. Cummings adds.

The couple’s annuities now include a $200,000 deferred-income annuity from New York Life with a $1,057 monthly payout starting in five years.

Of course, not all annuity purchasers should increase their exposure to stocks. To some degree, the decision depends on the investor’s risk tolerance and the types of annuities he or she owns. With variable annuities, the value of the contract can fluctuate with stock and bond prices. At the same time, fixed-payment annuities could involve risk if the issuer is on shaky ground, or if the annuity lacks automatic increases to protect against inflation.

In some cases, in fact, annuities may help an investor ratchet back too great a stock exposure.

Reduced Risk
At Steele Financial Solutions in Cherry Hill, N.J., Joel Steele recommended that a 61-year-old client with 100% of his portfolio in equities reduce his risk exposure and invest in deferred-income annuities. The client had booked some recent gains in stocks but was generally frustrated with the continuing ups and downs of the market, Mr. Steele says. Even with the recent gains, he adds, the client’s portfolio was only back where it had been 10 years earlier. The client also was anxious that his pension wouldn’t provide enough income for his wife in the event of his death.

At Mr. Steele’s recommendation, the client invested half of his assets in two deferred-income annuities with guaranteed monthly payouts starting in two and 15 years. Of the remainder, he has 17% in stocks and the rest in income-producing bond funds.

“He’s not completely out of the [stock] game, but he’s not going to be affected by any stock-market crash either,” Mr. Steele says. “We’re not talking about taking people out of the market,” he says of balancing deferred-income annuities and equities. “We’re just making sure they’re OK.”

Moshe Milevsky, an associate professor of finance in the Schulich School of Business at York University in Toronto, says that for income protection in later life, the best annuities are those that delay payments at least until the purchaser reaches his or her 80s. The payouts for these types of annuities tend to be bigger than for annuities whose payments start earlier, but many potential investors see the long wait as too much of a gamble.

Indeed, these products, generally referred to as advanced-life delayed annuities, or longevity insurance, have proved a hard sell for the insurance companies that offer them (see sidebar). But according to Mr. Milevsky, delayed payouts enable purchasers to allocate more of their portfolios to investments with higher growth potential, compared with purchasers of annuities that start their payouts within a few years.

Mr. Milevsky is also founder of QWeMA Group Inc., a developer of products for wealth management, investing and insurance, with a focus on retirement income planning. Based on algorithms that he has developed, the company, whose name is an acronym for Quantitative Wealth Management Analytics, recommends mixing longevity insurance and mutual funds as a strategy for protecting income in later life.

The Riskiness Of Stocks- A Zvi Bodi Article

S+P Roller Coaster

S+P Roller Coaster

I read a recent series of questions and answers in reply to a timeless cover story in the Wall Street Journal on the riskiness of stocks.  The article, by Zvi Bodi, covers the essential teachings of Professor Paul Samuelson, who wrote extensively on risk.

The essence is this: flipping a coin has a 50% probability of heads with each toss.  Tossing  for years does not change your odds.  Likewise, stocks are risky at ANY given time- MANY given times has no effect on the risk at A given time.  In other words, your risk is high no matter what.

So while time does not mitigate your risk, other factors may, such as your human capital or earnings potential. However, the reverse is also true.  As you get older and your earnings power diminishes, or your number of remaining earning years declines, your risk tolerance should also decline.

There are many fundamental reasons for guaranteed income such as annuities, but the wisdom from these economists is perhaps the most compelling.  With every day in the markets you roll the dice.  How lucky do you feel today?

I’ll quote a personal highlight:

A safer way to build and protect retirement assets is to picture your goals as clearly as possible. Then pare things back to the basics. Figure out the bare-bones level of income you need and invest in products that guarantee it……. Use the rest of your investment money to build reserves to fund your aspirational goals.

This describes perfectly our approach to annuities and financial planning- identify your baseline needs first, and cover those guaranteed expenses with guaranteed income.  Then, optimize the rest.. as you see fit.

Below you will find the rest of the article.  My only complaint is that like it does not mention annuities anywhere, when they should be foremost in the discussions of low risk alternatives to the markets.  Especially our Secondary Market Annuities- for all the complicated strategy described below of laddered TIPS and zero-cost collars and such, the simple truth is that a 5 to 6% guaranteed effective rate of return over many years is a GREAT rate of return.  No matter who you ask, no matter what market periods you look at….

With the long term guaranteed yields we have available to you in mind, enjoy the rest of the article below.

Why Stocks Are Riskier Than You Think
Most people can get the money they need for retirement without gambling heavily on equities, say Zvi Bodie and Rachelle Taqqu

A growing sense of urgency is driving many investors to take reckless risks with their money.

Even though they experienced the hazards of stock ownership firsthand in 2008, investors are venturing back into equities again. They’ve been advised that there’s no other way to make up the losses they suffered—or meet their looming retirement requirements—and, not to worry, the risk of stocks diminishes the longer you hold them. The Federal Reserve, meanwhile, has announced that it intends to keep interest rates low through 2014—providing a powerful inducement to stay in stocks since bonds will probably generate unusually low returns.

The desire to get back what you lost is understandable. But, as behavioral economists have shown, it can also cloud your judgment and lead you to take more risk than you can handle.

Despite the assurances of the financial industry, stocks are always a risky investment, and the longer you hold them, the better your chances of getting blindsided by a downturn. The usual way of mitigating that risk, diversification, holds no guarantees, either—for the simple reason that investments don’t always move the way we want in relation to one another.

A safer way to build and protect retirement assets is to picture your goals as clearly as possible. Then pare things back to the basics. Figure out the bare-bones level of income you need and invest in products that guarantee it, such as inflation-protected bonds. Use the rest of your investment money to build reserves to fund your aspirational goals.

But when you’re aiming to meet your aspirational goals, there is a way to limit your downside risk—by using instruments that let you limit your losses at the cost of some upside potential. You can do this through direct purchases of options, or you can buy mutual funds that use complex hedging strategies. These funds aren’t as transparent as stocks, but their aim is to protect your money from disaster.

A Hard Look at Stocks
It may be hard to let go of the belief that buying and holding stocks is a sure-fire key to asset growth. But that’s because people have been lulled into thinking that long-term stock investing greatly reduces the risks. The truth is that stocks are risky no matter how long you hold them.

Yes, equities can be expected to produce a superior average return in comparison to safer investments. That’s as it should be, because the higher return compensates investors for taking the added risk. But this does not mean that stocks become less risky over long time horizons.

There are a number of different approaches that demonstrate why the conventional wisdom about stocks is wrong. One of them has to do with bear markets, which happen regularly; the long growth stretch that began in 1983 and lasted through the 1990s has not been the norm. And the longer you hold onto your stocks, the greater your chances of running into one of those downturns.

Even with the long boom, bonds outperformed stocks over the 30 years since the fall of 1981—delivering an average annual return of 11.5% vs. 10.8%, respectively—with less risk and less volatility than equities.

To prove their claim that stocks are not very risky in the long run, stock enthusiasts argue that stocks have beaten bonds for every 30-year period starting in 1861—except for the most recent one. But their evidence is much thinner than it appears: Since 1861, there have been only five non-overlapping 30-year periods! Statistically, that’s simply too few independent periods to justify the conventional conclusions.

What’s more, the idea that “stocks do well in the long run” isn’t a practical guideline for individuals. For one thing, the “long run” means something different to different people depending on their ages and goals—for some, it’s 10 years, for others 30. And while the odds of getting good stock performance over that time are good, the consequences of a downturn can be severe, depending on how steeply markets decline, how much you have in the market, and when the downturn hits in your lifetime.

If you’re expecting stocks to outperform, say, 70% of the time, you need to think about how much you stand to lose the other 30% of the time. It does not do you a lot of good to have 20 years of great performance, only to be trounced in a crash just before you retire.

The usual way of protecting a portfolio—through diversification—is sensible and advisable. But it’s hardly a guarantee. Diversification aims to provide stability by mixing up different classes of assets, which are expected to behave differently in different circumstances.

Yet the correlations it’s based on aren’t constant. Bonds and stocks have moved in opposite directions at times, but in other periods they have not. And foreign markets are growing less and less decoupled from the U.S. Recently, prices of assets as diverse as large-cap domestic stocks, emerging-market stocks, oil and gold have been fluctuating together rather than in counterpoint.

A Safer Strategy
What’s a better approach to building a portfolio? First, forget the idea of “catching up.” Most of us find loss so painful that we’re willing to go out on a limb just to recover what’s gone. We’re willing to take risks we’d normally avoid to recoup what we see as rightfully our own.

Instead, when you start by looking at your destination and focus on what you absolutely need, you protect yourself from missing your essentials if the market falls short. And you steel yourself against a blind obsession with recouping loss.

Separate your basic must-have needs from your aspirations or wants, and create an investment plan that guarantees the basics with inflation-protected, safe investments. You may be surprised at how much less you need than you want, but try hard to be honest with yourself. Then put any other investment dollars you have available each year into riskier vehicles to meet your aspirational goals.

Intuitive and straightforward as this approach may seem, it’s not commonly pursued by most investors and advisers. Assessing what’s really necessary takes time and reflection. Few people do it systematically, if at all.

Once you decide how much money you need for your basics, create a safety net to guarantee that you can cover them. That’s where securities that protect against inflation—such as TIPS and I bonds—come in. (Although many people include insured bank certificates of deposit in this mix, CDs don’t provide inflation protection.)

For the best safety net, put together a “ladder” of TIPS, held in tax-deferred or tax-exempt accounts. Figure out how much money you need each year, then invest in TIPS with maturities that match your future spending dates. Your plan won’t be perfect, of course: Your personal rate of inflation may not match the Consumer Price Index, taxes may intervene, and life happens. But don’t let the perfect be the enemy of the safest available choice.

Today’s low-interest-rate environment poses some difficult challenges even with a bare-bones safety net in place. Today, TIPS and I Bonds do not yield more than the rate of inflation. And many people are starting practically from scratch, whether because the market collapse set them back enormously, or because they have not managed saving much for retirement yet.

It’s impossible to generalize about every investor’s situation, but many households are probably facing the prospect of a very small safety net in retirement.

With that outcome in store, many people may be tempted to gamble on riskier investments to meet their retirement needs. But your safety net is meant to be the money you can count on. By definition, you don’t want to put it at risk. If you bet your basics in the market and lose, you can easily end up worse off, with less to spend on your essentials.

If you don’t think you can create a safety net that’s big enough, there are other steps you can consider, although they can be tough. You might spend less today to save more for tomorrow. You might work extra jobs, move to a higher-paying career or retire later. You can also try scaling back your definition of needs.

How low can you imagine turning down the jets if need be? Is a community college a viable alternative for your child’s first two years out of high school? Can you lower your expenses in retirement by moving to a less-expensive location, downsizing your residence or traveling less?

It’s this kind of assessment that should be driving your risk decisions. It requires careful and honest introspection, as well as a lot of consulting with the key partners in your life.

Limiting Your Risk
Now that you’ve separated your needs from your wants, you can decide how much to limit the risk you take with your aspirational investments. If you’ve lived through 2008, you probably don’t want to see losses of 30% to 40% ever again.

There are several ways to protect the money outside your safety net. For instance, there are investment products that protect either principal or income by using hedging strategies involving various combinations of derivatives.

But you must be careful to read the fine print. You need to understand the managers’ strategy in detail, including which risks they’re hedging and which risks remain unhedged. It’s also important to weigh a fund’s expenses, both embedded and explicit. The costs of these transactions can be high, so do look carefully at the expense ratios of the fund along with all its fees.

Investors who are more seasoned can undertake some of these complex strategies on their own. For instance, when you buy an investment such as the S&P 500, you can buy a put option on it, too. This gives you the right (but not the obligation) to sell the investment at a future date at a price you determine at the time of purchase. Since your investment can’t fall further than the “strike price” you’ve selected, you’re effectively setting a floor on your losses.

Let’s say you buy SPY, an ETF that tracks Standard & Poor’s 500-stock index, at its recent price of $136.41. You’re willing to sustain a 15% loss, but not more, so you buy a put with a strike price of $116. Since you can now sell SPY at $116, you’re protected in case it drops any lower. Essentially, you have bought insurance with a deductible of 15%; that’s all you can lose.

Is it worth it? The put in this example, which expires in four months, would have cost $2.16 at the time you priced and bought your ETF shares. But the good news is that there is a way to avoid the cost of the put, by trading away some of the upside of your SPY shares. You can sell a call on your investment. This means that you are selling someone else the right to buy it at a stated strike price on or before a future date. If the shares reach the strike price, you are obligated to sell.

In order to end up with a near-zero cost for your options, the prices of the put and the call will have to be roughly the same. In our example, there is a four-month call that is priced at $2.17—close to the $2.16 you paid for your put—and it has a strike price of $143.

When you sell this call, your proceeds fully offset the cost of your put. If the value of the ETF rises before the option expires, you get to keep everything up to $143. But not more than that: Your gains beyond $143 have been traded away. So the strike price of the call you sell is the upper bound on your potential gain.

In this strategy, called a zero-cost collar, your costs are limited to your transaction costs alone, since your proceeds from selling the calls will zero out the cost of the puts. And your investment outcomes are now limited as well: In this case, you can’t lose more than 15% on the downside or gain more than 6% on the upside.

If you want to increase your potential upside and still have the costs cancel out, you’ll need to lower your floor. In our example, you can increase your potential gains to $147 if you are willing to take losses all the way to a lower threshold of $108 (that’s a loss of just over 20%). It’s akin to increasing your deductible on insurance in exchange for a reduction in the premium you pay.

For the most part, “structured” products for limiting risk are still on the drawing table. They remain to be perfected. But the notion of sacrificing a limited amount of safety in exchange for upside potential is profoundly relevant to retail investors’ needs right now.

So keep your eye out for them: It should not be long before growing consumer demand transforms them from next-generation investments into products whose time has come.

Retirement Equations, New Moshe Milevsky Book

I ordered a copy of Moshe Milevsky’s upcoming book,  The 7 Most Important Equations for Your Retirement, after reading an excerpt that is well worth sharing to AnnuityStraightTalk readers.

It is Milevsky we have to thank for much of the accessible but intelligent writing on annuities, mortality, and sequence of return risks.  He’s very understandable and sensible, which is not what you’d expect from an economist…

The review was here in AdvisorOne, and is well worth reading.  This particular piece (there are several excerpts on that website) highlights the work of the 1930’s Era Wharton professor Solomon Heubner, who was a pioneer economist in the often maligned world of life insurance.  Heubner pioneered the concept of using life insurance to protect the living by insuring the discounted present value of an individual’s lifetime earnings potential. 

Naturally, Heubner was also an advocate of annuities and offers two great quotes worth sharing here.  I’ll quote from Milevsky’s article, and he in turn is quoting Heubner: 

Although most students of the industry rightfully view Professor Huebner as a huge advocate of permanent and everlasting life insurance, he actually had quite a bit to say about retirement as well. His master plan was to have a policyholder convert some of his life insurance into a life annuity around the age of retirement.

His argument involved more than just mortality credits and insurance economics. In echoes of Jane Austen, he wrote:

“…Annuitants are long livers. Freedom from financial worry and fear, and contentment with a double income, are conducive to longevity. If it be true that half of human ailments are attributable at least in part to fear and worry, then the effectiveness of annuities for health and happiness must be apparent…”

I venture to guess that if Professor Huebner were alive today, he would be on the road with annuity wholesalers giving seminars to financial advisors and their clients, extolling the virtues of longevity insurance and life annuities.

Here is some additional evidence about Professor Huebner’s impact in retirement income planning. Many economists and financial experts have puzzled over the minimal appetite of consumers for life annuities — an aversion called the annuity puzzle by researchers in the field. And it seems that the annuity puzzle was puzzled over by Solomon Huebner in the 1930s, before any formal model of the lifecycle was properly developed by economists.

“…The prospect, amounting almost to a terror, of living too long makes necessary the keeping of the entire principal intact to the very end, so that … the savings of a lifetime, which the owner does not dare to enjoy will pass as an inheritance to others….Why exist on $600, assuming 3% interest on $20,000, and then live in fear, when $1,600 may be obtained annually at age 65, through an annuity for all of life and minus all the fear…”

As far as I’m concerned, this is yet another reason to include Solomon Huebner amongst the seven intellectual giants on whose shoulders 21st century retirement income planning research stands….

It’s fascinating that even 80 years ago, economists recognized and puzzled over ‘the annuity puzzle.’   There is still work to be done by the insurance industry to understand and overcome this consumer aversion to annuitization.  Economists see the world rationally… and markets are supposed to act that way too.  Every rational argument supports annuities…. yet media and the general public still resist.  

Let me know your  thoughts below-  if you’re reading this note you clearly see some benefits to annuities.  Why do you think the media and the general public generally resist annuities for retirement planning?

Are You a Stock or a Bond? A Moshe Milevsky Analysis

The title of my post this week comes from Professor Moshe Milevsky for the second time.  I’m giving you all a break from reading and including a link to this video where the good professor talks again about the difference between personal and financial capital.

Moshe Milevsky Annuities Analysis

Mr. Milevsky makes is very apparent that the amount of risk a person takes with financial assets should be inversely related to the type of risk associated with an individual’s personal capital.

If your income is unstable, your invested assets should be allocated conservatively.  Also, as your number of earning years decreases so should the level of risk on your financial assets.

Milevsky and I share these beliefs and I enjoy seeing someone of his stature provide evidence of the need for conservative retirement planning.

Annuities work well within this planning framework.  Each of you here understands that to a certain degree, which is why I am working to clarify the need for and use of annuities in retirement income planning.

Revisit the available reports and feel free to call or email at your convenience with specific questions you may have.

If you are not a member, sign up now for all the free information that will make the process of retirement income planning much more simple.

Please follow this link to see Dr. Milevsky’s video.

Thinking Smarter About Risk- Moshe Milevsky on Annuities

This article written by Dr. Moshe A. Milevsky in Monday’s Wall Street Journal is one all members and visitors of AnnuityStraightTalk should read.  It deals with the management of risk according to a set of factors rarely considered in financial planning circles.

The article discusses the difference between personal and financial capital.  Your personal capital reflects your future earning power while financial capital is comprised of the assets you have accumulated over your career.

Younger workers hold most assets in the form of personal capital while pre-retirees tend to have more financial capital.  Both forms have associated risks and proper financial planning can not be done without considering the two in conjunction.

If your personal income is negatively affected by downturns in the market then financial assets should be conservatively invested.  The closer a person comes to retirement, the more closely those assets should be guarded because personal capital decreases with the number of working years remaining.

If your financial capital needs protection, how do you plan to do it?  When considering safe investment vehicles, do annuities fit into your retirement picture?  Browse my site for information on how annuities can help protect your financial capital.

I highly recommend reading Dr. Milevsky’s article.

Find the article here.