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We have covered the value of pension-like income stream, and looked at the basic issues every investor will face as they attempt to put in place a solid retirement income plan. We also looked at the financial threats investors face in retirement as well as the unpredictability of the traditional management approach to income planning.
The next step is to explain how pension- like income offers benefits critical to ultimate retirement security and maximum lifetime profitability. It is often overlooked that something as simple as a pension can form the foundation of a truly optimal asset distribution strategy.
If you don’t expect to receive a pension from your company or employer, don’t worry, few people do these days. But several different types of annuities offer all the characteristics of the pension. The most important characteristic is that many of the risks we discussed are carried by another entity and income continues for life, however long that may be. Both pensions and annuities fit those criteria.
To illustrate the point I’ll reference two studies, one from Wharton and one from Ibbotson that will show not only the importance of a source of guaranteed income but also the benefit of minimal probability of failure that comes with it.
This Wharton study starts off with a bold statement claiming, “Retirement security is the central policy concern of our time.”
Although this is a weighted comment deserving clarification in a separate article, I firmly agree. The findings of the study also do a good job of qualifying this assertion throughout. We covered the basis of this assertion at the beginning of this series when we noted the change from employer-sponsored defined benefits to employee- funded defined contribution plans for retirement planning over the past few decades.
The authors remind us of the fundamental danger with the diversion from defined benefit plans.
In defined contribution plans the risk of outliving one’s assets is shifted from employer to employee and equally important the investment risk has been shifted to the individual.
When the individual bears all risk for performance of a retirement income plan it is difficult to determine appropriate spending levels. As such, the real point of the Wharton study was to explore the asset allocation options that retirees face when left with a lump sum of savings at the onset of retirement.
A review of previous literature in the paper reveals further studies that document the benefits of using guaranteed annuities.
“In 1965, Menahem Yaari demonstrated under a restrictive set of assumptions that full annuitization was the optimal asset allocation for retirement savings. For full annuitization to be optimal, he assumed that consumers were expected utility maximizers.”
In short, if you want to spend as much money as possible your best bet is to annuitize every penny of your life savings. Those results were echoed more recently…
Davidoff, Brown and Diamond (2005) have shown in an elegant proof that the original results of Yaari hold true under a significantly less restrictive set of assumptions.
Limitations Of The Study:
While full annuitization may be the best way to ensure that you can enjoy maximum expenditure, it represents a major emotional leap for most people. Full annuitization means giving up control of your money entirely.
More importantly, a major assumption of each of those studies is that the model leaves no remainder for heirs. Full annuitization also decreases future flexibility which I feel should be the central focus of a good retirement income plan.
Middle ground is most certainly found with partial annuitization and responsible preservation and growth of remainder assets. The benefit here is that you can guarantee to cover future living expenses while also retaining flexibility to meet changes in the future.
How to Retain Flexibility:
That leads me to the Ibbotson study which states,
“…a GMWB will improve overall retirement income levels without increasing income risk levels.”
For clarification, a GMWB stands for Guaranteed Minimum Withdrawal Balance and is nothing more than one version of a pension-like annuity and represents the specific product used for comparison.
Ibbotson was able to model several different portfolios with or without the use of a guaranteed income annuity. The findings are as follows:
With a guaranteed income annuity there was…
“…little to no chance of income reductions, greater chance of income increases and greater opportunity for long-term portfolio growth.”
“…all portfolios when combined with GMWB had higher average income and lower average risk than stand-alone traditional mutual fund portfolio.”
What Ibbotson was able to prove is that a guaranteed annuity will protect your baseline while allowing you to maintain maximum future growth potential. The annuity decreased total risk across the entire portfolio even when remainder assets were invested more aggressively. Guaranteed income truly offers security and prosperity throughout retirement.
These studies combined speak directly to the central point of our series which highlight the benefits and necessity of guaranteed income.
1) Cover your basic expenses with a source of guaranteed income you can’t outlive. Annuities allow you to do that more efficiently than any other asset class, and free you to allocate additional assets to optimize portfolio growth over time.
2) Continued portfolio growth with a guaranteed income safety net gives you the flexibility to ride out market corrections, and make additional funds available to provide for financial emergency or inflation.
I can’t make it simpler than that. The mainstream financial media may have you believe that designing a retirement income plan is supposed to be complicated. What several mathematic, scientific and economic studies have proven is that the answer has been around for hundreds of years.
And that’s the pension and annuity answer.
But, there’s still a little work to do…
Let’s talk about the value of pensions. In times past, workers who dedicated a lifetime of service to a chosen company were rewarded with an employer pension which provided a guaranteed paycheck for life… a rich benefit indeed!
For various reasons appropriate for a separate discussion, employer sponsored pensions have been slowly phased out over the past few decades. These days, fewer and fewer people can rely on an employer pension for retirement income and the ones that do exist are rarely able to meet the incomes of retirees. Times most certainly have changed…
The tables have turned and now the responsibility for retirement funding falls squarely on the shoulders of the individual. In the new age of trimming expenses to maximize shareholder values, pension liabilities were simply too expensive to keep on the balance sheet. True defined benefit pension plans have been phased out in favor of defined contribution pensions, which are mostly comprised of 401K and IRA accounts. This shouldn’t be news to anyone.
But while pensions have severe costs for employers, they are tremendously valuable for the retiree.
Guaranteed Lifetime Pension-Like Income:
Guaranteed lifetime income from a pension ensures stable cash flow across all years of retirement. Granted, there are challenges to a fixed income stream that decrease the power of that cash flow, but the overriding benefit is stability.
A stable base of income allows more flexibility with your other assets.
With a guaranteed baseline income secured, you can focus on growth with the other assets to overcome any financial obstacle you meet in the future.
Without guaranteed lifetime income, you may well be relegated to constant worry over appropriate spending levels. Negative investment performance could potentially cause a major lifestyle change, and reliance on bonds or similar vehicles to preserve assets and supply that income may not achieve the growth targets necessary for optimal performance or future cash flow.
The absence of pension-like income leaves far too many unanswered questions. And the biggest question is without a doubt how long you’ll live, also known as longevity risk. Since no one knows for sure how long each of us will live, it’s impossible to determine a sustainable spending rate without a portion of assets being dedicated to a lifetime stream of income.
Let’s recap this brief introduction to the value of guaranteed, pension like lifetime income…
1) The majority of current and future retirees are personally responsible for their income in retirement.
2) Because of the various challenges, including longevity risk, inflation and market volatility, a guaranteed base of lifetime retirement income is essential to creating an adequate plan.
3) Guaranteed, pension-like income will give you the foundation of strength you need, and the flexibility with your remaining assets to pursue the market growth.
4) Market growth from this position of strength is needed to take care of additional challenges that arise.
Next we continue with the threats to your retirement portfolio, and cite extensive empirical and actuarial evidence to prove how pensions provide the benefits needed to financially rise above any future challenge you’ll face.