The Pension And Annuity Answer

The Pension And Annuity Answer

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.

Pension-Like Income

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.”

And…

“…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…

Click on to see how it all ties together….