There are essentially two philosophies in retirement income planning: the “probability-based” model that relies on the upside potential of an equities-rich portfolio; and the “safety first” approach of blending fixed-income and income annuities. The challenge for financial advisors is to combine the two to meet client goals and manage risks.
An investments-only strategy can support greater legacy amounts than partial annuitization, particularly in the event of early death. But larger estates come at a cost: no contractual income guarantee and less liquidity than you might expect.
In fact, income annuities provide a more efficient approach to meeting retirement spending goals than commonly thought, maintains Wade Pfau, a retirement income professor with the American College of Financial Services, in a Journal of Financial Planning paper entitled “Retirement Income Showdown: Risk Pooling vs Risk Premium.”
Insurers pool sequence of return and longevity risks for a large base of retirees, allowing for retirement income spending that’s more closely aligned with average long-term fixed-income returns and longevity.
Following that strategy, adding annuities to retired clients’ asset mix may provide greater spending potential for those clients rather than simply assuming lower future returns and a longer time horizon when developing a plan.
Annuities help to hedge longevity risk and also align the retirement planning horizon to something much closer to life expectancy through mortality credits, Pfau’s paper notes. Knowing that some clients who buy annuities will die prematurely allows insurers to pass along money that would’ve gone to those clients to clients who are still alive. The longer clients live, the more of these credits they can expect to receive, thus increasing the effective yield on their investments during their lifetimes vs a bond ladder’s return.
The study underlying Pfau’s paper focused on a 65-year-old female client with $1 million at retirement, then employing an initial spending percentage of 4.5% to satisfy a prioritized list of three goals: funding retirement spending; supporting liquidity to cover contingencies or further lifestyle enhancements; and providing a legacy to the next generation.
When comparing fixed-income options, the study found that partial annuitization is preferable, due to both the upside potential mortality credits provide and the fact that retirees cannot outlive a lifetime annuity in the way they can a bond ladder.
When matching an annuity with an equities-heavy portfolio, the study’s portfolio clearly provided a far wider dispersion of potential results. But, Pfau’s paper notes, the need for retirees to opt for a lower, safe withdrawal rate to defend against sequence risk means the resulting portfolio effectively has less liquidity because so much has to be held in reserve. Partial annuitization actually reduces the need to have a large contingency.
Of course, many retirees may be underfunded significantly and unable to reach their goals even after pooling risks. Although income annuities can guarantee a lifestyle, they lack the ability on their own to provide significant upside potential.
Nonetheless, Pfau’s paper concludes: “Those favouring spending and true liquidity will find that it’s much more difficult than commonly assumed for an investments-only strategy to outperform a strategy with partial annuitization.”
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