Happy Holidays to you and yours. Here are just a few thoughts I want to share at year's end.
First, I would direct you to the post I wrote this time last year, My Year-End Review and Planning Regime, about steps you might want to take for a year-end review. As I warned then, don't bother being overly precise with your adjustments. This isn't an exact science.
I recall one reader whose adviser was suggesting she sell stocks and incur taxes just to correct an asset allocation by a percentage point or two. The process isn't that precise. It's impossible to know with any accuracy what your asset allocation should be unless you have a crystal ball that tells you next year's asset class returns. (If you do have a crystal ball, just allocate 100% of your assets to the asset class that will outperform all the others. But first, call me!)
I suspect that most retirees overthink the year-end adjustment process.
Next, President Trump signed the SECURE Act last week[1]. The age to begin RMD's was increased from 70.5 to age 72 beginning in 2020. However, "Americans who turned 70.5 years old in 2019 will still need to withdraw their required minimum distributions this year, and failure to do so results in a 50% penalty of their RMD", according to Jamie Hopkins, the director of retirement research at wealth management firm Carson Group.
Also, annuities can now be offered in 401(k) plans, though it may be a while before they actually become available. Thirdly, stretch IRAs are no longer available.[2]
Not everyone is convinced that the changes are dramatic. “The SECURE Act is a nice thing — anything we can do on a bipartisan basis in this day and age is something of value — but my sense is the changes in the act are really quite modest,” said Alicia Munnell, director of the Center for Retirement Research at Boston College and a columnist for MarketWatch.
I won't write yet another post on the topic because there are so many out there. I'll place some links in the references below and recommend that you start with Mike Piper's excellent piece at The Oblivious Investor.[3]
Wishing you a happy and prosperous 2020.
REFERENCES
[1] SECURE Act, downloads PDF.
[2] Hello SECURE Act, Good bye Stretch IRA | Ed Slott and Company, LLC, Ed Slott.
[3] Retirement and 529 Changes from the SECURE Act — Oblivious Investor, Mike Piper.
[4] The SECURE Act is changing retirement — here are the most important things to know -
MarketWatch.
[5] SECURE Act And Tax Extenders Creates Retirement Planning Opportunities And Challenges, Nerd's Eye View blog.
Thursday, December 26, 2019
Friday, December 13, 2019
Evaluate Annuities as a Component of Your Retirement Income Portfolio
I wish I could convince more of you, retirees and advisers, to give lifetime income annuities strong consideration for your retirement income plan. They solve a lot of problems from eliminating longevity risk to reducing your portfolio's sequence-of-returns risk.
Purchasing a single-premium income annuity (SPIA) is the single most efficient way to maximize retirement income. According to Wade Pfau's Retirement Researcher Dashboard, a 65-year old couple with $100,000 today could spend about $5,750 annually from a life-only SPIA, $4,900 from a TIPS ladder, or $3,000 using the "4% Rule."[1] Of course, only the SPIA guarantees income for as long as you live but it also ends with no value. The TIPS ladder and portfolio can either be depleted prematurely or end up quite valuable depending on your longevity and investment results.
Sadly, it appears that the last company to offer CPI-linked annuities, The Principal, has stopped offering the product. A CPI-linked or "real annuity" also protected against inflation. But as Moshe Milevsky recently asked rhetorically, "Who says you have to get your inflation protection from an annuity?"
Nominal (not inflation-adjusted) annuities can still play an important role. Our goal isn't to ensure that inflation does not ravage our annuity income but to ensure that inflation doesn't ravage our retirement income. As Milevsky's comment suggests, the two need not necessarily be the same.
A frequent objection to lifetime income annuities is that they have no residual value after death, but the terminal net worth issue isn't straightforward. If we look at a simple SPIA in isolation from the remainder of a retirement plan, then clearly its terminal value will be zero. However, Pfau has shown that the most efficient way to generate retirement income for those with adequate resources is a combination of annuities and an investment portfolio. Furthermore, he has shown that purchasing an annuity can actually increase your terminal wealth by allowing your portfolio to grow more aggressively and by reducing sequence-of-returns risk.
For those of us with a bequest motive, our goal should be to maximize terminal wealth (net worth) from all assets whether or not an annuity is depleted. If an annuity provides no terminal value but allows a portfolio to grow larger, then the annuity will have done its job.
I wish I could convince more of you to consider annuities but, frankly, I understand why you might not.
First, unless your adviser also sells insurance, she isn't paid to sell annuities. In fact, your advisor may have a disincentive. An annuity takes away investable assets that do generate fees for most advisers. An uninspired and uncompensated adviser is unlikely to go out of his way to find you a great SPIA or to encourage you to purchase one.
The trick is to find an adviser who will provide unbiased recommendations regarding both investments and annuities and who also has a deep understanding of annuity contracts. That sounds like a big ask but I know a few that I trust. They're out there.
Even the simplest SPIAs are complicated. The contracts are not standardized so each has to be evaluated on its own merits. Pfau's recent book, Safety-First Retirement Planning[2], explains this in a chapter dedicated to different types of annuities and suggests questions you need to consider before purchase. You can also find these questions in an article by Pfau at Advisor Perspectives.[3]
Second, a SPIA purchase is a one-time, lump sum irreversible transaction. That's a tough sell for any product, financial or otherwise.
An annuity needs to be evaluated as a component of the entire retirement income plan and not as a standalone purchase. This means that an annuity contract is neither good nor bad but that it might or might not improve your overall plan.
It's like adding a new risky stock to a portfolio. Whether the portfolio's results are improved depends on how that stock's performance correlates with the existing portfolio of stocks. A stock can be a poor investment on its own but a welcomed addition to a portfolio.
The entirety of the retirement plan includes all household assets available for retirement funding including retirement accounts, taxable accounts, emergency funds, and even home equity. All of these may play a role in deciding to annuitize. You might, for example, elect to generate maximum income by purchasing a lifetime income annuity and then fund a bequest with your home equity.
Should you decide to purchase an annuity a big question will be when to do so. An annuity is basically a bond portfolio with an insurance risk pool that provides mortality credits. These credits are provided to annuitants who live a long time by those that don't. Mortality credits increase over time but are minimal for younger annuitants.
The following chart created by actuary and retirement researcher, Joe Tomlinson shows the expected bond portfolio return for an annuity (blue line) and expected mortality credits by age (orange line) for a 65-year old female.[8] Keep in mind that the graph will change based on the annuitant's age, gender, marital status, and interest rates, so this chart is only for demonstration purposes.
Moshe Milevsky has studied the issue of when to optimally purchase annuities for nearly two decades and the advice is, well... complicated. He recently noted, however, that annuitizing too much too early seems highly suboptimal. This is because mortality credits are minimal at lower ages, annuity purchases are irreversible, many households have significant annuitized income from Social Security benefits, and annuity payments are exposed to inflation. Most households may be better off holding those assets in TIPS bonds for a while instead of annuitizing at the beginning of retirement. Laurence Kotlikoff's MaxiFi Planner is one of the tools available to help with the timing decision.[4]
Many retirees have strong reservations about the risk of an insurer failing. Tomlinson has also researched the number of annuities that have failed to deliver on their commitments historically. He found that very few have actually failed and those were from weaker insurers.[5] Purchase your annuites from a highly-rated insurer and you are very unlikely to encounter problems down the line.
Some express concerns about a massive failure of the insurance industry like the housing market crash in 2007. Tomlinson points out that insurance contracts are backed primarily by bonds and that there is no macroeconomic scenario in which a massive failure of the bond market wouldn't have an even worse impact on stocks.
While CPI-adjusted annuities may no longer be available, many insurers offer graduated-payment options or "Cost of Living Adjustments." Although these options suggest otherwise, they have no link to actual inflation. Regardless, researchers David Blanchett[6] and Joe Tomlinson[7] find that many annuities with a COLA option are currently priced more attractively than annuities with level payments, in other words, the insurers are accepting a smaller profit margin. The potential savings are worth investigating.
This raises the issue of how to calculate an annuity's expected value and compare it with other annuity options. This is a somewhat complicated process that Tomlinson explains in What Advisors Need to Know About Annuity Mortality Credits.[8] A retirement planner who knows his annuities should be able to perform this calculation for you.
The best annuity purchase you can make will be to defer your Social Security retirement benefits for as long as possible. If that doesn't provide an adequate floor of safe income, then you really should consider filling the gap with annuities. Integrated into your retirement plan, an annuity can solve a several retirement funding problems and mitigate those purchase objections.
To be clear, I don't think that everyone needs to purchase an annuity. Some households will have significant annuitized income from Social Security benefits. Wealthy households may not need them, although they may find the tax benefits attractive. But my guess is that a lot more households would benefit from annuities than purchase them.
I also encounter retirees who fear the stock market and have a strong preference for a dependable, budgetable "paycheck" each month. I generally advise them not to wait to annuitize. It isn't worth the angst to delay.
There are several common objections to life annuities but many of these objections can be mitigated if the purchase is properly integrated into the full retirement income plan and properly timed.
On a personal note, I have some challenges over the next few months that will make it difficult for me to post as regularly as I have in the past or to respond as quickly as I would like to your comments. Please bear with me and know that I will publish and respond to your comments at my first opportunity. Thanks.
REFERENCES
[1] Retirement Researcher Dashboard, Wade Pfau.
[2] Safety-First Retirement Planning, Amazon.com, Wade Pfau.
[3] Safety-First Retirement Planning, Advisor Perspectives, October 18, 2019, Wade Pfau.
[4] MaxiFi Planner software, Laurence Kotlikoff.
[5] How Safe Are Annuities?, Joe Tomlinson, Advisor Perspectives, August 14, 2012.
[6] Inflation-Linked SPIAs Are a Bad Deal, Advisor Perspectives, by David Blanchett, 5/20/19.
[7] Which Annuities Offer the Best Inflation Protection?, Advisor Perspectives, Joe Tomlinson
6/17/2019.
[8] What Advisors Need to Know About Annuity Mortality Credits, Advisor Perspectives, by Joe Tomlinson, 7/31/17.
Purchasing a single-premium income annuity (SPIA) is the single most efficient way to maximize retirement income. According to Wade Pfau's Retirement Researcher Dashboard, a 65-year old couple with $100,000 today could spend about $5,750 annually from a life-only SPIA, $4,900 from a TIPS ladder, or $3,000 using the "4% Rule."[1] Of course, only the SPIA guarantees income for as long as you live but it also ends with no value. The TIPS ladder and portfolio can either be depleted prematurely or end up quite valuable depending on your longevity and investment results.
Sadly, it appears that the last company to offer CPI-linked annuities, The Principal, has stopped offering the product. A CPI-linked or "real annuity" also protected against inflation. But as Moshe Milevsky recently asked rhetorically, "Who says you have to get your inflation protection from an annuity?"
Nominal (not inflation-adjusted) annuities can still play an important role. Our goal isn't to ensure that inflation does not ravage our annuity income but to ensure that inflation doesn't ravage our retirement income. As Milevsky's comment suggests, the two need not necessarily be the same.
A frequent objection to lifetime income annuities is that they have no residual value after death, but the terminal net worth issue isn't straightforward. If we look at a simple SPIA in isolation from the remainder of a retirement plan, then clearly its terminal value will be zero. However, Pfau has shown that the most efficient way to generate retirement income for those with adequate resources is a combination of annuities and an investment portfolio. Furthermore, he has shown that purchasing an annuity can actually increase your terminal wealth by allowing your portfolio to grow more aggressively and by reducing sequence-of-returns risk.
For those of us with a bequest motive, our goal should be to maximize terminal wealth (net worth) from all assets whether or not an annuity is depleted. If an annuity provides no terminal value but allows a portfolio to grow larger, then the annuity will have done its job.
I wish I could convince more of you to consider annuities but, frankly, I understand why you might not.
First, unless your adviser also sells insurance, she isn't paid to sell annuities. In fact, your advisor may have a disincentive. An annuity takes away investable assets that do generate fees for most advisers. An uninspired and uncompensated adviser is unlikely to go out of his way to find you a great SPIA or to encourage you to purchase one.
The trick is to find an adviser who will provide unbiased recommendations regarding both investments and annuities and who also has a deep understanding of annuity contracts. That sounds like a big ask but I know a few that I trust. They're out there.
Even the simplest SPIAs are complicated. The contracts are not standardized so each has to be evaluated on its own merits. Pfau's recent book, Safety-First Retirement Planning[2], explains this in a chapter dedicated to different types of annuities and suggests questions you need to consider before purchase. You can also find these questions in an article by Pfau at Advisor Perspectives.[3]
Second, a SPIA purchase is a one-time, lump sum irreversible transaction. That's a tough sell for any product, financial or otherwise.
An annuity needs to be evaluated as a component of the entire retirement income plan and not as a standalone purchase. This means that an annuity contract is neither good nor bad but that it might or might not improve your overall plan.
It's like adding a new risky stock to a portfolio. Whether the portfolio's results are improved depends on how that stock's performance correlates with the existing portfolio of stocks. A stock can be a poor investment on its own but a welcomed addition to a portfolio.
The entirety of the retirement plan includes all household assets available for retirement funding including retirement accounts, taxable accounts, emergency funds, and even home equity. All of these may play a role in deciding to annuitize. You might, for example, elect to generate maximum income by purchasing a lifetime income annuity and then fund a bequest with your home equity.
Should you decide to purchase an annuity a big question will be when to do so. An annuity is basically a bond portfolio with an insurance risk pool that provides mortality credits. These credits are provided to annuitants who live a long time by those that don't. Mortality credits increase over time but are minimal for younger annuitants.
The following chart created by actuary and retirement researcher, Joe Tomlinson shows the expected bond portfolio return for an annuity (blue line) and expected mortality credits by age (orange line) for a 65-year old female.[8] Keep in mind that the graph will change based on the annuitant's age, gender, marital status, and interest rates, so this chart is only for demonstration purposes.
Moshe Milevsky has studied the issue of when to optimally purchase annuities for nearly two decades and the advice is, well... complicated. He recently noted, however, that annuitizing too much too early seems highly suboptimal. This is because mortality credits are minimal at lower ages, annuity purchases are irreversible, many households have significant annuitized income from Social Security benefits, and annuity payments are exposed to inflation. Most households may be better off holding those assets in TIPS bonds for a while instead of annuitizing at the beginning of retirement. Laurence Kotlikoff's MaxiFi Planner is one of the tools available to help with the timing decision.[4]
Many retirees have strong reservations about the risk of an insurer failing. Tomlinson has also researched the number of annuities that have failed to deliver on their commitments historically. He found that very few have actually failed and those were from weaker insurers.[5] Purchase your annuites from a highly-rated insurer and you are very unlikely to encounter problems down the line.
Some express concerns about a massive failure of the insurance industry like the housing market crash in 2007. Tomlinson points out that insurance contracts are backed primarily by bonds and that there is no macroeconomic scenario in which a massive failure of the bond market wouldn't have an even worse impact on stocks.
While CPI-adjusted annuities may no longer be available, many insurers offer graduated-payment options or "Cost of Living Adjustments." Although these options suggest otherwise, they have no link to actual inflation. Regardless, researchers David Blanchett[6] and Joe Tomlinson[7] find that many annuities with a COLA option are currently priced more attractively than annuities with level payments, in other words, the insurers are accepting a smaller profit margin. The potential savings are worth investigating.
This raises the issue of how to calculate an annuity's expected value and compare it with other annuity options. This is a somewhat complicated process that Tomlinson explains in What Advisors Need to Know About Annuity Mortality Credits.[8] A retirement planner who knows his annuities should be able to perform this calculation for you.
The best annuity purchase you can make will be to defer your Social Security retirement benefits for as long as possible. If that doesn't provide an adequate floor of safe income, then you really should consider filling the gap with annuities. Integrated into your retirement plan, an annuity can solve a several retirement funding problems and mitigate those purchase objections.
To be clear, I don't think that everyone needs to purchase an annuity. Some households will have significant annuitized income from Social Security benefits. Wealthy households may not need them, although they may find the tax benefits attractive. But my guess is that a lot more households would benefit from annuities than purchase them.
I also encounter retirees who fear the stock market and have a strong preference for a dependable, budgetable "paycheck" each month. I generally advise them not to wait to annuitize. It isn't worth the angst to delay.
There are several common objections to life annuities but many of these objections can be mitigated if the purchase is properly integrated into the full retirement income plan and properly timed.
On a personal note, I have some challenges over the next few months that will make it difficult for me to post as regularly as I have in the past or to respond as quickly as I would like to your comments. Please bear with me and know that I will publish and respond to your comments at my first opportunity. Thanks.
REFERENCES
[1] Retirement Researcher Dashboard, Wade Pfau.
[2] Safety-First Retirement Planning, Amazon.com, Wade Pfau.
[3] Safety-First Retirement Planning, Advisor Perspectives, October 18, 2019, Wade Pfau.
[4] MaxiFi Planner software, Laurence Kotlikoff.
[5] How Safe Are Annuities?, Joe Tomlinson, Advisor Perspectives, August 14, 2012.
[6] Inflation-Linked SPIAs Are a Bad Deal, Advisor Perspectives, by David Blanchett, 5/20/19.
[7] Which Annuities Offer the Best Inflation Protection?, Advisor Perspectives, Joe Tomlinson
6/17/2019.
[8] What Advisors Need to Know About Annuity Mortality Credits, Advisor Perspectives, by Joe Tomlinson, 7/31/17.