What's a Floor?

After my last post, The Retirement Café: Unraveling Retirement Strategies: Floor-and-Upside (An Update), I received several comments and emails regarding floor portfolios that made me realize that the definition of a floor isn’t universally applied and that I need to communicate the definition that I use more clearly.

In "How retirement savers construct an income floor"[1], Stan Haithcock suggests the following:

"You need a solid income base to build on and to hopefully add to those guaranteed amounts. These income sources can include your Social Security, pensions (if so fortunate), income-producing real estate, dividends from stocks, bonds, and contractual annuity payments."

While I find that the column provides generally sound advice, I don't agree that all the assets in this list should be used to build a floor. Real estate income depends on real estate market performance, stocks have market risk so their dividends do, as well. Bond income has bond market risk unless laddered and held to maturity.

I received other comments from readers that considered potential floor assets to include a rolling 10-year TIPs ladder. Deplete your portfolio and how will you buy future rungs? There was even a suggestion that RMDs are floor income, although they totally depend on portfolio performance.

Some seem to define a floor portfolio as an income portfolio complementing the upside stock portfolio and believe that any investment that yields income is suitable for a floor. I don't view floors that way and I don't believe that Bodie, Merton and Samuelson[2] had that in mind when they envisioned lifecycle finance.

I found the following an excellent explanation from a Bogleheads thread[3]. "bobcat2" explains:

"The life-cycle approach ("floor" plus upside approach) is the general economics approach to financial planning including retirement planning. The older approach (called mean/variance or "probabilistic") is based on risk-return tradeoffs along the efficient frontier and is a special case of the life-cycle approach. In that special case, the floor goal is either non-existent or very low, and the aspirational goal is soft. ("I would like to have this much or more, but perhaps not realizing that the “or more” reduces the chances of meeting the goal.")

There is no pure life-cycle approach. You pick two goals. One goal is what you want [upside]. The other goal is a lower conservative goal that typically you want to hit with very high probability [the floor]. You are serious when you set or reset the goals and you employ investment strategies that are explicitly targeted to meet the goals. If you want to hit the lower goal with near certainty, you are going to have to hedge or insure, not diversify, the risk of reaching that goal. That means you need a matching strategy to reach that conservative goal both before and during retirement." 

We "insure" the "near certain" floor with annuities, Social Security benefits, pensions, and possibly a very long and expensive TIPs bond ladder or a shorter, non-rolling ladder supplemented with a deferred income annuity at its end[4] that's less expensive.

Dividends, bonds or bond funds other than laddered TIPs held to maturity, RMDs, real estate income and rolling ladders are not "near certain" and, therefore, not predictable.

---

What's a floor, anyway?

[Tweet this]

---

I view a floor portfolio as a safety net of near-certain income in case factors beyond my control should leave me with nothing else.

My grandparents suffered the effects of hyperinflation that destroyed their finances. People used to refer to their predicament as “living on a fixed income” but what they meant was that they no longer received pay increases from an employer to offset inflation. The purchasing power of their pensions and savings accounts eroded quickly.

When I think of a floor portfolio as a safety net, I imagine that my client’s other assets are depleted and that they are forced to live only on income from the floor. I want to make sure that their floor income can withstand some pretty serious inflation, so I consider inflation protection a critical component of a floor portfolio.

A dear friend lost his entire $4M retirement portfolio during the Tech Crash just a few years before his planned retirement. When I think of a floor portfolio as a safety net, I imagine that my client’s investment portfolio is depleted and he is forced to live only on income from the floor portfolio. I consider mitigation of market risk critical in a floor portfolio. Market risk (any market) belongs in the upside portfolio.

For a decade now, retirees have been hurt by historically low interest rates that have left safe income sources like CDs and money market returns barely worth the effort, so I consider the mitigation of all capital market risk to be critical in a floor portfolio.

Growing up in a rural community, I had several relatives and friends of relatives who were trying to get by on Social Security benefits alone. It wasn’t pretty.[5]

They were mostly widows whose husbands, often deceased for a decade or two, likely hadn't been able to afford to delay Social Security benefits or didn't understand the value of delaying, which greatly reduced their spouse’s survivors benefits. When I think of a floor portfolio as a safety net, I imagine that my clients don’t want to end up living off Social Security alone in old age. I recommend they delay Social Security benefits as long as possible. I consider mitigating longevity risk to be a crucial component of a floor portfolio.

It is also worth considering building a floor with as many judgment-proof and bankruptcy-proof assets as you can.

Those three goals, mitigating inflation risk, mitigating capital market risk, and mitigating longevity risk are, in my personal view, essential to a floor portfolio’s design. Combined, they provide a pretty strong safety net of near-certain, real lifetime income.

Of course, not all risk can be mitigated. Spending shocks, for example, can destroy our finances even with an adequate floor. The floor defines the amount of safe income available but it has no sway over costs.

One last but critical consideration is the amount of floor income you target. Don't overdo it. Even small floors can be expensive. Design the rest of your plan such that having to live off floor income alone is very unlikely.

Sleeping on the floor is a more tolerable consideration if the chances of ending up there are small enough. At the other extreme, retirees who plan to spend 5% of their investment portfolio for thirty years in retirement probably want a cushier floor. If I had a 10% chance of losing my bed, I'd keep an air mattress nearby.

I don't get to define what constitutes a floor but it is important to understand the definition I have in mind when I use the term in posts.

It's fine if you or your retirement planner use a different definition as long as you agree and understand how it differs from the lifecycle economics definition. Just know that, with a different definition, some of your floor might not be there in certain scenarios when you need it.

It's challenging to build a perfect floor for several reasons. The cost of retirement is unpredictable and changes over time[6]. You may not claim Social Security the year you retire and filling the safe income gap until you do can be problematic. Pensions provide lifetime income but most aren't inflation-protected. An inflation-adjusted immediate annuity is in many ways the best answer but many retirees won't buy one. Flooring is very expensive in today's economy.

For these reasons, you are unlikely to find a perfect answer and will need to make concessions. But, it's important to begin the process with some basic goals in mind and to imagine the future scenarios in which you might have to live off floor income.

I begin with the goal of a floor portfolio that provides near-certain safety-net income and I try to fill it with assets that in combination mitigate inflation risk, capital market risk, and longevity risk to guarantee that I can survive improbable but worst-case outcomes. Because floors are expensive, I build mine as low as I think I could tolerate and then I structure the rest of my retirement plan to minimize my chances of rolling off the bed.

---

REFERENCES

[1] How retirement savers construct an income floor, MarketWatch.



[2] Videos - Robert C. Merton Finance Class at MIT



[3] Wade Pfau: Lifecycle Finance - Page 3 - Bogleheads.org.



[4] The TIPS plus DIA strategy is discussed in this column by Wade Pfau. It contains links to the original research. Safe Retirement Income with TIPS and a deferred annuity, Wade Pfau.



[5]9 Ways to Retire on Social Security Alone, AARP.



[6] Estimating the True Cost of Retirement, David Blanchett. >

Unraveling Retirement Strategies: Floor-and-Upside (An Update)

When a reader recently quoted me from a four-year-old post, I realized I needed to update a few of them. I've learned some things in the past few years and, like many of us who research retirement finance, my thinking has "evolved."

(My wife would undoubtedly question both claims, but I refer specifically to retirement finance matters at present.)

Sometimes reading an old post is like seeing a photo of yourself from 1975 with mutton chop sideburns a la Neil Young and saying out loud, "What was I thinking?"

One such post is Unraveling Retirement Strategies: Floor-and-Upside[1], from February 6, 2014. I've made a few changes to reflect my updated perspective and to incorporate some of the excellent reader comments that post attracted. Specifically, I've become more enamored with annuitites and less with TIPS ladders.

The floor-and-upside strategy for financing retirement is sometimes referred to as “safety first” and derives from The Theory of Life-Cycle Saving and Investing[1].

The basic idea behind floor-and-upside is that a retiree devotes some of her retirement funding assets to building a lifetime stream of income and the remainder to an investment portfolio to provide liquidity and the possibility of increasing wealth over time.

It's important to note that growth of the upside portfolio isn't guaranteed and, in fact, the "upside" investment portfolio may shrink over time or even be depleted prematurely (an "upside portfolio" also has downside). The "floor" is a safety net that will provide income should the upside portfolio fail. The rest of your retirement plan should ensure that having to live off the floor income alone is very unlikely.

Assets suitable for constructing the floor portfolio include Social Security retirement benefits, life-contingent annuities, and pensions. A TIPS bond ladder is not guaranteed to last a lifetime but it is conceivable that one could be built for 35 years, for instance, that would be highly likely to outlast a joint lifetime. Whether or not the cost of the ladder would be acceptable is another matter.

You could build a really simple floor-and-upside strategy by using part of your retirement savings to buy a life annuity to guarantee a certain amount of income for as long as you live and then investing whatever is left of your savings in an S&P 500 index fund.

In fact, since most Americans are eligible for Social Security retirement benefits, most Americans have a "floor." Those who also have some savings to invest in retirement, therefore, have a floor-and-upside strategy. Social Security benefits alone, however, may not provide as much floor as desired.

Deciding how much floor income you should build into your plan is sometimes easy. I've had clients say, "I don't care about upside potential, I'm not as impressed with my husband's investing skills as he is. I just want a check in the same amount monthly for as long as I live." This is a person who wants nothing but floor.

I also have had clients and readers say, "I believe in my investing skills and that the market will always eventually go up throughout my lifetime." Since some suggest that they should invest their Social Security benefits, too, I assume there is a group of retirees who want no floor at all.

In between these extremes, the decision can be more difficult. The best I can recommend is that you imagine that you are 85 and your upside portfolio balance just went to zero, a victim of sequence of returns risk. What is the least amount of income you could have remaining that would not make your life an economic misery? This is the floor level you wish to have.

The next question, of course, is whether you can afford that much floor and your level of wealth may or may not dictate that you choose a lower level. Interest rates are historically low at present so floors are expensive.

(A reader once commented that anyone who can afford a floor doesn't need one. Not true. Everyone can afford some level of floor even if it consists only of Social Security benefits. No one suggests that your floor cover 100% of what you hope to spend in retirement. That would indeed be expensive. Floor income should cover food, housing, clothing, and the like, but not the annual European vacations you planned before your upside portfolio confirmed your wife's suspicions about your investing skills.)

Here's an example. Let's say you want to spend $60,000 annually in retirement and your household expects $30,000 from Social Security retirement benefits. Non-discretionary spending totals $48,000 of the $60,000 total. (The floor doesn't have to be your non-discretionary expenses, it can be whatever makes you comfortable, but that's a reasonable starting point.) You have saved a million dollars for retirement.

You need another $18,000 of longevity-protected income. Wade Pfau's Dashboard[3] (or a quick online annuity quote from someone like myabaris.com) tells us that a single-premium income annuity (SPIA) for a 65-year old couple today will generate about a 5.63% payout at today's rates. Divide 18,000 by .056 and you can estimate that you need to annuitize about $320,000 of your savings to generate the safe floor you desire.

Invest the remaining $680,000 in stocks and bonds (I recommend index funds) and you have a floor-and-upside plan with $48,000 of longevity-protected income (from Social Security benefits and the SPIA) in the unlikely event that you prematurely deplete your savings portfolio.

---

An update on Floor-and-Upside Strategies.

[Tweet this]

---

There are a few critical concepts to consider at this point. First, the income from both the floor and upside portfolios assumes normal expenses. There will always be a risk of unpredictable, catastrophic expenses — a lawsuit, medical expenses, a child or grandchild who needs your financial support — that can blow up your retirement plan. Insurance may help and a reserve fund might, too, but there is always the risk that neither will be enough. We're planning only for the expenses that we can predict to some extent.

The second important concept is that, if we depend on a portfolio or a TIPS bond ladder for income, their liquidity is somewhat illusory. Both are sometimes referred to as "fettered" assets because we depend on them for future income. We often can't really spend them on something else. Spend from either of these sources when they're intended to provide future income and we give up all or part of that future income.

An annuity will become worthless at death unless you purchase (often ill-advised) options to prevent that. A TIPS bond ladder or an investment portfolio may have a remaining balance at death but that residual balance will be available to our estate, not to us while we are living.

It is true that an annuity provides less flexibility (more liquidity) than a TIPS ladder but the flexibility of the ladder is limited. A large medical expense can't be paid immediately from an annuity, it's true, but paying it from a TIPS ladder isn't much better. You're paying the expense from the source of funding for future years of retirement. An annuity will always provide more income than a bond ladder so you might be better off using the higher income to pay the large expense over time.

Bottom line, if you suffer a huge uninsured expense in retirement, you have a serious problem with any strategy.

A third important concept is that in many scenarios annuitizing part of your savings will result in a larger estate. This is counter-intuitive. In the above example, many retirees would think, "I just took $320,000 out of any future estate value because the annuity will be worthless when I die."

But, the annuity enables the upside portfolio to be invested more aggressively and lowers the retiree's sequence of return risk by reducing the periodic amount spent from savings. This will often lead to a larger estate than a portfolio-spending strategy alone.

Floor-and-upside is a compromise between using all our savings to buy annuities and investing it all in the stock market. We buy enough annuities to provide a safety net and invest the rest.

Annuities will provide for maximum lifetime consumption but have no value at death. Depending entirely on the stock market will provide more consumption and possibly a residual balance at death if the stock market gods favor us and less spending and a smaller bequest if they don't.

How does this fit into the theory of life-cycle saving and investing? That economic theory suggests that households should prefer reducing their consumption a bit in good times if it will improve consumption a bit in bad times ("consumption-smoothing"). We buy health insurance when we are healthy in good economic times, though it may have no immediate benefit, so we will be able to consume more at times when we are unhealthy and have large medical expenses.

Floor-and-upside gives up some of the stock market gains in the good outcomes to make sure we have a bit more income in worse scenarios with poor market returns.

The floor-and-upside strategy will combine the two such that they provide a safety-net level of lifetime income and an opportunity for more consumption if those stock market gods smile down on us.

If they find us annoying, we'll still have the safety net.

In my next post, I'll describe the Constant-Dollar Spending Strategy (the "4% Rule").

---

REFERRALS

From time to time, I am asked for retirement planner references. In the past week, I received such a request as a blog comment. I would prefer you make the request by emailing me at JDCPlanning@gmail.com.

Also, there are relatively few retirement planners that I know and would trust with my own family and they are scattered around the country. All of them work remotely, primarily via email and phone as I used to, but if you want a planner you can meet in person, it is very unlikely that I will know one near you.

Thanks.

---

REFERENCES

[1] The Retirement Café: Unraveling Retirement Strategies: Floor-and-Upside.



[2] The Theory of Life-Cycle Saving and Investing, Federal Reserve Bank of Boston.



[3] Dashboard, RetirementResearcher.com.

That Time I Maximized Regret

My last post, Minimizing Regret, described a decision tool that was used by Jeff Bezos (now reported to be the world's richest person, by the way[1]) and Harry Markowitz, and one I have used extensively throughout my adult life when faced with important decisions. Last week I regretted not using it more.

My home has two HVAC systems, one for the downstairs and one for the upstairs bedrooms and bathrooms. I had both installed after we moved here eleven years ago.

Eleven years isn't an awfully long lifespan for a modern HVAC system; one hopes to get 15 years and perhaps 20 years of service before replacing them.

Ours had become unreliable. We had failures at least once in each of the past three winters so I decided to replace the downstairs unit with a more efficient gas furnace last fall. I hoped to get a year or two more service from the upstairs unit and reasoned that, even if it failed, we could limp along with the new downstairs unit while we repaired the upstairs. Besides, squeezing a couple more years out of the old unit and postponing the replacement costs was only good economics, right?

Last week, the Raleigh area experienced the worst cold spell in the past 130 years according to local news reports and measured at RDU. No doubt it was actually longer but they've only kept records for 130 years. Not surprisingly, our upstairs unit failed (heating systems rarely fail around here in July) plunging our bedroom and bathroom into a permafrost zone as temperatures outside fell to as low as 4º F.

(As an aside, please note that improbable events are not impossible, like 4º low temperatures in Chapel Hill, NC and investment portfolio failures, but I digress.)

Now, that may sound wimpy to the sturdy folks of Embarrass, Minnesota, but let's just say that I had different expectations when I retired to North Carolina.

Given the cold spell's demand on local HVAC service companies, it took two days to have a repairman spend 10 minutes determining that the cost of repairs would be nearly the cost of installing a new system. I learned this late Friday afternoon and had to wait until Monday morning to have the new furnace installed.

---

That time I maximized regret.

[Tweet this]

---

We lost heat on Wednesday, the day the cold spell began, and had an operational system again on Monday evening, the day the cold spell ended, proving for the umpteenth time that Murphy was not only a genius but also an optimist.

For five days, I slept in long flannel pajamas, wool socks, and a hoodie with a hot water bottle near my feet. (And let me just throw this out there: hot water bottles are a delight that we maybe shouldn't relegate to history's dustbin, as they say.)

I learned to shower, shave and get dressed in under 90 seconds.

Had I followed my own advice when deciding to delay installation of the upstairs heat pump instead of replacing both during the perfect temperatures last fall, I would have anticipated my regret from all possible outcomes.

Had I replaced the upstairs system last fall and missed out on the few dollars of savings I would gain from delaying, my inner financial analyst would have regretted the lost savings opportunity.

I would have anticipated regretting much more my actual outcome, a week of frosty indoor temperatures for the want of saving a hundred bucks or so.

By failing to give my decision the gravity it deserved, I maximized regret.

To put this into a retirement planning context, consider the ever-popular "probability of ruin." We can build a retirement plan that has "only" a 1-in-10 to 1-in-20 chance that we will outlive our savings, but it's probably worth a few minutes considering how much we might regret our plan if we lost that bet.

To my credit, I avoided the Tech Crash by reasoning that, while I would regret selling my tech stocks if prices continued to soar, I would regret far more losing the financial security I had already attained on paper.

A dear friend lost his entire $4M retirement savings when MCI crashed. He was nearing retirement age. That's a lot of regret.

It was 34º when we headed for the coffee shop the morning after we got the heat fixed.

It felt downright balmy.

---

REFERENCES


[1] Mr. Amazon Steps Out, The New York Times

Minimizing Regret

I'm reading Algorithms to Live By: The Computer Science of Human Decisions by Brian Christian and Tom Griffiths[1]. Following is an excerpt.

Regret can also be highly motivating. Before he decided to start Amazon.com, Jeff Bezos had a secure and well-paid position at the investment company D. E. Shaw & Co. in New York. Starting an online bookstore in Seattle was going to be a big leap—something that his boss (that’s D. E. Shaw) advised him to think about carefully. Says Bezos:

"The framework I found, which made the decision incredibly easy, was what I called—which only a nerd would call—a “regret minimization framework.” So I wanted to project myself forward to age 80 and say, “Okay, now I’m looking back on my life. I want to have minimized the number of regrets I have.” I knew that when I was 80 I was not going to regret having tried this. I was not going to regret trying to participate in this thing called the Internet that I thought was going to be a really big deal. I knew that if I failed I wouldn’t regret that, but I knew the one thing I might regret is not ever having tried. I knew that that would haunt me every day, and so, when I thought about it that way it was an incredibly easy decision."

Regret minimization can be a powerful tool for making retirement planning decisions. I have always used a similar approach to my critical life decisions. I wrote about it in a post some time back, but my process works like this.

I imagine myself at some point in the future long after having made the decision and I imagine that it turned out very badly. My future self then asks, "Do I still think it was a good decision? Would I make it again?" If my future self answers no, then my present self doesn't make that decision.

Even though I assume my decision turned out badly, I recognize that good decisions can have bad outcomes. I can accept bad outcomes if I made the best decision available to me at the time. A poor decision that ends well is just dumb luck.

Imagine that you are a basketball player about to take a game-winning (or losing) shot. Your shot is a low-percentage gamble but you can also pass to a teammate who has a better shot.

If you take the shot and win, you will have a great outcome from a poor decision. Try that often and you will lose a lot.

If you pass to the open teammate and he misses, you suffer a poor outcome from a good decision. Make that kind of decision often and you'll win more than you lose.

The fact that nearly all retirement finance decisions are probabilistic means that we can make bad decisions that turn out well or good decisions that turn out badly. To complicate matters, our own retirement is a one-time event. If we could have many retirements, a 90% probability of success would mean that 90% of our retirements would be successful, but we only get one. We can and should bet on the 90% probability but if we lose the bet, 100% of our outcomes (there will only be one) will be bad. When we lose the bet, the outcome won't be bad 10% of the time or only 10% bad.

Still, the better strategy is to consistently make good decisions or "the best bets", if you prefer. While we only get one shot at claiming Social Security benefits, for example, we will make many other retirement decisions and if we choose the 90% probability bet every time we are likely to win most of them.

Recently, a reader commented that since we can't be sure that delaying Social Security benefits will have a good outcome we really can't make a blanket assessment of the strategy. We can't make a blanket statement about the outcomes, true enough, but we can make a blanket statement about the quality of the decision.

Minimizing regret is an excellent tool for deciding when to claim Social Security benefits, assuming your financial circumstances afford you the option.

Retirees who delay claiming and die early in retirement might regret that they could have received greater benefits had they not delayed, at least to the extent that people who are no longer living have regrets.

Married retirees, however, will have surviving spouses whose survivors benefits may be limited (if they are the lower earner) by the higher-earning spouse claiming early and that spouse may not regret your decision to delay even if you do regret it.

Retirees who claim early and live a very long time will likely regret their lower lifetime benefits. Widows who live on reduced survivors benefits long after their husband passes because he claimed early might regret having let him make the financial decisions.

We might regret delaying claiming if Social Security were to be abandoned entirely by the federal government early in our retirement. I wouldn't regret my decision to delay in that scenario because I assign a low probability to my cohort losing those benefits. After that outcome, I believe I would say that I would make the same decision under the same circumstances if I had it to do over.

You, however, might not agree with that assessment or might be substantially younger and have a different outlook. Regret minimization can be subjective and risk can be dependent on one's life expectancy.

Regret can be a personal thing, though it can often be measured objectively in dollars. The dollar amount of regret can be defined as the difference between the outcome you expect and the outcome that would have resulted from clairvoyance, ie., from knowing the best answer. If the best possible strategy would have resulted in a $100 profit and yours results in $90, you have $10 of regret.

---

Minimizing regret can help you make better retirement planning decisions.

[Tweet this]

---

One way to look at the Social Security claiming decision is to consider how much you or your surviving spouse would regret that decision in various scenarios and to make the choice based on avoiding scenarios with the greatest regret. This process won't favor delaying claims for every person in every scenario, but often it will.

Minimizing regret doesn't have to be the only tool you use for a specific decision but it may provide an additional perspective. Optimization tools like MaximizeMySocial Security[2], Financial Engines[3] or AARP[4], for example, also provide useful input.

Likewise, Social Security claiming isn't the only retirement decision for which regret minimization might be useful. Let's look at asset allocation.

I am thoroughly enjoying Algorithms and plan to read it again as soon as I finish. Be forewarned, however, that if you're not a computer scientist, you might be happier reading tax tables. That having been said, here's another excerpt that I enjoyed.

Harry Markowitz won the Nobel Prize in Economics for developing Modern Portfolio Theory (MPT). MPT calculates an "efficient frontier" of portfolio allocations that maximizes portfolio returns for various levels of market risk.

MPT determines an optimal asset allocation based on risk tolerance, market volatility, risk-free rates and the covariance of asset classes.

How did the father of Modern Portfolio Theory allocate the assets in his own retirement portfolio?

"I should have computed the historical covariances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions fifty-fifty between bonds and equities."

Interestingly, a 50% equity allocation falls into the sweet spot of several very different research strategies. Using a complicated simulation strategy, Gordon Irlam found that the 95% confidence interval for the optimal asset allocation ranges from 10% to 80% equities.

Using a much simpler simulation strategy, William Bengen's work on sustainable withdrawal rates shows optimum asset allocations between about 35% and 60%.

In a paper entitled Nearly optimal asset allocations in retirement[5], Wade Pfau concludes, "with Monte Carlo simulations based on historical data parameters, a 4.4 percent withdrawal rate for a 30-year horizon could be supported with a 10 percent chance of failure using a 50/50 asset allocation of stocks and bonds. But the range of stock allocations supporting a withdrawal rate within 0.1 percentage points of this maximum extend from 27 to 87 percent."

That's a lot of research to find answers consistent with "My intention was to minimize my future regret. . . So I split my contributions fifty-fifty."

The Markowitz story also struck a chord with me on a topic to which I have been giving a great deal of thought lately.

We have faster computers, better algorithms, and more in-depth research into retirement financial planning but very little empirical evidence to show how much they actually improve outcomes.

There is talk of "evidence-based" strategies, but retirement research doesn't work like medical research. We can't ask one group of retirees to use a portfolio-spending strategy and a control group to buy annuities and compare the results after 30 years. Even if we could, market uncertainty means we can't expect similar outcomes the next time we run the experiment.

What we will find is evidence of uncertainty.

If Harry Markowitz thought that a fifty-fifty regret-minimizing strategy was preferable to mean-variance optimization, I won't argue.

Next, let me tell you about That Time I Maximized Regret.

REFERENCES

---

[1] Algorithms to Live By: The Computer Science of Human Decisions by Brian Christian | Goodreads


[2] When Should I Take Social Security to Maximize My Benefits? | Maximize My Social Security


[3] Social Security Retirement Calculator | Retirement Readiness


[4] Social Security Calculator – AARP


[5] Nearly optimal asset allocations in retirement, Wade Pfau.

Closing Out 2017

As the end of 2017 approaches and the holidays demand more attention, let me suggest a few topics to mull over a cup of hot cider. (See what I did there?)

The current status of a tax bill with major potential impacts on personal finance is the reason I don't spend a lot of time contemplating future taxes like Required Minimum Distributions at age 70½. Tax laws are just too unpredictable beyond the next few years.

My view of tax management is tactical and opportunistic. Republican Tax Bill Overhauls Rules Many Were Counting On from the New York Times[1] describes the impact of the new tax bill on people who "had a plan." I don't try to plan my taxes 15 years from now when I'm not sure what the law will be in 15 days, or whether future Congresses will change it back in 15 months.

To misquote an old, Yiddish proverb, "Man plans and Congress Laughs."

---

Some thoughts on closing out 2017. 

[Tweet this]

---

Speaking of opportunities, if you're early in retirement and will pay little or no federal tax for 2017, ask your tax planner about a Roth Conversion to pay little or no tax on some of your IRA savings. You have to make the conversion by the end of the year but if you later learn that you converted too much you can put back all or some of it with a "recharacterization."[2]

Retirement strategies span a spectrum from "safety-first" to "probabilist", the former recommending a safe floor of income from annuities, Social Security benefits and Treasuries before investing for upside potential, while the latter proposes that equity investment can solve both problems.

Another way to refer to these strategies is "risk pooling versus risk premium", or annuities versus stocks. In Risk Pooling Versus Risk Premium[3] Wade Pfau concludes that "Those favoring spending and true liquidity will find that it is much more difficult than commonly assumed for an investments-only strategy to outperform a strategy with partial annuitization." Pfau addresses some key issues like "true liquidity" and the diminishing advantage of stocks for leaving a legacy at advanced ages.

I've recently chatted with a start-up called Blueprint Income[4] that offers what is effectively a "mutual fund" of deferred income annuities. They will partner with top insurers to allow workers to "Contribute the amount you’re comfortable with whenever you see fit."

I find the idea quite interesting as it overcomes the issue of writing a single, large check and also provides diversification among the safest insurers. Take a look at their website linked below.

I have said before that as both a retirement researcher and computer scientist, I don't yet trust "robo-advisers." I am working with one that I believe is trying to do it right, though, NewRetirement.com. A Forbes column, NewRetirement: A New Approach to Retirement Planning, interviews its founder, Stephen Chen. The website is operational and you can try it at no cost.

Thanks for reading Retirement Cafe´ in 2017. I have a long list of posts to write beginning right after the holidays, but in the meanwhile, I'm going to have that cup of mulled cider and listen to the Pentatonix.

Wishing you and yours a great 2018.

Cheers. . .

---

REFERENCES

[1] Republican Tax Bill Overhauls Rules Many Were Counting On - The New York Times



[2] 6 Things to Know if You Are Thinking about a 2016 Conversion | Ed Slott and Company, LLC



[3] Risk Pooling Versus Risk Premium, Wade Pfau.



[4] Blueprint Income | Introducing the Personal Pension



[5] NewRetirement: A New Approach to Retirement Planning, Forbes.

The Return You Need

A topic that frequently appears in the comments section of my posts compares market returns to annuity or Social Security retirement benefits (also an annuity). The comment is usually some form of “I would only need a return of x% on my investment portfolio to outperform purchasing an annuity (or some other low-risk alternative) today.”

One of the most common mistakes I see retirees make is looking at a good return on a nearly risk-free investment and concluding that they would do better in the stock market because it has a higher long-term average return.

This is a good opportunity to review liability matching.

Long-term market return averages are interesting when we have an investment portfolio that isn't used to fund specific future liabilities (expenses).

Once we begin to spend periodically from that portfolio, we introduce sequence-of-returns risk[2]. We're trying to fund many expected future annual expenses and not knowing the price we will receive for those future stock sales introduces risk. The sequence of returns is often more important than long-term market return averages.

On the other hand, when we are saving and investing in stocks for a single future expense, like buying an annuity or paying for a wedding, we can't be sure that we will be able to sell the stocks at the price needed to pay that liability when it comes due. We may know how much the wedding will cost and when it will be held but we won't know the future value of our stock investments until the big day arrives. This doesn't introduce much sequence risk because we only sell one time instead of every year. This a "duration-matching", or "liability-matching", problem.

Two recent comments effectively asked what market return would be needed to make buying an immediate annuity (SPIA) in the future a better deal than buying a deferred income annuity (DIA) today. One commenter wants to claim Social Security benefits early, invest them in stocks, and use the proceeds to purchase a SPIA in four years. He asks what average market return would make this strategy come out ahead of postponing claiming benefits, which would increase them by 8% a year (simple interest).

The second reader wants to postpone buying a DIA, invest the purchase money in stocks, and buy a SPIA after 15 years. He believes that if he can earn 5.37% or so on stocks, he will break even on payouts.

Both questions are posed as the rate of stock returns these strategies will "need" to provide outcomes identical to buying a DIA now or postponing Social Security benefits. The needed rates of return, however, aren't the key to this analysis and besides,  the fact that you "need" a certain return, in my experience, doesn't make you more likely to earn it. Mick told us that if we try sometimes we might find we get what we need. Notice the words "sometimes" and "might."

Before we consider liability-matching, let me point out a few other concerns.

First, the presumed ultimate goal of these strategies is to purchase future "safe" income in the form of an immediate annuity or larger benefits. Does it make sense then, to expose the assets you have earmarked for safe income to stock market risk for four, 15 or any other number of years first?

It's a little like saying, "I really need to buy some very dependable income with this money but I think I'll bet it at the racetrack first because if I win I'll be able to buy even more safe income!" You need to consider other possibly less attractive outcomes.

Second, DIAs are significantly cheaper than SPIAs[3] and postponing Social Security benefits is an even better deal than DIAs. So, that means you not only have to outperform the 8% additional Social Security benefit for every year you postpone to age 70, but you also have to offset the cost advantage of DIAs or postponing Social Security benefits.

Third, buying a SPIA today or postponing benefits are relatively risk-free strategies — you know exactly how much income you will receive and when — while a stock investment is quite risky. You don't really "break even" when you earn the same benefit through a much riskier strategy.

If you wade through a swamp to get a cold beer, your buddy takes a boat, and you both end up with identical bottles of beer on the other side, your buddy got a better deal. Way better.

Finally, Social Security benefits are adjusted for inflation and most annuities aren't. You can purchase inflation-protected annuities but they are quite expensive and that makes the SPIA even less competitive in this analysis. It's very difficult to match the price or features of Social Security benefits on the annuities market.

A great example of what could go wrong with these strategies is available as recently as the Great Recession from late 2007 to early 2009. Stock indexes fell more than 50%.

Imagine that you employed the four-year early-claiming strategy in 2005 and ended up with half the money you needed to buy that SPIA in 2009. Or, imagine you implemented the 15-year strategy in 1994. The long-term market return average would have been irrelevant. The problem would have been needing to pay the bill at a market bottom.

Which brings us back around to liability matching, which offers the solution to this problem by matching the timing of a liability to the duration of the investment that will fund it.

I've talked about duration before, but here's a simplistic explanation. Duration measures the number of years that an investment needs to recover from a loss. The longer the asset's duration, the longer it takes to recover from losses.

If I know I will need $1,000 for an expense in four years, I can buy a $1,000 Treasury bond that matures in four years and know with relative certainty that I will have a thousand dollars to pay that expense in exactly four years. How much money will I have in four years if I invest in stocks, instead? That's unknowable. And, stocks have durations often measured in decades.

What if I buy bonds that mature in two years, instead of four? Then I will earn less interest because shorter bonds pay less. Ideally, the bond's maturity (equalling its duration as it nears maturity) will match the timing of the expense. Too short and we earn less, too long and we can't be sure of its value when the expense arrives.

The proper investment vehicle to fund this 4-year strategy would be short-term bonds that currently earn a percent or so, not stocks. Clearly, a percent or so return won't outperform postponing benefits. Investing in stocks might, but is it a high-risk strategy. It will sometimes miss badly.

"Might." "Sometimes."

Likewise, the 15-year investment to avoid purchasing a DIA today should match liabilities. That means investing in stocks for at most the first five years and then in much lower return bonds for the final ten years. Even if you're willing to risk your "safe money assets" in the market for five years before buying safe income, the average return you would need on stocks, with ten subsequent years of today's low bond yields, would be nearly 13%, not 5.37%.

And still, you couldn't know how much your stocks would be worth at the end of that five years, or your total capital after 15.

So, to summarize, investing in stocks to meet a known future liability like purchasing an annuity or even retirement itself is a risky strategy. It may be fine to invest in stocks when the liability is a decade or more in the future, or when there is no specific liability. But, as the liability's due date approaches, its far safer to begin shifting to lower duration, lower yielding, liability-matching assets.

Just ask the many workers who had to postpone retirement in 2009 because they no longer had the amount of savings they needed. That's why we recommend cutting your stock exposure the decade before retirement. They had a date when they expected to need retirement savings but they had to postpone retiring for several years until the market recovered because they were holding too much stock.

And, don't forget Occam's Razor[4]. In my experience, cute, complex or tricky strategies to fund retirement are generally flawed. The simplest answer is generally the best. Retirement advice contains many strategies that are "too cute by half."

There is a role for stocks in an adequately-funded retirement plan; providing secure income isn't it.

Take the boat.

Long-term average stock returns aren't the key issue.  The problem is market bottoms messing up your wedding. (And you were worried about rain!)

The analysis isn't as simple as comparing expected returns. You can drown in a river that averages a foot deep and you can go broke in a market that averages 9% returns over the long-term.


REFERENCES

---

[1] The Retirement Café: Clarifying Sequence of Returns Risk (Part 1)


[2] What is Duration? Investopedia


[3] Financial planner, Tom Morris, provided some quotes for a $1M DIA at age 62 today and a $1M SPIA at age 70. The DIA, if purchased today, would pay out $5,551 monthly when the 62-year old reached age 70. The SPIA would immediately pay out $3,227 monthly to a 70-year old if purchased today. The probability that a male aged 62 will live to receive income from the DIA is 89%. The probability that at least one spouse of a couple would is 99%.


[4] Occam's razor.



NOTES

---

Some older posts at The Retirement Cafe didn't convert well when I changed the format a few years back. I'm told some are difficult to read. I may someday go through hundreds of posts to find and correct them (really, it could happen).

In the meantime, they can easily be read from your mobile device which displays a black-on-white rendering. Or, if you prefer your computer, click the "View the mobile version" link at the top right of this page.

Alternatively, if you enter your email address in the Follow by Email box you will receive a black on white email version each time I post in the future, though that won't fix the older posts.

Thanks! And, sorry for the inconvenience.

Social Security Benefits: the Big Picture

In a previous post, Income Annuities: Immediate and Deferred, I discussed the problems that single-premium immediate annuities (SPIAs) and deferred income annuities (DIAs) can solve and I included the two charts below. These two problems are also considerations in deciding when to claim Social Security benefits.

The first chart demonstrates the use of an immediate annuity to increase the floor of safe income for retirees with otherwise inadequate Social Security benefits or pensions. (By “safe”, I mean income generated by assets that are not subject to market volatility. No asset is completely safe.) These are households that need safe income as soon as they retire.

Chart 1. Inadequate safe income throughout retirement.

The second chart demonstrates the use of a DIA to mitigate the risk of declining wealth late in retirement, should the retiree live that long.[3] This declining wealth could be the result of a failing portfolio, for instance, though as this chart shows, portfolios rarely fail before age 80.

Chart 2. Portfolio Depletion Risk in Late Retirement

Loss of standard of living can also result from an increase in expenses late in retirement even if the portfolio is successful, or it can be the result of a combination of portfolio losses and increased expenses. In either case, the DIA can mitigate the risk of a loss of standard of living later in retirement.

What does this have to do with Social Security benefits? A lot – Social Security retirement benefits are a deferred income annuity, the premiums for which are effectively paid from our FICA taxes. We can begin the benefits payout at age 62 or defer those benefits up to age 70.

I discussed the trade-offs between deferring benefits or claiming them early in Delaying Social Security Claims (or Not), but here’s a quick review.

We can increase our monthly Social Security retirement benefits by about 8% for each year we defer them up to age 70. This can ultimately result in receiving a check that is 32% larger when claimed at age 66 rather than age 62 and up to 76% larger when benefits are postponed from age 62 to 70.

However, there are risks to postponing. Single retirees who decide to postpone benefits to age 66, for example, and die before that age, would receive no benefits, at all. (A lower-earning spouse would receive survivors benefits as if the deceased had claimed retirement benefits at full retirement age.) In fact, the retiree would need to live several years past age 66 for the larger payments to repay the benefits that were skipped. (This isn't as unlikely as it sounds.)

If we spend from an investment portfolio to provide additional income while postponing benefits (instead of working longer, for example), we may increase sequence of returns risk at the worst time, early in retirement. Over-savers might not see a significant increase in sequence risk but retirees with smaller portfolios probably will.

In exchange for taking these risks, we can receive much higher total lifetime benefits, perhaps hundreds of thousands of dollars more, in the event that we live to an old age. In this way, we are mitigating the risk of scenarios shown in Chart 2 above (declining wealth and/or increasing expenses in late retirement). By claiming benefits at age 62, we are mitigating the early-retirement risks of scenarios with inadequate safe, floor income as shown in Chart 1.

There are a few common strategies for claiming Social Security benefits. One, the “break-even” strategy, suggests that a retiree claim benefits early if they don’t believe they will live past the age when the total of the (fewer) larger benefits overtakes the total of more, smaller benefits.

There are several problems with this strategy, the largest being that many healthy people seem to believe they know how long they will live with very little evidence to support that belief. (They are overconfident.) The second problem with break-even analysis is that it doesn't consider life expectancies and it's easy to underestimate the probabilities of surviving to the break-even age.

Here's an example from Brian O'Connell at US News and World Report.[1]

"The breakeven point, when the total dollars received by waiting until age 66 begin to exceed total dollars received by beginning at age 62, is approximately age 77," he adds. "Life expectancy tables show that a person who has attained age 62 will live to be 85.5, and a person who has attained age 66 will live to be 86.2. This means that if you have a normal life expectancy, you will end up with less dollars received [by claiming at 62]."

I often hear retirees say things like, "But I'd have to live 15 more years just to break even!"

In fact, the probability that a 62-year old male will live 15 more years to age 77 and profit by delaying claiming is about 72%, meaning that there is a 72% chance that he would lose the break-even bet by claiming at age 62.

A second common strategy, advocated by many Social Security optimization tools, is to postpone claiming benefits as long as you can to maximize lifetime benefits in the event that you live a long time. This is a “safety first“ strategy and one I prefer to guessing how long I will live.

---

Claiming Social Security retirement benefits: the big picture.

[Tweet this]

---

Although I prefer the second strategy to the first, both are missing critical elements of the decision by proposing that we claim Social Security benefits as an isolated exercise. In reality, the correct claiming decision is largely influenced by the composition of the remainder of our retirement plan.

A retiree with limited savings, for example, probably cannot afford to delay claiming Social Security benefits except by working longer. In that case, the claiming decision is strongly influenced by the retiree’s opportunity to continue working (her "human capital") and the amount of her retirement savings.

A household that has accumulated several million dollars in retirement savings, at the other extreme, won’t rely heavily on Social Security benefits, at all. It might be wise to claim late as longevity insurance. These households might even claim benefits early and invest them in the stock market since losses there would be unlikely to reduce standard of living. A household with marginal savings would risk their standard of living with this strategy.

Retirees with a significant pension and eligibility for Social Security benefits (those with "public" pensions are probably not eligible for both) would be less dependent on Social Security benefits for either immediate income or for mitigating the risk of loss of standard of living late in retirement. So, the availability of pension income is also a factor in claiming Social Security benefits.

Households that choose to fund retirement primarily with safe income assets like government bonds and income annuities avoid the risk (and rewards) of market volatility late in retirement. The more safe income they have, the less risk of depleting wealth late in retirement. The extent of the presence of these assets in the household retirement portfolio is a factor in the Social Security benefit-claiming decision.

I simulated a large number of retirement scenarios randomizing several of these factors including claiming benefits at age 62 and at age 70. I noticed an increase in the number of scenarios that did not meet spending demand throughout retirement when claiming at age 70.

Upon further analysis, I found that delaying claiming benefits increased spending from the investment portfolio in the failed scenarios for those early years of retirement, when sequence of returns risk is at its peak, and in marginal market return scenarios. In these specific scenarios, the additional portfolio spending was enough to deplete the portfolios a few years earlier than claiming at age 62 would have. The impact of increased portfolio spending on portfolio survival when delaying benefits is yet another factor not typically considered by claiming strategies.

Retirees may work longer to delay Social Security benefits, in which case there would presumably be no adverse impact on portfolio spending. In fact, portfolio spending would be delayed, reducing the risk of premature portfolio depletion.

On the other hand, retirees who claim Social Security benefits before Full Retirement Age (currently aged 66 for those about to retire) and continue to work will see their benefits reduced until they reach full retirement age.[2] 

In other words, your Social Security-claiming decision will be affected by how long you plan to work after you claim benefits before Full Retirement Age, the decision again depending on the human capital component of your retirement plan.

Perhaps the most challenging consideration is the risk of spending shocks. Even retirees with significant retirement savings face the risk of large unexpected expenses after they retire.

Retirement plans that contain long-term care insurance policies, umbrella liability policies and the like are at less risk of losing standard of living, though the risk is always non-zero. Not every retiree will be eligible for an LTC policy or will be able to afford one, and for those retirees postponing Social Security benefits will help mitigate that risk. The presence and extent of insurance policies in the retirement portfolio will, therefore, influence the claiming decision.

Marital status is another consideration. Claiming early not only limits one's own lifetime retirement benefits, it also limits survivors benefits for a lower-earning spouse. (When a spouse dies, the surviving spouse's survivors benefit will become the larger of the two previous retirement benefits.)

Deciding when to claim Social Security benefits is much like deciding when to purchase immediate annuities, deferred income annuities, neither or both. Claiming early mitigates the inadequate floor income problem and claiming late mitigates the risk of lost standard of living in late retirement.

One last consideration is the cost of retirement, which is largely dependent on how long we live. Retirees who postpone claiming and don't live long will indeed "leave money on the table." Then again, they will have had a relatively inexpensive retirement that they could probably still afford. Retirees who live a long time will have a very expensive retirement and will likely need the extra income later in life. In other words, postponing claiming Social Security benefits will reduce income for retirees who don't live long, but their cost of retirement will be lower, too.

The decision isn’t as simple as guessing how long you will live or figuring how to maximize lifetime benefits in the event that you live a long time. The best claiming decision depends on the retirement problem(s) you’re trying to solve and how Social Security benefits will work with the rest of your retirement plan. Following is a table of conditions that suggest claiming early and those that suggest claiming later.

Social Security benefits can solve the same problems as immediate and deferred annuities with even greater economic efficiency. The nature and extent of those problems, however, will be determined by other interrelated retirement plan decisions.

The key point is that a retirement plan is a portfolio of income-generating assets that interact with one another in much the same way as do stocks and bonds in an investment portfolio. Choosing a Social Security benefits-claiming strategy in isolation from the other decisions of the retirement portfolio excludes critical considerations and is likely to provide sub-optimal choices. It's like trying to pick a stock investment without considering what's already in your portfolio.

The same goes for setting an equity allocation, choosing an annuity allocation, implementing a tax strategy and most other major decisions. They're all interrelated. They work as a team.

The retirement financial model is so complex that I don’t see an obvious alternative to simulation to make the best decision. It's extremely challenging to look at one change to a spreadsheet and understand how it will affect other components. Without simulation, I would never have noticed, let alone have been able to measure, the impact that delaying claiming Social Security benefits might have on portfolio survivability.

If neither you nor your planner is able to perform the simulations, then my original recommendation stands: postpone claiming benefits for the higher-earning spouse as long as you can. Weight your decision using the factors in the table above. If you need the income right away, the decision has been made for you.

REFERENCES

---

[1] The Pros and Cons of Taking Social Security Early | Investing | US News, U.S. News and World Report.



[2] What happens if I work and get Social Security retirement benefits?, SSA.gov.



[3] Competing Risks: Death and Ruin, Cary Cotton, Alex Mears and Dirk Cotton, Journal of Personal Finance Vol 15 issue 2, Aug 24, 2016, page 36.

Income Annuities: Immediate and Deferred

Annuities are insurance contracts that you can purchase to provide a stream of income for as long as you live. Think of them as life insurance in reverse. With life insurance, you pay premiums periodically while you are alive and your beneficiaries receive a large lump-sum payment when you die. Annuities are just the opposite — you pay a large lump sum to the insurance company up front and they make periodic payouts to you until you die, no matter how long that might be.

The following diagrams show the cash flows for life insurance, single-premium immediate annuities (SPIAs) and deferred income annuities (DIAs). Blue cash flows go to you and red cash flows represent payments you make to the insurance company.

The difference between an immediate annuity and a deferred income annuity is that immediate annuities begin payouts in less than one year, while deferred income annuity (DIA) payouts can be deferred for many years.

I can purchase a $500,000 single premium immediate annuity today and begin receiving payouts next month if I wish. I can purchase a $100,000 single premium deferred annuity today and elect to not receive those payouts for ten years, for example, if I prefer.

Why would I want to defer an annuity’s payouts? Because deferred annuities and immediate annuities solve two different retirement problems.

Immediate annuities can be purchased at the beginning of retirement to help provide a lifetime of safe "floor" income. Retirees with little secure income may want to augment that safe income with an immediate annuity. Retirees with significant Social Security benefits and a pension may have plenty of safe income and not need an immediate annuity.

The following diagram shows the problem an immediate annuity can fix. The retiree has only a small portion of income generated from pensions and Social Security and may be exposed to a good deal of market risk in the red area. The green "floor" of safe income can be raised throughout retirement with an immediate annuity.

Some households may feel that they have adequate income in early retirement but worry that they might not have enough remaining wealth to fund their desired standard of living late in retirement should they live a very long time. Deferred annuities, also referred to as "longevity insurance", can solve that problem.

An immediate annuity (SPIA) provides income beginning in less than a year and continues those payouts for as long as the annuitant(s)[1] live. A deferred annuity (DIA) begins payouts at some contracted date in the future if and only if the annuitants survive to that date. At that time, DIA payouts also continue for as long as the annuitants live, but because the insurer will make fewer payouts with a DIA, and none at all if the annuitants don't survive until the future date, DIAs are a less expensive way to fund late retirement than SPIAs and much less expensive than spending from an investment portfolio.[2]

A good candidate for a DIA might be a household that relies on spending from an investment portfolio and is confident that the portfolio will fund early years of retirement but concerned that it will be prematurely depleted. A study my son and I conducted found that depleting a portfolio before age 80 should be quite rare.[3,7] A DIA is a good way to insure income after age 80 or so in the event of a failed portfolio.

See how portfolio survival rates begin to decrease sharply (risk of ruin increases sharply) once we reach age 80 to 85? Deferred income annuities can provide cost-effective protection against that increasing risk in late retirement for retirees who depend on an investment portfolio for income.

Why buy a deferred income annuity now and defer payments 20 years instead of just waiting 20 years to buy an immediate annuity? Because the DIA will be much cheaper and because there is no guarantee we will still have enough remaining savings to afford an immediate annuity when that time comes.

Assuming 3% annual inflation, a 65-year old man could buy a DIA today that would generate $10,000 of income per year in 2017 dollars ($15,580 in 2032 dollars) beginning at age 80 for a one-time purchase of $41,560.

An 80-year old could purchase an immediate annuity today that will generate $10,000 of immediate annual income for $91,070. It's much cheaper to buy the late retirement income in advance.

The immediate annuity would generate significantly more lifetime income, of course, but it requires more than twice the initial outlay. For households that only expect to need additional income in the event of a very long life, the DIA is the better choice.

This is not an apples-to-apples comparison. This assumes that life expectancies and interest rates will remain roughly the same over those 15 years. I have figured in 3% inflation, which could be high or low. The SPIA purchaser will almost certainly receive some income while the DIA purchaser will receive nothing unless she survives to age 80.

Nonetheless, the annuitant who does live to 80 will fund income the least expensive way. The DIA is longevity insurance and that's how insurance works. We accept a certain loss (premiums) to protect us from a potentially very large loss (running out of money in late retirement). We pay someone else to accept our risk.

Deferred annuities, like retirement finance in general, have an accumulation phase and a distribution phase. But, the phases might be easier to understand if we describe them as two different products.

---

When to buy a deferred or immediate annuity and when you probably don't need one, at all.

[Tweet this]

---

Imagine that the accumulation phase of a deferred income annuity (DIA) is like having a fixed-interest rate savings account. The money invested in this savings account is illiquid because the insurer can charge high surrender fees if the annuitant makes withdrawals sooner than the annuity contract allows. Taxes on earnings are deferred until they’re withdrawn, so sort of like a savings account held in a traditional IRA but without a tax break on the contributions.

The value of this account grows until the DIA is annuitized, or converted into a stream of lifetime income, or until the annuitants die, in which case the account value becomes zero. If the annuitants die during either phase, even if payouts have not begun, the results are pretty much the same as with an immediate annuity. That means that unless riders are purchased to guarantee some payout to your beneficiaries, the deferred income annuity will have no residual value.

The second product (the distribution phase) is a life annuity that you will choose to purchase with funds from the “savings account” if you survive the deferral period.  If the annuity is funded from an IRA or 401(k) — a “QLAC”, described below — you must begin annuitization by age 85. Funded outside a retirement account, you can often delay annuitization until age 90.

An annuitant might reach the age they expected to convert to an annuity, not need the income, and elect to delay annuitization until they do. Or, they might find they need the income sooner and move back the annuitization date a few years.

Inflation is a greater concern with deferred annuities than immediate annuities. While most deferred annuities don’t offer inflation protection, those that do offer it don’t provide inflation protection during the accumulation phase. The inflation protection kicks in only when the account is converted to an annuity. Since the deferral period can last a long time, inflation can become a significant issue as your axccount compounds during the accumulation phase at bond-like interest rates.

Another advantage of DIAs compared to immediate annuities is that they require a smaller cash outlay because they only provide income if you survive until late in retirement. According to researcher David Blanchett, "The cost of a DIA, for example, that would provide $10,000 a year of income, if you buy it at age 65, it would cost about 20% of what it would cost to have a SPIA starting today at age 65 to provide that same level of income." [4]

Wade Pfau wrote a column entitled Why Retirees Should Choose DIAs over SPIAs[5]. The short answer is that deferred annuities are the most economically-efficient way to finance the latter years of retirement should a retiree or spouse live a long time. The more technical answer is that DIAs "expand" the retirement income efficient frontier and create opportunities with higher expected returns for a given level of risk.

There is a special type of DIA worth mentioning, a qualified longevity annuity contract (QLAC). A QLAC is a deferred annuity that you can purchase with qualified funds from your retirement accounts with payouts deferred to as late as age 85.

According to Motley Fool[6], “a QLAC allows the insured to withdraw 25% — up to a maximum of $125,000 for single folks and $250,000 for married couples — from their qualified retirement accounts and exempt these funds from being considered in their RMD calculation from age 70½ onward.”

I recently recommended a QLAC to friends. They plan to annuitize it at age 82, but if they reach that age and their portfolio has held up well, they can choose to defer payouts up to three more years and receive larger checks then. On the other hand, if their portfolio underperforms, they can choose to annuitize a few years earlier and receive slightly smaller checks sooner.

Annuities are not particularly popular although interest in DIAs has recently grown.

One of the problems, I believe, is that retirees often consider annuities in isolation and not as part of an integrated plan. True, the money used to purchase an annuity cannot be left to your heirs. (Unless you buy special riders to continue payouts to your beneficiaries for some guaranteed minimum number of years. Those essentially offset mortality credits and defeat much of the purpose of buying the annuity.)

On the other hand, if you purchase an annuity and die early in retirement, the good news (financially) is that you will have had a relatively brief and inexpensive retirement. That may mean you had plenty of savings apart from the annuity to leave your heirs.

If you live to an old age, an annuity might help you avoid spending other savings that you can leave to heirs. Owning an annuity may give you more confidence (or may not, depending on your personal risk aversion) to invest your portfolio more aggressively and improve your odds of earning a greater return. As Pfau’s research shows, annuitants often end up with greater terminal wealth.

The point is that you need to consider annuities as an integrated part of a retirement plan and consider the entire plan’s terminal wealth instead of focusing on the fact that the annuity has no value at death. If the annuity ultimately becomes worthless but it has preserved other assets, it will have done its job.

This isn’t a thorough treatment of deferred annuities. My goal is simply to explain their salient characteristics for comparison with immediate annuities and Social Security benefits. If you want more information — and certainly if you are considering purchasing one — please see the references below.

The most important takeaway is that deferred income annuities (DIAs) are the most economically-efficient way to fund late retirement by providing "longevity insurance." Single-Premium Income Annuities (SPIAs) are a better way to provide income throughout retirement for retirees with an inadequate "floor" of safe income. The correct choice depends on the problem or problems you are trying to solve — you might even need one of each.

As I have mentioned often, I believe that retirees should plan retirement in a way that makes them happy. Some people hate annuities; some won't invest in the stock market. If you understand the pros and cons of each and can't be persuaded, buy what lets you sleep at night.

REFERENCES

---

[1] An annuity can cover a single life (annuitant) or joint lives (annuitants).


[2] The 4% Rule-At What Price?, Scott, Sharpe, Watson.



[3] Competing Risks: Death and Ruin, Cary Cotton, Alex Mears and Dirk Cotton, Journal of Personal Finance Vol 15 issue 2, Aug 24, 2016, page 36.



[4] Pros and Cons of 2 Key Annuity Types, David Blanchett interview video.



[5] Why Retirees Should Choose DIAs over SPIAs - Articles - Advisor Perspectives, Wade Pfau, 2013.



[6] What Is a QLAC, and Why Might You Want One?. MotleyFool.com.



[7] Note that these curves show the cumulative conditional probability of portfolio survival. Most studies show the probability, for instance, that a 65-year old's portfolio will survive to age 95. A Kaplan-Meier curve shows the probability that a retiree who actually lives to 80 and has not depleted her portfolio, for example, will experience portfolio failure at later ages. Retirees who have already died or already depleted their portfolios are not included in the Kaplan-Meier calculation of future probabilities.

Why a Rational Retiree Might Keep Going Back to that ATM

“In particular, the presumption that a client will adhere to a deterministic spending schedule, wake up one morning, go to an ATM, and discover that the “money process” has reached zero is silly and naive.” — Moshe Milevsky[1].

Milevsky refers to periodic, constant-dollar spending from a volatile portfolio, as simulated in sustainable withdrawal rates (SWR) research.

It is with no small measure of sadness that I find myself disagreeing, at least under certain conditions, with three of my favorite retirement researchers — Moshe Milevsky, Michael Kitces . . . and me.

For Michael’s perspective, I refer to a comment he made somewhere on the Internet some time ago referring to a paper entitled, “A 4% Rule — At What Price” by Jason Scott, John Watson and William Sharpe[2]. That research showed the high cost of mitigating longevity risk by over-saving. The large amount of “fettered” assets that must remain untouched to survive long periods of poor market returns make SWR strategies economically inefficient and expensive. Wade Pfau has referred to fixed spending from a volatile portfolio as the least efficient strategy.

I couldn’t locate that comment from Kitces so I will do my best to paraphrase from my (aging) memory. The problem with the Scott analysis, I recall Kitces suggesting, is that retirees don’t “do that.” They don’t just keep spending the same amount no matter the circumstances.

That was my intuition, as well. And in fairness, we were all three mostly right, though the devil is in the details.

It was hard to imagine that rational retirees would keep spending the same amount from a portfolio that appeared to be spiraling into ruin. (Cue Richard Thaler laughing aloud[4]). But, while Michael used that intuition to question the Scott research, I have always considered it an invalidation of the constant spending model as a planning tool. (As a research tool, it taught us about sequence risk.)

A predictive model says, “If you do this (follow the model’s policies in real life) then you can expect these results. If we don’t expect people to follow those policies, then we shouldn’t expect the outcomes that the model predicts. And, clearly, most of us don’t expect rational retirees to “do that.” So, why believe the results?

---

Why rational retirees might keep going back to that ATM.

[Tweet this]

---

I still have serious problems with the model, and not just this behavioral assumption, but it took a retiree going broke in his early 80’s to help me understand that there might well be rational reasons for a retiree to keep showing up at that ATM until it spits her card back at her.

(Please note this evidence that actual retirees go broke with SWR strategies and this isn't a hypothetical outcome that occurs only in Monte Carlo simulations. Considering elder bankruptcy rates, however, the evidence seems to show that the rate of ruin is an order of magnitude less than SWR models predict. On the other hand, I suspect the rate of reductions in standards-of-living is higher.)

A retiree contacted me after depleting his savings portfolio at age 82 with a failed SWR strategy. He was down to Social Security benefits and a little home equity and hoped I could show him a way out of selling his home and living off Social Security benefits.

Sadly, neither I nor several retirement planner friends could offer a suggestion beyond a home equity loan, which didn’t work out. It’s tough to rebound after you age out of the labor market.

After our discussions and a little thought, I realized that households with substantial savings relative to their spending might well see portfolio failure looming and reduce spending. If they do, they will likely see their portfolio recover, as I showed some time ago in a series of posts entitled, Clarifying Sequence of Returns Risk. You don't go broke with variable spending from a volatile portfolio. On the other hand, the spending is, well . . . variable.

Households with limited savings, on the other hand, may well find that their non-discretionary expenses gradually overwhelm their safe level of portfolio spending. Even though the portfolio would be doomed by continued spending, they will still need to pay for groceries and housing and may have little recourse other than to keep spending and pray for a tremendous bull market. They may find themselves in a “spending trap” in which they must sustain their level of spending simply to pay non-discretionary expenses with the knowledge that doing so will most likely soon bankrupt them.

If we consider that credit card debt is a major cause of elder bankruptcy, then we can expect retirees in such a spending trap to max out their credit cards to pay bills before depleting their credit along with their portfolio. (The 2017 Retirement Confidence Survey from EBRI notes that "18 percent of all workers describe their level of debt as a major problem and another 41 percent call it a minor problem.")

A credit card debt spending trap is similar. The household continues to spend from credit well past the point where they believe they can repay because it has no good alternative. We would not expect excessive credit card spending to be normal, rational behavior but if it is the best of a set of bad alternatives, we probably have to call it rational. Again, this occurs in households with little or no remaining savings.

I learned this lesson long ago when I was asked to help a lady who had run up $60,000 in credit card debt while her husband suffered a long bout of unemployment. "I didn't use the card at Nieman Marcus," she explained. "I bought groceries and clothes for my kids." Not irrational.

A similar conundrum applies to reverse mortgages. The sales pitches strongly suggest that a mortgagee can’t be forced from the home by foreclosure so long as the home remains their principal residence. In other words, just stay in the home and the reverse mortgage can’t be foreclosed. True, but notice how easily that suggestion rolls off the tongue.

A reverse mortgage borrower can lose her home through processes other than foreclosure. A retiree who chooses a reverse mortgage might find that despite her expectations when she retired, she no longer wishes to live in the home or can no longer afford its maintenance or the local cost of living. “Just” keeping the home as her principal residence might not be an attractive option.

I recently learned of a wealthy, retired corporate executive who lived in an expensive suburb of Houston. His wife developed dementia and her care bankrupted the household. Reverse mortgages were not a part of that story but it is easy to imagine that, had he borrowed one and spent most of the equity, he would choose to move to less expensive housing in a less expensive community even though that would trigger the mortgage’s repayment. While he could postpone repayment by just remaining in the home, that might not be his best option. Moving out, though it would trigger mortgage repayment, might be the rational choice.

So, returning to that “deterministic spending schedule,” I, too, prefer to believe that most people would note their deteriorating finances and reduce spending in time, but retirees with more limited resources might end up in a spending trap in which their portfolio’s death march is the best of a poor set of choices. They might also fall victim to the "boiling frog" scenario in which the deterioration is so gradual that it fails to set off trigger points in time (although the whole boiling-frog thing is fake news, according to The Atlantic.[3])

As a friend and Duke philosophy professor recently told me when I questioned people voting against their own interests, sometimes people are acting in their own interests but we just don't understand what those interests are.

This week that the Nobel Committee conferred its award to Richard Thaler seems appropriate to remind ourselves that our financial models are fairly irrelevant if we ignore the human behavior element or oversimplify it.

Sometimes a retiree may keep returning to that ATM for as long as possible because she has no better alternative. That's rational.


REFERENCES

---

[1] Financial Analysts Journal : It’s Time to Retire Ruin (Probabilities), Moshe Milevsky.


[2] A 4% Rule - At What Price? by Jason S. Scott, William F. Sharpe, John G. Watson.


[3] The boiled-frog myth: stop the lying now! The Atlantic.
 

[4] Richard Thaler, A Giant In Economics, Awarded The Nobel Prize, Forbes.



IN OTHER NEWS

---

I will participate on a panel of retirement advisers in a Twitter chat sponsored by Thomson Reuters and entitled "When Can You Retire?" on Wednesday, October 18 from 2 p.m. to 3 p.m. ET. Follow @Retirement_Cafe and @ReutersMoney to join us.

A fellow retirement planner was told at a seminar this week that "95% of retirees should get a reverse mortgage at the beginning of retirement to create income." Aside from writing a will, I can't think of any single thing that 95% of retirees should do. I am told that Mark Warshawsky estimated that 14% of 62+ households could potentially benefit. Sounds much more reasonable to me. Still others might benefit from a reverse mortgage to create an emergency fund.