Trying to rebuild a retirement portfolio in a low return
investment landscape has many challenges. Importantly there are two risks that
really have taken center stage, investment-performance risk and longevity risk.
Equity market returns have been lousy for about a decade, prompting new phrases
into our vernacular such as, “the new normal” and “stocks suck.” Over the last
generation life spans have increased to the point that the fastest growing
segment of Americans is the over 100 age group – aka the Willard Scott gang.
The odds of at least one spouse reaching the age of 86 is 25 percent.
Since the great recession of 2008 income losses for those
nearing retirement, specifically households led by people between the ages of
55 and 64 have taken the biggest hit, a decline of 9.7 percent. During
retirement, the income flowing from a portfolio made up of stocks and bonds is
sensitive to market fluctuations. This
can significantly increase an investor’s longevity risk, or outliving one’s
assets.
Creating a portfolio that confronts and diminishes these
risks requires adding longevity insurance into the mix. Yep, you guessed it,
I’m talking about annuities. But wait,
Ibbotson Associates research shows that investors can mitigate both longevity
and investment performance risks with a carefully constructed combination of a
guaranteed income stream and traditional assets such as mutual funds and ETF’s.
Annuities can be expensive (guarantees normally cost more)
and hard to understand. Determining how and when to use them can be confusing
too which is why few investments are as polarizing, but it is wise to set aside
preconceived notions in response to this current challenging environment. Many retirees should consider ways to turn a
portion of their portfolio into pension- like income streams.
A fairly recent innovation in deferred variable annuity (VA)
products is the guaranteed minimum withdrawal benefit (GMWB) rider. The GMWB
rider for life gives you the ability to protect your retirement investments
against downside market risk by allowing you the right to withdraw a fixed
percentage of the benefit base each year until death. The benefit base can step
up and resets to the high-water mark of the contract value on the rider
anniversary date when the market has performed well. The remaining contract
value at death will be paid to your beneficiaries, which removes concern about
giving up liquidity to your heirs (i.e. if I die early, my family loses).
After deciding whether longevity insurance has a place in
your retirement portfolio the next challenge is how much to allocate to this product
versus traditional assets. The easiest way is for your advisor to follow up the
strategic asset-allocation decision with a secondary “product-type”
optimization. Barring that, a recent
Ibbotson study using Monte Carlo simulation
based optimization to find an optimal product-type mix of traditional products
and a VA+GMWB by maximizing a utility function at the life expectancy offers helpful guidelines to product
allocation. See the major findings (below):
Ø
The higher the risk tolerance, the lower the
VA+GMWB allocation;
Ø
The longer the life expectancy (subjective), the
higher the VA+GMWB allocation;
Ø
The higher the age, the lower the VA+GMWB
allocation;
Ø
The higher the ratio between wealth and income
gap, the lower the VA+GMWB allocation; and
Ø
The preference for bequest has almost no impact
on the VA+GMWB allocation.
By adding products that offer guaranteed income for life to
your portfolio (if appropriate) you can avoid an extreme outcome (i.e.
outliving your assets) and better enjoy your retirement. But, as case studies
show investors and advisors must be careful when determining which products and
allocation percentages.
CBlakely CFP®, CTFA Auggie 2012
Sources: The New York Times; Allocation to Deferred Variable
Annuities with GMWB for Life, Xiong, Idzorek, Chen (Ibbotson); The Impact of
Skewness and Fat Tails on the Asset Allocation Decision, Xiong, Idzorek
(Financial Analysts Journal, Vol. 67 #2)
