A reprinted article from Volume 17, Number 1, 2016
T H E
J O U R N A L
O F
INVESTMENT
CONSULTING
An Overview of Retirement Income
Strategies
By Michael Finke, PhD, CFP®, and David Blanchett, CFA®, CFP®
I N T E R N AT I O N A L
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
WEALTH MANAGEMENT | An Overview of Retirement Income Strategies
An Overview of Retirement Income Strategies
By Michael Finke, PhD, CFP ® , and David Blanch ett, CFA ® , CFP ®
22
Figure 1 shows the distribution of lifetimes
of the last surviving spouse of a couple,
male and female, both age sixty-five, based
on the 2012 Society of Actuaries (SOA)
immediate annuity mortality table. In the
past twenty-five years, workers whose earnings placed them in the top half of Social
Security participants gained roughly five
years in longevity relative to workers in the
bottom half of earnings (Waldron 2007).
Recent longevity gains also have increased
among men and women in higher wealth
categories. Longevity gains are significantly
higher for men, resulting in extended joint
mortality because an increasing number of
males will outlive their female spouses
(Bosworth and Burke 2014). The SOA tables
provide a realistic estimate of expected joint
mortality for advising clients.
Individuals face two types of mortality risks
at retirement. Gains in medical science or
environmental improvements can result in
added longevity for all retirees. The possibility of gains in longevity to all retirees is systemic longevity risk and must be borne by
all individuals. Systemic risk will shift the
central tendency of the distribution in figure 1 either to younger or older ages, or it
may even change the standard deviation of
longevity. The wide distribution of longevity
represents the idiosyncratic risk that retirees
face when planning for retirement. They
could face a retirement time horizon that is
ten years, twenty years, or even forty years.
Not knowing the length of the retirement
time horizon means that retirees have three
Figure 1: Joint Mortality Distribution
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
65 68 71 74 77 80 83 86 89 92 95 98 101 104 107 110 113
Age
JOURNAL OF INVESTMENT CONSULTING
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
0.00%
Probability of Death
Introduction
A new generation of workers will transition
from accumulating assets in tax-sheltered
retirement savings plans to decumulating
financial wealth to provide retirement
income. Today’s retirees, along with their
advisors, are responsible for deciding how
to invest their wealth in retirement, and
how to turn these assets into sustainable
income. This paper introduces the theory
and research related to retirement income
planning; it uses simulations to illustrate
the important trade-offs of different strategies and financial products.
The Unknown Time Horizon
The primary difference between retirement
saving and retirement decumulation is the
unknown time horizon of the retirement
life-cycle stage. A thirty-year-old worker
can reasonably expect to save over a thirtyfive to forty-year period. This worker also
can draw from labor income, or human
capital, to increase or decrease the saving
amount over time in order to meet a retirement goal when faced with market volatility. A retiree has neither a defined time
horizon to plan for nor the ability to draw
significantly from human capital to smooth
variation in asset returns.
Probability of Survival
Overview
This paper provides an introduction to strategies that can be used to turn a retirement
portfolio into income. Defined contribution
savings present a retirement planning challenge when asset returns, longevity, and
spending needs are uncertain. We present
the fundamental trade-offs of managing an
investment portfolio and decumulating
investments in retirement, and we discuss
the potential benefit of financial products
that address portfolio and spending risks.
Simulations illustrate the trade-offs among
legacy, liquidity, and shortfall risk. We discuss a comprehensive strategy that combines longevity protection, portfolio allocation, and dynamic spending based on
realized portfolio returns to provide a
guideline for professionals building retirement income plans for clients. We then provide an overview of the benefits of adding
products such as annuities to a traditional
investment portfolio to reduce longevity
risk and increase expected spending. The
primary purpose of this paper is to provide
a fundamental overview of current research
and theory on retirement income planning.
WEALTH MANAGEMENT | An Overview of Retirement Income Strategies
The second choice is to select a sustainable
spending strategy that minimizes the risk of
outliving assets. Early research in retirement
income drawdown strategies from an investment portfolio coalesced around the socalled 4-percent rule (Bengen 1994) as a sustainable withdrawal rate. Bengen’s approach
calls for a conservative spending strategy
that also increases the risk of dying before
retirement assets are depleted. Conservative
retirees run the risk of leaving happiness on
the table by selecting a withdrawal rate that
is sustainable over a long-run planning horizon because they most likely will die with
significant unspent retirement savings. For a
household with a strong bequest motive this
may not be a significant trade-off. For other
households, the prospect of unspent wealth
may be far less appealing.
The third choice is to approach idiosyncratic mortality risk the same way an advisor would approach idiosyncratic investment risk; that is, by diversifying (or
pooling) this risk of an unknown lifespan
with other retirees. A range of annuitization
products exists that allows retirees to pool
the risk of outliving assets. In theory, pooling idiosyncratic risk—like diversification of
idiosyncratic investment risk—provides a
higher level of expected spending for a
given level of risk. Yaari (1965) showed that
annuitization is the optimal retirement
income strategy for a retiree with constant
spending needs and no bequest motives.
Retirees often have a range of retirement
goals. They may have a desire to leave a legacy to others. They enjoy having the security provided by investment assets to protect against unexpected spending needs.
Figure 2: Funding a 4-Percent Spending Rate with TIPS
$950,000
$750,000
Bond Portfolio
0.5%
Bond Portfolio
1%
$550,000
$350,000
$150,000
$40,000 Inflation Adjusted
Inheritance
Portfolio Value
primary choices when creating retirement
income plans. First, they can choose to draw
down assets quickly in order to spend the
most during ages when they are most likely
to be alive. This “live for today” approach
will result in an increased risk of running
out of financial assets, but it will reduce the
risk of failing to get the most out of retirement savings by leaving a large unintended
inheritance. It is safe to say that most clients
who have diligently saved for retirement
will not see this as the preferred approach.
–$50,000
–$250,000
65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95
Age
They may have varying opinions about the
appeal of products that trade a lump sum of
wealth for a guaranteed income. And they
may have different ideas about how much
risk they are willing to take with short-run
volatility and potentially outliving assets.
Building the right strategy for an individual
involves understanding these often competing preferences and developing a strategy
that incorporates the right mix of investment and pooling products.
Understanding Non-Annuitized
Drawdown Strategies
The vast majority of retirees in the United
States do not annuitize. This so-called
annuity puzzle (addressed in detail in
Mitchell et al. 1999) means that most
Americans will accept idiosyncratic longevity risk and will spend down assets over
time from an investment portfolio. This
means they must manage the risks of a volatile investment portfolio, an unknown
time horizon, and unknown inflation, as
well as unknown spending needs.
How long will an investment portfolio last
in retirement? A simple way to illustrate a
portfolio’s ability to fund an income goal is
to select an initial withdrawal rate holding
investment and inflation risk constant.
Fortunately, Treasury inflation-protected
securities (TIPS) allow us to estimate a
baseline time horizon for sustainable
spending using risk-free securities.1
Figure 2 illustrates a fixed spending strategy using risk-free investments. A retiree
Real return
determines
when you will
run out
first picks a desired spending rate—in this
example 4 percent of initial retirement
wealth, or $40,000 from a $1-million portfolio. This also highlights an oft-ignored
feature of the 4-percent rule—that the
amount withdrawn is only 4 percent of
wealth during the first year, and each subsequent year may be a higher or lower percentage of remaining investment assets. The
spending amount increases by the rate of
inflation, but inflation-adjusted TIPS simply will rise in value with spending. In a
risk-free portfolio, the $40,000 in real
spending represents a larger and larger percentage of remaining assets.
As a retiree ages, the value of the TIPS
portfolio falls by the amount spent each
year. Retirees who die in their seventies or
eighties will leave a legacy of unspent
retirement assets. Retirees who live to
about age ninety-two or ninety-three will
leave no bequests. But retirees who live any
longer will run out of money. At today’s
TIPS rates, a 4-percent spending amount
will be sustainable to roughly the average
joint longevity age of a higher-income couple. A retiree who wants to protect against
outliving assets to, say, the ninetieth percentile will need to spend at a lower rate
(for example, 3 percent of initial wealth).
Figure 2 also illustrates that the date at
which a retiree runs out of money is
entirely a function of the real, after-inflation
rate of return. Whether the portfolio is
invested in TIPS, corporate bonds, or
equities, the real return (after fees) on the
VOLUME 17 | NUMBER 1 | 2016
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
23
WEALTH MANAGEMENT | An Overview of Retirement Income Strategies
Investment Risk in a
Retirement Portfolio
Most retirees will not invest an entire portfolio in TIPS. They will accept a certain
amount of inflation and investment risk by
selecting a mix of securities, such as equities
and nominal bonds. An ideal retirement
portfolio will provide the highest expected
return for an appropriate level of risk.
What is risk in retirement? Although investors often focus on short-run volatility
when assessing risk tolerance, retirement
risk can best be viewed as the extent to
which one might have to adjust spending
(Finke et al. 2012). A retiree who holds a
risky portfolio that experiences strong asset
returns will be at little risk of outliving
assets. This means that the retiree will be
able to maintain a high level of spending
through retirement. A risky portfolio with
disappointing returns will result in a
reduced level of spending later in life (or if
spending is held constant, an increased risk
of outliving assets).
Figure 3 shows the results of a simulation
using a 4-percent inflation-adjusted initial
withdrawal rate and various portfolios of
stocks and bonds. The results are calculated
using a series of Monte Carlo simulations
and show the total wealth at each year of
age. A less risky 80-percent bond portfolio
will produce a narrower band of remaining
retirement wealth as a retiree ages. Like the
TIPS portfolio, the lower expected rate of
return on the bond portfolio will result in
the depletion of assets at a younger age. In
addition to greater risk of asset depletion
later in life, the average legacy amount will
be lower because there will be fewer simulations in which wealth grows during a bull
market for equities.
24
Figure 3: Retirement Portfolio Risk and Wealth Values
$500
80% Equity
50% Equity
20% Equity
$400
Wealth
$300
$200
$100
$0
–$100
–$200
0
5
10
15
20
Years
25
30
35
40
Figure 4: How Investment Risk Affects Retirement Wealth
Higher Equity Portfolio
Higher Bond Portfolio
100% TIPS
Retirement Wealth
portfolio will determine how long the portfolio value will sustain a constant inflationadjusted level of spending. If the real return
on investments is volatile, then the date
that assets are depleted will depend on
when the real returns are realized in the
retirement life cycle. As we will show, low
real returns early in the life cycle have a
much larger impact on portfolio sustainability than low returns later in retirement.
SUCCESS
70
75
80
Increasing retirement portfolio risk to
50-percent equities broadens the range of
simulated wealth values later in retirement.
The increased risk means that there will also
be scenarios where retirees will run out of
money earlier in retirement than if they had
invested in a less risky 20-percent equity
portfolio. The majority of simulations will
result in larger legacy amounts and longer
sustainable retirement periods. An 80-percent
equity portfolio will further broaden the
range of wealth amounts later in retirement.
These simulations show what appears to be a
cone of retirement wealth outcomes whose
diameter is determined by the amount of
risk taken in a retirement portfolio. Figure 4
illustrates how portfolio allocations affect
85
Age
90
95
100
wealth outcomes over time. Figure 4
assumes constant inflation-adjusted spending. A 100-percent TIPS portfolio is simply a
straight line. The year of depletion is determined by the real return on the TIPS when
they are purchased. A portfolio more heavily
weighted toward bonds will have a narrower
range of retirement wealth values and a
higher equity portfolio will have a greater
range of outcomes.
Figure 4 also demonstrates a peculiarity of
judging retirement portfolio strategies from
the traditional 4-percent withdrawal rate
perspective. When gauging the efficacy of a
strategy based on the probability of success,
a strategy is better if it increases the percentage of simulations in which the portfolio
JOURNAL OF INVESTMENT CONSULTING
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
WEALTH MANAGEMENT | An Overview of Retirement Income Strategies
The risk of a balanced portfolio in retirement also can be shown by comparing
the percentiles of retirement wealth over
time using historical data. Figure 5 shows
the range of possible outcomes from investing any dollar amount and withdrawing
a 4-percent inflation-adjusted amount
each year. The investment growth less
spending is presented using various time
horizons and is based on a 60-percent stock,
30-percent bond, and 10-percent cash portfolio as well as a 1-percent asset management fee. Historical U.S. bond, equity, and
cash returns between January 1926 and
March 2013 are used to determine the mean
and standard deviations of asset classes.
If we focus on ensuring a 5-percent margin
of safety (i.e., the fifth percentile in figure 5),
then we accept that 5 percent of retirement
outcomes will fail at the point where the
5-percent line crosses the horizontal axis at
$0. In this case, we find that in 5 percent of
cases retirees will run out of money after
twenty-three years, and in 25 percent of
cases they will run out of money in thirtyseven years. If we had assumed historical
returns and no investment management fee,
Multiple of Initial Balance at Retirement
If the primary objective was to increase the
probability of sustainability to age ninetyfive, then a retiree who held a TIPS portfolio until age ninety optimally would shift
the entire portfolio to equities in order to
have some chance of success. Many retirement planning software packages use
Monte Carlo methods to estimate the safety
of a strategy based on how often the
income goal is funded over a thirty-year
time horizon. But if success is judged
instead on how many years a retiree can
maintain a constant level of spending, simulations will favor a more balanced and
consistent investment risk strategy.
Figure 5: Variation in Retirement Wealth by Percentiles
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
–0.50
–1.00
0
5th Percentile
5
10
25th Percentile
15
20
25
Years in Retirement
50th Percentile
30
75th Percentile
35
40
95th Percentile
Figure 6: Variation in Retirement Wealth Using Contemporary Asset Values
Multiple of Initial Balance at Retirement
lasts thirty years, or until age ninety-five for
a client who retires at sixty-five. As figure 4
shows, a TIPS strategy using today’s low
real rates will have a 0-percent chance of
successfully funding a 4-percent spending
goal for thirty years. But it would have had
a 100-percent success rate if we had judged
success based on a twenty-five-year time
horizon.
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
–0.50
–1.00
0
5th Percentile
5
10
25th Percentile
15
20
25
Years in Retirement
50th Percentile
then the 5-percent threshold of safety would
have resulted in a sustainable retirement
portfolio of more than twenty-five years.
The so-called 4-percent rule (Bengen 1994)
was based on prior rolling returns of U.S.
equities and bonds for which a 4-percent
retirement withdrawal rate could be sustained over a thirty-year retirement.
Subsequent analyses using a Monte Carlo
technique to simulate variation in asset
returns (Cooley et al. 1998) found that a
4-percent withdrawal rate could provide a
failure rate of 5 percent or less. The simulation in figure 5 incorporates more recent
asset return data that slightly reduces this
safe withdrawal rate.
Finke et al. (2013) find that safe withdrawal
rates are highly sensitive to assumed rates
30
75th Percentile
35
40
95th Percentile
of returns on bonds and stocks. Because
today’s bond yields are significantly below
their historical average, it is possible to simulate retirement safety using a more precise
estimate of future returns on the bond
portfolio. Using these more relevant current bond rates rather than historical bond
rates, we find that thirty-year failure rates
increase significantly from less than 5 percent to 33 percent. Figure 6 illustrates the
safety of a 4-percent withdrawal rate at various confidence levels if we assume that
portfolio returns will be 2 percent below
the historical average.
In addition to the impact of current
long bond yields, Blanchett et al. (2014)
show that today’s equity valuations also
have significant predictive power when
VOLUME 17 | NUMBER 1 | 2016
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
25
WEALTH MANAGEMENT | An Overview of Retirement Income Strategies
estimating future safe withdrawal rates in
retirement. Figure 6 shows that one in four
retirees who live twenty-seven years in
retirement will run out of savings if they
follow the 4-percent rule using today’s
bond yields. By incorporating today’s high
historical Shiller price/earnings valuation
and simulating future equity returns, the
estimated safety of a 4-percent rule can fall
to as low as 50 percent over a thirty-year
time horizon. Finke et al. (2013) estimate
that a safe withdrawal rate is likely below
3 percent using updated asset valuations
and the same simulation method that led to
the acceptance of the 4-percent rule.
An advisor who chooses to employ a static
withdrawal rate strategy using a spending
amount that is based on a percentage of
the initial account value at the date of
retirement needs to recognize that this is
likely not the optimal method for creating
a retirement income plan. By following a
static spending amount while ignoring the
impact of inflation, asset returns, and
changes in expected longevity that occur
as a client moves through retirement, the
result will either be an increased risk of
depleting assets or an equally harmful
risk of underspending if asset returns are
higher and inflation is lower than expected.
A more efficient strategy would involve
maintaining the flexibility to change spending over time.
Dynamic Spending Strategies
An important implication of figure 4 is that
risk in a retirement portfolio will result in a
greater likelihood of catastrophic failure. If
risk is real, there is some possibility that
equities will experience an extreme loss in
value or an extended bear market. If losses
occur early in retirement, continued withdrawals from the portfolio to maintain
inflation-adjusted spending will limit the
portfolio’s ability to eventually bounce back.
For example, assume a 60-percent equity
portfolio with an initial value of $1 million
and an initial annual withdrawal of $40,000
taken out at the beginning of the year. A
40-percent drop in equity values, such as
occurred in 2008 in the United States,
coupled with a $10,000 growth in the bond
26
portfolio, would leave a portfolio value of
$740,000 after the first year. A 25-percent
drop in equities in the second year coupled
with a $41,000 withdrawal for spending
would leave the retiree with less than
$600,000 after the second year. On a thirtyyear time horizon, this retiree would be
looking at funding the next twenty-eight
years using an account balance that is now
40-percent smaller.
This risk of low asset returns early in retirement is commonly known as sequence of
returns risk. Milevsky and Abaimova (2006)
find that returns experienced during the
first ten years of retirement have a larger
impact on retirement income sustainability
than returns experienced over the last
twenty years if the spending rate is established in the initial year of retirement and
remains constant through life. This is
because the portfolio value in each sub­
sequent year is a function of the returns
experienced in all prior years, and because
the rate of spending does not take into
account new information about realized
portfolio returns.
Sequence of returns risk can be mitigated
significantly through the use of a dynamic
withdrawal strategy. A dynamic strategy
allows a retiree to reassess the remaining
portfolio balance and life expectancy over
time. One simple dynamic strategy was
developed by the Internal Revenue Service
as a method of forcing withdrawals from
qualified accounts such as individual retirement accounts (IRAs), and its consideration of remaining longevity as a way of
establishing a target withdrawal rate works
surprisingly well as a general decumulation
strategy.
The required minimum distribution calculation (RMD) computes the withdrawal
rate based on the current portfolio value
and the expected remaining longevity.
Blanchett et al. (2012) find that the RMD
rule is a far more efficient retirement
income strategy than a fixed withdrawal
rate strategy based on the initial portfolio
balance. Taking current wealth and longevity into account when estimating a safe
spending rate reduces the risk of outliving
assets when returns are low and safely
increases a retiree’s lifestyle when returns
are high.
Figure 7 shows how an advisor can implement a dynamic withdrawal strategy such
as the RMD method. At the beginning of
the year, the advisor assesses a client’s
retirement wealth balance. This wealth
balance will be a function of last year’s
balance adjusted for portfolio returns and
the withdrawal amount from the prior year
(and thus can either be larger or smaller
than the prior year). A percentage based
on remaining longevity is applied to the
existing balance to set a safe spending
amount for the coming year. The RMD formula simply sets the withdrawal rate from
current wealth as a function of 1/(target
distribution period), which in figure 7 is
based on the expected individual or joint
longevity. An advisor can also choose to
set the target distribution period based on
the average expected longevity (Blanchett
[2013] suggests life expectancy plus two
years), or a percentile of longevity—for
example, the top fifth percentile.
The trade-off of following a variable spending plan is that real spending from year to
year may vary according to the portfolio’s
volatility. As mentioned previously, in
retirement the volatility of the portfolio
should be viewed in terms of income flexibility. The more flexible the client can be
about the spending, the more risk can be
taken in the investment portfolio. It also
should be noted that a safe portfolio will
provide fewer opportunities for income
growth later in retirement, which may place
the retiree at greater risk that the safe
spending amount will fail to keep up with
spending needs.
The efficiency of the RMD method is
surprisingly similar to a more complex
method developed by Blanchett (2013),
which is more technically precise especially
for time periods greater than fifteen years.
The additional characteristics included in
this estimate are equity allocation, the
target probability of success, and fees.
Equation 1 is a simple formula for estimating dynamic withdrawal rates.
JOURNAL OF INVESTMENT CONSULTING
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
WEALTH MANAGEMENT | An Overview of Retirement Income Strategies
Figure 7: RMD Method Withdrawal Rate by Age
25%
(1)
The formula also provides a means for
clients to better understand the trade-offs
of lifestyle and safety when selecting a
withdrawal rate. A lower level of safety will
increase the optimal withdrawal rate, and
some clients may be more willing to accept
the risk of eventually having to cut back on
spending later in retirement. This concept
of retirement risk tolerance is different than
the concept of risk tolerance in the accumulation stage, which often is conceptualized as the willingness to accept changes in
wealth. In retirement, the purpose of
wealth is spending (or legacy), and variation in financial assets means variation in
lifestyle. A more risk-tolerant retiree will
accept greater variation in lifestyle to
increase the average withdrawal rate.
Incorporating Annuitization
Annuities can provide the dual benefit of
increasing the amount of income that can
be spent each year at a given probability of
success and reducing the consequences for
a retiree who both lives a long life and
experiences very low asset returns.
Economists have long called for greater use
of annuitization in retirement income planning (Mitchell et al. 1999). Annuities provide an easy way to reduce idiosyncratic
longevity risk in retirement, providing
higher levels of spending and security.
Many clients are resistant to annuitization.
By definition, annuitization requires giving
Withdrawal Rate
If, for example, an advisor selected a thirtyyear retirement period, a 50-percent equity
allocation, a 95-percent probability of success, and an alpha of −1 percent (management fees on a zero-alpha portfolio), the
estimated percentage of a portfolio to withdraw would be 3 percent. Reducing the
time horizon to twenty years increases the
withdrawal percentage to 4.5 percent, and
increasing the probability of success to
90 percent raises the withdrawal rate to
4.8 percent.
20%
15%
10%
5%
0%
60
65
70
75
80
85
90
Age
Male
Joint
Female
Figure 8: Illustrating the Comparative Efficiency of Annuitization by Age
Cost of Funding $100,000 in Spending
Percentage of Wealth = 0.195
– 0.037 × ln (Years)
+ 0.0126 × Equity%1/2
– 0.447 × Probability of Success
+ 0.507 × Alpha
$100,000
$90,000
$80,000
$70,000
$60,000
$50,000
$40,000
$30,000
Difference =
Annuity Efficiency
$20,000
$10,000
$0
65
75
Age
Cost of Buying $100,000 Income
up ownership of financial assets to pool
these assets with other retirees. Pooling
assets means that retirees who die earlier
subsidize the spending of those who live
longer lives. This is the essence of mortality
pooling. Guarantees, such as a return of
premium for those who are uncomfortable
with this aspect of mortality pooling, may
be helpful in the adoption of annuities—
but they reduce the income benefit.
A simple way to understand the benefit of
annuitization is to compare the cost of
funding a year of retirement spending using
investment assets or through the purchase
of an annuity that holds comparable assets.
Fixed annuities invest in the equivalent of
long-duration bond assets, so one can
85
95
Mortality Weighted Cost
easily compare the efficiency of funding a
year of income through a bond versus funding a year of income through an annuity.
Figure 8 compares the cost of buying
income using a bond ladder to the cost of
buying income through an annuity at various years in retirement. The example is
independent of annuity or asset management expenses; however, in a competitive
market, annuitization expenses often are
similar to or less than typical asset management fees. As a retiree ages, the increase in
the likelihood of mortality reduces the cost
of purchasing income through an annuity.
For example, among a group of ten males
only one will be alive at age ninety-six,
so they can pool funds to provide the same
VOLUME 17 | NUMBER 1 | 2016
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
27
WEALTH MANAGEMENT | An Overview of Retirement Income Strategies
income at one-tenth the cost. This increase in
the rate of return from investment versus
annuitized assets is known as mortality credits, and mortality credits increase with age.
Annuities may be broadly placed in two
primary categories—immediate or
deferred, and fixed or variable. Immediate
annuities begin making income payments
soon after purchase, but income payments
can be delayed for years or even decades
with deferred annuities. Fixed annuities
pay an income that is established upon purchase, but variable annuities may have a
higher or lower income payment based on
the performance of assets linked to the
product. The most common types of fixed
annuities are single-premium immediate
annuities (SPIAs) and deferred immediate
annuities (DIAs).
An SPIA should be viewed as a bond ladder
that is pooled among retirees. For this reason, an SPIA should replace the bond portion of a retiree’s portfolio in equal dollar
amounts. For example, a retiree who holds
a $1-million portfolio consisting of 50-percent equities and 50-percent bonds should
view a $250,000 SPIA purchase as a component of the bond portfolio. The remaining
investment portfolio should be rebalanced
to contain 67-percent equities ($500,000
equities and $250,000 bonds) to maintain
the same level of risk across the different
types of wealth.
In a comparative analysis of a conventional
non-annuitized investment strategy with an
investment portfolio that substitutes an
SPIA for a portion of the bond allocation,
Pfau (2013) shows that the SPIA reduces the
expected cost of funding a given level of
retirement income. This result is not surprising because an SPIA will provide
income at a lower cost than a bond portfolio, especially later in retirement when mortality credits are high. When placed in the
context of a traditional investment-only
withdrawal strategy, an SPIA will increase
the income that can be drawn from an
aggregate portfolio at a given level of safety.
An SPIA also will provide a higher guaranteed income base if investment assets are
depleted. Mortality credits from annuities
28
increase safe withdrawal rates, and they also
mitigate the consequences of a shortfall.
In an analysis comparing the efficiency of
DIA versus SPIA strategies, Blanchett
(2014) finds that deferred income annuities
are nearly as efficient as SPIA strategies at
today’s annuity prices. As DIA pricing
becomes more competitive, it is possible
that partial-annuitization strategies that
incorporate a DIA will become even more
efficient than the use of an SPIA. This efficiency increase occurs because a DIA provides annuitization income later in retirement when mortality credits are the highest.
DIAs also are appealing behaviorally
because a retiree can purchase a relatively
large amount of income later in life for a
modest up-front annuity expenditure. In
addition to the mortality credit benefit,
changes in regulation now allow DIAs that
meet certain criteria to be purchased from
individual retirement account (IRA)
assets—also known as qualified longevity
annuity contracts (QLACs). Although
QLACs are limited to $125,000, or up to
25 percent of total IRA assets, a male retiree
can purchase more than $40,000 in annual
income that begins at age eighty-five. This
partial-annuitization strategy also allows
the retiree to maintain an equity allocation
that appears similar to a non-annuitized
strategy (in this case 57-percent equities
versus 67-percent equities in the above
SPIA strategy), and retain much of the
annuitization benefit from late-life mortality
credits. QLACs also receive a modest deferral benefit from avoiding required minimum
distributions between age seventy and onehalf up to age eighty-five.
Fixed annuities provide simplicity in structure, but they have two disadvantages. The
first is that they do not provide liquidity
because the retiree pools assets with other
retirees in order to receive mortality credit
benefits. The second is that fixed annuities
commonly invest in bond-like assets that
do not benefit from a risk premium.
Retirees may choose rationally to accept
some risk in their annuitized assets to
increase the possibility of a higher retirement income, accepting the possibility that
the income amount will be affected by the
performance of asset markets. Waring and
Siegel (2015) emphasize the firm-specific
risk of deferred annuities that may begin
making payments decades in the future and
suggest the use of riskless longevity insurance that pools TIPS investments.
In the United States, the most common
type of annuity is a variable annuity with a
guaranteed lifetime withdrawal benefit
(GLWB) rider, which also is commonly
referred to as a guaranteed minimum withdrawal benefit (GMWB) rider. This rider
has a variety of features that make it popular—it provides guaranteed lifetime
income, it allows the annuitant to pass on
the remaining contract account balance to
a beneficiary at death, and it allows the
guaranteed lifetime income payment to
potentially increase if the markets perform
well. In the following section, we briefly
introduce how these products work, discuss
how to think about them in the context of
providing guaranteed income, and provide
insight as to where these products work
best for retirees.
An Introduction to Guaranteed Lifetime
Withdrawal Benefit (GLWB) Annuities
Variable annuities with a GLWB rider (or
GLWB annuities) provide guaranteed
income for life for the annuitant. The
income received by the annuitant is based
on some guaranteed percentage (also
known as the lifetime distribution factor) of
the benefit base, as described below. The
lifetime distribution factor is a percentage
value that defines the amount of income
that will be received and is based on when
the annuitant starts receiving benefits.
Distribution factors vary across providers,
but 5 percent is a common distribution factor for a sixty-five-year-old single individual
(male or female) and 4.5 percent would be a
common distribution factor if the youngest
member of the couple is age sixty-five.
The actual income received by the annuitant
is determined by multiplying the distribution factor by the benefit base. The benefit
base is a shadow account that is used to
determine benefits and is not a value that
can be cashed out by the retiree. The benefit
JOURNAL OF INVESTMENT CONSULTING
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
WEALTH MANAGEMENT | An Overview of Retirement Income Strategies
At death, any remaining contract value in
the GLWB annuity would be paid to the designated beneficiary. Even if the value of the
GLWB annuity portfolio drops to zero
during the annuitant’s lifetime, the annuitant
is still guaranteed lifetime income. This concept is displayed visually in figure 9, where
the income increases based on the strong
initial performance, then stays constant after
age seventy-three as the contract value falls
below (and stays below) the benefit base.
Because an annuity is a form of insurance,
and insurance companies tend to be relatively good at pricing risk, the average person should not expect to be better off with
an annuity than if he or she were to try and
fund retirement income from a pool of
assets. Therefore, the true question when
determining if a GLWB annuity is a good
product for a retiree is whether the benefits
received by the annuitant are worth the
cost, which can be estimated by the potential income received from a portfolio without an embedded guarantee.
A GLWB rider only pays off if two things
happen. First, the underlying portfolio
within the variable annuity no longer must
Figure 9: Example of Contract Value, Benefit Base, and Income Growth for
a GLWB Annuity
$200,000
Value
$150,000
$100,000
$50,000
$0
65
70
75
80
Age
Contract Value
85
90
95
Benefit Base
$10,000
Value
base is equal to the current annuity contract
value or the maximum contract value at each
of the previous policy anniversary dates. For
example, if a male retiree age sixty-five
invested $100,000 in a GLWB annuity and
received a lifetime distribution factor of
5 percent, he would be guaranteed income
of at least $5,000 per year for life from the
annuity ($100,000 × 5 percent = $5,000).
If the annuity portfolio value were to increase
to $110,000 on the second anniversary date,
the benefit base would step up to $110,000
and the guaranteed lifetime income amount
would increase to $5,500 ($110,000 × 5 percent = $5,500). If the portfolio value were to
fall to $90,000 the following year and never
again exceed $110,000 in value, the guaranteed withdrawal amount would still be
based on the high-water-mark value for the
annuity, which was $110,000. Therefore the
annual income generated from the GLWB
annuity would be $5,000 in year one and
$5,500 in year two and until the annuitant
passes away.
$5,000
$0
65
70
75
80
Age
Annual Income
85
90
95
Figure 10: When a GLWB Annuity Adds Value
VA Equity Allocation
Less Annuity
More Annuity
Less Aggressive
More Aggressive
Risk Tolerance
High
Low
Age
Older
Younger
Life Expectancy
Lower
Higher
Fees
Higher
Lower
Income Need
Lower
Higher
n/a
n/a
Bequest Preference
be able to sustain the withdrawal and, second, the annuitant must still be alive.
Blanchett (2011) estimated the chances of
actually realizing the value to be relatively
small, approximately 8 percent; however,
the cost is also quite small, representing
approximately 7 percent of the initial purchase price.
One thing that tends to reduce the relative
cost of a GLWB annuity is that it allows the
annuitant to take on more market risk than
if the guarantee had not been available.
Because the GLWB rider guarantees some
minimum level of income, retirees tend to
be more comfortable investing in equities
within the variable annuity. For example,
Milevsky and Kyrychenko (2007) note that
annuitants who are age sixty-five and older
with income guarantees have equity allocations that are approximately 20 percent
higher than those without.
Determining whether or not a GLWB annuity is right for a retiree is a complex decision
based on a host of factors. Xiong et al.
VOLUME 17 | NUMBER 1 | 2016
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
29
WEALTH MANAGEMENT | An Overview of Retirement Income Strategies
(2011) and Blanchett (2012), among others,
have explored GLWB annuities and determined certain factors that should be considered when purchasing a GLWB annuity.
These factors are noted in figure 10. For
example, a conservative retiree who has a
longer-than-average life expectancy who
can purchase a GLWB annuity with lowerthan-average fees is likely to benefit more
from a GLWB annuity than an aggressive
retiree with a shorter-than-average life
expectancy who can purchase a GLWB
annuity only with above-average fees.
Traditional withdrawal-rate methodology
assumes a fixed, inflation-adjusted withdrawal amount to fund retirement spending. A more-efficient method will vary
spending based on remaining longevity and
account balance. A dynamic withdrawal
strategy can increase spending if a retiree
receives high market returns and can
reduce the risk of outliving assets when
markets underperform. To implement a
dynamic strategy, a retiree must have the
budget flexibility to increase or decrease
spending over time.
Variable annuities with GLWB riders are a
relatively new way to create retirement
income for retirees. Although they are
complex products, they offer an innovative
way to provide guaranteed income for retirees that may be attractive to some clients.
Determining whether or not a GLWB
annuity is best for a retiree is a complex
decision but a worthwhile exercise, especially for retirees looking to annuitize some
of their wealth.
Annuitization can reduce the expected cost
of funding income in retirement and reduce
the risk of a shortfall by providing a higher
base of lifetime income. Fixed annuities can
be substituted for bond investments within
a conventional portfolio and allow the
retiree to increase the safe withdrawal rate.
Deferred annuities may be more efficient at
providing guaranteed income because they
provide mortality credits during later years
when annuitization provides the greatest
value. Variable annuities with a guaranteed
lifetime withdrawal benefit provide access
to a risk premium that can increase income
and also give a retiree access to an account
balance that provides liquidity early in
retirement. Conclusion
Implementing a retirement income strategy
involves considering a host of unknown
factors including asset returns, inflation,
spending, and, most importantly, the retiree’s possible lifespan. Simple asset allocation strategies that were appropriate in the
accumulation stage of the life cycle may be
less appropriate in the decumulation stage.
Creating an appropriate withdrawal and
investment plan involves weighing the costs
and benefits of various products and lifestyle factors.
A non-annuitized investment strategy will
focus on maintaining a withdrawal rate that
balances lifestyle with the risk of outliving
assets. Risky assets increase the variation of
wealth outcomes, and the acceptance of
investment risk should be viewed as acceptance of a greater potential variation in
income and terminal wealth values. Safe
assets provide security for shorter time
horizons but increase the risk of shortfall
later in life unless the individual lives frugally in retirement.
30
Michael Finke, PhD, CFP®, is a professor and
director of retirement planning and living in
the personal financial planning department
at Texas Tech University. Contact him at
[email protected].
David Blanchett, CFA®, CFP®, is head of
retirement research at Morningstar
Investment Management. Contact him
at [email protected].
Acknowledgment
This study was funded by a grant from
Investment Management Consultants
Association® (IMCA®).
Endnote
1. For an excellent discussion of the use of TIPS
within a dynamic spending strategy in which retirees
incorporate both current rates of return and expected
longevity, see Waring and Siegel (2015).
References
Bengen, William P. 1994. Determining Withdrawal Rates
Using Historical Data. Journal of Financial Planning 7,
no. 4 (October): 171–180.
Blanchett, David M. 2011. The Expected Value of a
Guaranteed Minimum Withdrawal Benefit (GMWB)
Annuity Rider. Journal of Financial Planning 24, no. 7
(July): 52–61.
———. 2012. Optimal Portfolio Allocations with GMWB
Annuities. Journal of Financial Planning 25, no. 10
(October): 46–56.
———. 2013. Simple Formulas to Implement Complex
Withdrawal Strategies. Journal of Financial
Planning 26, no. 9 (September): 40–48.
———. 2014. Determining the Optimal Fixed Annuity for
Retirees: Immediate versus Deferred. Journal of
Financial Planning 27, no. 8 (August): 36–44.
Blanchett, David M., Michael Finke, and Wade D. Pfau.
2014. Asset Valuations and Safe Portfolio Withdrawal
Rates. Retirement Management Journal 4, no. 1
(spring): 21–34.
Blanchett, David, Maciej Kowara, and Peng Chen. 2012.
Optimal Withdrawal Strategy for Retirement-Income
Portfolios. Retirement Management Journal 2, no. 3:
7–20.
Bosworth, Barry, and Kathleen Burke. 2014. Differential
Mortality and Retirement Benefits in The Health and
Retirement Study, Brookings Policy Abstract. http://
www.brookings.edu/research/papers/2014/04/differential-mortality-retirement-benefits-bosworth.
Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz.
1998. Retirement Savings: Choosing a Withdrawal Rate
that is Sustainable. Journal of the American Association
of Individual Investors 20, no. 2 (February): 16–21.
Finke, Michael, Wade D. Pfau, and David M. Blanchett. 2013.
The 4 Percent Rule Is Not Safe in a Low-Yield World.
Journal of Financial Planning 26, no. 6 (June): 46–55.
Finke, Michael, Wade Pfau, and Duncan Williams. 2012.
Spending Flexibility and Safe Withdrawal Rates.
Journal of Financial Planning 25, no. 3 (March): 44–51.
Milevsky, Moshe A., and Vladyslav Kyrychenko. 2007.
Asset Allocation and Guaranteed Living Benefits in
Variable Annuities. http://www.ifid.ca/pdf_workingpapers/WP2007JUNE28_AAVA.pdf.
Milevsky, Moshe, and Anna Abaimova. 2006. Risk
Management during Retirement. Chapter 9 in
Retirement Income Redesigned: Master Plans for
Distribution, edited by Harold Evensky and Deena
Katz, 163–184. New York: Bloomberg Press.
Mitchell, Olivia, James Poterba, Mark Warshawsky, and
Jeffrey Brown. 1999. New Evidence on the Money’s
Worth of Individual Annuities. American Economic
Review 89, no. 5 (December): 1,299–1,318.
Pfau, Wade D. 2013. A Broader Framework for
Determining an Efficient Frontier for Retirement
Income. Journal of Financial Planning 26, no. 2
(February): 44–51.
Waldron, Hillary. 2007. Trends in Mortality Differentials
and Life Expectancy for Male Social Security-Covered
Workers, by Average Relative Earnings. ORES
Working Paper No. 108. https://www.ssa.gov/policy/
docs/workingpapers/wp108.html.
Waring, M. Barton, and Laurence B. Siegel. 2015. The
Only Spending Rule Article You Will Ever Need.
Financial Analysts Journal 71, no. 1 (January/
February): 91–107.
Xiong, James X., Thomas Idzorek, and Peng Chen.
2011. Allocation to Deferred Variable Annuities with
GMWB for Life. Journal of Financial Planning 23, no. 2
(February): 42–50.
Yaari, Menahem. 1965. Uncertain Lifetime, Life Insurance,
and the Theory of the Consumer. Review of Economic
Studies 32, no. 2 (April): 137–150.
JOURNAL OF INVESTMENT CONSULTING
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
I N T E R N AT I O N A L
5619 DTC Parkway, Suite 500
Greenwood Village, CO 80111
Phone: +1 303-770-3377
Fax: +1 303-770-1812
www.IMCA.org
© 2016 Investment Management Consultants Association. Reprinted with permission. All rights reserved.
IMCA® and INVESTMENT MANAGEMENT CONSULTANTS ASSOCIATION® are registered trademarks of Investment Management Consultants Association Inc.
CIMA®, CERTIFIED INVESTMENT MANAGEMENT ANALYST®, CIMC®, CPWA®, and CERTIFIED PRIVATE WEALTH ADVISOR® are registered certification marks of Investment Management Consultants Association Inc.
Investment Management Consultants Association Inc. does not discriminate in educational opportunities or practices on the basis of race, color, religion, gender, national origin, age, disability, or any other characteristic protected by law.