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Advice
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Wade Pfau Answers Questions From May 18 A4A Webinar |
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Sunday, May 20, 2012 03:53
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As there were many questions and not enough time, I agreed to write up a blog post to answer questions posed during the webinar. Here it is:If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now |  |
Q: Comment on idea of drawing down assets on purpose anticipating "spend
rate" decreasing. Also comment on how Long-term care impacts.
The basic 4% rule indicates that you use a constant inflation-adjusted withdrawal amount throughout the entire 30 year period. But I have recently explored two reasons why people might decrease spending as they age. First, as I investigated at Advisor Perspectives in " How Do Spending Needs Evolve During Retirement?", people may naturally spend less as they slow down at later ages. Second, it is rational to plan to intentionally reduce spending since the probability of survival decreases with age. Both of these links explain how this allows for more spending earlier in retirement. Long-term care is the great unknown, though. The first link addresses that. How to properly plan for large and uncertain health expenses is an important issue in need of more research.
Q: With most respectiable estimates for stock and bond returns for the
next 7-15 years being in the low single digits maybe mid at best net of
inflation its painfully obvious 4% won't work. How does your research
account for projected returns on various asset classes which
historically over long periods of time is fairly easy to estimate?
Usually, research is based on the historical data. In the presentation, I did discuss two more alternatives considered in Joseph Tomlinson's work. These are to adjust bond returns to match current bond yields, and to assume a lower forward-looking equity premium. These assumptions do cause a substantial increase for the failure of the 4% rule as shown in the presentation.
Q: Great presentation! Doesn't this make a case for equity-indexed
products with income riders? I've never used them before but have been
considering as of late.
I will return to this question again later. I need to study equity indexed annuities more before I can provide a suitable answer.
Q: in terms of a retirement saver's asset allocation, does it ever make
sense to consider the present value of their social security payments as
a "government bond" in their overall retirement asset allocation?
Yes, I think so. Retirement income strategies should be based on a retiree's human, social, and financial capital, not just financial capital. So you can think of Social Security as sort of like a bond. Alternatively, in matching assets to liabilities, Social Security provides a good match for basic needs, which allows for a more aggressive asset allocation to meet discretionary needs. This is another way of developing the same sort of point.
Q: i follow wade's blog, and based on his research and his summaries of
other advisors' research, it seems like (at the end of the day), a
withdrawal rate in the 3-4% range is usually the "answer." have we seen
enough research to generally agree that range is "okay"?
3-4% is in the range of what is supposed to be safe in a worst-case scenario. It is not the average outcome. I have come to think that the floor/upside approach has a lot of potential for retirement. 3-4% should typically work out, but there is no guarantee and it is important to at least have your basic needs met, no matter the outcome. After all, as RMA curriculum board member Mike Zwecher wrote, retirees "only get one whack at the cat."
Q: In a previous webinar-I believe last year-you had a speaker
discussing MPT and highly diversified strategies whose returns would
have more than provided for a 4% SWP, even starting in adverse
environments. Isn't this therefore too simplistic and doesn't take into
account the ability of advisors and managers to outperform eoither on an
absolute or on a risk-adjusted basis.
This research assumes that people earn the returns provided by the market indices, and my Monte Carlo simulations assume a symmetric sort of distribution for market returns. If you develop a strategy that supports higher returns, lower volatility, or less downside risk than the underlying indices, then your abilities can be used to support a higher withdrawal rate. If you do think you can provide this superior outperformance, I do suggest that you take up Bob Seawright's Active Management Challenge.
Q: Guaranteed Annuities with Living Benefits solves most of the issues
you raise!
Yes, they are designed to provide downside protection and upside potential all in one convenient package. Given their potentially high fees, I wonder if keeping these goals separate (such as with partial annuitization with a SPIA for a floor and a diversified portfolio for the upside) may still be a better approach for retirees. But you do raise an interesting point.
Q: Wade - Review Moshe Milefshiy's maretials
Moshe Milevsky is great. I once wrote that he is The Simpsons of the retirement planning research world. There is a famous episode of South Park in which Butters tries to bring disarray to the town of South Park. But for every evil scheme he considers, it turns out that The Simpsons already had a plot point about the same thing. In the case of retirement planning, Moshe Milevsky has already done it all. I did review his book, Pensionize Your Nestegg (Part 1 and Part 2). He has some new books coming out this year, and I will be sure to review those too.
Q: How does the intergration of Alternative Assets figure in to your
analysis?
Q: Thanks Wade! very interesting perspective and analysis. I like the
use of Monte Carlo to show clients how their spending might turn out.
Thanks.
Q: Do I unerstand then that teh client needs to plan to have
guarantees through pensions and annuities , but inflation reduces
value by 50% over 30 years. and discretionary returns may not have
continued well.
Yes, inflation risk is one of the big three risks retirees face, in addition to longevity risk (outliving assets) and sequence of returns risk. Inflation-adjusted SPIAs for flooring and building a TIPS ladder are two ways to deal with this.
Q: but what if the goal is to use up teh wealth in life. If I live 30
years , if Ilive 40 years, how much can I take from my accounts each
year using averages and having nothing left ?
In general, withdrawing a constant inflation-adjusted amount over retirement is not an optimal strategy. If you do not want to annuitize and do not worry about leaving a bequest, you could use a strategy such as withdrawing ( 1 / remaining life expectancy ) each year. This could cause your withdrawals to fall to uncomfortably low levels if we experience bad market returns, but it will help to make sure your wealth is getting used up.
Q: What are the ending wealth values for your MC alternative to the
Trinity Study?
Q: then you include admin fees and advisor fees and a retiree can not
take any money out of the portfolio?!
Yes, this is a problem. You can see about the impact of fees (which more generally represents underperformance from the indices... if managers produce alpha to counteract their fees, then this issue doesn't apply) in Figure 9 on page 17 of my article "Capital Market Expectations, Asset Allocation, and Safe Withdrawal Rates." Just follow the links for a free PDF download of the article.
Q: Have you considered the effects of a "diversified" portfolio over
these time periods? Does it make a difference? Small quibble, but I
would have to disagree that Social Security is guaranteed.
Social Security will need to have some cuts at some point, so your point is well taken. Nothing is truly guaranteed.
Q: Talk more about bond laddders as a hedge.
Q: Don't TIPs lack deflation protection?
You can't lose the real value of your principal if there is deflation. I'm not sure what you are getting at with the question. Are there other assets that will perform better with deflation? Maybe, and deflation could cause TIPS prices to fall for those who want to sell before the maturity date. But the idea is to hold the TIPS to their maturity date and not try to actively trade them. In this regard, you don't have to worry about deflation.
Q: How would you measure the maximization ultilization of assets on an
individual client basis? Asset optimization strategy measurements?
I'm sorry, I'm not sure, but I think your question might be getting at: how do we define the proper utility function for individual clients? It is hard. But as I explain in "Spending Amounts vs. Spending Value," it is impossible to avoid the idea of utility and just doing something which incorporates diminishing returns from additional spending may do a lot to help us get better solutions, even if the exact preferences of the individual cannot be modeled. I think this is becoming an active area for research in financial planning now with work by Joseph Tomlinson and by students and professors at Texas Tech University. Dick Purcell, who hates the over-mathematization of utility maximization, did suggest that the figures I showed in this blog entry do provide the type of info retirees could use to figure out their preferences.
Q: What did you mean when you said that using corporate bonds, as in the
Trinity study, caused more failueres? Is that because of behavioral
issues -- investors selling due to volatility?
No, it is not because of behavioral issues. The research assumes that people do not make mistakes, and that they stick to the chosen asset allocation. The issue is that corporate bonds are more volatile than intermediate-term government bonds, and this volatility causes slight increases in failure rates. Safe withdrawal rates are a delicate balance between return and volatility, and in this case the extra return from the corporate bonds was not enough to compensate for the extra volatility.
Q: What's you opinion about using scenario planning to comes up with return
and risk inputs on asset clases? Any system for economic scenario
analysis that you like? Have you designed one? Windham Capital's Mark
Kritzman came up with one and spoke about it at one of my webinars. It's
an interesting approach for making assumptions about the future.
(Kritzman manags about $35B and wrote the quant portin of the CFA exam.
Let me know if I can make an introduction to get you a look at his
software.)
This sounds interesting and potentially useful. Yes, I'd be happy to learn more. Thanks.
Q: One really important thing you said was that asset allocation is not
that important for retirees. Please explain. And try to include some
idea of what that means for advisors.
In terms of downside protection, there are a wide range of stock allocations that end up doing just about as well as one another. That showed up in Figure 2.3 and Table 2.3 of my presentation. In terms of upside, more stocks provides more upside potential.
What might this mean for advisors? I hadn't thought about that much, but let me try to provide a quick answer. Perhaps one area is that advisors can focus on other issues (such as building a floor, dealing with some of the emotional aspects of the retirement decision, etc.) with their clients and not get overly worried about choosing a perfect asset allocation.
You mentioned to previous articles that you wrote. Can we provide them
on A4A?
Thanks for that question. I do maintain my Retirement Researcher blog where I will surely provide a link to anything I write in the future. Please consider an email subscription to it (it's free). I am also a monthly columnist at Advisor Perspectives. I put a lot of effort into those columns and sometimes they are mini-research articles. The archives can be found here. And as for research articles, I have them all listed at my university webpage. Most of my retirement planning research is near the top of the list.
Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan, and the curriculum director for the Retirement Management AnalystSM designation program. He maintains a blog about retirement planning research at
wpfau.blogspot.com
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For Financial Planners, This Is One The Most Important Stories Of The Year |
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Saturday, May 19, 2012 18:18
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Tags: advisor industry people | investing for income | investment strategies | retirement income | retirement planning | social security | stress test Wade Pfau on Friday explained why the 4% “safe” withdrawal rate being relied on by many of the nation’s top financial planning professionals may not really be so safe for retirees. An understanding of Pfau’s analysis probably should be required of all financial advice professionals.
Pfau’s presentation, which can be viewed by all members of A4A, succinctly reviews the groundbreaking research by William Bengen, a CFP practitioner who in 1994 began publishing on safe withdrawal rates for retirement portfolios and continues to publish on this topic. However, Pfau tweaks Bengen’s assumptions how much retirees are likely to allocate to stocks and examines the issue in the context of the experience of other developed nations to assess the 4% assumption.
The news is sobering; Pfau finds a 3.2% rate to be safe.
If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
But whether you agree with Pfau’s conclusion is not so important. What is important for financial advice professionals is understanding Pfau’s methodology and reasoning, so that you can come up with your own view of a safe withdrawal for retiree portfolios you are designing.
And that’s what makes Pfau’s presentation so valuable. He is a great teacher. He connects the dots in complicated statistical analysis to make the topic easy to understand.
Below are comments from 107 attendees who took the time to rate Pfau’s session and gave him an average rating of 4.4 out of 5, which amounted to about half of those who attended, and many other planners will view A4A replay, download the slides and receive CFP and CIMA CE credit for watching it. (Incidentally, while the 4.4 rating is high for any A4A speaker, the fact that Pfau did not get an even higher rating tells you about how demanding and difficult independent advisors are.)
Pfau, who recently joined the Retirement Industry Income Association as director of curriculum for the Retirement Management Analyst designation, is a thought leader whose research in the years ahead is sure to have significant influence on financial planners, insurance agents, CPAs, investment advisors, wealth managers, product manufacturers, and other segments of the financial advice industry. While I was initially skeptical about the confusion that adding yet another professional designation might cause for consumers, the fact that Pfau — an academic with no interest in selling product or protecting the provinces that have long characterized the financial advice business — has associated himself with RIIA has made me a believer.
- Excellent recap of the history of SWRs addressed from several perspectives, and possible ways to address this issue going forward... Pfau did an outstanding job. Despite reading most of his papers this webinar helped me focus my thoughts on the big picture... Thank you Wade, and please continue your most outstanding work... BTW it was your Twitter feed which brought me here today.
- This is one of the most valuable webinars, if not the most, I have ever attended. There was too much data for an hour but it was very well done.
- Sobering reality check on withdrawal rates.I'm depressed now
- One of your best guests. Thank you.
- Great !
- Very good, quite technical. How about tying in a future webinar that will provide some input on how to solve for the scenarios that were discussed.
- Excellent.
- Great content.
- Very important topic.
- Not too much in that safe withdrawal rates depends on assumed future returns, which are anyone's best guess.
- No new news. Good education value for income planning
- Great topic, graphics were well down, Wade Pfau is outstanding.
- I enjoyed it.
- This was great well-paced and easy to follow Wade's explanations.
- Really made me think about shifting to a more conservative withdrawal approach for folks soon to retire.
- Very timely! Rich data...this was great. Thank you for asking my question about equity-indexed annuities, too. I've been driving myself crazy with this issue all week.
- Helpful. Good topic.
- The presentation was purely theoretical , but the data gives professionals data means to construct plans.
- Excellent
- Great insights challenging conventional wisdom. Gives me something to think about.
- Best presentation of the year!
- I think it was great. Spending policy is key to our business and advising clients. I think it requires researching and reading a number of different studies to have conviction in our advice. Wade's presentation is one of those sources.
- Please note my question relating to a previous webinar and MPT approaches. This is an extremely complex question, and although this is very helpful, in the real world it is too simplistic.
- great challenge to a long held belief that 4% was always a safe rate of withdrawal
- Great
- Great synopsis of where we've been and why it's probably not adequate. Really like the idea of building the floor. Wish it was cheaper to build a ladder with TIPs! No interest-related investments or products are particularly attractive right now that I know of, including immediate annuities. Best deal is Soc Sec, but will that be pulled out from under us with changes to COLAs, etc.? Fascinating time to be a planner.
- Makes one think about the proper withdrawal rate for retirees....know a lot depends on client's guaranteed income floors (soc sec, pensions, annuities). It also makes one reconsider what rate is sustainable for clients with a low guaranteed income floor. And, good point in assuming that historical data is relevant to today's economics...i.e., has the US ever had this much debt, the number of people on government subsidy payments (be it soc sec, Medicaid, welfare) in comparison to those that pay taxes).
- Lots of data to wade through and not sure sufficiently clear conclusions. Was difficult to stay engaged but the subject is so important that it was worth listening closely. Questions and Answers helped clarify his approach. Thank you Andy.
- Excellent this is the next frontier of financial planning.
- Incredible number crunching and displayed in an understandable fashion
- I like this approach on Friday afternoons.
- This was great
- Great research, very provocative but right on the point. I couldn’t agree more with Wade Pfau's conclusions.
- Good information but presentation was a bit weak. Would love to get a copy of the slides to study a little more?
- Interesting to see Dr. Pfau's model. I'd like to see him explore the final observation he made regarding the Retiree 2000 Vintage and look at where this cohort is now on average, and re-setting the study for a new, 18-year rollout.
- Content was excellent. Wade needs to speak a little louder as sometimes he is hard to understand. Great content overall. Thank you.
- Very interesting analysis. Offers a more realistic withdrawal rate for today's world.
- Very interesting methods for analyzing withdrawal rates. Thanks!
- Very informative.
- Really great!
- This was a terrific presentation; I appreciated the different views and approaches to the data. A little too academic, but excellent data and perspective. The big question is how do I use the info in a practical way?
- This was a superb webinar. Please do more and thank you!
- Seemed flimsy rationale. Pfau not fully aware of products (i.e. equity indexed annuities)
- Great!
- Excellent and scary I have no idea now what to plan for retirementexcept plan to pray
- Less Andy, more Wade
- A good challenge to typical planning advice and sorely needed. One of the best A4A webinars so far.
- Hit it out of the park!
- Wade provided much to think about indeed. Impossible to thoroughly cover this topic in an hour but he maximized his use of time well nevertheless.
- Timely
- Great background/illumination regarding 4% withdrawal rate. Began to wander a little as we started to discuss why that may no longer be appropriate, but the idea of the floor came through loud and clear.
- Super
- Very timely
- Excellent!
- GREAT content. Very thought provoking.
- Repetition by the presenter caused the presentation to progress painfully slowly, but the information was informative.
- A little complicated.
- Relevant content, outstanding presenter
- Very thought provoking.
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Wade Pfau on a Preview of the May 18 A4A Webinar at 4pm |
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Friday, May 18, 2012 06:20
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If the long-term average real return from the stock market is 7%, does that mean one can safely use a 7% withdrawal rate from a 100% stocks portfolio without worrying about running out of wealth or even dipping into the original principal? The answer is No. But answering yes is a common mistake; one which William Bengen set out to dispel.If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
Stocks do not earn their average real return each year. Some years they go up, and some years they go down. For a retiree who is withdrawing from their savings, the sequence of returns matters. If the market value of one’s assets falls in the early retirement period, then withdrawals will dig a further hole. Climbing out of this hole becomes increasingly difficult even if a subsequent recovery arrives. This is the sequence of returns risk.
William Bengen’s seminal study in the October 1994 Journal of Financial Planning, “Determining Withdrawal Rates Using Historical Data,” helped usher in the modern area of retirement withdrawal rate research by codifying the importance of sequence of returns risk. The problem he set up is simple: a new retiree makes plans for withdrawing some inflation-adjusted amount from their savings at the end of each year for a 30-year retirement period. What is the highest withdrawal amount as a percentage of retirement date assets that with inflation adjustments will be sustainable for the full 30 years?
To answer this question, he obtained a copy of Ibbotson Associates’ Stocks, Bonds, Bills, and Inflation yearbook, which provides monthly data for a variety of U.S. asset classes and inflation since January 1926. He decided to investigate using the S&P 500 index to represent the stock market and intermediate-term government bonds to represent the bond market.
His exceedingly clever trick was to construct rolling 30-year periods from this data. He could consider a retirement lasting from 1926 through 1955, then 1927 through 1956, and so on. This technique is called ‘historical simulations.’ For each rolling historical period, he could calculate the maximum sustainable withdrawal rate. Though he did not produce the following illustration for his article, what he would have been looking at in his spreadsheet is something like this:
To bring greater realism to the discussion of safe withdrawal rates in retirement, he then focused his attention on what he called the SAFEMAX. It is simply the highest sustainable withdrawal rate for the worst-case retirement scenario in the historical period. With a 50/50 allocation for stocks and bonds, the SAFEMAX was 4.15%, and it occurred in 1966. That is the impact of sequence of returns risk. 4% turned out to be a much more realistic number than 7%. It was from these humble origins that the world of financial planning received the 4% rule.
[Note: I am following the same assumptions as in Mr. Bengen’s original research, except that I deduct withdrawals at the start of each year rather than the end of each year. I do think this is more realistic, and since it results in less time for assets to grow, withdrawal rates are slightly less with this assumption. My SAFEMAX is 4.04%.]
One other important issue coming out of William Bengen’s original study is asset allocation. In particular, Mr. Bengen recommended that retirees maintain a stock allocation of 50-75%. More specifically, he wrote, “I think it is appropriate to advise the client to accept a stock allocation as close to 75 percent as possible, and in no cases less than 50 percent.”
I will have a lot more to say about asset allocation (as well as about the 4% rule), and this stock allocation does sound rather high with respect to what we usually hear is reasonable for retirees. It is particularly poisonous to the ears of advocates of a safety-first retirement planning approach such as Zvi Bodie. But for now, let’s understand from where the 50-75% stock allocation recommendation comes.
One starting point to think about this is to consider Figure 2.2, which shows the time path of maximum sustainable withdrawal rates for different asset allocations. It’s hard to see exactly what is going on in the 1960s, but the general idea is that higher stock allocations tended to support higher withdrawal rates with little in the way of downside risk. I mean, the SAFEMAX does not appear to be that much lower with higher stock allocations.
This point can be seen more clearly in Figure 2.3, which shows the SAFEMAX across the range of stock allocations. Low stock allocations resulted in lower SAFEMAXs, with an all-bonds portfolio even falling below a 2.5% SAFEMAX, but there appears to be a sweet spot between about 35% stocks and 80% stocks in which higher stock allocations have no discernable impact on the SAFEMAX. A 4% withdrawal rate tended to work no matter what stock allocation is chosen in this range. On the downside, retirees would have been just as well off with 80% stocks as with 35% stocks.
So why then did William Bengen recommend 50-75% stocks? The answer lies in Figure 2.4, which shows the median remaining real wealth after 30 years as a multiple of retirement date wealth. In this figure, we can see a general upward trajectory in remaining wealth as the stock allocation increases. In the average case, retirees using at least 45% stocks would have found that their entire initial principal had remained intact, even after adjusting with inflation! And with higher stock allocations, wealth tended to continue to grow more and more in the average case. So while Figure 2.3 showed that there was little in the way of downside with higher stock allocations, Figure 2.4 shows that there was a whole lot of upside available with higher stock allocations. This is the source of Mr. Bengen’s recommendation.
Finally, one other way to look at this is found in Figure 2.5. For different stock allocations, I plot not only the SAFEMAX, but also the median sustainable withdrawal rate and the best-case scenario sustainable withdrawal rate. This is another way to see the same point: with higher stock allocations, sustainable withdrawal rates tended to rise, but even the worst-case scenario held their ground even with a more volatile stock allocation.
Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan, and the curriculum director for the Retirement Management AnalystSM designation program. He maintains a blog about retirement planning research at
wpfau.blogspot.com
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Wade Pfau On Why Economists See an Annuity Puzzle |
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Monday, May 14, 2012 03:54
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Economists are known for describing the annuity puzzle. The puzzle is: why do people not purchase income annuities (exchange a lump sum payment for a guaranteed lifetime income stream) to the extent predicted by economic theory? If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
A number of explanations have been offered. Today I will not get too much into the explanations for the puzzle. Instead, I want to focus carefully on the theory behind why the “annuity puzzle” is said to exist in the first place.
Economists describe the annuity puzzle as a problem of maximizing lifetime expected utility. “Utility” can be off-putting, and I am not going to show any mathematical equations. I will focus on the intuition, and what is essential here is getting a good definition for the value provided by spending. Rather than looking directly at the level of spending, economists look at the value it provides, noting that additional spending provides diminishing increases in value. I reviewed these concepts in “Spending Amounts vs. Spending Value.”
For the basic model, one assumption is that people don’t care about leaving bequests (one explanation for the annuity puzzle, then, is that people don’t like to annuitize all of their assets because they want a chance to bequeath something). This means, they don’t mind exchanging all of their wealth at retirement for a guaranteed income stream for life.
For the basic model as well, there is no investment risk. Financial markets are simplified to one asset which always and forever provides the same return. This return is fixed. For non-annuitized assets, your portfolio of remaining wealth earns this fixed return each year. The annuity provider can also earn this return, and so the annuity payout rate incorporates this return as well as the return of principal.
Of course the assumption of a fixed return is not realistic. But the purpose of building models is to simplify reality in ways that still allow us to make some sense out of reality. By using this simplified assumption about asset returns, we can narrow in on the implications of having an uncertain lifespan.
The annuity provider also provides mortality credits. This gets to the heart of the uncertainty in the model. The uncertainty is longevity risk. The retiree doesn’t know their age of death. However, this is a known unknown, in the words of Donald Rumsfeld. That is, retirees and the annuity provider both know the probability distribution for the age of death, and the probability of survival to each subsequent age past 65. Individuals can’t self-insure to protect from this longevity risk. If they don’t annuitize, they have no chance but to plan for a long lifespan. On the other hand, the annuity provider can pool longevity risk across a large population of customers, and those who die earlier than average subsidize later payments to those who live longer than average. Because the annuity provider can pool the longevity risk, they are able to make payments at a rate much closer to what would be possible when planning for remaining life expectancy, rather than planning for a much longer horizon. Annuities should not be thought of so much as an investment, but rather as insurance to protect against running out of wealth while still alive.
I will assume retirement date wealth of $100. This amount doesn’t impact the results. I assume a male retiree at 65 and use the Social Security Administration 2007 Period Life Tables to obtain survival rates past this age. These survival rates for males can be seen in the following figure. Results will differ by age, gender, and mortality data source, but the basic principles will remain the same. I assume a maximum possible retirement length of 35 years, so no retirees live past 100. This doesn’t have much effect, since the probability of a 65 year old male living past 100 is less than 1%.
At retirement, retirees choose their annual spending amounts for ages 65-100. Since they know the future investment returns, this is easy to do. They don’t know how long they will live, but they can decide on how much they will spend each year should they still be alive. There are 4 factors which impact the decisions about the future spending path:
1. Survival probabilities: Since the probability of survival decreases over time, retirees have an incentive to increase spending early in retirement relative to late in retirement. Earlier spending is more likely to actually happen and so it receives a larger weighting in the function that adds up the lifetime value of spending. Higher survival probabilities will reduce annuity payout rates and help push more spending from early to later retirement.
2. The investment return: A higher investment return supports a higher annuity payout rate. As well, knowing that your remaining portfolio will grow at a faster rate allows you to spend at a higher rate earlier in retirement, and also pushes you to delay spending to later in order to leave more wealth in your portfolio to grow at the higher rate and allow for more lifetime spending.
3. The retiree’s impatience: A factor which also impacts retirees separate from survival probabilities is how impatient they are to spend. If the discounting to future spending caused by impatience is greater than the future investment return, then retirees have a strong incentive to shift spending to earlier in retirement. Likewise, more patient retirees who can get a larger return than the discounting from their impatience are willing to delay spending so that their wealth can grow more and they can spend more later on.
4. Risk aversion: This is the technical name for a key parameter in the utility function. It describes the shape of the curve which defines the value of spending. Lower numbers imply a less steep curve so that retirees do get more value from spending and have a greater willingness to increase spending at the expense of future reductions. Higher numbers imply that retirees really get hurt by less spending and this overwhelms the additional gains from more spending early on. In the context of retirement and in describing spending in terms of value, I think we should rename risk aversion as spending flexibility. A small number means the retiree is flexible! They can let their spending fluctuate more as the interaction of the other 3 factors warrants. A larger number provides a stronger push toward consumption smoothing, as retirees care less about upside and really wish to maintain as high of spending as possible in worst-case scenarios.
The Results
In order to keep this short, I think we can see lots of interesting results by focusing on just one scenario. I will consider the case that investment returns are zero, and the discounting factor for impatience is also zero.
With a real return of zero, the annuity payout rate based on an actuarially fair annuity with this mortality data is 5.66%. That is, the $100 of wealth is used to purchase an annuity at retirement for the 65 year old male, the guaranteed income stream each year for life is $5.66. That happens by pooling the mortality risk across the population.
Meanwhile, for someone who doesn’t buy an annuity, they have to plan for a potential lifespan of 35 years. With a zero return on assets, to smooth consumption across their potential lifetime, they could spend 100/35 = $2.86 each year. Much less than an annuity, but that is because the planning horizon has to be longer to protect against the low probability event of living a long, long time.
Now we get into the really interesting part. Something I’ve been trying to get a dialogue going about is whether the general population is aware of one of the key insights coming from lifecycle finance economic models. That is, you should intentionally plan to decrease spending as you age to account for the lower probability of living to each subsequent age. But how much should you plan to reduce your spending? That depends on your spending flexibility / risk aversion.
There are now two competing tradeoffs: you want to spend the same amount every year for as long as you live to get the most lifetime value from your spending, but you also want to frontload your spending to early retirement when you have the highest chance for survival. Again, I’m assuming a case where investment returns and impatience are both zero and both cancel each other out.
The following figure shows the optimal spending path, both for the case with annuitization and for different degrees of spending flexibility for the case when the retiree does not annuitize. This figure shows why economists see an annuity puzzle: why not annuitize since it provides a higher lifetime spending path? But beyond this, we can also see how people optimize without annuities. I need to rename something here, because low values imply greater flexibility rather than high values. Someone with flexibility of 1 is quite willing to let their spending decrease over time to reflect the low probability of survival as they age. Spending starts at the same amount as the annuity but declines to very low levels by one’s late 90s. With flexibility of 2, more effort is made toward keeping a smooth level at $2.86. But again, it is still optimal to front load spending. You can also see for coefficients of 5 and 10 how we obtain greater smoothing even in the face of the decreasing survival probabilities. How much lower would you let your spending fall in your 90s to allow more spending in your 60s? It’s an important and highly personal question! Personally, I’m sort of attracted to the pattern coming with flexibility=5.
One final part of the puzzle is that economists like to note the “annuity equivalent wealth.” That is, how much additional wealth would you need in order to obtain the same expected lifetime value of your spending when you don’t annuitize as when you do annuitize? Clearly, the value of spending is higher with the annuity since it allows greater spending at all ages. I calculate that with flexibility=1, the retiree needs 53% more wealth to be just as satisfied as with an annuity. The corresponding numbers increase up to the flexibility=10 case, where 90% more wealth is needed to be just as happy. That is a key part of the annuity puzzle: with flexibility of 10, you would need 90% more wealth to have the same utility from not annuitizing as from annuitizing. So why not annuitize?
Well, there are many explanations, and I will revisit those at a later date. Or alternatively, here is your homework assignment, class: List potential explanations in the comments for why the “puzzle” may not really be as puzzling as I just made it sound.
Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan, and the curriculum director for the Retirement Management AnalystSM designation program. He maintains a blog about retirement planning research at
wpfau.blogspot.com
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There's A Growing Gap Of Opportunity As The Boomer Population Ages |
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Wednesday, May 09, 2012 16:20
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Tags: Boomers | life planning | retirement
As the age-denying Baby Boomer generation grows older, it may need your help to face reality. The growing gap between the Boomer and Echo-boom generations is highlighting the fact that Boomers’ reticence to deal with the challenges of aging is becoming a burden on younger generations. If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
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People across the globe are having fewer children. That means there will be fewer people to fill the jobs Boomers vacate as they retire. Global median age is expected to rise from 29 years old in 2010 to 39 by 2050.
Real life examples are already pointing to some of the demographic issues. As more and more people live beyond age 100, their children begin to face their own aging issues. A 107-year-old may have children in their 80s who are unable to care for them because of their own care needs. The fact that most Americans only have about $25,000 in retirement savings doesn’t make the picture any brighter.
These predictions point to a demographic reality, yet they seem to ignore the fact that the Echo-boom generation is as large in number as the Boomer generation. Although these problems are real and need to be addressed in a timely, one of the biggest gaps seems to be that an industrious younger generation is on the rise and may add unexpected relief. Still, relief relative to the oldest Boomers may not be timely.
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