As I mentioned last time, retirement income planning has emerged as a distinct field in the financial services profession. But because it is still relatively new, the best approach for building a retirement income plan remains elusive.
There are two fundamentally different philosophies for retirement income planning, which I call probability-based and safety-first. Those philosophies diverge on the critical issue of where an individual is best served to place their trust: in the risk/reward tradeoffs of an equity portfolio, or on the contractual guarantee of insurance products. The fundamental question is about the type of strategy that can best meet the retirement income challenge for how to combine retirement income tools to meet goals and manage risks.
Those favoring investments rely on the notion that the market will eventually provide favorable returns for most retirees. Though stock markets are volatile, stocks can be expected to outperform bonds over a reasonable amount of time. Those believing strongly in investments consider upside potential from a portfolio to be so significant that there is a very limited role for insurance solutions. Why needlessly cut off the upside?
On the investment side, there is also a general unease about relying on the long-term prospects of insurance companies or bond issuers to meet contractual obligations. Perhaps not fully understanding the implications of how sequence-of-returns risk differs from market risk, the belief is that in the rare event that the performance for the equity portfolio does not materialize, it would imply an economic catastrophe that would sink insurance companies as well.
Meanwhile, those favoring insurance believe that contractual guarantees are reliable and that an overreliance on the assumption that favorable market returns will eventually arrive is emotionally overwhelming and dangerous for retirees. Indeed, they are more concerned about the implications of market risk than those favoring investments. Even if there is a low probability of portfolio depletion, each retiree gets only one opportunity for a successful retirement.
At the very least, essential income needs should not be subject to the whims of the market. As well, advocates from this side view investment-only solutions as undesirable because the retiree retains all the longevity and market risks. These are risks that an insurance company is in a better position to manage.
But retirement income planning is not an either/or proposition. We must step away from the notion that either investments or insurance alone will best serve retirees. Each tool has its own advantages and disadvantages. An entire literature on “product allocation” (introduced by Peng Chen and Moshe Milevsky in 2003) has arisen, showing how a more efficient set of retirement outcomes can be obtained by combining investments with insurance.
The Advantages and Disadvantages of Investments in Retirement
With investment solutions, a more comfortable lifestyle may be supported if you are willing to invest aggressively in the hope of subsequently earning higher market returns to support a higher income rate. And should decent market returns materialize and sufficiently outpace inflation, investment solutions can be sustained indefinitely.
Portfolio balances are also liquid in the technical sense that they are accessible to a retiree and are not locked away as part of a contractual agreement, such as an annuity. Upside growth could also support a larger legacy and provide liquidity for unexpected expenses.
However, the dual impact of sequence-of-returns and longevity risk creates a real possibility that you cannot support your desired lifestyle over the full retirement period. These are risks a retiree cannot offset easily or cheaply in an investment portfolio. Investment approaches seek to reduce sequence and longevity risk by having the retiree spend conservatively.
Retirees spend less as a way to avoid depleting their portfolio through a bad sequence of returns in early retirement, and they also spend less because they must plan to live well beyond their life expectancy. The implication being, should the market perform reasonably well in retirement, the retiree will significantly underspend relative to their potential and leave an unintentionally large legacy.
At the same time, longevity protection (the risk of outliving savings) is not guaranteed with investments, and sufficient assets may not be available to support a long life or legacy. A “reverse legacy” could result if the portfolio is so depleted that the retiree must rely on others (often adult children) for support. This is particularly important in light of the ongoing improvements in mortality, which means that today’s retirees will live longer than those from earlier cohorts.
For healthy individuals in their sixties, we are approaching the point where forty years must replace thirty years as a conservative planning horizon. Retirees experience reduced risk capacity as they enter retirement; with reduced flexibility to earn income, they are more vulnerable to forced lifestyle reductions resulting from the whims of the market. An investment strategy could backfire.
Investment assets may also be less liquid than they appear. Though they are technically liquid, a retiree who spends assets that were meant to cover spending needs later in life may find that those later needs can no longer be met.
Additionally, individuals experience declining cognitive abilities with age, which makes it increasingly difficult for them to manage the investment and withdrawal decisions required for a systematic withdrawal strategy. However, concern over managing an effective withdrawal strategy may be offset by working with a high-quality financial planner.
The Advantages and Disadvantages of Insurance in Retirement
Insurance companies pool sequence and longevity risks across a large base of retirees, as a traditional defined-benefit pension does, allowing for retirement income spending that is more closely aligned with average long-term fixed income returns and longevity. This may support a higher lifestyle than what is feasible for someone self-managing these risks by assuming low returns and a longer time horizon.
Guarantees can also provide a peace of mind for your lifestyle that leads to a less stressful and more enjoyable retirement experience. Overly conservative retirees become so concerned a running out of money that they spend significantly less than they could, and a monthly annuity payment can provide the explicit permission to spend and enjoy retirement. The receipt of a monthly check from an annuity can also simplify life for those with reduced cognitive skills or for surviving spouses who may be less experienced with regard to financial matters.
Longevity protection is a primary benefit from an insurance solution, as it provides a guaranteed income for as long as you live. It hedges longevity risk and calibrates the planning horizon to something much closer to life expectancy. Those who do not live long subsidize the income payments to those who do live longer than life expectancy (“mortality credits”).
Both groups enjoy higher spending because they have pooled the longevity risk and do not have to plan based on an overly conservative time horizon. This higher income also provides flexibility to spend less than possible and maintain more reserves to manage inflation risk.
A death benefit can be created with life insurance to provide a specific legacy amount. Additionally, an income annuity dedicates assets specifically toward the provision of income, allowing other assets to be earmarked specifically for growth. This can allow for a larger legacy, especially when the retiree enjoys a long life and more of their income is supported by the annuity’s mortality credits.
But many retirees may be significantly underfunded and may not be able to reach their goals even after pooling risks. Though income annuities can guarantee a lifestyle, they lack the ability on their own to provide upside potential, and inflation-protected versions are costly. In such cases, individuals may need to rely on the growth potential of their investments to achieve their retirement goals and protect against inflation. Though risky, some retirees may tolerate those disadvantages and conclude that the loss of upside potential is not worth the sacrifice.
Liquidity could also be a problem with insurance solutions when there are unexpected expenses to be met. While some annuity products offer liquidity, there is generally a high cost for this flexibility. It is also a potential weakness for insurance solutions. Efforts to provide liquidity can undermine the true advantages of annuitization.
The point about liquidity is that partial annuitization helps free up other assets on the balance sheet from having to support spending needs, and this combination can work to provide a greater amount of true liquidity. As for a legacy, though the death benefit in an insurance contract may grow over time, it is not likely to keep pace with inflation. Also, income annuities do not offer legacy benefits without adding additional riders, which reduce the power of mortality credits.
