In prior columns I’ve written about a framework to consider how to generate retirement income. On one hand you have insurance-based strategies that have an underlying income guarantee and on the other investing-based strategies that are probability-based.
Guarantees are today most commonly in the form of guaranteed withdrawal benefits (GWBs). They may come on variable or fixed indexed annuity products and transfer investment risk and longevity risk from you to the insurance company.
While some go to casinos and profit, on average the casino wins. Otherwise, they would not be in business. Same too goes for insurance companies providing GWBs: on average the consumer will lose, since they are implicitly purchasing income insurance and transferring risk to the insurance company.
Purchasing insurance for your retirement income may be fine. You should be cognizant of making the tradeoff of having increased certainty for your income at the expense of having less money – the cost of the income insurance – for yourself, your heirs, or charity.
Yet, everyone already has some level of guaranteed income from Social Security or pension benefits. The next question becomes: “Should I buy more?”
History & Costs
Withdrawal benefits began appearing on insurance products in the late 1990s. Studies on the benefits and costs have most commonly made comparisons of guaranteed withdrawals to equivalent withdrawals from a non-guaranteed portfolio of stocks and bonds.
Dr. Wade Pfau, Professor of Retirement Income at The American College, demonstrated in a 2011 paper that a non-guaranteed withdrawal plan “would not have failed to provide the guaranteed withdrawals of an annuity over any 30-year period dating back to 1926.” Perfection is quite a good record.
But perhaps history won’t repeat itself. You might live longer than 30 years in retirement. Perhaps future returns may be lower than historical. Or perhaps having an underlying guarantee will allow you, the investor, to stay more disciplined through market downturns or even have a higher equity allocation than you may otherwise have in a non-guaranteed portfolio.
David Blanchett, head of retirement research at Morningstar, considered many of these possibilities in a 2012 study utilizing a different methodology than Pfau. He reaffirmed Pfau’s conclusion that taking withdrawals from a non-guaranteed portfolio has a high probability – 93% for couples – of better outcomes.
Blanchett estimated the net cost of the guarantee at 7.4% of the dollars invested into the couple’s annuity. For example, suppose you are considering investing one million dollars into one of these two options. If choosing the guaranteed option, in addition to the one million dollar check, you will need to write an additional check for about eighty thousand dollars for the income guarantee to produce equivalent cash flows of the non-guaranteed option. If insurance companies priced guarantees in this explicit nature, very little would likely be sold.
Making sure your money lasts your lifetime and supports your lifestyle is a valid goal for all retirees. The fear of running out of money can be great. Thus, the reason why products with guarantees are sold.
I’ve written much about the retirement planning process. In a nutshell: understanding and prioritizing costs to live your lifestyle, making allowances for how your spending will likely change in retirement, claiming Social Security and pensions in ways that are likely to optimize benefits, and then stress test your plan and measure the return your investment assets will need to meet your goals.
If the stress test shows that your needs-based spending goals are funded to a high probability even if negative markets strike, then you likely do not need buy income insurance. Rather, a prudent planning and investing process is likely to yield better results.
If, however, you are a very conservative investor, have good health and a history of longevity, do not have much discretionary income beyond your needs, or are more concerned about income certainty rather than having more money for yourself or your heirs, then income guarantees may make sense. Smart choices still need to be made on how best to do so.
Kevin Kroskey CFP®, MBA