FRI:Structuring Income For Retirement

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Barry Barnitz
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FRI:Structuring Income For Retirement

Post by Barry Barnitz »

Structuring Income for Retirement by W. Van Harlow, Ph.D., CFA Managing Director Fidelity Research InstituteSM; Moshe A. Milevsky, Ph.D. Professor, Schulich School of Business, York University Executive Director of The IFID Centre, Toronto, Canada
INTRODUCTION
New Year’s Day, 2008, will mark another milestone in America’s growing retirement finance challenge. That is when the oldest members of the Baby Boom generation,those born in 1946, will begin turning 62,the average age for retirement in America today, and become eligible to draw Social Security income. As all 76 million Baby Boomers cross that same age threshold over the next generation, America’s retirement finance structure will continue a profound, long-term structural change. Traditional sources of “guaranteed” income — Social Security and defined benefit pensions — will replace a smaller and smaller share of pre-retirement income. A guaranteed income “gap” worth many billions of dollars a year will yawn open and widen steadily — into the indefinite future. Guaranteed income, simply put, is income you cannot outlive. For this reason, it is also referred to as longevity insurance, since it insures against the possibility of outliving one’s financial resources. Millions of individuals will therefore have to decide how to use their own life savings and investments to create income streams they can’t outlive — insuring themselves against “longevity risk.”This very predictable challenge is already “baked” into American demographics, law and financial trends. Current Social Security law, for example, mandates both steadily rising retirement age eligibility and increasing deductions from future Social Security checks to cover rising Medicare costs. The system is thus on track to replace less than 30% of pre-retirement incomes for retirees by the 2030’s — a long, steady fall from today’s 39% replacement rate. As Exhibit 1 shows, the percentage of private sector active workers covered by defined benefit (pension) plans that provide them with assured income at retirement has been declining dramatically — from 84% in 1979 to just 37% in 2005. This shift has been offset to some degree by the rise of defined contribution workplace savings plans such as 401(k)s, which now reach about 90% of all workers. A critical difference, however, is that workers in defined benefit plans have some of their retirement income planning done for them, in effect, by their employer’s pension fund, which gives them a guaranteed monthly income for life. Workers in defined contribution plans (as well as individual retirement savers in general) must make their own plans for creating — or buying — lifetime income streams. This inevitable decline in guaranteed or “annuitized” income will be offset to some degree by the rising wealth that future retirees are building today in defined contribution workplace savings and individual retirement savings. But even if these savings prove large enough to fill the gap, more and more Americans every year will need to consciously calculate how large a share of their life savings to commit to securing guaranteed income, what investment vehicles to use to meet their income goals, and how they might change the allocation of their remaining “non-annuitized” assets to ensure optimal results. The purpose of this report is to review these financial challenges and provide new insights into investment solutions that will provide individuals with a solid retirement plan. In particular, this report describes a conceptual framework that addresses the complex interplay between the uncertainty of future investment returns, the uncertainty around life expectancy and the role that guaranteed income can play in helping retirees to achieve a financially secure retirement. We explore ways to structure income for retirement given the tradeoffs among spending rates, retirement risk, and bequest desires.
Last edited by Barry Barnitz on Sun Sep 02, 2007 10:05 pm, edited 2 times in total.
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Post by Levett »

Another informative piece, Barry. Much appreciated. Bob U.
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nisiprius
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Did I get the gist right?

Post by nisiprius »

The gist is that retirees are underutilizing annuities. I don't think it's misrepresenting the paper to say that it advocates more use of annuities. The phrase "...gaps in investor education and planning..." seems to be saying that investors should be educated more in the use of annuities.

Since this happens to be what I think myself... I want to be sure I'm not selectively paying attention to what I want to hear!
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Re the Fidelity Annuity Post

Post by MPS »

Fidelity's argument reminds me of the argument full-service brokers make, i.e., if we can just figure out how to market it right, people will invest with us.

With annuities (regardless of which type), we're casting our lot with the insurance companies. Their track record doesn't impress me much (Katrina; or the relentless press for increased rates despite swelling coffers, as they cherry-pick their customers).

Who will protect us from the insurance companies in our old age?
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Re: Did I get the gist right?

Post by biasion »

[removed]
1. Do not confuse strategy with outcome | 2. Those who fail to plan plan to fail | 3. Do not assume the unlikely is impossible, and | 4. Be ready to deal with the consequences if you do.
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Post by livesoft »

Maybe the "gap" is created by financial firms skimming off 5+% front-end loads and 1.5% to 3% fees every year?
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Post by biasion »

[removed]
1. Do not confuse strategy with outcome | 2. Those who fail to plan plan to fail | 3. Do not assume the unlikely is impossible, and | 4. Be ready to deal with the consequences if you do.
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Post by earlyout »

A little bit of skepticism is usually a good thing. See the thread on this paper in the M* IDR forum.

EO
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nisiprius
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Re: Re the Fidelity Annuity Post

Post by nisiprius »

MPS wrote:Fidelity's argument reminds me of the argument full-service brokers make, i.e., if we can just figure out how to market it right, people will invest with us.

With annuities (regardless of which type), we're casting our lot with the insurance companies. Their track record doesn't impress me much (Katrina; or the relentless press for increased rates despite swelling coffers, as they cherry-pick their customers).

Who will protect us from the insurance companies in our old age?
If the mortality tables are OK, and if the insurance companies have thrown in a reasonable safety margin and profit factor, then they should be able to pay off their annuities... unless they somehow are allowed to raid the annuities to fund something else they've done that's gone wrong.

Annuities are insured by an industry consortium, up to $100,000 in most states, for whatever that's worth.

If boomers turn out to be much longer-lived than the insurance companies expect, then they have a problem and something will break. I'd think that what will happen is that they'll be allowed to renege on the contract, and renegotiate with a reduced payout. One way this could happen is: the insurance company that issued the annuity goes bust; the guarantee association "makes good" by paying you the present value of the annuity according to the mortality table on which it was based; and when you attempt to use that sum to fund a replacement annuity, low and behold the annuities from all of the solvent companies use new mortality tables that assume longer lives and therefore pay out less.

In other words, annuitants will get screwed, but only by getting less than was promised, not by getting nothing.

Annuities are much simpler and involve much less uncertainty and guesswork than the future of (say) stocks. It's a fairly simple calculation involving not much more than a mortality table. The insurance companies ought to make money unless the mortality tables turn out to be badly wrong... and to date, medical advances haven't really lengthened the life span, they've just gradually upped the chances of achieving the same life span.

There are risks, but it seems a lot less chancy than trying to guess the economic future of the United States over the same time period.
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Executive Life

Post by Adrian Nenu »

"Annuities are much simpler and involve much less uncertainty and guesswork than the future of (say) stocks. It's a fairly simple calculation involving not much more than a mortality table. The insurance companies ought to make money unless the mortality tables turn out to be badly wrong... and to date, medical advances haven't really lengthened the life span, they've just gradually upped the chances of achieving the same life span.

There are risks, but it seems a lot less chancy than trying to guess the economic future of the United States over the same time period."

- ever hear of Executive Life?

Adrian
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Post by livesoft »

Well, Ty Bernicke continues his pro-annuity stance in this month's articlein the J Fin Planning. Discussion of Mr Bernicke's research will probably merit its own thread.
Part 2 systematically back tests the alternative two-bucket strategy against the lower-cost traditional mutual fund strategy over every 30-year time horizon from 1926 through 2004. The results show that the two-bucket strategy with a variable annuity achieved an 18 percent higher average income and a 369 percent greater average inheritance with the assumptions tested.
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Re: Executive Life

Post by nisiprius »

Adrian Nenu wrote:"There are risks [in annuities], but it seems a lot less chancy than trying to guess the economic future of the United States over the same time period."

- ever hear of Executive Life?

Adrian
anenu@tampabay.rr.com
Sure. Ever hear of the [Your State Name Here] Guaranty Association?*

It's very hard to make a sensible assessment of that kind of risk, and it exists in every form of investment or quasi-investment.

On a thirty-year time frame, the insurance companies I intend to buy annuities with could all go bust, and the guaranty associations could fail to do what they say they're going to do, or we could get hyperinflation and the Treasury might decide not to honor TIPS, or the stock market could crash from all the boomers trying to sell at the same time, or someone could discover a way to harvest vanadium from sea squirts and the price of vanadium could drop to near-zero, or some president could postpone the next election, dissolve Parliament, I mean Congress, institute martial law and change all the rules, or I could be dead, or what's-his-name--Aubrey de Grey--could find the longevity secret and I'll live 300 years, or the Y2K people could turn out to be right except it will happen in the year 2048.

Is there a risk involved in buying an annuity? Sure. But there's no reason in the world why a halfway competent, semi-honest insurance company should go broke selling annuities. They've been doing it successfully for a very long time.

You can go broke buying stock even if the stockbroker is 100% solvent and honest.

Hey, you Flagship investors with more than $500,000 in Vanguard: how much sleep do you lose over being over the SIPC insurance limit?

*(Candor compels me to add that I learned of both Executive Life and guaranty associations quite recently... in this forum. And I will act on it to the degree of getting several smaller annuities with several different companies instead of one big one with one company).
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Re: Executive Life

Post by mas »

nisiprius wrote:... or the Y2K people could turn out to be right except it will happen in the year 2048...
I think you mean January 19, 2038..
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