REVIEWING THE RISKS

LONGEVITY

Your Longevity Risk is the risk that you will outlive your retirement assets. Due to improvements in medical technology, nutrition, disease control, public health, and environment, human longevity has improved over the last 5 decades. Figure 1 shows the life expectancies of Americans at birth.

Notice the improvement in life expectancies from one decade to the next.  According to the Society of Actuaries, in 2014, life expectancy at birth in the United States of America was 86.6 years for males and 88.8 years for females. Averages alone do not tell the entire story since once we actually reach our retirement years, the chances of surviving for more than a decade are quite substantial. In fact, true across the entire life span, is the fact that as we survive each stage of life and the associated risks, we have increasing odds of surviving to higher ages.

Table 1 provides a sample of survival probabilities for 65-year old male and females:  Perhaps the most compelling of longevity statistics are the probabilities of survival for at least one member of a couple.

For example, the chance that at least one member of a couple survives to age 85 is 82.5%; the probability that one spouse or even both are alive at age 90 is three in five.

Longevity is the #1 risk in retirement.  The reason for this is because longevity is a multiplier of all the other risks we face in retirement.  The longer you live, the more you are going to experience other risks such as Health Care risks, Long-Term Care risks, Market Risks, Inflation Risks, etc.  Every Retiree should have a plan to combat longevity if they want a sustainable retirement.

Figure 1.  Average Life Expectancy

Table 1.  Probability of Survival at Age 65

Values are generated using the Gompertz-Makeham Law of Mortality calibrated to RP-2014 Mortality Table with MP-2014 Projection Scale applied.

INFLATION

Your Inflation Risk is the risk that the purchasing power of your retirement income will not be able to keep up with your standard of living. Central banks usually commit themselves to ensuring that inflation is kept at acceptable levels. They do this by fine tuning monetary policy so that the change in the Consumer Price Index (CPI) is kept within a certain range. 

Inflation is the increase in the prices of goods and services over time. The inflation rate is calculated by observing the change in price of a basket of goods and services. CPI is an indicator of average inflation for a typical urban consumer.

In the US, the Bureau of Labor Statistics (BLS) computes various consumer price indices nationally and for different geographical areas. Figure 2 shows a graph of the average cumulative CPI-U from 1970 to 2014.

Source: U.S. Bureau of Labor Statistics (1982-84 = 100)

So why is inflation a concern? Inflation is a risk in retirement because it erodes the purchasing power of the consumer. It is less of a risk before retirement because most workers’ salary increases are at least somewhat tied to inflation. In the figure above, in a span of 30 years, a basket of goods that cost $100 in 1984 costs $237 by the end of 2014.

However, CPI-U understates inflation for retirees because health care costs, prescription drugs, medical appliances, and long-term care become a significant part of the expenditure.

These items are not captured by the CPI-U in the proportions consumed by the elderly. The decline in purchasing power over the course of retirement is a risk that has to be managed.

SEQUENCE OF RETURNS

Your Sequence-of-Returns-Risk is the risk that you will experience poor portfolio performance early in retirement. When constant withdrawals are made from an account, there is a larger negative impact on the performance of the account in a down market than in an up market because a lower portion of each withdrawal payment is made up of interest or yield and therefore a higher portion of each withdrawal payment is made up of capital.

In other words, the timing of the returns is important and is an additional risk that needs to be addressed.  To illustrate the impact of Sequence-of-Returns risk, consider the following example: Assume you have $250,000 in assets and you earn 17% in year one, 10% in year two, and -8% in year three and then this sequence repeats itself indefinitely.

On average, you are earning 6.3% and the volatility of the returns (as measured by the standard deviation of the returns) is 10.5% (which is typical of a balanced portfolio  invested in North American equities and fixed income assets). Further, assume that you will withdraw $1,650 monthly or $19,800 annually. How long is the money going to last?  As depicted in Figure 4, the funds will last around 28 years.

Now, if we reverse the sequence, i.e. earn -8% in year one, 10% in year two, and 17% in year three (the average still being 6.3% and volatility still being 10.5%), then the funds will last around 21 years.  The difference of 7 years in the example above is attributable to nothing else but the sequence in which the returns are realized.

As an individual, one does not get to choose the retirement date based on what sequence will materialize.

Figure 4: Sequence-of-Returns Risk Illustration

THE FACTS​

Any of these three risks can force the individual to adjust his/her standard of living and in extreme cases can cause a dependency on social programs, friends, and family, which clearly would not make for a dignified retirement.

One cannot control the timing of the bear market just as we do not have control of our lifespan or the rate of inflation throughout our retirement.

However, rather than trying to predict the outcomes of any of these random events, one could insure against adverse outcomes using a product allocation strategy.

HOW DOES PRODUCT ALLOCATION HELP?

The financial services industry has responded by offering an expanded repertoire of insurance and investment products to help mitigate these retirement risks. These products are certainly beneficial to some (and possibly most) individual clients.

The challenge is determining which of these products should be recommended for allocating an individual client’s wealth and in what proportions.

Product Allocation is a technique that allows an individual to hedge against the risks identified in the previous section by allocating funds across three broad categories:

• Income Annuities (immediate or deferred)
• Managed Accounts (stocks, bonds, mutual funds, commodities, etc.), and
• Hybrid Accounts (Fixed Index Annuities) with Guaranteed Lifetime Income Benefits (GLB).

Income Annuities such as Single Premium Immediate Annuities (SPIA) or Deferred Income Annuities (DIA) are used to capture the benefit and value of longevity protection within a retirement strategy. Financially speaking, the embedded longevity insurance protects the annuitant (the individual on whose life the policy is based upon) living past their life expectancy.

While most of us would like to live to a ripe old age, proper planning requires that the financial cost of living much longer than expected be mitigated. Annuities insure us against longevity.

Managed accounts provide a Systematic Withdrawal Plan (SWP) or a method by which the account is periodically liquidated to generate income. With exposure to capital markets, a managed account, if markets perform well, provides protection from the effects of inflation.

Hybrid Accounts composed of Fixed Index Annuities with a Guaranteed Lifetime Income Benefit (GLB) may grow with the market while providing a hedge against a bad sequence of returns and some longevity protection, however because they are built to be a spread product they will not provide the same level of growth since your money is not truly in the market but with the trade off in growth, they offer great protection from market loss and even offer guarantees that your principal won't be lost.

Each product varies in its effectiveness at addressing the risks and retirement goals of a retiree, which may include maintaining liquidity, maximizing estate value, or increasing sustainability. There is no ‘free-lunch’ — valuable benefit offered by a product is typically offered at the expense of another risk management attribute.

For example, a SPIA offers a good hedge against longevity risk but at the expense of liquidity, bequest, and flexibility. On the other hand, a managed account provides full flexibility but fails to address longevity or Sequence-of-Returns risk.

Our goal with product allocation is to try to find the best trade-off between income sustainability and financial legacy for the particular client.

Figure 5: Retirement Product Attributes
Source: The QWeMA Group

SPIA and DIA offer the most efficient forms of longevity insurance and can be viewed as the best substitute for traditional pension which many individuals no longer own. Conversely, unless one purchases an income annuity with increasing payments (Cost of Living Adjustment (COLA) or CPI-U indexing options), the SPIA/DIA scores the lowest on its ability tackle inflation.

It should be noted that SPIAs with an option for increasing payments are the only products that provide longevity protection and explicit inflation protection, this option is not considered here as it tends to be expensive and rarely used in practice.

Given the fixed nature of payments, SPIA/DIA offers a good hedge against Sequence-of-Returns risk and the product typically provides the least expensive way to establish a guaranteed income floor in any retirement plan.
 

On the other hand, a SWP’s risk management attributes are opposite to that of a SPIA/DIA. The investment choices with the SWP are virtually endless and the underlying asset allocation is under complete control of the investor. When managed well, the asset allocation offers indirect protection against rising inflation because in most years the market outperforms inflation.

Hybrid accounts such as Fixed Index Annuities (FIA) with GLB riders offer a good hedge against the sequence-of-returns risk. Guarantees and promises are the core of GLBs. Many promise at least the return of the initial investment, despite the performance of the market. GLBs are analogous to (albeit complex) long-term equity put options that can be purchased in the open market to provide downside protection on a portfolio. Thus, their embedded guarantees, earn GLBs the high score for hedging sequence of return risk.

However, not all GLBs are created equal. While some variations guarantee an income for life, thus providing some longevity protection, they are typically more costly than the pure form of longevity insurance offered by SPIA/DIA. Finally, like managed accounts, GLBs do not typically provide explicit inflation protection; however, many offer systematic payment step-ups or minimum percentage increases that could potentially offset the impact of inflation.

These inflation protection attributes can be thought of as more costly than those of a managed account because the fees for these hybrid accounts are typically higher than those of managed accounts.

From a financial engineering perspective, while a SWP and a GLB behave similarly in the first few years, the GLB contains a long dated put option that kicks in if and when the underlying account hits zero. Thus, while a SWP would terminate and cease providing income if the underlying account hits zero, a GLB on the other hand would continue to provide with a lifetime of guaranteed income. Stated differently, this means that a client who relies exclusively on a SWP to fund retirement is essentially ‘short’ this long-dated put option, which exposes him/her to both longevity and sequence of returns risk and may therefore reduce the probability of providing a bequest or estate transfer.
As seen in Figure 5 (previous page), the risk management attributes of the three retirement income products are only half of the story. The allocation among the products should also be selected in the context of at least three goal-achievement objectives: liquidity, behavioral “self-discipline”, and legacy (or estate value).
 

For instance, a total allocation to a SPIA/DIA would be inappropriate if the retiree’s primary future goal was to leave a large sum to his or her estate. Likewise, if the client spends their full monthly benefit payment, the client may have difficulty budgeting for a fluctuating spending rate or large lump sum withdrawals for unexpected cash needs. After all, the reason SPIA/DIA is able to offer such effective longevity insurance is the irreversibility of the initial lump sum payment.

Thus, while some SPIA/DIA contracts do address liquidity, other products address these needs better.
 

On the other hand, the SPIA/DIA is highly effective at overcoming potential behavioral mistakes that investors are prone to making – such as spending beyond their means. Further, many of us are susceptible to making irrational decisions and errors with our investments in the absence of restrictions or a guiding system in place and that can decrease the chances of meeting our spending goals in retirement.

When the initial irreversible payment is made to the insurance company issuing the SPIA/DIA, the control over the investment management decisions is also transferred away from the investor and the insurance company guarantees the monthly benefit payment for life. This leaves little room for the client’s behavioral biases and blunders.

With a SWP, a disciplined and well-informed investor can meet liquidity needs and estate goals because he or she retains the control over asset allocation and withdrawal rate; but without discipline of, for example taking a cut in income when necessary, and the financial acumen of, for example knowing when a cut is necessary, the SWP ranks low in effectiveness in helping the investor to avert behavioral mistakes.
 

The GLB’s liquidity is restricted by withdrawal limits imposed by the rider. Moreover, GLBs restrict withdrawals beyond a certain limit by charging surrender fees as well as reducing the benefits. The policyholder does have
liquidity with a GLB, even if it may come at a hefty price and it is therefore superior to a SPIA on this trait.

A GLB rider can also be effective in addressing some behavioral weaknesses because the surrender charge acts
as a deterrent to making excessive withdrawals. When purchasing a GLB, the investor effectively purchases protection against poor market performance in that if the account value goes to zero, the product will continue to provide guaranteed payments for life.

On the other hand, if the variable annuity is annuitized or if the
underlying investments perform poorly, and the GLB is irreversibly converted into a retirement income stream then no death benefit will be paid. This attribute makes the GLB good for purposes where the estate is of secondary concern after the client’s requirements for guaranteed lifetime income.
 

Finally, when it comes to evaluating fees, the basic SPIA/DIA tends to be the cheapest product option while the GLB is the highest because of the fees that must be charged for the embedded options, guarantees and the management of the underlying investments. The fees charged for a SWP typically fall between that of the other two income products because it is simpler than a GLB but its management is typically more involved than a SPIA/DIA.

PUTTING IT ALL TOGETHER: 4 Steps to Apply a Product Allocation Strategy For Your Retirement