From the June 2012 issue of Investment Advisor • Subscribe!

Five Facets of a Secure Retirement

Morningstar’s Peng Chen explains how to confront planning risk

Illustration by <a href="http://www.stevenpuetzer.com">Steven Puetzer</a>. Illustration by Steven Puetzer.

For typical retirees in the United States, their goal is to fund a comfortable retirement. However, there are two primary risks investors face in managing their retirement portfolios—longevity risk and financial market risk.

The average 65-year-old retiree can expect to live another 20 years, and record numbers are expected to live past the century mark. Mortality tables indicate that roughly half of retirees will live longer than their life expectancy. This points to the large degree of variation that exists in terms of exactly how long each individual might live. This variation creates considerable uncertainty around how much money people will need to fund a retirement (i.e., longevity risk).

Financial market risk adds another variable. Once in retirement, a portfolio made up of stocks and bonds is very sensitive to market fluctuations. A series of ill-timed downturns in the market can drastically reduce a nest egg, forcing retirees to substantially lower their standard of living.

Fortunately, investors and advisors have access to effective tools to combat these risks. Research papers from Ibbotson Associates, a unit of Morningstar’s investment management division, show that investors can mitigate both longevity and investment-performance risks with a carefully constructed combination of longevity-insurance products, such as fixed lifetime immediate annuities (SPIA) and variable annuities with guaranteed lifetime withdrawal benefits (VA+GLWB), which offer investors a guaranteed income stream, and traditional assets, such as ETFs and mutual funds. 

Five factors primarily drive the product-type allocation decision: a client’s age, financial market risk tolerance, wealth versus retirement expenses, risk preference toward longevity and bequest goal. Below are some general guidelines for how much the average American retiree might want to allocate to guaranteed products in retirement based on these factors:

1. Age

As a general guideline, allocations to SPIAs should slightly increase with age, rising from about 50% of an average 65-year-old’s portfolio to close to 60% by age 75. This increase with age is mainly because the value of the annuity is higher for older investors. When a policyholder dies, the asset pool of all annuity holders is essentially spread over fewer people. Therefore, the annuity payments increase dramatically with the age at which the contract starts.

In contrast, the allocation to VA+GLWBs should slightly decrease with age. Holding a VA+GLWB is like portfolio insurance. The older an investor is, however, the less time they will hold their portfolio and the less likely they are to need portfolio insurance.

2. Finance Market Risk Tolerance

Conservative investors prefer certainty; they want downside protection and guaranteed income. Therefore, conservative investors should have a higher allocation to longevity insurance than aggressive investors. The average conservative retiree may want almost 60% in guaranteed products, while aggressive retirees may want half that amount.

3. Wealth Versus Retirement Expenses

The ratio of total net worth to retirement expenses not covered by existing guaranteed income (such as Social Security and defined benefit pension income) has a large impact on the allocation to annuity products. Retirees with a high ratio of around 80, i.e., those with a great deal of wealth relative to non-covered expenses, have no need for longevity insurance. Their portfolios can withstand market downturns and longevity risk without threatening their living standard. On the other hand, an investor with a more moderate wealth gap ratio of 20, for example, may want to allocate 40% of assets to annuity products.

4. Risk Preference Toward Longevity

Using mortality tables, it’s easy to determine a person’s life expectancy, but that number is just an average. People have more detailed knowledge of their family history, lifestyle and general health than what mortality tables can tell them. Therefore, clients should be able to make a qualitative assessment of their life expectancy. Those investors who expect a higher probability of living longer than average life expectancy or who are simply more concerned about living a longer life may want to allocate as much as 65% to guaranteed products as opposed to 35% for an investor who expects a shorter lifespan, all else being equal.

5. Bequest Goal

The trade-off between “spend it in retirement” and “leave it to heirs” also has a large impact on the optimal annuity allocation. Clients who want to spend their retirement income in their lifetime (the “spend it in retirement” approach) should have a larger allocation to longevity insurance, with the allocation tilted toward immediate fixed annuities instead of VA+GLWBs. Clients who want to leave the largest possible bequest to beneficiaries need less longevity insurance. The allocation within the annuities portion should tilt more to VA+GLWBs because the contract value is paid to the investors’ beneficiaries on death. They likely will also benefit from investing in traditional assets, such as stocks and bonds.

The burden on retirees to finance their own retirement spending is growing. Fortunately, there are solutions. Most investors can avoid an extreme outcome by allocating a portion of their portfolios to insurance products that offer guaranteed income for life. But, advisors and investors have to be careful in how they determine the proper allocation to these products. Using our research results as guidelines, advisors can go a long way to helping their clients manage longevity risk and have a fruitful retirement.       

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