Since at least 1965 and the seminal research of Menachem Yaari, economists have recognized that retirees should convert far more of their assets into guaranteed income vehicles during retirement than they do. Guaranteed income is the surest way available to deal with the three great threats to retirement income security: longevity risk, sequence risk and stupidity risk. As I have noted in this space before, that consumers so rarely do what they ought to do in this regard is known as the “annuity puzzle.”
Longevity risk is increasing steadily in that life expectancies continue to expand throughout the developed world and is exacerbated because consumers are both retiring earlier and have less and less access to private pensions. Moreover, the distribution of longevity is wide — a 22-year difference between the 10th and 90th percentiles of the distribution for men (dying at 70 versus 92) and a 23-year difference between the 10th and 90th percentiles of the distribution for women (dying at 72 versus 95). Guaranteed income vehicles hedge longevity risk simply and efficiently as risk pooling makes them 25–40% cheaper than do-it-yourself options. Thus retirees who purchase an income annuity assure themselves a higher level of consumption and guarantee it as well.
Sequence risk relates to market volatility and the order in which returns on a retiree's investments occur. Essentially, when drawing income from a portfolio, low or negative returns during the early years of retirement will have a greater impact upon overall success rates than if those negative or low returns occurred at a later point of retirement, even if the overall average return was the same. Therefore, if poor returns and ongoing withdrawals deplete a portfolio before the “good” returns finally show up, financial disaster can and does occur.
Stupidity risk relates to the management of portfolios in order to provide retirement income. Such allegedly “safe” withdrawal rate provision assumes that both consumers and advisors will make and continue to make good choices throughout retirement. What we know about cognitive and behavioral biases as well as the real life actions of consumers and advisors during periods of market stress doesn't just suggest, rather it screams, that we should be skeptical about the ability of people to make good decisions and keep making good decisions when the going gets tough.
How, then, should be deal with these risks?
Insurance companies initially created SPIAs, single premium immediate annuities. They were and are both simple and efficient. The annuitant gives the insurance company a check and the carrier agrees to pay the annuitant an agreed amount for life. But consumers have always resisted purchasing SPIAs. They focus not on living longer than expected but on the chance they might die sooner than expected and thus “lose” money. They also hate giving up control of their assets. And in today's interest rate environment, SPIA payout levels are none too attractive.
So insurance carriers came up with GLWBs — guaranteed lifetime withdrawal benefit riders. GLWBs provide guaranteed income but also allow some measure of control of the assets as well as the possibility of having some money left over for heirs after death. In other words, at the most basic level, using income guarantees in this way provides a “floor with upside” approach to investing for retirement income. GLWBs have thus seen a great deal of interest.
However, in today's environment, the inherent trade-offs in the insurance contracts are much less attractive than they once were. A combination of lower expected returns, limited investment options, higher implied volatility and higher annuity costs has caused many good advisors to conclude that guaranteed income riders no longer represent a “floor with upside” but instead provide a floor and little else. Therefore, careful analysis of any prospective GLWB is absolutely imperative. However, less than stellar construction of GLWBs in today's environment does not necessary lead to the conclusion that guaranteed income — in whatever form makes the most sense — can readily be dismissed. The risks that guaranteed income vehicles are designed to mitigate are no less existent or dangerous today than they have ever been.
Most “safe withdrawal” analysis assumes safety as something like a 90%–95% success rate over a set period of time, commonly 25–30 years and emphasizes that most of the time, this approach should not only work, but should provide significant portfolio growth. However, with the consequences of failure being so high — being destitute at a time in life when vulnerability is at a peak — a 5–10% failure rate (which may be too low given that “100-year floods” seem to happen in the markets at least a couple of times a decade) hardly qualifies as anything like “safe.” Moreover, limiting the analysis to a set period of time is similarly deceptive on account of longevity trends.
Simply put, safe withdrawal approaches emphasize portfolio optimization and the hope for upside over putting safety first. The lure of optimization and our inherent excessive optimism conspire to push us away from guaranteed income options. I think that's a mistake.
In 1703, the great philosopher, logician and mathematician Gottfried Wilhelm Leibniz noted his profound concern about relying too heavily on probabilities: “Nature has established patterns originating in the return of events, but only for the most part”; he added that “no matter how many experiments you have done…, you have not thereby imposed a limit on the nature of events so that in the future they could not vary.” (My emphasis, but note that Leibniz emphasized the italicized portion by writing it in Greek even though the rest of the document — a letter to the great mathematician Jacob Bernoulli — was written in Latin.)
Once we recognize that our portfolio modelling efforts have an R-squared of less than 1.00, we must accept the possibility that optimism based upon portfolio optimization is necessarily misplaced. When the R-squared is less than 1.00, the crucial element in the decision at issue is not the likelihood of being right and what we get out of it, it is the consequences of being wrong. As the great Peter Bernstein put it: “There is no certainty. Rational people do not bet the ranch on a model with an [R-squared] of less than 1.00, that works out only for the most part. And God forbid it works out only for the minor part! Consequences, not probabilities, determine the decisions that matter.”
In the real world, outcomes are inherently uncertain, but we still have some control over what is going to happen or at least some control over the consequences of what is going to happen. Dealing with such inherent uncertainties is what risk management is all about. The current environment for guaranteed income isn't great. But don't be too quick to bank on portfolio optimization to save the day. As the Roman Stoic Seneca expressed it, “Our minds should be sent forward in advance to meet all the problems, and we should consider not what is wont to happen, but what can happen.”