Every advisor knows that annuities offer retirees retirement income security. But there’s less certainty about how much of a retiree’s nest egg should be allocated to an annuity to minimize the person’s probability of outliving their retirement income.
The Employee Benefits Research Institute takes some of the guesswork out of allocation in a study released this month. The study analyzes the impact of longevity and immediate annuities on retirement income adequacy. The study finds that the “optimal level of annuitization and asset allocation that would provide a desired level of confidence that individuals will have sufficient retirement income, based on the three different types of risk: investment income, longevity, and long-term care.”
The study’s results offer a prescient guide for advisors looking to maximize their client’s retirement success through annuities. Although parts of the study are quite technical, wading through it to its results can be enlightening.
First we examine the study’s methodology and then conclude with excerpts from the study’s results.
The EBRI Study’s Methodology
The simulation used in the study used three “building blocks.” Each block was assigned characteristics which would then be used in income replacement rate analysis. The building blocks, from one to three, offer an increasingly realistic picture of retirement risks.
Building Block 1 was crafted to examine “investment risk related to equity allocation.” Retirees who increase their equity allocation may end up with investment income that exceeds expectations – but they also face significant risk. Building Block 1 was assumed to have average health-care costs—including health insurance premium costs (including Medicare) and out-of-pocket, unreimbursed medical expenses. Retirees in this block are assumed to have an average life expectancy.
Building Block 2 was used to examine both investment and longevity risk, longevity risk being “the risk of a retiree outliving his assets.” Individuals in this block are assumed to have the ability to purchase a life annuity at current prices. Retirees in Building Block 2 are assumed to fall across the entire spectrum of the longevity tables. Health care cost assumptions were the same as those made for Block 1.
Building Block 3 includes the risks included in block two but expands significantly on the second block by including (1) nursing home or home-based health care, and (2) prescription drug costs in “health care costs.” Incidence and cost of long-term care in the model are based on the National Nursing Home
Survey and the Home and Hospice Care Survey. Building Block 3 uses a probability matrix that assumes retirees are in one of four health states: (1) death; (2) not receiving long-term care; (3) receiving nursing home care; or (3) home health care patient.
The EBRI Study’s Conclusions
One component of the study calculated the final earnings multiple necessary for retirees to avoid outliving their retirement income. In other words, what percentage of the retirees’ final annual salary should that person have saved for retirement in order to keep up their standard of living?
Although the results of the study are too substantial to duplicate here, as an example, the study found that low-income retirees who want a 90%+ probability of retirement income adequacy but who don’t want to annuitize their retirement funds needs 12.4 times their earnings in retirement funds with 5% allocated to equity. But that’s just for simplified Building Block 1. Under the more realistic Building Block 2, which includes longevity risk in addition to investment risk, retirees need 20.4 times their earning in retirement funds. And Building Block 3, which includes investment, longevity, and long-term care risk in its model, the earnings multiple almost doubles to 40.2.
The study also considered the optimal allocation of retirement funds to equities and annuities in order to avoid outliving their retirement income.
“Several studies on longevity annuities…show that a modest allocation of retirement wealth to a longevity annuity can deliver as large a benefit as a significant allocation to an immediate annuity.”
This study pinned down the optimal allocation of retirement funds to equities and annuities. For example, under Building Block 2, a retiree who wants a 90% chance of having adequate retirement income should allocate 15% to 20% of his initial retirement wealth to a longevity annuity with a 30%-40% equity allocation. Under the more realistic assumptions of Building Block 3, a retiree who wants that same confidence level of not running out of retirement funds “should increase the allocation of his retirement wealth to a longevity annuity (25%) and equities (70%).”
Interestingly, both immediate and longevity annuities are more effective for lower income retirees than for higher income retirees “to reach a desired level of retirement income adequacy.”
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