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June 10, 2011 at 05:02 AM
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
