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:
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.