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August 31, 2015 at 08:00 PM
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?
Annuity Evolution
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.
