Do annuity alternatives for income planning make sense?

By Bob Seawright

Asset Marketing Systems


Financial services professionals have placed their primary focus upon asset accumulation for decades. However, many analysts today are recommending a shift in attention toward products which are designed to provide income from those assets to help producers retain clients after they retire. This changing emphasis -- asset distribution rather than asset accumulation -- is predicated upon a number of factors, including the decreasing levels and importance of Social Security benefits, the disappearance of defined benefit pensions, the explosion of retirees as boomers age, and, perhaps most importantly, increasing longevity. Today there is a 23 percent chance that at least one member of a 65-year-old couple will live to age 95. And with improving health care, even more people will live to 95 and beyond in the future, according to the Society of Actuaries. Moreover, a study by the Gallup Organization discloses that more than half of 30 to 64 year olds in the United States say they are worried they will outlive their money after they retire and, for the first time since Gallup has been tracking the measure, a majority of those not retired say they will not have enough income to live comfortably in retirement. The need for first-rate income planning is both real and obvious.

The value of annuities

Most of the focus in this area up to this point has been on annuity products, for the simple reason that they make such good sense. As summarized by "Investing your Lump Sum at Retirement," from the Financial Institutions Center at the University of Pennsylvania's renowned Wharton School:

"When individuals consider the list of positive attributes associated with life annuities (i.e., guaranteed payments you cannot outlive, low cost, access to invested capital, and reasonably priced features such as inflation adjustment and legacy benefits), the argument for this income solution in retirement is compelling. The key in all of this is to begin by covering all of the basic living expenses with lifetime income annuities. Then, to provide for additional desirable consumption levels, you will want to annuitize a goodly portion of the remainder of your assets, while making provisions for extra emergency expenses and, if desired, a bequest. These last two items can be accomplished through combinations of insurance and savings." See also, the Wharton Financial Institution Center's "Rational Decumulation" for more details.

The mutual fund alternative

Not surprisingly, mutual fund companies don't like losing assets to insurance companies. Accordingly, they have begun to develop alternatives to annuities, designed to manage retirement savings and parcel cash out to retirees in monthly increments. These funds are hailed as turnkey retirement plans for investors needing regular income payouts and professional money management. Let's look at these funds generally and see to what extent they make sense as compared to annuities.

Fidelity was the first entrant in the mutual-fund managed payout space, launching its line of funds in 2007. Fidelity's income funds are essentially target-date funds in reverse, designed ultimately to wind down all the money in each fund at a specific date, which ranges from 2016 to 2042. The funds are geared to pay back the capital plus gains each month until the money runs out at the end of the target year, with the percentage of distribution increasing the closer the fund gets to its target-date. The distribution level is set at the start of each year and stays in place all year.

In 2008, Vanguard launched three managed payout funds of its own to address this market. The funds were structured as funds-of-funds, with each designed to provide level monthly payments throughout each year, and with payments adjusted each year based on the fund's performance over the previous three years. Vanguard's funds, in contrast to Fidelity's, aim to preserve the initial investment and have no expiration date. They're designed to invest shareholders' money so that it generates enough income to support monthly payments and enough capital appreciation to perpetuate the investor's principal.

Schwab has also launched it own set of payout funds, which differ from the Fidelity and Vanguard funds in that they are designed to avoid invading principal. However, because the payout rates on the Schwab funds are variable, investors cannot be sure of how much income they will receive each month, or even if they will receive income each month. Other mutual fund companies have offered their own products, but the styles offered by Fidelity, Vanguard and Schwab predominate.

Mutual fund performance

So far, the performance of these payout funds has merely served to point out the benefits of annuities. With the market's downturn, these funds have had to dip into principal quite extensively to meet their payout obligations, payout levels have been reduced, and share values have dropped dramatically. As a representative example, the Vanguard Managed Payout Growth and Distribution Fund Investor Shares (VPGFX), as of August 21, 2009, have lost well over 25 percent of their value since the fund was launched in 2008. As the chart below shows, portfolio declines that are compounded by regular withdrawals can lead to a reduced capital base and ultimately to unrecoverable losses, whether within a payout fund or a managed portfolio. This risk is sometimes referred to as the "arithmetic of loss."



Accordingly, the performance of these funds has not only been abysmal to date, it seems highly likely to get worse, as time passes and withdrawals continue.

Making the comparison

Crucially, unlike annuities, payout funds offer no guarantees, as recent performance demonstrates. Principal is not guaranteed, and no specific payment amount is guaranteed. This lack of guarantees makes proper planning impossible and can cripple a retiree's lifestyle.

The advantages of payout funds, such as they are, primarily relate to liquidity. Consumers may liquidate these funds at any time without penalty (even though a 25 percent loss doesn't compare well to most surrender charges). However, these funds are necessarily imprecise -- with no guaranteed income and no certainty about income amounts year over year, they are highly likely to suffer volatility in the income stream -- and are taxed like any other mutual fund. That is, each time a withdrawal is made from a mutual fund account, shares are sold and an income tax gain or loss is reported.

The biggest disadvantage of these funds is obviously the lack of guarantees. An annuity owner who dies before the actuarial tables suggest is likely is merely unlucky. A managed payout fund owner whose account expires before he or she does (which may be long before his or her life expectancy) risks becoming destitute. The economic models invariably attest to this fact -- that the cost of not being able to cover basic expenses in retirement far exceeds the potential upside provided by these funds. The central concern in the distribution phase of life is shortfall risk, the risk of outliving one's money. Downside risk management and the sequence of investment returns -- particularly in the initial years of withdrawals -- are of paramount importance, highlighting why guarantees are imperative. Indeed, it is difficult to understate the importance of guarantees when it comes to retirement income.

The plight of managed-payout funds boldly dramatizes what can happen to retirees if they experience a serious market downturn early on, when they are starting to draw down income from an investment account. T. Rowe Price has done some good research in this area, based upon a fairly standard portfolio and 4 percent annual withdrawals, rising with inflation. The study concluded that with negative annualized returns for the first five years of retirement, there is a whopping 57 percent chance of running out of money within 30 years. Since managed payout funds have already suffered significant losses in the first years of their existence, they are already at severe risk of ultimate failure. Moreover, such significant losses are not as aberrational as some might think:

    Even in large portfolios, high standard-deviation events tend to occur far more often than a normal distribution suggests. This seems especially true on the downside, which will call this variable excess risk 'iceberg risk,' because it is mostly hidden from view but threatens major damage. It might also be called 'Noah risk,' after the proverbial flood that drowned the world.... Also, in the Biblical story, the world was amply warned about the flood but refused to listen. In contrast, icebergs reflect a type of risk that people look for but may not see.
    Kent Osband, Iceberg Risk: An Adventure in Portfolio Theory (2002).
When these "black swan" events happen early in one of these accounts or in an individual retiree's portfolio which is also providing income, the results are often catastrophic. The managed payout funds in the market today, which have suffered significant losses already, will be very hard-pressed to provide that which the buyers of those funds sought when the funds were purchased, emphasizing their major flaws and risks.

The winner, and still champion...

Despite the best efforts of the mutual fund industry to find an alternative, the Wharton experts said it best in "Investing your Lump Sum at Retirement:" "... annuitization of a substantial portion of retirement wealth is the best way to go. The list of economists who have discovered this includes some of the most prominent in the world, [including multiple] Nobel Prize winners. Studies supporting this conclusion have been conducted at such heralded universities and business schools as MIT, The Wharton School, Berkeley, Chicago, Yale, Harvard, London Business School, Illinois, Hebrew University, and Carnegie Mellon, just to name a few. The value of annuities in retirement seems to be a rare area of consensus among economists." Understandably, the mutual fund industry has sought to tap into the retirement income market, but their products don't match up to annuities. For virtually all retirees, you simply can't beat guarantees.

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