Solving retirement investment dilemmas with annuities
By Chris Conklin
Insurance Insight Group
The conventional wisdom says that smart retirement investment is about building a balanced portfolio of stock- and bond-based investments that will provide an adequate total return over time. While there will sometimes be heart-wrenching short-term fluctuations in the value of these holdings — particularly the stocks — the conventional wisdom says that they are safe over the long run, and owning significant portions of them is necessary in order to produce a secure retirement.
However, two dramatic stock market declines over the past decade, along with today’s historic low bond yields, have many investors questioning the wisdom of this approach. Sometimes their advisors, even while they reassure their clients that everything will be fine, inwardly wonder if their advice is correct.
The conventional wisdom is wrong
The reality is that giving this conventional advice to a retiree or near-retiree could be disastrous, and few financial firms would follow this advice if the retirement funding liability was their own.
Consider, for example, a financial firm that is responsible for providing investment advice to a defined benefit pension plan. Healthy, well-funded pension plans tend to have the great majority of their assets invested in bonds and only a small portion in stocks. The reason is that their responsibility is to be able to provide a steady, promised rate of income to the group of retirees regardless of economic conditions, and stocks are very ill-suited to that purpose.
But pension fund managers have an advantage over individuals. At the very least, pension fund managers can rely upon the law of large numbers to ensure that the longevity of the recipients remains fairly predictable. If the pool of retirees is reduced to one or two people, the longevity is so unpredictable that the only way they can mitigate the longevity risk is to buy an annuity from an insurance company.
Consider the risks to an individual
If you meet with a client to put together a financial strategy, your financial model will typically either ask for or rely upon assumptions for many events, including investment returns and longevity, that are wildly unpredictable. Perhaps a Wall Street Journal article from February 2000 expressed it best:
“Retirement is the great financial riddle. Think of the uncertainties. You don’t know how long you will live. You don’t know what investment returns you will earn. You have only a limited sum of money. And there are no second chances.”
Imagine, for example, that you were an advisor in Japan in 1990. The Nikkei average was at about 39,000 points. You recommended a sizable allocation to stocks because you believed they are safe over the long run and necessary to beat inflation. Now, 20 years later, with the Nikkei average at about 9,000 points — down 77 percent from its high — your clients demand an explanation for your original recommendation.
What can you say? “You win some, you lose some”? That doesn’t cut it. And in the United States in 2010, you can’t guarantee your clients that our situation won’t be any different.
What a retiree needs
Consider what you would need to retire with confidence:
- You would need a steady income that increases over time to bridge the gap between your expenses and what you will receive from Social Security and any pensions.
- You would need that income to continue for the rest of your life, no matter how long you live.
- You would need that income to increase substantially if you were to need long term care assistance since your expenses would increase substantially.
Thus, the conventional investment portfolio is very poorly matched to the liability it is trying to offset.
The annuity solution works
If you set aside your conventional thinking and consider what asset mix will provide what a retiree needs, you quickly realize that annuities are a big part of the solution.
Annuities are specifically designed to provide a steady income that lasts as long as a person lives, because insurance companies pool longevity risk. Many annuities can provide for a payment stream that increases at a certain percentage, such as 3 percent annually, but there are also annuities that base their payment increases upon the Consumer Price Index. And, thanks to the Pension Protection Act of 2006, annuities can provide long term care benefits on an income tax-free basis.
Some people have shied away from annuities because in the past, in order to tap into the lifetime income, you had to give up liquidity and control. But that concern is no longer a valid criticism, as there are many deferred annuities on the market that provide guaranteed lifetime income without giving up access to the annuity’s cash value.
With annuities, you can have access to and control of your cash value, which is guaranteed and protected from investment risk. Those same annuities can provide you with a steadily increasing income that is guaranteed to continue for the rest of your life. And, those annuities can provide for the income to increase if and when you should need long term care assistance.
Deep down, you know what’s right
Let me ask you a question: Of the retirees you know, who feel the most secure? Is it those with a sizable holding of stocks and bonds that fluctuates in value daily, or those receiving a monthly pension check that is certain in amount and guaranteed to continue for the rest of their lives?
I’ll bet you answered that it's those receiving a monthly check. If you or your clients are not receiving one from a former employer’s pension plan, the best way to get one is by purchasing an annuity.