Revisiting the Research on SPIAs in Retirement Portfolios

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The conclusions drawn by Michael Kitces and Wade Pfau in their paper, The True Impact of Immediate Annuities on Retirement Sustainability, are flawed.

In 2013, Kitces and Pfau undertook a deep look at two important topics dealing with drawdown strategies. Their first paper – the one with which I take issue – was followed by Reducing Retirement Risk with a Rising Equity Glidepath. Their first paper discussed the true impact of single premium immediate annuities (SPIAs). But the rising equity glidepath research is intertwined in their annuity analysis, so I also address it within this commentary.

Summarizing the prior research methodology

The Kitces-Pfau research follows the path of the 2001 research from John Ameriks, Mark Warshawsky and Bob Veres, which concluded that buying a SPIA improved the sustainability of retirement portfolios. The Kitces-Pfau research attempted to identify and quantify the components that provided this added benefit. The authors concluded that “a significant portion of the benefits provided by a stocks/SPIA strategy can be explained by the implied rising equity glidepath of the strategy.” That is, investing in annuities actually created a rising stock allocation in the retiree’s investment portfolio, and this element made retirement income more sustainable under a greater range of market conditions.

To arrive at this conclusion, Kitces and Pfau evaluated the annuity purchase in the context of a total-balance-sheet perspective. With a balance-sheet approach, the annuity is no longer disregarded in the asset allocation as merely a source of income, but is instead counted as an asset each year at its declining present value. By combining the remaining present value of the annuity with the remaining financial portfolio, the authors provide a more accurate picture of total wealth and, I might add, a more accurate picture of the diversification of that wealth. (I will use the term “financial portfolio” to refer to the non-annuity portion of the retirement portfolio, consistent with Kitces and Pfau’s use of that term.)

In order to determine which approach provided improved portfolio sustainability, Kitces and Pfau created three separate portfolio scenarios:

1. The retirees used a systematic withdrawal strategy from a portfolio of stocks and bonds, which was rebalanced annually to a static 50/50 asset allocation.
2. The retirees used 50% of their portfolio to purchase a SPIA and maintained a 100% stock allocation in the remaining 50% invested in the financial portfolio. They maintained this 100% stock allocation in the portfolio throughout retirement.
   With this ”total wealth approach,” the asset allocation will be 50% stocks and 50% annuities for the first year only. Each year thereafter, as the present value of the annuity declined (the fixed-income share) and the financial portfolio, which remained 100% stocks, either stays the same or grows, the asset allocation became more equity-centric. This is the element in the stock/SPIA strategy that the authors suggested came from a rising equity glidepath.
3. The initial stock allocation for the first year of retirement is the same 50/50 as in Portfolio 1, but no SPIA was purchased. Instead, in each subsequent year, the stock/bond allocation was rebalanced so that the portion of assets in stocks matched the ”evolving implied portion“ of total wealth in stocks from the stocks/SPIA combination in Portfolio 2. Portfolio 3 was thus labeled the “implied glidepath.”

For each scenario, the authors applied three different capital-market assumptions for a 65-year-old male, a 65-year-old female, a 65-year-old couple and a 75-year-old male. They repeated the baseline capital-market scenario for each cohort using two initial drawdown rates of 4% and 6%. Each of those scenarios assumed the SPIA had inflation protection, but they repeated all of the scenarios assuming the SPIA had no inflation protection.