Evaluating Investments Versus Insurance In Retirement
June 30, 2015
by Wade Pfau
Warren Buffett: If You Own A Good Business, Keep It
Buying private businesses is easier than acquiring public firms, and investors should avoid selling good investments at all costs, according to the Oracle of Omaha, Warren Buffett. Q2 2020 hedge fund letters, conferences and more In an interview with CNBC in March 2013, Buffett was asked if he was looking at any businesses, in particular, Read More
Retirement-income planning has emerged as a distinct field in the financial services profession. But because it is still relatively new, the best approach for building a retirement income plan remains elusive. In the past, I’ve described two fundamentally different philosophies for retirement-income planning: probability-based and safety-first. Those philosophies diverge on the critical issue of where an individual must place their trust: in the risk/reward tradeoffs of an equity portfolio, or on the contractual guarantee of insurance products.
Those favoring investments rely on the notion that the market will eventually provide favorable returns for most retirees. Though stock markets are volatile, stocks can be expected to outperform bonds over a reasonable amount of time. Those believing strongly in investments consider upside potential from a portfolio to be so significant that there is a very limited role for insurance solutions. Why needlessly cut off the upside? On the investment side, there is also a general unease about relying on the long-term prospects of insurance companies or bond issuers to meet their contractual obligations. Perhaps not fully understanding the implications of how sequence-of-returns risk differs from market risk, the belief is that in the rare event that the performance for the equity portfolio does not materialize, it would imply an economic catastrophe that would sink insurance companies as well.
Meanwhile, those favoring insurance believe that contractual guarantees are reliable and that an overreliance on the assumption that favorable market returns will eventually arrive is emotionally overwhelming and dangerous for retirees. Indeed, they are more concerned about the implications of market risk than those favoring investments. Even if there is a low probability of portfolio depletion, each retiree gets only one opportunity for a successful retirement. At the very least, essential income needs should not be subject to the whims of the market. As well, advocates from this side view investment-only solutions as undesirable because the retiree retains all the longevity and market risks. These are risks that an insurance company is in a better position to manage.
But retirement-income planning is not an either/or proposition.
We must step away from the notion that either investments or insurance alone will best serve retirees. Each has its own advantages and disadvantages. An entire literature on “product allocation” (introduced by Peng Chen and Moshe Milevsky in 2003) has arisen, showing how a more efficient set of retirement outcomes can be obtained by combining investments with insurance.
Before showing how greater integration can be achieved, let’s take a step back and look at a detailed summary of the advantages and disadvantages of investments and insurance when it comes to meeting retirement goals.
It is important to first clarify the goals for a retirement-income plan. It seeks to meet the specific financial goals identified by a client in a way that best manages the wide variety of risks that threaten those goals. The primary financial goal for most retirees relates to their spending: maximize spending power [lifestyle] in such a way that spending can remain consistent and sustainable without any drastic reductions, no matter how long the retirement lasts [longevity]. Other important goals may include leaving assets for subsequent generations [legacy], and maintaining sufficient reserves for unexpected contingencies [liquidity].
Using those bracketed terms, financial goals for retirement can be summarized as:
Investments and insurance have advantages and disadvantages when it comes to meeting each of these goals.
Remember, if you have a question or comment, send it to [email protected]
© 2015, Advisor Perspectives, Inc. All rights reserved.