Why Advisors Should Use Deferred-Income Annuities
November 24, 2015
by Michael Finke
Retirement income planning is a mathematical problem in which an investor begins with a lump sum of wealth and withdraws cash flows from it over time. The lump sum is invested in assets with future nominal payouts that are either unknown (stocks) or fixed (bonds). The objective is to combine the stock and bond investments to produce an income that is as stable as possible over a predetermined time horizon.
It is common to use a 30- or 35-year time horizon when planning cash flows from an investment portfolio for a newly retired 65-year old client. For simplicity’s sake, in this analysis I’ll assume the client is a single male (the results can easily be adapted to a female or married couple).
The main difference between pre-retirement and post-retirement planning is that the time horizon is much more certain during the accumulation stage. If the client is 50, then he has about 15 years before reaching retirement age. Once the retirement age is reached, however, he has no idea how long his final life-cycle stage will last.
I will show that an eminently effective way to fund retirement is through a deferred-income annuity (DIA), particularly if it is purchased through an IRA as a qualified longevity annuity contract (QLAC). First, I will examine the conceptual justification for DIAs and why they are favored by economists. I will then describe the advantages of purchasing a QLAC, including the ability to avoid required minimum distributions (RMDs).
A conceptual framework for funding retirement
Without knowing the exact time horizon, it is common to develop a plan that will provide a stable income for all but the longest-lived retirees. To estimate the safety of a retirement income plan, we can look at the 2012 Society of Actuaries (SOA) mortality table, which is appropriate for most higher-income planning clients (who will live longer than the Social Security average). If we choose a 30-year time horizon, then 16.6% of male retirees will outlive their assets. Choosing a 35-year time horizon means that 4.2% of males will outlive their assets. Joint mortality is a much higher 37.2% at age 95 and 11.9% at age 100 for same-age couples.
The only way to ensure nominal spending certainty is to invest in fixed-income assets (inflation-adjusted income certainty requires investing in Treasury Inflation Protected Securities). “Risk assets” (primarily equities) provide a higher expected future spending (how much higher is a function of the equity risk premium, which may be much lower today than in the past), but the tradeoff is volatility in future assets available for spending. For this reason, it is appropriate to fund essential spending with fixed income assets and discretionary spending with risk assets.
If we choose to fund 35 years of spending for our 65-year old retiree at $44,623 per year (I will explain later why I’m using this number), then we’ll need to create a ladder of duration-matched bonds that pay this amount in each future year of retirement. Today, a AAA-rated corporate bond is yielding exactly 4%. After 1% asset management fees, you’ll need to purchase $24,707 of 20-year duration corporates to fund $44,623 in spending at age 85. If you need greater security, you could invest in a Treasury bond yielding about 3%, which would cost $30,030 today after asset management fees.
What is the likelihood that your 65-year old client will be around to spend the $44,623 in 20 years? Only 60.2% of males will live to age 85. Let’s say you have nine male friends who each want to invest $24,707 in bonds today in order to spend $44,623 at age 85. Why not get together and each chip in 60% of $24,707, or $14,875? You’ll save 40% on the cost of funding income with bonds in your 85th year because your dead friends will be helping to support the living.
Each year the deal gets even better. At age 90, only 38.4% of men will still be alive. So you can reduce the cost of funding income today by 60%. At age 95, you can cut your cost by over 80%. Do you want to fund income to age 100? Then you can buy income for a 95% discount by pooling assets with your friends.
What is the tradeoff of pooling? Your friends who die early will be funding the spending of those who remain. Is this a significant tradeoff? Well, to be blunt, they’re dead so they don’t care. Their beneficiaries might care, but as I will show later, the risk of pooling to beneficiaries is actually negligible or even nonexistent.
Pooling is the right way to approach funding later life income with safe assets.