Archives for October 2010

The typical approach to investing can be broken down into two steps:

1. Make a list of all your financial goals.
2. Then, put together an investment plan that will give you the best chance of reaching those goals.

That’s always seemed pretty logical to me. To date, it’s the way I’ve approached my own investing. But I’m starting to ponder whether a different approach makes more sense.

Dreaming Big: A Good Idea?

In  step #1 above, we’re usually encouraged to dream big. List everything you’d like to be able to do — retire at 50, travel the world, own a second home, send your kids to Ivy League schools, etc.

A natural consequence of dreaming big is that, in many cases, the only way to reach such ambitious goals is to earn high returns. And the only way to earn those high returns is to invest via higher-risk investments.

Unfortunately, high-risk investments don’t always pan out. That’s why they’re high-risk.

In their book Spend Till the End, Laurence Kotlikoff and Scott Burns argue that the reason we’re encouraged to dream big is simply that the financial services industry is looking out for its own interests rather than ours. They make more money when we take on more risk in hopes of higher returns.

• When we trade stocks frequently or invest via actively managed mutual funds, they make money.
• They don’t make a lot of money when we invest via low-cost Treasury bond funds. (And they make even less if we buy TIPS or other Treasury bonds directly.)

Switching the Process

What if we did things in the other order? What if we approached investing by figuring out what returns we could reliably earn with low-risk investments, then we set goals based on that?

Retiring at 50 would be ruled out for nearly everyone. As would the possibility of a second home. And the Ivy League education for your kids would probably be ruled out too.

But you know what else would be ruled out? The possibility of going broke in your seventies with another decade (or three!) left to live simply because your high-risk investments didn’t perform as well as you’d hoped.

To be clear: I’m not trying to make the case that nobody should take on any risk in their portfolio. If you’re comfortable with the ramifications of risky investments, then by all means, go ahead and use them.

Rather, my point is that, instead of starting with goals and working backward to the portfolio, perhaps it makes sense to start with the portfolio. Determine how much risk you’re comfortable taking, assess what level of returns you can expect based on that level of risk, and then develop your goals based on that information.

The more I write about annuities, the more questions I receive about them. One thing that’s become obvious is that many investors are confused about the differences between the various types of annuities.

Let’s start at the beginning.

An annuity is a contract with an insurance company in which you agree to pay the insurance company an amount of money (a “premium”), and they agree to make payments to you of a specified amount, with a specified frequency, for a specified period of time.

Lifetime vs. Specific Period

Many annuities are lifetime annuities, which means that the period in question is the rest of your life. For example, the insurance company promises to pay you $1,000 every month until you die.

Other annuities are joint lifetime annuities, or simply joint annuities, whereby the insurance company promises to pay a certain amount every period until both you and the other annuitant (usually your spouse/partner) have passed away.

Finally, some annuities aren’t lifetime annuities at all. They simply pay out for a fixed number of years, at which point the payments stop. For example, you could purchase a 3-year annuity that would make payments every month for 3 years.

Note that an annuity with a fixed period is different from a bond. Bonds pay interest over their life and return the principal to you as one lump-sum at maturity. With an annuity, the principal is returned over the life of the annuity.

For the most part, when I write about annuities, I’m referring to lifetime annuities. Their promise to provide income for as long as you live makes them unique — they protect against longevity risk in a way that no other investment does.

Fixed Annuities vs. Variable Annuities

Fixed annuities pay a fixed amount over the life of the annuity. Note: The fact that an annuity is a fixed annuity doesn’t necessarily mean that its payout never changes. You can buy fixed annuities with payouts that increase at a given rate each year — say, 3% — or that increase in keeping with inflation.

Variable annuities are essentially an insurance product wrapped around a portfolio of mutual funds. They typically promise to pay a fixed amount each period, with the potential for that amount to ratchet upward if the underlying mutual funds perform well.

Generally speaking, I’m not a huge fan of variable annuities. They’re usually complex and expensive, and because they each tend to offer different bells and whistles, it’s difficult to compare them to see which provider offers the best deal.

In contrast, fixed annuities are easy to understand and easy to compare. For example, when shopping for a fixed lifetime annuity, if two different insurance companies have similar credit ratings, just go with the one that provides a higher payout for a given premium.

Immediate Annuities vs. Deferred Annuities

With an immediate annuity, the insurance company begins sending you checks immediately after you pay the premium.

With a deferred annuity, there’s a delay between the time at which you pay the premium(s) and the time at which the insurance company begins to send you checks. For the most part, unless you’ve maxed out your retirement accounts and are looking for additional means of tax-deferred saving, there aren’t too many cases in which deferred annuities make sense.

Single Premium Annuities vs. Multiple-Premium Annuities

With a single premium annuity, the premium is a single lump-sum. You write one check to the insurance company, and they start making payments to you at the agreed-upon date.

Other annuities require you to pay premiums over a period of time. For example, you might pay a premium every month until age 65, at which point you stop making payments and the insurance company starts making payments to you.

That’s Just the Beginning

The above descriptions are only a starting point — they don’t even come close to covering every single type of annuity out there. For example, there are several sub-categories of variable annuities. And within the category of fixed annuities, there’s a whole range of additional features (“riders”) you can add to the contract.

In my opinion, the one annuity that every investor should understand (not necessarily buy, but at least understand) is the single premium immediate fixed lifetime annuity. I know that sounds like a mouthful, but based on the terminology above, you can tell that such an annuity would involve:

• You making a single payment to the insurance company, and
• The insurance company making fixed payments to you (or, if you prefer, payments that increase with inflation) for the rest of your life.

When saving for retirement (and planning your spending in retirement), you have to plan for the possibility that your retirement will last for three decades or more. Of course, it might only last for one decade — in which case you deprived yourself throughout your life so that you could save three times the amount that you actually needed.

Pile that uncertainty on top of the uncertainty that comes from market risk and inflation risk, and you can see that retirement planning is a series of guesses. You have to plan for a financial-worst-case scenario in which you live well into your 90s, market returns are poor, and inflation is high.

And even if you do plan for that, you still can’t be absolutely sure that you saved enough.

So what’s the alternative?

Purchasing a single premium immediate fixed annuity with a portion of your portfolio.

Lifetime Annuities Eliminate Longevity Risk

In Moshe Milevsky and Alexandra Macqueen’s book Pensionize Your Nest Egg (my review here), they frequently describe annuities as “longevity insurance.” I like that description. It puts annuities in terms that most of us can understand.

For example, with homeowners insurance, we know that there’s a good chance that the money spent on the premium will go to waste. But, unless you can afford to “self-insure” (that is, unless you have enough money such that you’d be OK if your uninsured house burnt down), it’s still important to have.

Same thing goes for annuities: If you have so much money that you would be OK in the event that you live well into your 90s, market returns are poor, and inflation is high, then you don’t need to buy one. Otherwise, you probably should.

Eliminating Market Risk

In addition to protecting you from longevity risk, fixed annuities protect you from market risk. If you have a fixed annuity that, together with Social Security, provides enough income to cover your necessary expenses, you don’t have to worry about:

• Poor stock market performance, or
• An unfavorable sequence of stock market returns.

Your annuity will provide a steady payout no matter how the market is doing.

Eliminating Inflation Risk

Lastly, buying an inflation-adjusted annuity can protect you from inflation risk. (Though the inflation protection will significantly lower the initial payout.)

Remember, though, that if you really want to eliminate inflation risk, it’s important to get an annuity with a payout that’s linked to the Consumer Price Index (CPI) rather than one that increases at a fixed rate per year.  An annuity with a payout that increases at a flat 3% per year won’t protect you in the case of severe inflation.

Standard Caveats Apply

Despite how helpful annuities can be for retirement planning, they have their drawbacks:

• They carry credit risk.
• The money spent on the annuity will not go to your heirs when you die (unless you purchase a rider that allows it to do so, in which case the annuity’s payout is significantly decreased).
• They’re not liquid. So, unlike other retirees, if you opt to annuitize a large portion of your portfolio, you’ll have to keep an “emergency fund” to use in the event of a large unexpected expense.