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How Do You Know if You Need an Annuity?

Last Monday’s article briefly touched on some of the factors involved in whether or not it makes sense for somebody to purchase a single premium immediate annuity (“SPIA” — essentially a pension from an insurance company) with part of their portfolio. Several readers wrote in with related questions, such as this one:

“My question is related to SPIA and when to buy them. How do you know if you need a SPIA? Example: If you have a $1 million portfolio (60% bonds 40% equity) and you need to take 4% a year out are you a candidate for a SPIA?”

Generally speaking, a SPIA is useful when you want to increase the amount that you can safely spend from your portfolio per year. Said differently, it’s useful when your desired spending level might not be safe, given your portfolio size and given the other characteristics of your situation.

Based on the example the reader provided, there’s no way to know whether the person is a candidate for such an annuity. Much more information is needed. I would ask the person in the example the following questions.

How old are you? What kind of health are you in? Are you married? If so, how old is your spouse and what kind of health are they in? The key point with all of these questions is that the longer your life expectancy — or joint life expectancy — the riskier that 4% withdrawal rate is. If you’re 80 and single, a 4% withdrawal rate is super duper safe. If you’re 55, married to a 52-year-old, and you’re both in great health, that 4% withdrawal rate is quite a bit riskier.

Also, when you say that you “need” to spend 4% per year, what do you mean by “need”? For example, if the portfolio’s returns were poor within the first 5 or 10 years of retirement, how much of a disaster would it be to spend, say, 3% or 3.5% from the portfolio instead? The more flexibility you have, the safer the 4% initial withdrawal rate and the lower the need for an annuity.

And have you already claimed Social Security? If you haven’t, delaying Social Security (especially for the higher earner of the two of you, if you’re married) is a great way to increase your level of guaranteed income, and the payout is much better than the payout from annuities purchased from insurance companies. Conversely, if you’re already age 70 (or are already planning to delay until 70) and you are thinking (due to the factors discussed above) that your 4% necessary withdrawal rate is riskier than you’d like, a SPIA becomes more relevant.

And, speaking of Social Security, how much total safe income do you have? For example, if you’re planning to spend $40,000 from the portfolio per year but you also have $80,000 per year of Social Security/pension income, the impact of portfolio depletion would be much less dramatic than if you have $15,000 per year of Social Security/pension income. And, therefore, holding all else constant, a 4% withdrawal rate is much riskier if you have a lower level of guaranteed income from other sources than if you have a higher level of guaranteed income. (This was the major point of the article from David Blanchett that we discussed last week.)

And how strong is your “bequest motive”? That is, how much do you care about leaving money to heirs? One of the big drawbacks of purchasing a SPIA is that it reduces the size of your portfolio, so if you die soon after purchasing the annuity, your heirs will receive less than they would have received otherwise.

Overall point being: In some cases, a person with a $1,000,000 portfolio who plans to spend $40,000 per year (adjusted for inflation) from that portfolio has absolutely no need for a SPIA. Another person with different circumstances — but still with the same portfolio and still planning to spend the same amount from it — should think very seriously about purchasing a SPIA.

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The Relationship Between Guaranteed Income and Safe Withdrawal Rates

Spending from your portfolio in retirement is always a balancing act between two competing goals:

  1. Minimize the likelihood of depleting your portfolio during your lifetime (i.e., don’t overspend), and
  2. Have as high a standard of living as possible (i.e., don’t underspend and end up with a giant pile of unspent money when you die).

In a recent paper David Blanchett of Morningstar looked at how that balancing act is affected by the portion of your spending that comes from guaranteed sources (e.g., Social Security, pension, lifetime annuities) as opposed to from a portfolio of stocks/bonds with unpredictable returns.

If your spending is primarily portfolio-funded (rather than coming from guaranteed sources), you cannot afford to take significant risk of depleting the portfolio. That is, Goal #1 (don’t overspend and deplete your portfolio) is so much more important than Goal #2 (don’t underspend) that you can’t really afford to think about Goal #2 very much. Conversely, if your overall spending is funded primarily by guaranteed sources, then Goal #1 becomes less important relative to Goal #2 and the “just right” rate of spending from your portfolio is going to be higher.

A lot higher, as it turns out. Here’s one of Blanchett’s findings:

“Results from this analysis suggest that optimal initial safe withdrawal rates varied significantly when guaranteed income was considered, from approximately 6 percent when 95 percent of wealth was in guaranteed income, versus approximately 2 percent when only 5 percent of wealth was in guaranteed income.”

In other words, holding all of the other variables constant, it’s reasonable for a person with a very high level of guaranteed income to spend from their portfolio at roughly three-times the rate of a person with a very low level of guaranteed income.

An important takeaway here is that if you are basing your own spending rate upon one or more specific pieces of “safe withdrawal rate” research, you should check that their assumptions are a good fit for your own personal circumstances. Does the research demand a higher (or lower) level of safety than you require given your own circumstances?

Another important point is that this factor (i.e., the percentage of your spending that comes from guaranteed income sources rather than from a stock/bond portfolio) is under your control to a significant extent. If you want to increase your level of safe income, you can delay Social Security and/or purchase a lifetime annuity with part of your portfolio. These are not things that everybody should do. But they do meaningfully increase the amount you can safely spend per year, because:

  1. The payout on the part of the portfolio that gets annuitized (or the part that gets spent down to delay Social Security) is higher than the safe withdrawal rate from a stock/bond portfolio, and
  2. As Blanchett discusses in the paper, your safe withdrawal rate from the rest of the portfolio can now be higher because it’s less problematic if the portfolio is ultimately depleted.

To be clear though, while this one factor does have a big impact, it’s not the only thing influencing the appropriate spending rate from a portfolio. The appropriate spending rate also varies significantly depending on:

  • The expected returns from stocks and bonds,
  • Your life expectancy (an 85-year-old can safely spend a higher percentage of their portfolio per year than a 65-year-old),
  • Your flexibility to adjust spending, and
  • The strength of your “bequest motive” (i.e., your desire to leave behind a lump-sum for your heirs).

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Can I Retire Cover

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Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

“Total Market” Investing and Multi-Factor Models

A reader writes in, asking:

“I would like to ask you about factor investing. For background, I am a plain vanilla investor. I use the Vanguard Market-cap weighted Total World Stock fund. As simple as it gets!

However I have been reading literature about the case for factor investing. There seems to be a broad consensus that multi-factor models explain returns much better than the CAPM. [Mike’s note: the Capital Asset Pricing Model is an older model in finance that states that a portfolio’s expected return is a function of how sensitive the portfolio is to market risk. More recently, various multi-factor models have said that a portfolio’s expected return also depends on other things, such as how much of the portfolio is allocated to small-cap stocks (as opposed to large-cap stocks) or to value stocks (as opposed to growth stocks).]

I have heard many recommending tilting to small and value stocks.

Do I need to be concerned about my plain vanilla strategy? Am I potentially missing out on much superior returns over the long run?”

It’s true that there is, roughly, a consensus that multi-factor models explain returns better than CAPM. That isn’t an argument for or against a “total market” portfolio though.

To back up a step, a one-factor model such as CAPM tells us that stocks are riskier than bonds and should therefore usually have higher returns. But that’s not an argument for an all-stock portfolio (or any other particular stock/bond allocation). It all depends on your own personal balance of desire for return and willingness to take stock market risk.

Similarly, in multi-factor models, value stocks and small-cap stocks are generally considered to have higher risk and higher expected return than their counterparts. But that’s not an argument for any particular value/growth allocation or small/mid/large allocation. Again it all depends on your personal balance of desire for return and willingness to take risk.

In my experience, it’s usually the salespeople (e.g., certain advisors or purveyors of mutual funds) who argue that a given allocation is better, while the academics are much more neutral on the matter. For instance, Eugene Fama (one of the two people originally behind multi-factor research) was super clear in a video interview on Dimensional Fund Advisors’ website. The video disappeared when they restructured their site a few years back, but here’s the relevant quote:

Interviewer: Some people cite your research showing that value and small firms have higher average returns over time and they assume that you would recommend most investors have a big helping of small and value stocks in their portfolios. Is that a fair representation of your views?

Fama: Um, no. (Laughs) Basically this is a risk story the way we tell it, so there is no optimal portfolio. The way I like to talk about it when I give presentations for DFA or other people is, in every asset pricing model, the market portfolio is always an efficient portfolio. It’s always a relevant portfolio for an investor to hold. And investors can decide to tilt away from that based on their personal tastes.

But that’s what it amounts to. You can decide to tilt toward more value or smaller size based on your tastes for these dimensions of risk. But you needn’t do it. You could also decide to go the other way. You could look at the premiums and say, no, I think I like the growth stocks better. Then, as long as you get a diversified portfolio of them, I can’t argue with that either.

So there’s a whole multi-dimensional continuum here of efficient portfolios that anybody can decide to buy that I can’t quarrel with. And I have no recommendations about it because I think it’s totally a matter of taste. If you eat oranges and I eat apples I can’t really quarrel very much with that.

As far as still-available interviews with Eugene Fama, here are two:

In the first video, Fama talks about the origin of the 3-factor model. While he doesn’t explicitly get around to portfolio construction in this interview, he does state very clearly that his view is that the higher returns are the result of higher risk. (Around 5:26 is where the conversation leads to this point.)

The second video is longer and covers a lot of topics. The video’s publisher explicitly requests that it not be quoted, so I won’t quote it. Instead, I’ll just point out that around 28:45, Fama says things very similar to the interview that I quoted above. And at 35:28 he says something very clear about holding a market portfolio and whether he thinks it’s a good choice or not.

In my view, overweighting small-cap stocks or value stocks in your portfolio is a perfectly reasonable thing to do. But on occasion you’ll encounter people who indicate that doing so is the smart way to invest and only an uninformed investor would say otherwise. But that’s clearly not true.

Investing Blog Roundup: Another Challenge to DALBAR’s Math

Since 1994, research firm DALBAR has published an annual report that shows that mutual fund investors dramatically underperform their own mutual funds due to poor timing decisions (i.e., buying and selling at disadvantageous times), and their report is frequently cited within the investment industry. The underperformance that DALBAR reports, however, is quite a bit larger than the underperformance that Morningstar reports on the same topic.

Two months ago, Advisor Perspectives published an article from researcher Wade Pfau asserting that the difference is primarily due to DALBAR just doing the math incorrectly. DALBAR replied — disagreeing of course. But they they did not really provide any evidence or examples of how they do their math and why it would make sense to do it the way they do it.

This week, David Blanchett (head of retirement research for Morningstar) performed an independent calculation of investor performance to see whether his findings would mirror Morningstar’s official findings or DALBAR’s findings. The result is that we now have one more source indicating that DALBAR’s findings are way off the mark.

The takeaway: It looks like mutual fund investors aren’t nearly as dumb as some prominent sources would have you believe.

Other Investing Articles

Thanks for reading!

Using a Trailing Stop Loss to Reduce Risk

A reader writes in, asking:

“What are your thoughts on implementing a Stop Loss/Trailing Stop Loss for your positions? More specifically, does a trailing stop loss make sense given the added protection against downside risk? I thought it might be an interesting question given the current stock market valuation.”

How Does a Stop Loss Work?

For those who are unfamiliar, a stop loss order is an order that says, “if the price of this holding falls below $x, sell my shares.” A trailing stop loss is an order that says, “if the price of this holding falls by a certain dollar amount (or percentage) from its highest point since I placed this order, sell my shares.”

Example: Bob holds shares of an ETF that is currently worth $90, and he sets a trailing stop loss to sell if the price falls by 10%. That would currently mean that if the share price falls to $81, his shares will be sold. However, if the share price moves upward, the trigger price for his order will move upward as well. For example, if the share price climbs to $100, the new trigger price would be $90 (i.e., a 10% fall from the new high).

Does a Stop Loss Reduce Risk?

To answer the reader’s question, yes, a trailing stop loss is an effective way to provide some “added protection against downside risk.” It isn’t perfect protection, because the price at which the sell order is actually filled could ultimately be lower than the trigger price if the price is falling very quickly. Still, it does reduce risk relative to simply holding something without a stop order.

But, to state the obvious, the fact that something reduces risk doesn’t necessarily make it a good idea. Selling all of your existing holdings and moving everything into a short-term TIPS fund would also reduce risk, but it wouldn’t make sense for most people.

Is a Stop Loss a Good Idea?

Many people first learn about stop orders (trailing or otherwise) and think it’s a simple way to “miss” downward movement. For example: “I’ll set a trailing stop order to sell when the price falls by 10% and then I’ll buy again after it has fallen by 15%. That way I’ll get to miss out on part of the fall while still being able to experience the eventual rebound.”

The problem with this line of thinking is that it neglects to consider what happens if the stock falls 10%, but then rebounds before having fallen by 15%. In such a case, the person has sold their holding but does not buy back in at any point. At some point, they will have to decide whether they want to go ahead and buy back in anyway at a higher price than the price at which they sold.

Moving these two price points closer together (rather than 10% and 15%) does reduce the likelihood of such a scenario, but it also reduces the “payoff” when the strategy works out. That is, it reduces the amount of price decline that the investor gets to avoid.

In addition, on each roundtrip (i.e., selling the holding then eventually buying it again) there are transaction costs that must be overcome in order for the strategy to provide a net gain.

To state the issue another way: A stop loss order essentially says that you don’t want to sell at today’s price. But you would be willing to sell at a price lower than today’s price. For example, I don’t want to sell it today for $100, even though I could. But I would be willing to sell it in the future if the price falls to $90.

This is a line of thinking that does not, in itself, make sense. It only makes sense if you think that prices are predictable. That is, it only makes sense if you think that the lower price tomorrow means that it’s about to go down further rather than going back up. Unfortunately, short-term stock movements are not usually predictable. (This is why strategies that use price movements to predict future price movements are not generally successful.)

In summary, yes, trailing stop orders do reduce risk. But my personal view is that I don’t think most people should bother with them. Most people, if they desire to reduce the risk in their portfolio, are going to be better served by doing it in a simpler manner: by adjusting their asset allocation.

When Are Variable Annuities Useful?

This is the final article in a three-part series about variable annuities. The first article discussed how variable annuities work. And the second article discussed how variable annuities are taxed.

To recap, a variable annuity is essentially one or more mutual funds (or other similar investment options) wrapped in an insurance policy. The insurance aspect of the product creates some unique characteristics:

  • A death benefit,
  • The ability to “annuitize” the policy (i.e., convert it into a guaranteed stream of income),
  • Various optional riders that provide other insurance characteristics, and
  • Unique tax treatment.

Death Benefit

As a reminder, the death benefit is the fundamental insurance aspect of a basic variable annuity. The most common death benefit says that if you die while holding the policy and the account value at that time is less than your net contributions, your beneficiary will receive an amount equal to your net contributions rather than the (lower) account value.

The problem here is that this is such a strange sort of insurance. It doesn’t protect you against loss. Nor does it protect your loved ones in the event of your death as life insurance would. Instead, it only protects if both of those events occur at the same time (i.e., you die and at the time of your death the account value is less than your net contributions to the policy). And even then the insurance only provides enough money to “top them off” (i.e., bring the amount they receive back up to the net contribution), whereas a simple term life policy could provide a much larger death benefit per dollar of premium.

Another key point is that the death benefit is most likely to pay off in the first few years you own the policy, because at least in theory after several years the account value will have gone up. So you can eventually (sometimes quickly) reach a point where it becomes clear that the death benefit will have no value at all, and yet you’re stuck paying for the death benefit (via the “mortality and expense risk fee”) every year for the rest of the time you hold the policy.

It’s not that the death benefit doesn’t have any value. The problem is that there’s nobody who needs exactly this sort of insurance. It’s not an especially good fit for anybody.

A general financial planning guideline is that it doesn’t make sense to buy insurance that you do not need. And the death benefit on a variable annuity is insurance that most people do not need.

Ability to Annuitize

The second insurance aspect of a variable annuity is the option to annuitize the policy (i.e., convert it from a somewhat-liquid asset into a guaranteed stream of income). But that’s not necessarily valuable in itself, because with any other liquid asset you always have the option to sell it and simply buy an immediate annuity with the proceeds.

In other words, the ability to annuitize a deferred variable annuity only ends up being helpful if it helps you avoid a meaningful tax cost on that exchange or if the variable annuity has a meaningfully higher payout than what would be offered on the market for immediate annuities.

Optional Annuity Riders

A variable annuity could be a useful part of a financial plan when a particular rider provides a high value to you relative to its cost. The trouble here is that the value of a rider is usually super difficult to determine.

The insurance company has a team of actuaries, financial analysts, and attorneys working together to create the product in such a way that they believe it will be profitable for them. The consumer, on the other hand, doesn’t have nearly the same level of information or analytical ability.

And when a financial services company has a significant information advantage over the client (that is, when the client can’t really tell whether they’re getting a very good deal, a very bad deal, or somewhere in the middle), it is not usually the financial services company that gets the short end of the stick. This doesn’t mean that you should never purchase a variable annuity, nor does it mean that you should never purchase a rider on a variable annuity. It does, however, mean that you should be very skeptical about whether or not you’re getting good value for your money.

Tax Planning Uses

As we discussed last week, the circumstances in which a variable annuity’s tax treatment would be most beneficial would be something like this:

  • You have a high marginal tax rate,
  • You want to invest in an asset that a) has a high expected return (as measured in nominal dollars rather than inflation-adjusted dollars) and b) does not receive very favorable tax treatment (e.g., high-yield bonds or REITs),
  • You do not have room for that asset in your retirement accounts,
  • You expect to hold the asset for a long time (such that the tax-deferral has many years to create significant value), and
  • You expect to deplete the asset during your lifetime rather than leaving it to your heirs (otherwise you’d want a taxable account so they could receive a step-up in cost basis).

This is uncommon, but it’s not unheard of. Also, this situation would be significantly more common if interest rates were higher because the annual tax cost of holding regular “total market” bond funds in a taxable account would be greater than it is at the moment.

The most common financial planning use of variable annuities is simply as a replacement for worse (i.e., more expensive) variable annuities that a person has already purchased. As we discussed last week, if you liquidate a variable annuity, there can be undesirable tax consequences. If, however, you exchange that variable annuity (via a “1035 exchange“) for another variable annuity (or a qualified long-term care contract) then you do not have to pay any tax on the transaction.

As a result, for people who have purchased very expensive variable annuities, it is often advantageous to exchange them for variable annuities with lower ongoing costs (e.g., the Vanguard Variable Annuity or the Monument Advisor variable annuity from Jefferson National/Nationwide). A key point, however, is that a 1035 exchange only gets around adverse tax consequences. It does not get you out of paying surrender charges.

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