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Lifetime Annuity: Avoid the Period Certain

A reader writes in, asking:

“Can you please write an article about SPIAs with guarantees of a minimum payout period?”

For those who are unfamiliar, a single premium immediate lifetime annuity (sometimes referred to as a SPIA) is an insurance product where you give the insurance company a lump sum of money (which you cannot get back) and in exchange the insurance company promises to pay you a certain amount of money every month for the rest of your life. In short, it’s a pension that you purchase from an insurance company.

Such annuities are useful because they protect against longevity risk (i.e., the financial risk that comes from living very long and therefore having to pay for a very long retirement).

One thing that stops many people from buying such annuities, however, is the fear that they’ll die soon after purchasing the annuity. For example, if you spend $100,000 on a SPIA that pays you $6,000 per year for the rest of your life, but the rest of your life only turns out to be a couple of years, you will have had a net loss of $88,000.

And that’s why insurance companies offer the option to purchase a “period certain,” whereby the insurance company promises to pay out for at least a given period of time. For example, for a lifetime annuity with a 10-year period certain, the insurance company promises to pay out for the rest of your life but no less than 10 years. (So if you died after two years, the insurance company would continue to make payments for another 8 years to your named beneficiary.)

Of course, because of this guarantee, a lifetime annuity with a period certain will cost more (i.e., will require a higher premium) for a given level of income than you would have to pay for a lifetime annuity without a period certain.

Why a Period Certain Is a Bad Deal

The whole point of insurance is risk pooling. For example, consider 1,000 people who purchase homeowners insurance from a given insurance company. Most of those people will not have their homes destroyed by a fire or a tornado. And that fact — the fact that the insurance company is going to collect money from all of those people without ultimately having to make a huge payout to them — is how the insurance company can afford to make a huge payout to the person whose home is destroyed by a fire.

A key point, however, is that for every dollar that an insurance company receives in premiums, they keep some part of it to cover their administrative costs and to provide profit to shareholders. So only some of the money spent on premiums ultimately goes to pay for claims to people purchasing the insurance product in question. So in general it is unwise to purchase an insurance product unless:

  1. There is risk pooling going on (i.e., many people are going to ultimately get a bad deal so that some people can get a very good deal), and
  2. You need such risk pooling (i.e., you cannot reasonably afford to cover this risk out of pocket on your own).

With a lifetime annuity, risk pooling occurs because some annuitants will die prior to reaching their life expectancy (i.e., the insurance company will pay less than the “expected” amount to those people — which is how it can afford to pay more than the “expected” amount to the people who live beyond their life expectancy).

But if the insurance company is providing a period certain, it knows it must pay out for that entire period. In other words, the annuity then offers no risk pooling for that period. Instead, what’s occurring for that period is just the insurance company gradually paying your money back to you — after taking a piece off the top for profit and expenses — without any actual net insurance effect.

In most cases you would be better off investing the money yourself for the period certain, then buying the annuity at the end of that period. (Of note: if you would be considering a 10-year period certain, don’t buy 10-year bonds. Instead buy longer-term bonds to offset the interest rate risk that you face with the annuity purchase. See this prior article and this Bogleheads discussion for a more thorough explanation.)

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

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."

61: The Magic Retirement Age?

David Blanchett of Morningstar recently released a piece of research discussing the uncertainty of retirement age: The Retirement Mirage (pdf). I linked to it in the most recent roundup, but I wanted to highlight its findings, as I know that any single article in a roundup can be easy to miss.

Blanchett looked at 12 years of data from the University of Michigan’s Health and Retirement Study (HRS). The HRS is interesting because it tracks a large group of people (approximately 20,000) over a period of time, so you can see how people’s circumstances and views change over time.

Blanchett learned two interesting things from the HRS data.

First, he found that you’re likely to retire closer to age 61 than you think. In Blanchett’s words:

“According to the Health and Retirement Study data, planned and actual retirement ages align at 61, with those planning to retire earlier than that tending to retire later than expected, and those planning to retire after 61 tending to retire earlier than expected. In other words, actual retirement ages pull toward 61, with each retirement year planned before or after age 61 resulting in a half-year’s difference in actual retirement age. For example, someone who plans to retire at age 69 will likely retire at age 65 (69 – 61 = 8 × 0.5 = 4; 69 – 4 = 65)”

Of those planning an early retirement, many are ultimately unable to retire as early as planned.

And of those planning on working well into their 60s, many are unable to do so for one reason or another. (Alternatively, some people are probably retiring earlier than anticipated because they’re finding that they do not need to work as far into their 60s as planned.)

So, what might help us to predict who will be in the “retiring earlier than planned” or “retiring later than planned” groups? That leads us to Blanchett’s second noteworthy finding:

“The rich HRS data set allowed us to test more than a dozen factors, including general personal characteristics such as gender, marital status, and education, along with factors that might be expected to lead to retiring early, such as job stress level, how physical a job is, and whether health problems limit someone’s work. However, these factors had little or no predictive power on retiring early. The only factor that appeared to tell us much about when someone might retire was their planned retirement age and its distance from the previously noted ‘magic’ retirement age of 61. […] Not only do many people retire earlier than expected, but it’s nearly impossible to predict who will be part of this group.”

This obviously presents some challenges as far as retirement planning. But it also suggests a few financial/life strategies that are likely to be worthwhile.

If you’re planning an early retirement, keep your professional skills sharp, as there’s a good chance you’ll be working longer than you anticipate. Also, if you’re currently in the position of “grinding it out” at a job that you hate, with the hope of being happy once you achieve an early retirement, you may want to consider a different approach. “Just 2 more years” could well turn out to be 3, 4, or 5 more years. Focusing instead on making changes that allow you to be happy while still working is likely to be a good idea.

At the other end of the spectrum, if for example you are currently age 60 and planning to work until 68, socking away that last chunk of necessary retirement savings may be more urgent than you think. Retirement may ultimately be something that happens to you, rather than a decision you make.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

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."

Investing Blog Roundup: 2018 “Can I Retire” Now Available

The 2018 edition of Can I Retire is now available (print edition here, Kindle edition here). That’s (finally) the last of the 2018 updates to reflect the new tax law. To be clear, the biggest change with this update is simply new tax information. So if you’ve read a prior edition, there’s probably not a lot to be gained from buying/reading the new edition as well.

For anybody who hasn’t yet read the book and is curious what’s in it, the table of contents is as follows:

Part One: How Much Money Will You Need to Retire?

1. How Much Income Will You Need?
Calculating your expenses
Adjusting for inflation
Adjusting for taxes
Adjusting for pensions, Social Security, and other income

2. Safe Withdrawal Rates: The 4% “Rule”
Why only 4%?
Volatility is bad news when selling.
Sequence of returns risk
It’s only a guideline.

3. What if 4% Isn’t Enough?
Possible options
Increasing returns isn’t easy.

4. Retirement Planning with Annuities
What is a SPIA?
Annuity income: Is it safe?
Minimizing your risk

5. How Much (and When) to Annuitize
Creating a safe floor
Annuitizing as a backup plan
Social Security as an annuity

Part Two: Managing a Retirement-Stage Portfolio

6. Asset Allocation in Retirement
Assessing your risk tolerance
There’s no “right” answer.
Stocks vs. bonds
Bond risk levers
Stock risk levers
Rebalancing your portfolio

7. Index funds and ETFs vs. Active Funds

8. 401(k) Rollovers
Reasons to roll over a 401(k)
Reasons not to roll over a 401(k)
How and where to roll over a 401(k)

Part Three: Tax Planning in Retirement

9. Roth Conversions
Roth conversions & retirement planning
How to execute a Roth conversion
Roth conversions of nondeductible contributions

10. Distribution Planning
Fill your 0% tax bracket
Taxable account before retirement accounts
Roth before tax-deferred?
Social Security: It’s complicated.

11. Asset Location
Tax-shelter your bonds
The role of interest rates
Tax-shelter your REITs
Foreign tax credit

12. Other Tips for Taxable Accounts

Again, you can find the book here on Amazon.

Other Recommended Reading

Thanks for reading!

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

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."

Building a Safe Floor of Retirement Income — in Advance

A reader writes in, asking:

“I’ve been reading about the safety first school of retirement planning because I think that appeals to me more than the probability method of just spending from risky investments and assuming everything will ‘probably’ be okay. My question is how to start putting such a plan into action in advance.

With the old school probability method, I would just keep building my mutual fund holdings, possibly rebalancing to hold more bonds instead of stocks. The ‘safety first’ method focuses on delaying social security or buying an annuity. But I can’t delay social security until I’m 62. And I can’t, or shouldn’t, buy an annuity in my 50’s either. So what should I, as a safety first investor in my 50’s, be doing right now in the years leading up to retirement?”

As a bit of background for readers unfamiliar with the terms, there are two broad schools of thought with regard to retirement planning. The first school of thought plans to finance retirement spending primarily via liquidating a mutual fund portfolio (or a portfolio of individual stocks/bonds) over time. This approach relies heavily on historical studies and/or Monte Carlo simulations to calculate how safe a certain level of spending is, given various assumptions. This approach is sometimes referred to as the “probability” school of thought, because it focuses on metrics such as “probability of portfolio depletion.”

The second approach essentially says, “I don’t want to bet my retirement on the validity of such studies/assumptions. I’d rather lock in sufficient safe income (e.g., via annuities, pension, Social Security) to satisfy my needs and only use mutual funds to finance my discretionary spending.” This school of thought it sometimes referred to as the “safety first” or “safe floor” method of retirement planning.

The answer to the reader’s question about how to start implementing a “safety first” plan in advance is that you start building a TIPS ladder (or other bond ladder, or CD ladder) that you will use to fund your spending while you delay Social Security, or to fund your annuity purchase.

To plan in advance for delaying Social Security, you would allocate a portion of the portfolio to a bond ladder that will provide the necessary cash each year for 8 years. For example, if you’re passing up $1,500 per month ($18,000 per year) for 8 years, you could start building an 8-year bond ladder, with roughly $18,000 maturing each year.

If Social Security at age 70 still doesn’t give you a sufficient “safe floor” of income to meet your needs/satisfy your risk tolerance, then you should start thinking about a lifetime annuity.

To start planning in advance for an annuity purchase, you’d do something similar — build up bond holdings that you would eventually use to fund the purchase. What’s different about this, relative to delaying Social Security, is that you don’t know how much the annuity will cost. For example, if you anticipate buying a lifetime annuity at age 70 that pays $10,000 per year, there’s no way to know right now (in your 50s) how much that annuity will cost, because you don’t know how high or low interest rates will be when you turn 70.

The solution, rather than buying a bunch of bonds that mature when you turn 70, would be to work on building bond holdings that, when you turn 70, will still have a duration roughly equal to that of the annuity you expect to purchase. This way, the market value of your bonds will rise/fall along with the cost of such an annuity, helping to offset the interest rate risk that you face with the annuity purchase. (Here’s a great Bogleheads thread on that topic.)

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

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."

Retirement Planning Roadmap (Also, Two Books Updated for 2018)

A quick bit of news for today: the 2018 editions of my book about sole proprietor taxes and my LLC vs. S-Corp vs. C-Corp book are now available. Each book now reflects the new 2018 tax law (including the new deduction for pass-through business income, among other things).

So, of the six books that needed updates to reflect 2018 tax law, five are now finished. (Can I Retire? is the one that is still in the works.)

I recently came across a new publication from Vanguard Research, which they are calling their “Roadmap to Financial Security.” In short, it’s a how-to guide to actually creating a retirement plan.

If you’re working with a financial planner for your retirement planning, presumably they have a process of their own. But for people taking a DIY approach to retirement planning, Vanguard’s paper does a good job of laying out an explicit process for creating a plan.

Specifically, it’s a four-step process, with an aim at achieving financial security, which they define as “the peace of mind that results when retirees feel confident that they will attain all of their financial goals and be able to continue doing so in the future.”

Step one is to determine retirement goals. They make a point of noting that for most people there’s not a single goal of “retirement,” but rather four separate categories of goals — basic living expenses, contingency reserve, discretionary expenses, and legacy funding — the magnitude and importance of which will vary from one person to another.

Step two is to understand the risks. They describe five major risk categories: market risk, health risk, longevity and mortality risk, event risk (i.e., major unplanned expenses), and tax and policy risk. Again, the significance of each will vary from one person to another — as will the solutions selected to manage those risks.

Step three is to assess the available financial resources, such as guaranteed income (e.g., pension, Social Security, lifetime annuity), liquid assets, and other resources (e.g., insurance, home equity, work).

And step four is to develop a plan to achieve goals and mitigate risks. This is the step where you bring everything together (i.e., where you actually determine how to deploy those resources to best achieve your goals in the face of the relevant risks).

I like it. It’s nothing fancy (and nothing super detailed), but it’s clear and easy to follow. You’re essentially building a retirement balance sheet. On one side you have the liabilities that you will have to fund (i.e., the goals you intend to pay for). On the other side, you have your financial resources. And you take the time to consider risks — both risks to those resources as well as risks that might increase the size of the liabilities.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

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."

An Ideal Retirement Spending Strategy?

Late last year, Steve Vernon, Joe Tomlinson, and Wade Pfau released a new piece of research (full version here, summary version here) that evaluated many different retirement income strategies according to several different criteria:

  1. Average annual real retirement income expected during retirement,
  2. Increase or decrease in real income expected during retirement (i.e., does the income go up for down over time),
  3. Average accessible wealth expected throughout retirement (liquidity),
  4. Rate at which wealth is spent down,
  5. Average bequest expected upon death,
  6. Downside volatility,
  7. Probability of shortfall relative to a specified minimum level of income, and
  8. Magnitude of such shortfall.

The report was pretty lengthy, so I put off reading it. But I recently had a long day of traveling (to the White Coat Investor conference), with plenty of time to read.

The report is primarily focused on discussing metrics for testing retirement income strategies, rather than recommending any particular strategy. And the authors repeatedly make the point that no strategy is perfect — it’s always a tradeoff between the different goals/metrics. That said, the authors do spend quite a bit of time discussing one particular strategy, essentially saying, “given our assumptions, this strategy is a pretty good one, when measured by the metrics discussed here.”

In short, the strategy works as follows:

  • Delay Social Security until 70.
  • For the part of the portfolio that is used to fund the delay, invest in something safe, such as a money market fund or short-term bond fund. (For example, if you are forgoing $150,000 of Social Security benefits by waiting from 62 until 70, set aside $150,000 in something safe in order to fund the extra spending necessary until age 70.)
  • For the rest of the portfolio, use IRS required minimum distribution (RMD) tables to determine the amount of spending each year.

And with regard to asset allocation for the rest of the portfolio, the authors write:

“Our metrics support investing the RMD portion significantly in stocks – up to 100% if the retiree can tolerate the additional volatility (which is modest because of the dominance of Social Security benefits). However, the asset allocation to stocks for a typical target date fund for retirees (often around 50%) or balanced fund (often ranging from 40% to 60%) also produces reasonable results.”

Overall, this is basically a combination of several findings that we’ve seen repeatedly from other research over the last several years (including research by these same individuals). Specifically:

  • Delaying Social Security is usually advantageous (especially for the higher earner in married couple);*
  • It’s good to have safe money set aside in order to fund such a delay;*
  • For the rest of the portfolio, a high stock allocation is reasonable (if you can tolerate the volatility) given that you have a significant “safe floor” of income from delaying Social Security;*
  • It’s usually wise to adjust spending over time based on portfolio performance, rather than spending a fixed inflation-adjusted amount each year of retirement;
  • It’s usually wise to adjust spending based on your remaining life expectancy (i.e., you can afford to spend a larger percentage of your portfolio per year when you are age 90 than when you’re age 60); and
  • Using the RMD tables to calculate a spending amount each year does a reasonably good job of achieving the two prior points.

The authors also note that it’s wise to keep a separate emergency fund that would not be used to generate retirement income but which would be used as necessary to pay for unforeseen one-time expenses (e.g., home repairs). And they note that some people may want to make adjustments based on differing goals. For example, retirees who wish to spend at a higher rate during early retirement may wish to carve out a separate piece of the portfolio to fund such spending (and such piece of the portfolio should likely be invested conservatively given that it will be spent over a short period of time).

Again, no retirement spending strategy is perfect, because there’s always a tradeoff between competing goals (e.g., a higher level of spending now, as opposed to a higher expected bequest for your heirs). But a strategy roughly like the one discussed above does appear to be “pretty good” according to a whole list of different metrics.

In his summary write-up, Steve Vernon even concludes with the following:

“I’ve been studying retirement for my entire professional career, and at age 64, I’ve been thinking seriously about my own retirement. This actuary will be using a version of [the strategy discussed above], based on my 30+ years of study. My life-long quest may just be coming to an end!”

*With regard to these three bullet points, I find that it can be helpful to think of them in combination. That is, as you move from 62 to 70, you’re spending down your bonds to buy more Social Security. In other words, you’re shifting your portfolio from “stocks and bonds” to “stocks, a little bonds, and a lot of Social Security” — which is an improvement for most people given that delaying Social Security is, on average, a better deal than you can get from regular fixed-income investments and given that it helps reduce longevity risk.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

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."
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