Moshe Milevsky has popularized a concept he calls Product Allocation in his book Pensionize Your Nest Egg. No, this is not what your local whole life insurance salesman is trying to do when he suggests you invest a big chunk of your savings into cash value life insurance. This is what a retiree may wish to do in order to deal with the unique risks a retiree faces.
According to Milevsky, the three big risks a retiree faces are:
- Inflation Risk
- Longevity Risk
- Sequence of Returns Risk
According to Milevsky, each of these risks has a solution, which can be incorporated into a portfolio using a specific product. The first product is a Systematic Withdrawal Plan (SWP.) This is the classic “safe withdrawal rate” style retirement plan where you invest in a stock and bond portfolio (hopefully using low-cost index funds) and take out ~ 4% a year of your portfolio each year to spend. There are lots of variations, of course, but the point of these SWPs is that your money will keep growing allowing you to keep up with inflation throughout your retirement. This portion of your portfolio also provides for any legacy you wish to leave behind, as well as any large, unforeseen expenses. But mainly, it is to combat inflation.
The second product is a pension. This may be Social Security, an employer provided pension, or a purchased pension, such as a Single Premium Immediate Annuity (SPIA.) A SPIA is a lump sum of money given to an insurance company in exchange for a monthly payment every month for as long as you live. Since all of these pensions will pay until the day you die, they protect against longevity. Sometimes these pensions have an inflation-adjustment, and so also help combat inflation along with longevity. Pensions solve many retirement income issues (including declining cognitive abilities) with the main downside being that there is no lump sum of money for you or your heirs to access.
The third product is a variable annuity (VA) with a living benefit rider. Although I have a healthy skepticism of these complex, often overly expensive products, Milevsky considers them a solution for Sequence of Returns risk. Due to their high expenses, they will underperform a traditional portfolio when economic times are good. However, when times are bad, you can activate the rider and basically turn it into a pension. The idea here is that if sequence of returns risk rears its ugly head in your first few years of retirement, the bear market basically “pensionizes” the VA thanks to the living benefit rider. If it doesn't, then you get market returns minus the cost of the VA and its rider. This essentially moderates what you would have gotten from a traditional portfolio- not quite as good in the best case scenario, but not quite as bad as in the worst case scenario.
Milevsky is so fond of these VAs that in his mathematical model (which relies heavily on assumptions which may or may not be valid) he suggests a retiree allocate 1/3 of his portfolio to each of these products.
One other reason he advocates for these VAs is that it allows you to take more equity risk, and he suggests you take it in the VA. For example, he might say that instead of a 50/50 portfolio, you could use a 60/40 portfolio if you had a VA to moderate the risk. He might also say you fill up the VA preferentially with equities, that way if sequence of returns risk shows up, your investment portfolio isn't hurt as much (since it is mostly fixed income) while the VA becomes a pension.
I'm not entirely convinced the VA is an essential part of this equation. VA subaccounts often have hefty expense ratios of 1-2%. Add on the costs of the VA (which at-cost Vanguard says are 0.19% in its VAs) plus another 0.75% a year for the living benefit rider, and now we're underperforming a standard portfolio by 2%+ a year. 30 years of 5% growth instead of 7% growth on a lump sum reduces the end portfolio size by 43%. Besides, simply purchasing inflation-indexed SPIAs with a larger portion of the nest egg by itself helps protect against longevity, inflation, and sequence of returns risks and avoids even having to wrap your head around how these complicated products work. Michael Kitces seems to agree that these living benefits riders aren't all they're cracked up to be, especially given recent changes in this marketplace.
I emailed both Mike Piper and Wade Pfau, both of whom have spent a great deal of time thinking about retirement income issues like these to get their thoughts on allocating a significant portion of their portfolio to VAs. Here are their thoughts:
Mike Piper:
Doing the actual analysis on annuities with living benefit riders is beyond my skill set, so I rely on the opinions of other people whom I trust. The following articles from Wade Pfau (including the linked-to articles) may be of interest:
Wade Pfau:
Milevsky's book is great, but I do share your concerns about VAs with guarantees. My efforts to create efficient retirement frontiers with product allocation always point to keeping upside and downside separated by using stocks and SPIAs. For me, allocations to VAs are 0%. I'm not sure what exactly Moshe is assuming about the VAs to get them on the frontier with a sizeable allocation.
So there you have it. Everyone still agrees that purchasing a SPIA, especially an inflation-adjusted one, is a good idea for most retirees, especially those without a pension or those with barely enough to support their desired lifestyle. But purchasing VAs for their living benefits riders is still controversial, at best. And even Milevsky isn't suggesting you go out and purchase cash value life insurance for retirement income.
What do you think? What role do you see for “product allocation” in your life? Do you already own or plan to buy a SPIA? Why or why not? Do you already own or plan to buy a VA with living benefits? Why or why not? Comment below!
I see delaying Social Security as our longevity insurance. A SPIA may or may not come into the equation for us depending on how markets treat us over the next 10-12 years. I lost interest in Milevsky once he added tontines to my financial vocabulary. Is there a place for tontines or VA’s in retirement planning? Perhaps. But, a simple indexed retirement plan with reasonable savings starting early in your career will decrease your likelihood of needing to pursue any discussion of these vehicles which enrich the pockets of the providers at the expense of your financial fears or inadequate planning.
I’m with you, WCI. Investments and Insurance are both vital, but it’s best not to mix the 2.
Funny that tontines were mentioned. I had a group of friends that supposedly had a tontine for marriage. The last to marry would collect the pot of $100 each. I don’t know if it was real, if it was meant to encourage staying single, or an acknowledgment that they weren’t the greatest marriage material. Their shenanigans introduced me to the concept anyway, and I can see it’s use in retirement planning in the distant past. If you’re relying on a tontine these days, you’re doing it wrong.
IDK if this has been covered before, but do you think SPIAs are necessary for a new retiree, even if they have accumulated well over 25x annual expenses? If so, what % of the portfolio do you feel should be allocated to the SPIA rather than just using a SWR?
No, if you have gobs of money I don’t think you need a SPIA. I think it’s still okay to buy one even if you have gobs of money, but it’s not necessary. It’s a fairly clean insurance instrument that provides longevity insurance and thus “permission to spend.” Certainly if you’re looking to maximize your retirement spending for a given amount of money, it’s a great option. For those of us who just want to put a higher floor under our spending than SS provides, it’s also a good option. Required? No. Many people have successfully retired without SPIAs.
And I don’t think it’s about a percentage of your nest egg. I think it’s more about matching up the payments with both your spending level and the amount your state provides protection for. For example, I would never want to have a SPIA that paid MORE than my base level of spending. I also would feel uncomfortable having more than I can have covered in my state by the state guaranty corp, at least at any one company. So I think practically speaking, if you’re putting more than $1M total into SPIAs, that’s probably too much in my view. So a six figure amount is probably right.
For the person just trying to bounce his last check and not that large of a nest egg, I still would start feeling uncomfortable at a percentage of 50%+ of the nest egg, even if it didn’t violate the other two rules above.
Great question. Maybe worth a post sometime.
Aren’t these types of annuities invested in only bonds? Is there any history of annuities going bust? Just wondering. I’ve read up and watched a lot on big financial scams and seem to be overly cautious now. Martin Frankel’s insurance fraud comes to mind. So I’m keen on learning more about the annuity industry to see how they will actually be able to provide life long income especially in these very low interest rate environments. I’ve just become skeptical of some these long term financial products with their commitment clauses and high commissions to agents.
Our household is a long way off from retirement but we have a steady savings and investment plan with a frugal life style. I’m pretty sure the political and economic landscape will change quite a bit in the years and decades to come so I’m planning for retirement as if social security won’t be available for us when our time comes. I’ve decided to just create my own pension plan and self prepare the old fashioned way.
Be careful not to apply the general rule of not mixing insurance and investing that comes from all these crazy complicated annuities and cash value life insurance to the relatively simple case of a SPIA. Think of it not as an investment invested in bonds, but simply a guaranteed payment, which lowers your need for income from the rest of your portfolio.
At younger ages, such as earlier than 60, the predominant factor on the SPIA rates available is the current interest rate environment. At 70+, the main factor is the mortality credits from your peers dying off. It is much less sensitive to interest rates then.
As mentioned above, it’s not required but a great case can be made for it.
An annuity is a contract with the insurer who is required by state law to have on reserve an amount in excess of their contractual obligations. In addition each state has an insurance fund that guarantees your deposit with the insurance company similar to FDIC. Most states have a limit of this insurance up to $250,000. I would only buy an annuity from a company that has an excellent rating from the rating services and a Comdex rating over 90.
Most of us docs with wealth will never need any annuity products
The people at vanguard substantiated that with me as well
ANNUITIES are sold, not bought
I don’t know that it’s quite that black and white. I do agree that most annuities are sold, not bought. But just like people go out and deliberately buy term life insurance and disability insurance, so do some deliberately buy SPIAs for very good reasons. I think of it more as a method of spending your money rather than investing it.
I go back and forth on buying a spia. You really would need to buy multiple products from different companies to avoid the fear of the company going bankrupt who sends you the checks. It seems like a
Lot of trouble. I have read that retirees who a have a check coming in each month either by spia or pension are happier. I plan to do nothing at this point and see what products are available as I near 70.
I don’t know there is a huge hassle there (you only buy it once and then it’s automated payments into your checking account) or all that risky (as long as you stay under your state guaranty limit.) That’s $200K in my state. So a $200K annuity on me, a $200K annuity on my spouse, and perhaps one for each of us from a totally different company. That’s $800K we could use at age 70 or so. Right now that pays 7.8% on a 70 year old male and 6.6% on a 67 year old female. So that’s $57,600 per year in our situation. That’s a pretty good floor under our income and far more income that anyone using any kind of reasonable SWR would take out of a portfolio. So while the return may be lower than a 100% stock portfolio, the amount that is safe to spend is much higher, at least until after a decade or two of inflation.
My state the guaranty limit is 100k. So this adds to the complexity. I mean you really would have to spread the money between several different firms to protect yourself from insurer bankruptcy.
Don’t discount what you may get for you and your spouse from Social Security. It could make a SPIA unnecessary for you. I agree with the younger WCI readers not counting on SS in their initial planning. But, as we older ones get closer it is silly to ignore it. Max benefit at 70 this year works out to about 42K/year. Add spousal benefits on top of that. Bogle has mentioned he and his wife receive around 60K/year. That’s a pretty good floor and pretty good longevity insurance to me. Remember you’ve put a great deal of earnings into the pot during your career. Would any readers receiving benefits care to chime in?
I read that recent book on SS by Larry Kotlikoff (Get What’s Yours). Several of his points were recently voided by Congress but I enjoyed the book. I have wasted my breath trying to convince family members to take SS at 70. My oldest brother took it at 62 because he was convinced he could invest the money and come out ahead. He is an engineer so this decision surprised me. He now admits he was wrong. My other brother is a lawyer and took it at 66 and his wife at 62. They are convinced that it will stop paying in a few years so better get it while you can mentality. I plan to take it at 70. I worry about longevity so this is great insurance thanks to the inflation indexing. Congress will tinker with it especially at the high end but not eliminate it entirely. I expect it will tax 100% of the benefit and start raising the retirement age in the future.
the bottom line is that from 33-67% stock portfolio in retirement there is no chance of running out of money; most likely quite the opposite
Not about to give an insco 800k even with those returns for 20yrs or so
Call Vanguard and ask them if they are appropriate for your needs
If you have a 50% stock portfolio and spend 8% of it a year there certainly is a chance of running out of money. I’m not sure you “get” the point of a SPIA. Certainly if you have $5M and you’re spending $150K a year you don’t need one. But if you have $1M, get $30k from SS, and want to spend $80-100K a year you would be very wise to take a very careful look at using some of your money to buy a SPIA.
I wonder how people fund those SPIA purchases. If you’re taking 400-600-800k out of your (previously) tax deferred accounts to pay for them, won’t you get hit with relatively high taxes?
Good question. This post should answer it:
https://www.whitecoatinvestor.com/individual-retirement-annuity-the-solution-to-the-spia-rmd-dilemma/
no one suggests withdrawing 8%; 3-4% is the norm
once you buy the annuity, the funds are gone
in ret plan its taxable of course
in personal accts all annuity income is taxed as ORDINARY INCOME(not good)
getting 50-70k/yr from an annuity-HOW MUCH PRINCIPAL IS NEEDED to pony up
Kenny: You have made 2 assertions that are inaccurate. “Once you buy an annuity, the funds are gone”. Annuities offer several different types of payout options. If you buy a “Life Only” annuity, you are correct. If you buy a Life Income with cash refund annuity, your beneficiaries will receive all payments until the initial premium has been received. Life Only annuities have the highest payout rate as a result. If you buy an annuity and you live long enough to receive mortality credits, there would be no refund because you were paid income in excess of your premium. (The whole point)
2. In personal accts…ORDINARY INCOME(not good) This is also inaccurate. If using non-qualified accounts to fund the annuity, a portion of each payment is a return of your principle, and a portion is interest. Only the interest component is taxed as ordinary income. The checks received once you have received back your initial premium will become taxable. Each SPIA illustration shows an exclusion ratio which tells you how much of each payment is tax free and how much of each payment is taxable. Your 1099 would reflect this as well.
Because annuities pay income based on life expectancy, the payout rate is age based. It takes less money at older ages to generate the same check as it would at younger ages. Annuities can create the highest level of income from a given sum of money than any other investment. As a result, if you use them to cover your monthly fixed expenses, you can invest the balance more aggressively than you could if all your money was needed to generate income. Also, when the market falls like 2008, a 4% w/d rate would no longer be 4%, and you could run out of money without an adjustment to your expenses if you live to 95 or 100. A great book explaining this concept is Pay Checks And Play Checks by Tom Hegna.
Excellent points except the last sentence. The “4% rule” used in the SWR studies is 4% of the original amount, adjusted to inflation. If you are going to use a % of the remaining portfolio, you can actually be more aggressive than 4%. In fact, technically you could withdraw 10% a year and you would never run out of money…although those withdrawals would get very small eventually.
I would love to see the SWR study. Do you have a link? You make an excellent point, the withdrawals would get small and the income shortfall would grow. Where would the money come from as expenses grow? If the portfolio suffered a major loss in one or more years early in retirement (sequence of returns), the portfolio may run out of money even earlier without adjusting the withdrawal rate. Do you have a spreadsheet you can point me to that shows the 10% or 4% withdrawal rate based on initial amount?
The classic SWR study is the Trinity Study, here’s the original: http://afcpe.org/assets/pdf/vol1014.pdf
If you really want to get into the nitty-gritty of this stuff, I’d suggest Wade Pfau’s blog found here:
http://retirementresearcher.com/
The reason the 4% figure is so low is because of sequence of returns risk. If you didn’t have to worry about that, you’d be up at 6-8%.
Age 65 1k/month for life YOU HAVE TO PUT on 167k
from vanguard website
so to generate 60/yr you have to invest 835k!!!!!!
Ken-
You seem really bothered by this point with a half dozen comments and emails about it. A SPIA isn’t right for everyone and no one is saying YOU should buy one. But you seem to be saying that NO ONE should be buying one, which is not true.
You seem appalled by the idea of spending $835K to buy an income of $60K a year. But under a 4% SWR plan, you need to use $1.5M to do that same $60K a year. That’s the benefit of the SPIA-the guaranteed income. So if “3-4% is the norm” here’s a way you can spend more without running out of money. 8% might be a very reasonable amount for a 72 year old willing to annuitize.
In a tax-deferred retirement plan (an individual retirement annuity) the payments are all 100% taxable at your regular marginal rate (like any withdrawal from that account.) If you buy it in a Roth IRA, all payments are tax-free. Outside a retirement plan, some of it is considered return of principal, and so isn’t taxed.
Kenny: That is a 7.18% guaranteed payout for life. Do you have another investment idea that can deliver that much income for so little money? If you live 13.92 years, every payment will be a mortality credit because you would have received all your money back. There is very little chance in today’s volatile market environment that you could sustain this withdrawal rate if you live too long.
I read Milevsky’s book and agree with the above criticisms. Another disappointment was his limited discussion of Deferred Income Annuities (DIA). These seem to help solve longevity risk in a more efficient manner than SPIAs – future payments are higher and costs lower due to “mortality credits”, i.e. those who die early don’t collect any payments. I am more concerned about outliving my money than funding my retirement between 65-85 yo; the financial problem is not dying young, but living long.
Yes, that “longevity insurance” is an interesting topic.
Mortality credits apply in the same way to both deferred annuities and to immediate annuities…no differences there. The reason deferred annuities appear to be so much more “efficient”, is because there is a small but very real chance that you will die before ever reaching your payout age. Actuarially speaking, there is very likely to be no pricing difference between immediate and deferred.
You would think that, but there is a dramatic difference in pricing among term life policies and between immediate annuities. That competition drives prices down. The more complex the annuity, the fewer companies offer it, and the less competition there is.
Buying a SPIA does not mean you automatically forfeit your initial premium if you die prematurely. You can buy one with a refund option which means that if you die before the entire deposit is paid out then your beneficiary received the balance that was not paid out yet.
Yes, you can make SPIAs more complicated by adding on more features. The problem is the more you add on, the lower your yield and the less competition there is for a SPIA with those features. It becomes harder to compare apples to apples.
What happens if you purchase a SPIA amount within your state’s guaranty limit and then move to a different state?
Is it covered by the original state where the purchase was made or by the new state of residence?
I would guess your current state, but I’m not 100% sure. Certainly look into both state’s limitations. They are usually pretty similar amounts though, in the $100-250K range.