Guaranteed Retirement Income

Posted On November 12, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /

Guaranteed Retirement Income increases satisfaction. When you receive Social Security, a Pension, or other monthly payment, you don’t have to worry about market volatility or if you will run out of money. You’re guaranteed to receive the payment for as long as you live. That is peace of mind.

Research shows that people prefer pension payments versus taking withdrawals from an investment portfolio. When you were working, you had a paycheck show up every month and you didn’t feel bad about spending it. There would be another paycheck next month. Unfortunately, with an investment portfolio, retirees dislike spending that money. There is “range anxiety” that their 401(k) or IRA will run out of money. There is fear that a market drop will ruin their plans. After spending 40 years building up an account and it’s not easy to reverse course and start to spend that nest egg and see it go down.

Corporate and Municipal pensions have been in decline for decades. As a result, most of us have only a Social Security benefit as guaranteed income. That’s too bad. 401(k) plans are a poor substitute for a good pension. You need to accumulate a million bucks just to get $40,000 a year at a 4% withdrawal rate. It places all the responsibility on American workers to fund their own retirement, and this has led to wildly disparate retirement readiness between people. Even those who accumulate significant retirement accounts still have the worries about running out of money. Sequence of Returns, poor performance or mismanagement, cognitive decline, or longevity are all risks.

The solution to create guaranteed lifetime income is a Single Premium Immediate Annuity, or SPIA. A SPIA is a contract with a life insurance company in which you trade a lump sum in exchange for a monthly payment for life. For as long as you live, you will get that monthly check, just like a Pension or Social Security. When you pass away, the payments stop. For married couples, we can establish a Survivor’s Benefit that will continue the payout (sometimes reduced at 50% or 75%) for the rest of the survivor’s life, if the owner should pass away.

How much would it cost? For a 65-year old man, a $100,000 premium would establish a $537/month payment for life. That is $6,444 a year, or a 6.4% rate on your premium. For a 65-year old woman, it would be $487, a month, or $5,844 a year (5.8%) For a couple, if the wife was also 65, that same premium would offer $425/month for both lives (100% survivors benefit). That’s $5,100 a year, or 5.1%. The greater the expected longevity, the lower the monthly payment.

There are some fairly obvious advantages and disadvantages of a SPIA.

Pros

Lifetime income, fixed, predictable, and guaranteed
No stock market risk, no performance concerns, no Sequence of Returns risk

Cons

Permanent decision – cannot reverse later
Some people will not live for very long and will get only a handful or payments back
No money leftover for your heirs
No inflation protection – monthly payout is fixed

I’ve been a financial advisor since 2004 and I have yet to have a client who wants to buy a SPIA. For some, the thought of spending a big chunk of money and the risk that they die in a year or two, is unbearable. However, the payout is fair, because some people will live for much longer than the average. The way insurance works is by The Law of Large Numbers. An insurance company is willing to take the risk that someone will live for 40 or 50 years because they know that if they sell thousands of annuities, it will work out to an average lifespan across the group. Some people live longer than average and some live less than average.

Two Ways to Use a SPIA

Although they remain unpopular, SPIAs deserve a closer look. Let’s immediately throw away the idea that you should put all your money into a SPIA. But there are two ways that a SPIA might make sense as part of your retirement income plan.

Use a SPIA to cover your basic expenses. Look at your monthly budget. Assume you need $3,000 a month to cover all your expenses. If you have $2,200 in Social Security benefits, buy a SPIA that would cover the remaining $800 shortfall. For the 65-year old couple above, this $800/month joint SPIA would cost $188,235. Now you have $3,000 a month in guaranteed lifetime income to cover 100% of your basic expenses. Hopefully, you still have a large investment portfolio that can grow and supplement your income if needed.

The nice thing about this approach is that it takes a bit less cash than if you follow the 4% rule. If you needed $800 a month ($9,600 a year), a 4% withdrawal rate would require you have a portfolio of $240,000. The SPIA only requires $188,235.

Let’s say you have a $1 million portfolio. You could (a) put it all in the portfolio and start a 4% withdrawal rate, or (b) put $188,235 into the SPIA and keep the remainder in the portfolio. Here’s what that would look like for year one:

a. $1 million at 4% = $40,000 potential income
b. $188,235 SPIA = $9,600, PLUS $811,765 portfolio at 4% = $32,470. The combined income from the SPIA and portfolio is now $42,070

You have increased your income by $2,070 a year and you have established enough guaranteed income to cover 100% of your monthly needs. Then, you are not dependent on the market to cover your basic expenses each month.

2. The second way to think of a SPIA is as a Bond replacement for your portfolio. Instead of buying Treasury Bonds and worrying if you will outlive them, you can buy a SPIA, and the insurance company will buy very safe bonds. The insurance company then assumes your Longevity risk.

Back to our example above, let’s say your $1 million portfolio is invested in a 60/40 allocation (60% stocks, 40% bonds). Just consider the SPIA as part of your fixed income sleeve. If you had a target of $400,000 in bonds, rather than letting them sit in 10-year Treasuries earning 0.7% today, go ahead and put $188,235 in the SPIA and keep $211,765 in bonds. Your $600,000 in stocks remains the same. Now, on your SPIA, you are getting a withdrawal rate of 5.1% to 6.4%. And although you are eating your principal with a SPIA, you have no longevity risk, it’s a guaranteed check. You have reduced the withdrawal requirement from your equities and can better weather the ups and downs of the stock market.

Is a SPIA Right For You?

A SPIA isn’t going to be for everyone. But if you want lifetime guaranteed retirement income a SPIA is a solid, conservative choice. Used in conjunction with the other pieces of your income plan (Social Security and Investment portfolio), a SPIA can help you sleep well at night. Especially for investors who are in great health and with a family history of longevity, it may be worth putting some money into a SPIA and turning on that monthly check. It can help offset the stock market risks that could derail your plans.

I know many parents think putting money into a SPIA will reduce money for their kids to inherit. That might be true. Of course, if you live a long time and run out of money, you won’t be leaving any money to your kids either. Our goal with any retirement income solution is to make sure you don’t outlive your money, which hopefully also means you are able to leave some money to your heirs.

What if the insurance company goes under? Isn’t that a risk? It is. Thankfully, most states protect SPIA policy holders up to $250,000. If you are planning to put more than $250,000 into a SPIA, I would seriously consider dividing your funds between several companies to stay under the limits. Read more: The Texas Guaranty Association. (Note that this information is provided solely for educational purposes and is not an inducement to a sale.)

In the next three articles in this five-part series, we will look at different withdrawal strategies for your investment portfolio. These approaches include the 4% rule, a Guardrails approach, and 5-year Buckets. All of these will help you manage the risks of funding retirement from stocks. But before we get to those, I wanted you to realize that you don’t have to put all your money into stocks to create retirement income. These withdrawal approaches are likely to work, and we know they worked in history. But if you want to buy your own pension and have a guaranteed retirement income, a SPIA could be the right tool for the job.

Retirement Income at Zero Percent

Posted On May 3, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /

With interest rates crushed around the world, how do you create retirement income at zero percent? Fifteen years ago, conservative investors could buy a portfolio of A-rated municipal bonds with 5 percent yields. Invest a million dollars and they used to get $50,000 a year in tax-free income.

Not so today! Treasury bonds set the risk-free rate which influences all other interest rates. Currently, the rate on a 10-year Treasury is at 0.618 percent. One million dollars in 10-year Treasuries will generate only $6,180 in interest a year. You can’t live off that.

You can do a little better with municipal bonds today, maybe 2-3 percent. Unfortunately, the credit quality of municipal bonds is much worse today than it was 15 years ago. A lot of bonds are tied to revenue from toll roads, arenas, or other facilities and are seeing their revenue fall to zero this quarter due to the Coronavirus. How are they going to repay their lenders?

Debt levels have risen in many states and municipalities. Pension obligations are a huge problem. The budget issues in Detroit, Puerto Rico, Illinois, and elsewhere are well known. Shockingly, Senator McConnell last week suggested that states maybe should be allowed to go bankrupt. That would break the promise to Municipal Bond holders to repay their debts. This is an appalling option because it would cause all states to have to pay much higher interest rates to offset the possibility of default. And unlike Treasury bonds which are owned by institutions and foreign governments, Municipal Bonds are primarily owned by American families.

With Treasuries yielding so little and Municipal Bonds’ elevated risks, how do you plan for retirement income today? We can help you create a customized retirement income plan. Here are three parts of our philosophy.

1. Don’t Invest For Income

We invest for Total Return. In Modern Portfolio Theory, we want a broadly diversified portfolio which has an efficient risk-return profile, the least amount of risk for the best level of return. We focus on taking withdrawals from a diversified portfolio, even if it means selling shares.

Why not seek out high dividend yields and then you don’t have to touch your principal? Wouldn’t this be safer? No, research suggests that a heavy focus on high yields can create additional risks and reduce long-term returns. Think of it this way: Company A pays a 5% yield and the stock grows at zero percent; Company B pays no yield but grows at 8%. Clearly you’d be better off with the higher growth rate.

When you try to create a portfolio of high yield stocks, you end up with a less diversified portfolio. The portfolio may be heavily concentrated in just a few sectors. Those sectors are often low growth (think telecom or utilities), or in distressed areas such as oil stocks today. The distressed names have both a higher possibility of dividend cuts, as well as significant business challenges and high debt.

The poster child for not paying dividends is Warren Buffett and his company, Berkshire Hathaway. He’s never paid a dividend to shareholders in over fifty years. Instead, he invests cash flow into new acquisitions of well-run businesses or he buys stocks of other companies. Over the years, the share price of BRK.A has soared to $273,975 a share today. If investors need money, they can sell their shares. This is more tax-efficient, because dividend income is double taxed. The corporation has to pay income taxes on the earnings and then the investor has to pay taxes again on the dividend. When a company grows, the investor only pays long-term capital gains when they decide to sell. And the company can write off the money it reinvests into its businesses.

2. Create a Cash Buffer

Where a total return approach can get you into trouble is when you have to sell stocks in a down market. If you need $2,000 a month and the price of your mutual fund is $10/share, you sell 200 shares. But in a Bear Market when it’s down 20%, you’d have to sell 250 shares (at $8/share) to produce the same $2,000 distribution. When you sell more shares, you have fewer shares left to participate in any subsequent recovery.

This is most problematic in the early years of retirement, a fact which is called the Sequence of Returns Risk. If you have a Bear Market in the first couple of years of retirement, it is more likely to be devastating than if you have the same Bear Market in your 20th year of retirement.

To help avoid the need to sell into a temporary drop, I suggest keeping 6-12 months in cash or short-term bonds so you do not have to sell shares. Additionally, I prefer to set dividends to pay out in cash. If we are receiving 2% stock dividends and 2% bond interest, and need 4% a year, we would have to sell just two percent of holdings. This just gives us more flexibility to not sell.

Also, I like to buy individual bonds and ladder the maturities to meet cash flow needs. If your RMD is $10,000 a year, owning bonds that mature at $10,000 for each of the next five years means that we will not have to touch stocks for at least five years. This approach of selling bonds first is known as a Rising Equity Glidepath and appears to be a promising addition to the 4% Rule.

3. Guaranteed Income

The best retirement income is guaranteed income, a payment for life. This could be Social Security, a government or company Pension, or an Annuity. The more you have guaranteed income, the less you will need in withdrawals from your investment portfolio. We have to be fairly conservative in withdrawal rates from a portfolio, because we don’t know future returns or longevity. With guaranteed income, you don’t have to fear either.

We know that Guaranteed Income improves Retirement Satisfaction, yet most investors prefer to retain control of their assets. But if having control of your assets and the ability to leave an inheritance means lower lifetime income and higher risk of failure, is it really worth it?

I think that investors make a mistake by thinking of this as a binary decision of 100% for or against guaranteed income. The more sophisticated approach is to examine the intersection of all your retirement income options, including when to start Social Security, comparing lump sum versus pension options, and even annuitizing a portion of your nest egg.

Consider, for example, if you need an additional $1,000 a month above your Social Security. For a 66-year old male, we could purchase a Single Premium Immediate Annuity for $176,678 that would pay you $1,000 a month for life. If you instead wanted to set up an investment portfolio and take 4% withdrawals to equal $1,000 a month, you would need to start with $300,000. So what if instead of investing the $300,000, you took $176,678 and put that into the annuity? Now you have guaranteed yourself the $1,000 a month in income you need, and you still have $123,322 that you could invest for growth. And maybe you can even invest that money aggressively, because you have the guaranteed annuity income.

Conclusion

It’s a challenge to create retirement income at zero percent interest rates. Unless you have an incredibly vast amount of money, you aren’t going to get enough income from AAA bonds or CDs today to replace your income. We want to focus on a total return approach and not think that high dividend stocks or high yield bonds are an easy fix. High Yield introduces additional risks and could make long-term returns worse than a diversified portfolio.

Instead, we want to create a cash buffer to avoid selling in months like March 2020. We own bonds with maturities over five years to cover our distribution or RMD needs. Beyond portfolio management, a holistic approach to retirement income evaluates all your potential sources of income. Guaranteed income through Social Security, Pensions, or Annuities, can both reduce market risk and reduce your stress and fear of running out of money. The key is that these decisions should be made rationally with an open mind, based on a well-educated understanding and actual testing and analysis of outcomes.

These are challenging times. If you are recently retired, or have plans to retire in the next five years, you need a retirement income plan. We had quite a drop in March, but recovered substantially in April. The economy is not out of the woods from Coronavirus. I think global interest rates are likely to remain low for years. If you are not well positioned for retirement income, make changes soon, using the strength in today’s market to reposition.

How to Create Your Own Pension

Posted On May 5, 2018 By Scott Stratton, CFP(R), CFA In Retirement Planning /

With 401(k)s replacing pension plans at most employers, the risk of outliving your money has been shifted from the pension plan to the individual. We’ve been fortunate to see many advances in heath care in our lifetime so it is becoming quite common for a couple who retire in their sixties to spend thirty years in retirement. Today, longevity risk is a real concern for retirees.

With an investment-oriented retirement plan, we typically recommend a 4% withdrawal rate. We can then run a Monte Carlo simulation to estimate the possibility that you will deplete your portfolio and run out of money. And while that possibility is generally small, even a 20% chance of failure seems like an unacceptable gamble. Certainly if one out of five of my clients run out of money, I would not consider that a successful outcome.

Social Security has become more important than ever because many Baby Boomers don’t have a Pension. While Social Security does provide income for life, it is usually not enough to fund the lifestyle most people would like in retirement.

What can you do if you are worried about outliving your money? Consider a Single Premium Immediate Annuity, or SPIA. A SPIA is an insurance contract that will provide you with a monthly payment for life, in exchange for an upfront payment (the “single premium”). These are different from “deferred” annuities which are used for accumulation. Deferred annuities come in many flavors, including, fixed, indexed, and variable.

Deferred annuities have gotten a bad rap, in part due to inappropriate and unethical sales practices by some insurance professionals. For SPIAs, however, there is an increasing body of academic work that finds significant benefits.

Here’s a quote on a SPIA from one insurer:
For a 65-year old male, in exchange for $100,000, you would receive $529 a month for life. That’s $6,348 a year, or a 6.348% annual payout. (You can invest any amount in a SPIA, at the same payout rate.)

You can probably already guess the biggest reason people haven’t embraced SPIAs: if you purchase a SPIA and die after two months, you would have only gotten back $1,000 from your $100,000 investment. The rest, in a “Life only” contract is gone.

But that’s how insurance works; it’s a pooling of risks, based on the Law of Large Numbers. The insurance company will issue 1,000 contracts to 65 year olds and some will pass away soon and some will live to be 100. They can guarantee you a payment for life, because the large number of contracts gives them an average life span over the whole group. You transfer your longevity risk to the insurance company, and when they pool that risk with 999 other people, it is smoothed out and more predictable.

There are some other payment options, other than “Life Only”. For married couples, a Joint Life policy may be more appropriate. For someone wanting to leave money to their children, you could select a guaranteed period such as 10 years. Then, if you passed away after 3 years, your heirs would continue to receive payouts for another 7 years.

Obviously, these additional features would decrease the monthly payout compared to a Life Only policy. For example, in a 100% Joint Policy, the payout would drop to $417 a month, but that amount would be guaranteed as long as either the husband or wife were alive.

There are some situations where a SPIA could make sense. If you have an expectation of a long life span, longevity risk might be a big concern. I have clients whose parents lived well into their nineties and who have other relatives who passed 100 years old. For those in excellent health, longevity is a valid concern.

There are a number of different life expectancy calculators online which will try to estimate your longevity based on a variety of factors, including weight, stress, medical history, and family history. The life expectancy calculator at Time estimates a 75% chance I live to age 91.

Who is a good candidate for a SPIA?

Concerned with longevity risk and has both family history and personal factors suggesting a long life span,
Need income and want a payment guaranteed for life,
Not focused on leaving these assets to their heirs,
Have sufficient liquid funds elsewhere to not need this principal.

What are the negatives of the SPIA? While we’ve already discussed the possibility of receiving only a few payments, there are other considerations:

Inflation. Unlike Social Security, or our 4% withdrawal strategy, there are no cost of living increases in a SPIA. If your payout is $1,000 a month, it stays at that amount forever. With 3% inflation, that $1,000 will only have $500 in purchasing power after 24 years.
Low Interest Rates. SPIAs are invested by the insurance company in conservative funds, frequently in Treasury Bonds. They match a 30-year liability with a 30-year bond. Today’s SPIA rates are very low. I can’t help but think that the rates will be higher in a year or two as the Fed raises interest rates. Buying a SPIA now is like locking in today’s 30-year Treasury yield.
Loss of control of those assets. You can’t change your mind once after you have purchased a SPIA. (There may be an initial 30-day free look period to return a SPIA.)

While there are definitely some negatives, I think there should be greater use of SPIAs by retirees. They bring back many of the positive qualities that previous generations enjoyed with their corporate pension plans. When you ask people if they wish they had a pension that was guaranteed for life, they say yes. But if you ask them if they want an annuity, they say no. We need to do a better job explaining what a SPIA is.

The key is to think of it as a tool for part of the portfolio rather than an all-encompassing solution to your retirement needs. Consider, for example, using a SPIA plus Social Security to cover your non-discretionary expenses. Then you can use your remaining investments for discretionary expenses where you have more flexibility with those withdrawals. At the same time, your basic expenses have been met by guaranteed sources which you cannot outlive.

Since SPIAs are bond-like, you could consider a SPIA as part of your bond allocation in a 60/40 or 50/50 portfolio. A SPIA returns both interest and principal in each payment, so you would be spending down your bonds. This approach, called the “rising equity glidepath“, has been gaining increased acceptance by the financial planning community, as it appears to increase the success rate versus annual rebalancing.

There’s a lot more we could write about SPIAs, including how taxes work and about state Guaranty Associations coverage of them. Our goal of finding the optimal solution for each client’s retirement needs begins with an objective analysis of all the possible tools available to us.

If you’re wondering if a SPIA would help you meet your retirement goals, let’s talk. I don’t look at a question like this assuming I already know the answer. Rather, I’m here to educate you on all your options, so we can evaluate the pros and cons together and help you make the right decision for your situation.