|
|
Advice
|
Wade Pfau On Why Economists See an Annuity Puzzle |
|
Monday, May 14, 2012 03:54
|
Economists are known for describing the annuity puzzle. The puzzle is: why do people not purchase income annuities (exchange a lump sum payment for a guaranteed lifetime income stream) to the extent predicted by economic theory? If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now |  |
A number of explanations have been offered. Today I will not get too much into the explanations for the puzzle. Instead, I want to focus carefully on the theory behind why the “annuity puzzle” is said to exist in the first place.
Economists describe the annuity puzzle as a problem of maximizing lifetime expected utility. “Utility” can be off-putting, and I am not going to show any mathematical equations. I will focus on the intuition, and what is essential here is getting a good definition for the value provided by spending. Rather than looking directly at the level of spending, economists look at the value it provides, noting that additional spending provides diminishing increases in value. I reviewed these concepts in “Spending Amounts vs. Spending Value.”
For the basic model, one assumption is that people don’t care about leaving bequests (one explanation for the annuity puzzle, then, is that people don’t like to annuitize all of their assets because they want a chance to bequeath something). This means, they don’t mind exchanging all of their wealth at retirement for a guaranteed income stream for life.
For the basic model as well, there is no investment risk. Financial markets are simplified to one asset which always and forever provides the same return. This return is fixed. For non-annuitized assets, your portfolio of remaining wealth earns this fixed return each year. The annuity provider can also earn this return, and so the annuity payout rate incorporates this return as well as the return of principal.
Of course the assumption of a fixed return is not realistic. But the purpose of building models is to simplify reality in ways that still allow us to make some sense out of reality. By using this simplified assumption about asset returns, we can narrow in on the implications of having an uncertain lifespan.
The annuity provider also provides mortality credits. This gets to the heart of the uncertainty in the model. The uncertainty is longevity risk. The retiree doesn’t know their age of death. However, this is a known unknown, in the words of Donald Rumsfeld. That is, retirees and the annuity provider both know the probability distribution for the age of death, and the probability of survival to each subsequent age past 65. Individuals can’t self-insure to protect from this longevity risk. If they don’t annuitize, they have no chance but to plan for a long lifespan. On the other hand, the annuity provider can pool longevity risk across a large population of customers, and those who die earlier than average subsidize later payments to those who live longer than average. Because the annuity provider can pool the longevity risk, they are able to make payments at a rate much closer to what would be possible when planning for remaining life expectancy, rather than planning for a much longer horizon. Annuities should not be thought of so much as an investment, but rather as insurance to protect against running out of wealth while still alive.
I will assume retirement date wealth of $100. This amount doesn’t impact the results. I assume a male retiree at 65 and use the Social Security Administration 2007 Period Life Tables to obtain survival rates past this age. These survival rates for males can be seen in the following figure. Results will differ by age, gender, and mortality data source, but the basic principles will remain the same. I assume a maximum possible retirement length of 35 years, so no retirees live past 100. This doesn’t have much effect, since the probability of a 65 year old male living past 100 is less than 1%.
At retirement, retirees choose their annual spending amounts for ages 65-100. Since they know the future investment returns, this is easy to do. They don’t know how long they will live, but they can decide on how much they will spend each year should they still be alive. There are 4 factors which impact the decisions about the future spending path:
1. Survival probabilities: Since the probability of survival decreases over time, retirees have an incentive to increase spending early in retirement relative to late in retirement. Earlier spending is more likely to actually happen and so it receives a larger weighting in the function that adds up the lifetime value of spending. Higher survival probabilities will reduce annuity payout rates and help push more spending from early to later retirement.
2. The investment return: A higher investment return supports a higher annuity payout rate. As well, knowing that your remaining portfolio will grow at a faster rate allows you to spend at a higher rate earlier in retirement, and also pushes you to delay spending to later in order to leave more wealth in your portfolio to grow at the higher rate and allow for more lifetime spending.
3. The retiree’s impatience: A factor which also impacts retirees separate from survival probabilities is how impatient they are to spend. If the discounting to future spending caused by impatience is greater than the future investment return, then retirees have a strong incentive to shift spending to earlier in retirement. Likewise, more patient retirees who can get a larger return than the discounting from their impatience are willing to delay spending so that their wealth can grow more and they can spend more later on.
4. Risk aversion: This is the technical name for a key parameter in the utility function. It describes the shape of the curve which defines the value of spending. Lower numbers imply a less steep curve so that retirees do get more value from spending and have a greater willingness to increase spending at the expense of future reductions. Higher numbers imply that retirees really get hurt by less spending and this overwhelms the additional gains from more spending early on. In the context of retirement and in describing spending in terms of value, I think we should rename risk aversion as spending flexibility. A small number means the retiree is flexible! They can let their spending fluctuate more as the interaction of the other 3 factors warrants. A larger number provides a stronger push toward consumption smoothing, as retirees care less about upside and really wish to maintain as high of spending as possible in worst-case scenarios.
The Results
In order to keep this short, I think we can see lots of interesting results by focusing on just one scenario. I will consider the case that investment returns are zero, and the discounting factor for impatience is also zero.
With a real return of zero, the annuity payout rate based on an actuarially fair annuity with this mortality data is 5.66%. That is, the $100 of wealth is used to purchase an annuity at retirement for the 65 year old male, the guaranteed income stream each year for life is $5.66. That happens by pooling the mortality risk across the population.
Meanwhile, for someone who doesn’t buy an annuity, they have to plan for a potential lifespan of 35 years. With a zero return on assets, to smooth consumption across their potential lifetime, they could spend 100/35 = $2.86 each year. Much less than an annuity, but that is because the planning horizon has to be longer to protect against the low probability event of living a long, long time.
Now we get into the really interesting part. Something I’ve been trying to get a dialogue going about is whether the general population is aware of one of the key insights coming from lifecycle finance economic models. That is, you should intentionally plan to decrease spending as you age to account for the lower probability of living to each subsequent age. But how much should you plan to reduce your spending? That depends on your spending flexibility / risk aversion.
There are now two competing tradeoffs: you want to spend the same amount every year for as long as you live to get the most lifetime value from your spending, but you also want to frontload your spending to early retirement when you have the highest chance for survival. Again, I’m assuming a case where investment returns and impatience are both zero and both cancel each other out.
The following figure shows the optimal spending path, both for the case with annuitization and for different degrees of spending flexibility for the case when the retiree does not annuitize. This figure shows why economists see an annuity puzzle: why not annuitize since it provides a higher lifetime spending path? But beyond this, we can also see how people optimize without annuities. I need to rename something here, because low values imply greater flexibility rather than high values. Someone with flexibility of 1 is quite willing to let their spending decrease over time to reflect the low probability of survival as they age. Spending starts at the same amount as the annuity but declines to very low levels by one’s late 90s. With flexibility of 2, more effort is made toward keeping a smooth level at $2.86. But again, it is still optimal to front load spending. You can also see for coefficients of 5 and 10 how we obtain greater smoothing even in the face of the decreasing survival probabilities. How much lower would you let your spending fall in your 90s to allow more spending in your 60s? It’s an important and highly personal question! Personally, I’m sort of attracted to the pattern coming with flexibility=5.
One final part of the puzzle is that economists like to note the “annuity equivalent wealth.” That is, how much additional wealth would you need in order to obtain the same expected lifetime value of your spending when you don’t annuitize as when you do annuitize? Clearly, the value of spending is higher with the annuity since it allows greater spending at all ages. I calculate that with flexibility=1, the retiree needs 53% more wealth to be just as satisfied as with an annuity. The corresponding numbers increase up to the flexibility=10 case, where 90% more wealth is needed to be just as happy. That is a key part of the annuity puzzle: with flexibility of 10, you would need 90% more wealth to have the same utility from not annuitizing as from annuitizing. So why not annuitize?
Well, there are many explanations, and I will revisit those at a later date. Or alternatively, here is your homework assignment, class: List potential explanations in the comments for why the “puzzle” may not really be as puzzling as I just made it sound.
Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan, and the curriculum director for the Retirement Management AnalystSM designation program. He maintains a blog about retirement planning research at
wpfau.blogspot.com
Read more...
|
|
|
There's A Growing Gap Of Opportunity As The Boomer Population Ages |
|
Wednesday, May 09, 2012 16:20
|
|
Tags: Boomers | life planning | retirement
As the age-denying Baby Boomer generation grows older, it may need your help to face reality. The growing gap between the Boomer and Echo-boom generations is highlighting the fact that Boomers’ reticence to deal with the challenges of aging is becoming a burden on younger generations. If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
People across the globe are having fewer children. That means there will be fewer people to fill the jobs Boomers vacate as they retire. Global median age is expected to rise from 29 years old in 2010 to 39 by 2050.
Real life examples are already pointing to some of the demographic issues. As more and more people live beyond age 100, their children begin to face their own aging issues. A 107-year-old may have children in their 80s who are unable to care for them because of their own care needs. The fact that most Americans only have about $25,000 in retirement savings doesn’t make the picture any brighter.
These predictions point to a demographic reality, yet they seem to ignore the fact that the Echo-boom generation is as large in number as the Boomer generation. Although these problems are real and need to be addressed in a timely, one of the biggest gaps seems to be that an industrious younger generation is on the rise and may add unexpected relief. Still, relief relative to the oldest Boomers may not be timely.
Read more...
|
|
Becoming An Expert On Medicare Legislation And Benefits Could Be Your Next Business Growth Tool |
|
Tuesday, May 08, 2012 12:50
|
|
Tags: healthcare | investing | retirement planning
Retirees may be in for a surprise when they discover that Medicare will only pay for 51% of their health care expense instead of the 68% they guessed on a recent survey.
Over half of retirees say their biggest worry about retirement is having enough to pay for health care, yet it is a worry they rarely talk about with their financial advisors. Developing a strategic health care back-up plan for your clients might be an excellent way to position your business for its next phase of strong growth. If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
Getting up to speed on Medicare reforms can be to your advantage, especially in light of the possible 30% cut to doctors’ reimbursements unless Congress extends current laws. It’s yet another aspect of retirement planning that you can help your clients manage.
The first Baby Boomers turned 65 January 1 of 2011. Another 10,000 Boomers will reach that minimum Medicare benefits age every day for the next 20 years. That means there’s already a significant Medicare and health care market that you could be developing. Educating yourself now, before the legislation happens late this year or early next will position you well either way the legislation goes. |
|
A Practical, Low-Cost Approach To Helping Couples Resolve Conflicts Over Money And For Working With Clients Whose Behavior Does Not Match Their Goals |
|
Monday, May 07, 2012 23:19
|
|
Tags: client communications | financial planning | hehavioral finance | investor behavior | life planning With many life-planning programs providing training to advisors to help them advise clients on the “soft side” of money, here’s a a simple but effective low-cost methdology for helping couples resolve conflicts over money and for coping with clients whose behavior is inconsistent with achieving their goals.
There is no extended training program associated with this technique and there is no certification process connected to it. It is not a proprietary program and it’s open to anyone who feels comfortable using it. If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
 It’s a physical card sort, a different process than a long interview or questionnaire. The approach was developed in connection with the Money and Family Life Project at the Ackerman Institute For The Family.
The cards come with a book entitled, Money and Meaning, by Judith Peck. The book comes with two sets of “Values Card” and the instructions for their use. You can find the cards online for free, but you’ll want to read Peck’s book to learn how to use them in your work with clients.
One deck of cards represents content values and the other deck represents process values. Clients sort both sets of cards into an order reflective of their value priorities, facilitating what can otherwise be a difficult conversation.
This methodology was developed by a consortium of financial planners and therapists, not by any one individual or group. I know many wealth managers who have found this methology of great value, but whether you use it would really depend on how comfortable you are tackling these issues with clients.
Please let me know how if you have questions about using the cards or helping clients with these issues.
Read more...
|
|
Wade Pfau On Problems With Applying The 4% Withdrawal Rate Rule To Economies Beyond The U.S. |
|
Sunday, May 06, 2012 14:19
|
|
Tags: retirement | retirement income | retirement planning From an international perspective, a 4% real withdrawal rate is surprisingly risky. Even with some overly optimistic assumptions, it would have only provided "safety" in four of 17 developed countries studied, and a fixed asset allocation split evenly between stocks and bonds would have failed at some point in all 17 countries.
If you're a private wealth advisor, please join Advisors4Advisors (A4A) to get its full benefits. Register now, and we will donate $20 of our $60 membership fee to Bubbles The Clown’s financial literacy program, and you can post an icon on your website saying you support Bubbles' 501(c)3 charitable organization. Plus, get other membership benefits, including: - Analysis daily of issues affecting advisors
- Aggregation of news from dozens of sites targeting wealth managers
- Reviews by advisors of practice management applications
- 30 independent experts blogging on advisor business issues
- 24/7 access to webinars with 50 hours of CFP® CE and 100 hours of IMCA CE
Register Now | |
An argument in support of the 4% rule is that, despite what I have argued before, is that the U.S. post-1926 did suffer a number of calamitous market events, such as the Great Depression and the Great Stagnation of the 1970s. It's hard to imagine an even future retirees ever facing more difficult times. Thus, the historical success of the 4% rule suggests that we can reasonably plan for its continued success in the future.
My first foray into researching about personal retirement planning was a study about the sustainability of the 4% rule in other developed market countries. Here I will provide further perspective about the results described in my article, An International Perspective on Safe Withdrawal Rates: The Demise of the 4% Rule? in the December 2010 Journal of Financial Planning.
From an international perspective, a 4% withdrawal rate has been problematic. In the original article, to avoid claims of bias that I choose an asset allocation which exaggerates the risk of the 4% rule, I used a rather generous and unrealistic “perfect-foresight assumption.” For each country and in each retirement year, I used the asset allocation (between stocks, bonds, and bills) which supported the highest withdrawal rate. Though not always, in many cases this meant using 100% stocks. With the perfect-foresight assumption and an updated dataset which includes two more countries, the calculated SAFEMAX (this is the maximum sustainable withdrawal rate over 30-years in the worst-case scenario from a country's history) exceeds 4% in Canada (4.4%), New Zealand (4.1%), Sweden (4.1%), Denmark (4.1%), the GDP-weighted world portfolio (4.1%), and the US (4%). The perfect foresight assumption is quite unrealistic, though, and here I will focus on a more plausible 50/50 retirement asset allocation. In terms of the SAFEMAX, 50% stocks and 50% bills generally outperforms 50% stocks and 50% bonds. For this reason, I will further consider results for the stocks and bills case. Though not shown here, I do also note that stock allocations below 50% support lower SAFEMAXs in all countries except Switzerland and Sweden. The results for 50/50 are in Table 3.2.
|
Table 3.2
Maximum Sustainable Withdrawal Rates, for Retirees 1900-1981
Asset Allocation: 50% Stocks & 50% Bills
|
|
|
|
|
|
Withdrawal Rate = 4%
|
Withdrawal Rate = 5%
|
|
|
SAFEMAX
|
SAFEMAX Year
|
10th Percentile
|
# Years in Worst Case
|
% Failures Within 30 Years
|
# Years in Worst Case
|
% Failures Within 30 Years
|
|
United States
|
3.96
|
1937
|
4.42
|
29
|
1.2%
|
19
|
41.5%
|
|
Canada
|
3.96
|
1937
|
4.58
|
29
|
1.2%
|
19
|
42.7%
|
|
New Zealand
|
3.78
|
1935
|
4.06
|
27
|
8.5%
|
18
|
42.7%
|
|
Denmark
|
3.65
|
1937
|
4.17
|
25
|
7.3%
|
19
|
62.2%
|
|
World
|
3.58
|
1937
|
4.09
|
23
|
3.7%
|
17
|
57.3%
|
|
Australia
|
3.5
|
1970
|
3.78
|
21
|
13.4%
|
15
|
39.0%
|
|
United Kingdom
|
3.36
|
1937
|
3.8
|
22
|
24.4%
|
16
|
48.8%
|
|
Sweden
|
3.22
|
1914
|
3.83
|
20
|
12.2%
|
14
|
41.5%
|
|
World Ex-US
|
3.21
|
1934
|
3.71
|
20
|
22.0%
|
13
|
52.4%
|
|
Switzerland
|
3.13
|
1915
|
3.42
|
19
|
34.2%
|
13
|
62.2%
|
|
South Africa
|
3.01
|
1937
|
3.81
|
21
|
15.9%
|
17
|
30.5%
|
|
Norway
|
2.98
|
1939
|
3.09
|
17
|
47.6%
|
12
|
69.5%
|
|
Netherlands
|
2.82
|
1941
|
3.76
|
17
|
22.0%
|
13
|
65.9%
|
|
Ireland
|
2.79
|
1937
|
3.15
|
19
|
36.6%
|
14
|
64.6%
|
|
Spain
|
2.16
|
1936
|
2.61
|
12
|
53.7%
|
10
|
87.8%
|
|
Belgium
|
1.58
|
1914
|
2.02
|
11
|
56.1%
|
9
|
73.2%
|
|
Finland
|
1.32
|
1917
|
1.8
|
6
|
43.9%
|
5
|
56.1%
|
|
Germany
|
1.01
|
1914
|
1.22
|
3
|
56.1%
|
3
|
70.7%
|
|
France
|
0.82
|
1943
|
1.31
|
7
|
75.6%
|
6
|
86.6%
|
|
Italy
|
0.8
|
1940
|
1
|
5
|
80.5%
|
4
|
86.6%
|
|
Japan
|
0.26
|
1937
|
0.29
|
3
|
37.8%
|
3
|
43.9%
|
|
Note: Assumptions include a 30-year retirement duration, no administrative fees, constant inflation-adjusted withdrawal amounts, and annual rebalancing.
|
|
Source: Own calculations from Dimson, Marsh, and Staunton (1900 - 2010) data.
|
With a 50/50 asset allocation, the 4% rule did not survive in any country, though it came close in the U.S. and Canada, with support for 29 years of expenditures and a SAFEMAX just below 4%. Even allowing for a 10% failure rate, 4% made the cut only in Canada, the US, New Zealand, Denmark, and the GDP-weighted world portfolio. In 10 of 19 countries, the SAFEMAX fell below 3%. World War II era Japan, in particular, faced the sort of crisis suggested by William Bernstein, as the SAFEMAX was only 0.26% for 1937 retirees. The 4% rule would have supported expenditures for only 3 years. Shockingly, the 4% rule would have failed more than half of the time for countries including Spain, Belgium, Germany, France, and Italy. Italians attempting to use the 4% rule would have actually faced failure in 80.5% of cases. The table also shows results for a 5% withdrawal rate, and failures rates are substantially higher than for 4%. Even if the 4% rule could somehow be deemed as safe, there is clearly not much room for error when seeing how quickly failure rates rise for 5% withdrawals. I do not use hyperbole when suggesting that the results in this table do not portray the 4% rule in a positive light.
To expand the previous table further, Figure 3.2 shows a boxplot of the distribution of withdrawal rates for each country, ranked by order of their SAFEMAX from smallest to largest. For each country, the red central marker is the median, the edges of the box are the 25th and 75th percentiles, and the whiskers extend to the most extreme datapoints not defined as outliers. Outliers are plotted individually. This figure does provide a broader view about the range of outcomes for each country.
Figure 3.3, meanwhile, shows the distribution of withdrawal rates across countries for each retirement year. From this figure, we can see the contemporaneous correlation of withdrawal rates across countries and also observe general historic trends. In recent years, those who have challenged the 4% rule are sometimes accused of falling victim to recency bias, placing too much weight on the poor financial market conditions of the recent past. However, Figure 3.3 suggests that recency bias may instead be responsible for too much faith in 4%. Across countries, the median sustainable withdrawal rate was under 4% in many cases prior to about 1945. Since World War II, however, the median outcome never fell below 4%, and in only a few cases did the 25th percentile fall below 4%. Indeed, in recent years the performance of the 4% rule across countries was much stronger than the earlier part of the historical period. While some of the worst outcomes can be connected with World Wars I and II, given the broader view of history suggested by William Bernstein, is it appropriate to ignore those cases? Whether there are important structural changes which might explain why the earlier period is less relevant to today’s environment is an exercise to be left for the reader’s interpretation.
Keep in mind also that I am only looking at the 19 developed market countries in the dataset, with data going back to 1900. Travel back in time to 1900, though, and ask people to put together a list of 19 developed market countries for the 20th century, and you would probably find frequent mention of countries like Argentina, Russia, and China, among others. As those countries never made the dataset, even the results I describe here include survivorship bias.
From the perspective of a U.S. retiree, the issue is whether the future will provide the same asset return patterns as in the past, or whether Americans should expect mean reversion that would lower asset returns to levels more in line with what many other countries have experienced. And for international readers, do keep in mind that the 4% rule is based on U.S. historical data, and mileage may vary quite dramatically in other countries.
It may be tempting to hope that asset returns in the 21st century United States will continue to be as spectacular as in the last century, but John Bogle cautioned his readers in his 2009 book Enough, “Please, please, please: Don’t count on it.
”This speaks to the RIIA's fundemental goal of retirement planning to first build a floor and then expose to upside.
Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan, and the curriculum director for the Retirement Management AnalystSM designation program. He maintains a blog about retirement planning research at
wpfau.blogspot.com
Read more...
|
|
|
|
|
<< Start < Prev 1 2 3 4 5 6 7 8 9 10 Next > End >>
|
|
Page 1 of 31 |
|
|
.png)
