Thursday, December 16. 2010
The inspiration for today's blog post is drawn from a discussion I had today while visiting Tom Curran and Art Dicker (and some other on Tom's team) at Curran Investment Management in Albany, New York, after speaking for the FPA Northeast New York chapter. During our conversation, the subject came up about how so many people used to view retirement income guarantees as an all-or-none solution, but that increasingly it seems that the blended approach - where some of the income is guaranteed, and some is allocated to more "traditional" investment vehicles - is a more appealing way to balance a client's needs for safety and growth.
Personally, my thinking has evolved along similar lines... until recently. After all, it's hard to argue with the idea of insuring a portion of someone's income, and then investing for the rest. It seems to balance risk with growth. It ensures (and insures) that even if things go terribly wrong, the client will still have some income (in addition to Social Security?), and won't go broke. So what's the problem?
The problem is that, if you're focusing on what it takes to achieve a client's goals, just insuring 50% of a goal seems to be a remarkably inadequate solution, if someone is really concerned about making sure that the goals are achieved. After all, if a couple's goal is to spend $60,000/year for the rest of their lives, then if "the bad stuff" happens and they must rely on the $30,000 (50%) that was insured, then haven't they still catastrophically failed to achieve their goals? The good news is that they won't be destitute without income. But if the purpose of the plan was to achieve the goal - the goal has still been failed! The client couple will still have to go through a drastic change in their standard of living; they may still need to sell their house and relocate; they may still be unable to enjoy the niceties of their lives that their spending goal was meant to afford.
In other words, does guaranteeing 50% of your retirement income goal simply ensure that if you must rely on the guarantee, you still failed to achieve your goal? If you really want to achieve the goal, and insuring the goal is important, doesn't that mean you need to insure 100% of the target, not just a portion of it? And if you don't really care enough about the goal to insure 100% of it, why bother insuring it at all, since guaranteeing only 50% of your goal simply means that you're guaranteed to not achieve your goal by relying on that guarantee?
Of course, some people might only use a portion of their portfolio to buy a guarantee for all of the income they need for their basic necessities; but technically, if someone has enough "excess" wealth to fully insure their guarantees and still have wealth left over, they arguably didn't necessarily need to pay to insure the goal anyway, since by definition they apparently already had a lot of excess reserves left over and available "just in case." But to say the least, even clients in this situation seem to agree that the guarantee is best served when "all" of the basic goal is insured, not just a part of it.
So what do you think? Is insuring "part" of a goal really an effective way to manage risk, or is it just a guarantee that if the bad stuff really happens, that the client will be guaranteed to fail their original goals?
In planning for retiring clients, it's crucial to get an understanding of what the client's goals are in the first place - so that recommendations can be made about how to financially secure those goals. In the context of setting a spending goal, a popula
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Furthermore, this strategy makes sense from a lifecycle spending perspective. Without a permanent (annuitized) income stream, you must always leave some money in the bank - just in case you live another year, or five, or ten. However, if you know that your basic needs will be covered, no matter how long you live, you will have more freedom to comfortably spend a greater part of your capital earlier into your retirement - a period during which you have a substantially higher probability of being alive to enjoy it.
I don't disagree with the appeal of immediate annuities as a way to manage longevity risk. The problem I find is that in practice, few can actually apply them in the manner you suggest here.
First of all, unfortunately most immediate annuities are not inflation-adjusted, and consequently you have to keep a "reserve" to deal with future inflation needs for an unknown time horizon - which means, in essence, you haven't avoided the need to have a pot of money to protect for an unknown time horizon, which in theory was what the annuity was intended to protect against.
Conversely, for the few annuities available that do provide a full inflation-adjusting payment stream for a life contingency, the cost is higher than what many people can afford. In addition, I find that in practice, the pool of money necessary to provide for an inflation-adjusting immediate lifetime annuity is often such a large pool of money that arguably the annuity wasn't needed anymore anyway; the client could simply conservatively manage the large pool of money themselves for a comparable outcome (and without completely sacrificing all of their legacy goals).
I don't dispute that there is a lot of appeal to annuities from a theoretical perspective. But I find that in practice, they're very difficult to structure in ways that don't provide either incomplete protection of goals that still relies on "outside pots of money" to provide an additional backstop, or are so expensive that the solution isn't practical for the majority of clients (and the ones who can afford it may no longer need the guarantee).