In today’s low-return environment, retiring clients have become concerned about the potential risk of outliving their retirement assets, leading to increasing calls for strategies that annuitize at least a portion of these clients’ portfolios.

Several studies have suggested that using single-premium immediate annuities (SPIAs) this way can improve retirement income sustainability. However, those findings may overestimate their overall impact, according to the findings of a recent research paper.

In a paper entitled The True Impact of Immediate Annuities on Retirement Sustainability: A Total Wealth Perspective, Wade Pfau, professor of economics at the American College of Financial Services in Bryn Mawr, Penn., and Michael Kitces, research director with Pinnacle Advisory Group Inc. in Columbia, Md., examined the relative success of dynamic stock/bond portfolios and stock/SPIA portfolios to determine the impact of adding annuities to the mix.

The focus was to finance an inflation-adjusted amount equal to either 4% or 6% of initial retirement-date assets and to sustain that income stream for as long as possible in retirement.

Although SPIAs can enhance retirement outcomes in certain circumstances, a partial annuitization strategy, as commonly implemented, really is an indirect form of the “bucket” approach, which liquidates fixed-income assets disproportionately in the early years and lets the balance of the portfolio run.

The researchers’ conclusion was that gradually increasing exposure to equities as clients age actually improves their chances of succeeding in their retirement goals.

This approach to later-in-life asset allocation, which the paper calls a “rising glide path,” also minimizes exposure to potentially unfavourable sequences of returns.

In fact, the majority of the benefits commonly attributed to partial annuitization is largely the indirect result of this rising glide path. Although adding SPIAs to portfolios provides superior results for very long-lived retirees, extreme longevity is required before the contribution from mortality credits – the “other people dying” factor – makes any real difference.

Knowing that some clients who buy annuities will die prematurely allows insurers essentially to pass along money that otherwise would have gone to those clients to clients who are still alive. The longer clients live, the more of these mortality credits they can expect to receive, thus increasing the effective yield on their investment while they’re living.

The study found, however, that clients must live into their 90s before the mortality credits make any appreciable difference.

For clients with a typical life expectancy, SPIAs not only fail to add significant value but actually produce results inferior to simply replicating equities’ rising glide path without annuitizing at all.

If there’s a benefit to liquidating bonds disproportionately in the early years and letting the stocks run, liquidating the stocks later, this benefit can be accomplished simply by using a straightforward portfolio mix of 50% stocks/50% fixed-income that automatically takes all withdrawals from the bonds in the early years and allows the equities exposure to rise steadily over time.

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