MOST RESEARCH ON OPTIMAL retirement income strategies assumes retirees make decisions only at retirement. In reality, financial advisors have the opportunity to modify their clients’ strategies during retirement – particularly in making decisions concerning annuities.
Conventional wisdom holds that most retirees should annuitize most of their investments unless they want to leave a big estate, because adopting a more static approach to retirement income will allow retirees to spend comfortably without running the risk of outliving their money.
However, in a recent Journal of Retirement study entitled “Dynamic Choice and Optimal Annuitization,” David Blanchett, head of retirement research, investment management, for Chicago-based Morningstar Inc., suggests that retirees who opt for a more dynamic approach can do better by reducing the amount of capital they allocate to annuities at retirement and delaying the timing of any annuitization significantly.
A static withdrawal strategy assumes that annual portfolio withdrawals are determined at retirement (as some percentage of the initial portfolio value, increased by inflation). In contrast, a dynamic approach assumes the amount of portfolio income varies during retirement.
Such a dynamic model is based on the premise that retirees seek to annuitize only as the ability to fund their desired retirement income diminishes, Blanchett says.
He likens the ability to purchase an annuity through retirement to a put option: an annuity can be purchased if necessary, but may not be required if the portfolio outperforms expectations. Therefore, the ability to purchase an annuity creates an effective “floor” on the amount of income a client will be able to generate from his or her portfolio.
In order to help to sustain a client’s income goal, Blanchett suggests financial advisors look to the “funded ratio,” a measure commonly used to define the health of a pension plan. A funded ratio is a point-in-time measurement of the likelihood that a client’s assets will be able to deliver the future distributions he or she is going to need. A ratio below 100%, for example, is a telling sign that the money put aside, including any future income, is likely to come up short.
Such a regular review helps both advisors and clients manage longevity risk. Only if clients find themselves consistently withdrawing more than the sustainable percentage from their account should they then consider an annuity, Blanchett believes.
Blanchett’s study looked at 27 scenarios that applied three variables: the amount of certainty the retiree would like regarding the level of income during retirement; the relative importance of having assets at death to pass to heirs; and expected life expectancy. Each variable was ranked as low, moderate or high.
Blanchett then applied the scenarios to four models: a static withdrawal strategy or a dynamic withdrawal strategy, with annuitization only at retirement; and the same two strategies with annuitization both at and during retirement.
His analysis suggests that the costs of delaying the annuity decision are relatively small – as long as clients choose a dynamic withdrawal strategy and start incorporating annuities by the tenth year of their retirement.
The result, he estimates, is as much as 1% more in risk-adjusted performance annually during retirement.
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