Notes from Jason Scott's FAJ article "The Longevity Annuity: An Annuity For Everyone?"
The retirement conundrum is how to "turn a pool of assets into a stream of retirement income."
Academics says annuities are the way to go. People don't like annuities and the advisory industry doesn't like annuities. Annuities are too complicated, too expensive, and force you to give up your assets.
The research indicates that a deferred annuity (as distinct from an immediate annuity) is optimal for retirees unwilling to fully annuitize. For a typical retiree, allocating 10-15% of wealth to a deferred annuity set to start late in retirement creates spending benefits comparable to an allocation to an immediate annuity of 60% or more.
It was four decades ago that economic theory concluded that individuals who wish to maximize guaranteed spending in retirement should convert all their available assets to an immediate annuity.
Deferred annuities are preferable to immediate annuities because of the well documented behavioral biases in decision making and maximize the insurance benefit per premium dollar.
The benefit of insurance depends upon the cost of insurance to the cost of replacement of the asset insured. You are looking to maximize the benefit per premium dollar (self insurance cost - insurance cost)/insurance cost). To evaluate the potential insurance benefit, one simply considers the likelihood of a payout. If an insurance payout is unlikely, insurance is generally cheap relative to self insurance and insurance can provide substantial benefits. If an insurance payout is highly likely, insurance cannot be provided at must of a discount to self insurance.
Securing spending in the future with bonds (liability matching using zeros) is analogous to setting aside the full replacement cost of the car (or income desired). A zero coupon annuity offers spending in 20 years at nearly a 50% discount to self insurance in the bond market.
Implication: Get retirees or those close to retirement to take some portion of their accumulated assets and purchase a 10, 15, 20, 25 year deferred annuity. They can use the difference to live on (along with social security) until the deferred annuity kicks-in (while using the residual assets as well).
Immediate and deferred annuities just represent a bundle of zero coupon annuities. The difference is that immediate annuities add near term, low value annuity payments to the bundle, ie. they are much more expensive because they are much more likely to be claimed.
The optimal bundle of zero coupon annuities to purchase depends upon the amount of assets the retiree is willing to annuitize.
Uber wealthy don't really need to deal with this issue. Also the poor (those with few liquid assets) and the unhealthy are not good candidates for deferred annuities.
Showing posts with label annuities. Show all posts
Showing posts with label annuities. Show all posts
Saturday, February 14, 2015
Life Cycle Investing in Theory and Practice by Zvi Bodie
Scientific studies of actual financial behavior have revealed people consistently make certain mistakes because of lack of knowledge, faulty logic, cognitive dissonance, and biased statistics.
Practice is far behind theory. Contemporary theory uses multiperiod hedging techniques and contingent claims analysis, while online quant models appear to be ad hoc blends of trial and error Monte Carlo forecasting and Markowitz static mean-variance model of efficient portfolio diversification.
Important insights from modern financial science:
The fraction of an individual's financial wealth optimally invested in equity should "normally" decline with age for two reasons. The first stems from the fact that human capital is usually less risky than equity and that the value of human capital usually declines as a proportion of an individual's total wealth as one ages. Second, at any given age, the greater the flexibility an individual has to alter their labor supply, the greater the amount they will invest in risky assets. Those with more risky human capital should start out with lower levels of risky assets. The complexity of the financial services marketplace is a good reason for the industry to develop more simple, guaranteed return products and for advisors to help clients navigate the shoals.
Economists generally believe that people are made better off when offered more choices, as long as they can always choose what they had before (the value of choice and options). But when people do not have the knowledge to make choices that are in their own best interests, increasing the number of choices does not necessarily make them better off. In fact it may make them more vulnerable to opportunistic salespeople or unqualified professionals. The industry is heavily biased toward equities for the long run.
New Life Cycle Products
Accumulation phase: occupational funds, college accounts, real estate accounts
Retirement phase: escalating annuities, bundled-risk annuities
Escalating annuities provide guaranteed minimum standard of living defined in terms of a flow of lifetime consumption. Payments increase with inflation and with the performance of the market, and increases are locked in for life. (not the same thing as a variable annuity)
People don't like annuities because they lose control of their money.
Practice is far behind theory. Contemporary theory uses multiperiod hedging techniques and contingent claims analysis, while online quant models appear to be ad hoc blends of trial and error Monte Carlo forecasting and Markowitz static mean-variance model of efficient portfolio diversification.
Important insights from modern financial science:
- A person's welfare depends not only on their end of period wealth but also on the consumption of goods and leisure over their entire lifetime.
- Multiperiod hedging (rather than time diversification) is the way to manage market risk over time, ie. buckets.
- The value, riskiness and flexibility of a person's labor earnings are of first order importance in optimal portfolio selection at each stage of the life cycle.
- Habit formation can give rise to a demand for guarantees against a decline in investment income.
- Because of transaction costs, agency problems, and limited knowledge on the part of consumers, dynamic asset allocation will and should become an activity performed by financial intermediaries, rather than by retail customers (the value add of advisors).
- Measure of welfare: lifetime consumption of goods and leisure (vs wealth).
- Time frame: Many periods where stocks are risky in short and long term (vs single period where stocks seem safe in long run)
- Risk management: precautionary saving, diversification, hedging, insuring (vs precautionary saving, diversification)
- Quant model: dynamic programming and contingent claims analysis (vs mean variance efficiency and Monte Carlo simulation)
- Capital market expectations: inferred from current prices, eg. swaps curves and implied volatilities (vs based on historic statistics)
The fraction of an individual's financial wealth optimally invested in equity should "normally" decline with age for two reasons. The first stems from the fact that human capital is usually less risky than equity and that the value of human capital usually declines as a proportion of an individual's total wealth as one ages. Second, at any given age, the greater the flexibility an individual has to alter their labor supply, the greater the amount they will invest in risky assets. Those with more risky human capital should start out with lower levels of risky assets. The complexity of the financial services marketplace is a good reason for the industry to develop more simple, guaranteed return products and for advisors to help clients navigate the shoals.
Economists generally believe that people are made better off when offered more choices, as long as they can always choose what they had before (the value of choice and options). But when people do not have the knowledge to make choices that are in their own best interests, increasing the number of choices does not necessarily make them better off. In fact it may make them more vulnerable to opportunistic salespeople or unqualified professionals. The industry is heavily biased toward equities for the long run.
New Life Cycle Products
Accumulation phase: occupational funds, college accounts, real estate accounts
Retirement phase: escalating annuities, bundled-risk annuities
Escalating annuities provide guaranteed minimum standard of living defined in terms of a flow of lifetime consumption. Payments increase with inflation and with the performance of the market, and increases are locked in for life. (not the same thing as a variable annuity)
People don't like annuities because they lose control of their money.
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