Retirement Research
Following are summaries of major research studies that demonstrate the important role of fixed annuities in securing retirement income. Also included with each summary is a link to the original article.
Wharton Financial Institutions Center
» Policy Brief: Personal Finance, August 14, 2007
Investing your Lump Sum at Retirement
David F. Babbel, Fellow, Wharton Financial Institutions Center;
Professor of Insurance and Finance, The Wharton School,
University of Pennsylvania
Craig B. Merrill, Fellow, Wharton Financial Institutions Center;
Professor of Finance and Insurance
The Marriott School of Management, Brigham Young University
ELM Summary: This essay describes the conclusions from an earlier study by the same authors as well as findings by other prominent economists. It concludes that income annuities can provide secure income for one's entire lifetime for 25-40% less money than it would otherwise cost an individual, thanks to an insurer's ability to spread risk across large numbers of people.
The authors note that "...economists have come to agreement from Germany to New Zealand, and from Israel to Canada, that annuitization of a substantial portion of retirement wealth is the best way to go. The list of economists who have discovered this includes some of the most prominent in the world, among whom are Nobel Prize winners. Studies supporting this conclusion have been conducted at such heralded universities and business schools as MIT, The Wharton School, Berkeley, Chicago, Yale, Harvard, London Business School, Illinois, Hebrew University, and Carnegie Mellon, just to name a few. The value of annuities in retirement seems to be a rare area of consensus among economists."
In the press release accompanying the essay release, Prof. Babbel said: "Our research shows that only lifetime income annuities can protect individuals in an efficient way from the risk of outliving their assets and that this simply cannot be duplicated by mutual funds, certificates of deposit, or any number of homegrown solutions. We believe we've shown that income annuities clearly should be more widely used, given that highly rated insurance companies are reliable and inexpensive sources of guaranteed income streams in retirement."
Employee Benefit Research Institute (EBRI)
» Issue Brief, September, 2006
Measuring Retirement Income Adequacy:
Calculating Realistic Income Replacement Rates
ELM Summary: The author is Jack VanDerhei, EBRI Fellow and Research Director of the EBRI Fellows Program. He notes that for decades "replacement rates" have been the primary rule of thumb measure used to estimate an adequate level of income during retirement. Replacement rate is annual retirement income divided by annual income just before retirement. For example, someone who retires from a job with $100,000 in salary and has $75,000 in retirement income has a replacement rate of 75% (which many financial planners would consider adequate).
A weakness of replacement rate models is that some important retirement risks are not taken into account, including investment risk, longevity and the risk of potentially catastrophic health care costs. Taking these risks and inflation into account and using a Monte Carlo model, the study demonstrates that (1) an adequate replacement rate depends on the retiree's income level and the nature of one's retirement assets, and (2) for most retiree groups, converting some retirement assets to an income annuity at retirement can lower the replacement rate needed to achieve a 90% probability of income adequacy. For example, the study illustrates one example where an 124% replacement ratio, half of which is provided by an annuity, can have a probability of adequacy, equal to replacement ratios of 148% to 180%, with no annuity purchase and various earnings assumptions (page 28).
Journal of Financial Planning
» 2000 January Issue - Article 7
Meeting the Needs of Retirees: A Different Twist on Asset Allocation
by John Rekenthaler, CFA
ELM Summary: In this early 2000 article, the author educates the financial planning community about the pitfalls of developing retirement income plans based on "average" investment returns. He uses historical charts to show that, for the retiree making withdrawals from assets, the sequence of the annual returns on those assets can be of greater importance than the average of those annual returns.
The author makes the case that traditional asset allocation models, used to optimize accumulations while saving for retirement, do not work for allocating assets during retirement. In retirement, the asset allocation mix should recognize that a long time horizon, which is a friend of the young investor, is an enemy of the retiree who needs income from the portfolio for every year of retirement. Asset allocation models also need to consider that volatility in portfolio returns, which may average out for investors accumulating assets, will damage the level of withdrawals that a retirement portfolio can sustain.
The author (correctly) predicts that new asset allocation models will be developed for the asset "draw down" phase to account for the risks which are not present during the asset accumulation phase.
Journal of Financial Planning
» 2001 December Issue - Article 6
Making Retirement Income Last a Lifetime
by John Ameriks, Ph.D., Robert Veres and Mark J. Warshawsky, Ph.D.
ELM Summary: The authors explore the sustainability of alternative asset withdrawal plans using different asset allocation mixes during retirement. The probability of failure of various plans is examined for various model portfolios ranging from asset allocations that they label from conservative to aggressive.
An historical chart illustrates that, regardless of the asset allocation strategy, the withdrawal rates that were sustainable for a full 30 years were between 3.50% and 5.00% per year adjusted for inflation. The aggressive portfolio sustained the higher withdrawal rates for the 30 year period. Looking specifically at a 4.50% inflation-adjusted withdrawal rate, historical analysis shows that, relative to the conservative portfolios, the more aggressive portfolios had a higher likelihood of sustaining income for a long withdrawal period. But even the aggressive portfolio showed a tendency to fail too frequently to be considered a stable withdrawal plan for a long retirement.
Finally the authors examine whether the purchase of an immediate fixed annuity helps or hurts the sustainability of the withdrawal plans considered. Using both an historical analysis and a Monte Carlo analysis, their charts illustrate that for all time periods and for all investment portfolios in the study, the addition of the fixed annuity leads to better results. The authors also provide a "discussion" of the pros and cons of an immediate annuity purchase and the factors that should be considered.
Journal of Financial Planning
» 2004 March Issue
Determining Withdrawal Rates Using Historical Data
by William P. Bengen, CFP
ELM Summary: The author shows how to use historical performance data to determine "safe" withdrawal rates and asset allocations during retirement so that retirees do not outlive their savings. This paper is actually a reprint of the author's 1994 landmark research on this subject.
From the historical data, Bengen concludes that the maximum "safe" withdrawal rate is about 4% for the typical retiree of age 60-65 relying on a conventional portfolio of stocks and bonds. The 4% withdrawal rate is used to calculate the actual withdrawal dollar amount in the first year of retirement. This withdrawal amount (in dollars, not percentages) is then increased in each future year for actual inflation.
Looking at the historical evidence, he characterizes 5% withdrawal rates (adjusted for actual inflation) as "risky" and 6% rates as "gambling."
Journal of Financial Planning
» 2003 June Issue
Merging Asset Allocation and Longevity Insurance: An Optimal Perspective on Payout Annuities
by Peng Chen, Ph.D., and Moshe A. Milevsky, Ph.D.
ELM Summary: Chen is a vice president and director of research at Ibbotson Associates. Milevsky is an associate professor of finance at Schulich School of Business at York University in Toronto, Canada.
Modern portfolio theory is widely accepted in the academic and finance industries as the primary tool for developing asset allocations. Its effectiveness is questionable, however, when dealing with asset allocations for individual investors in retirement, because it does not consider longevity risk and the portfolio's random time horizon.
This article reviews the need for longevity insurance (i.e., income annuities) during retirement and establishes a framework to study the total asset and product allocation decision in retirement, which includes both conventional asset classes and immediate payout annuity products.
Retirees must make their own decisions on what products should be used to generate income in retirement. However, there are two important risks that must be considered when making these decisions:
- Financial market risk — the volatility in the capital markets that causes portfolio values to fluctuate. If the market drops or negative corrections occur early during retirement, the portfolio may not be able to cushion the added stress of systematic withdrawals. This may make the portfolio unable to provide the necessary income for the desired lifestyle or it may simply run out of money too soon.
- Longevity risk — the odds of outliving one’s portfolio. Life expectancies have been increasing and retirees should be aware of the substantial chances for a long retirement and plan accordingly. This risk is further magnified for individuals taking advantage of early retirement offers or who have a family history of longevity.
The authors claim that an optimal asset/product allocation mix in a well-balanced retirement portfolio is derived from a two step process. First, a conventional asset allocation process is used to derive an optimal asset mix (without regard to longevity risk). And, then the product (i.e., income annuity) purchase decision is developed after considering the retiree's bequest motives and health assessments.