Retirees are facing perhaps their greatest financial challenge at any time since the Great Depression. Life expectancies are increasing, Social Security income may be curtailed, and traditional pension plans are disappearing. Seniors can no longer rely on positive real returns from traditional cash equivalent assets such as certificates of deposit and Treasury bills. Meanwhile current monetary and fiscal policy does not bode well for the future purchasing power of the dollar.

Millions of older Americans are worried, justifiably, that their financial resources might fall short of their spending plans, and that they may even outlive their savings altogether. In this environment, money managers, planners and insurance companies have stepped up their efforts to push products that are often inconsistent with investors’ best interests. Retirees are faced with a daunting and often confusing array of alternatives that go well beyond simply “spending down” an investment portfolio. Options range from plain-vanilla immediate annuities to far more exotic notions such as reverse mortgages and viatical settlements.

Here we set the stage for a series of follow-on articles in which we will attempt to cut through the clutter and help our readers, both young and old, to approach retirement planning in a rational manner.

The second article in this month’s issue takes the first step by examining immediate annuities in detail.

Brave New World

Over the last several decades defined-contribution plans such as 401(k)s have replaced the traditional defined-benefit pension plans for many Americans. With 401(k)s replacing traditional pensions as a primary source of retirement income, a growing number of retirees face a new challenge: Deciding what to do with a large lump-sum of retirement money. In the past, retirees received a monthly pension check from their former employer.

Now many have a large sum in their 401(k) or IRA, but have no assurance of a steady income and are concerned about inflation and how to make their savings last. Many advisors, including AIS, have recommended investing retirement assets in portfolios of stocks and bonds, and making systematic withdrawals from the portfolio. The allocation to stocks is reduced for individuals who fear stock market fluctuations. Upon retirement, many have recommended an annual withdrawal equal to four percent of the starting portfolio value, adjusted for inflation. Previous studies have shown this rate would usually work, even for investors living well into their 90’s.

This approach is coming under increasing scrutiny. For example, Joe Tomlinson of Advisor Perspectives analyzed the four percent rule by applying it to a portfolio of 35 percent TIPs and 65 stocks utilizing a Monte Carlo simulation. Such simulations allow both longevity and investment returns to vary.

His results indicated nearly a 20 percent failure rate (defined as running out of money before death) under the assumption that historically low interest rates will continue and lower stock returns will prevail. He also analyzed the data using inflation-adjusted single-premium immediate annuities (SPIAs) rather than bonds. This reduced the failure probability. However, only when the entire portfolio was annuitized (immediate annuity) was failure eliminated. He concludes that: “When we update the return data to consider the current interest rate environment and incorporate lower future stock returns, a bleaker picture emerges. To make the 4 percent rule work prospectively, it may be necessary to include products like SPIAs that provide longevity guarantees.”

Of course much depends on the assumptions used with respect to future returns. However, considering the many other challenges facing seniors,
especially longer life expectancy, price inflation and uncertainty regarding social security, it is time to re-examine conventional wisdom. A review of annuities and other alternatives is well justified.

In the coming months we will analyze various ways to address the retiree conundrum. We will focus on those solutions that appear most viable, as well as those that are dubious but promoted heavily. Inevitably, any alternative will involve trade-offs. Our goal is not to proclaim a perfect solution, but to make these choices evident so you can choose the optimal path consistent with your circumstances

Also in This Issue

A Closer Look at Immediate Annuities
Greece, Europe, and Your Portfolio
A Reader Inquires
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles