Traditional financial advice suggests you invest in a mix of stocks and bonds in planning for your retirement, and shift the mix more towards bonds as you age. The reason for this advice is that bonds tend to be less risky and have lower volatility than stocks, and are often countercyclical to equities. When stocks don't perform well, bonds do, and vice versa.
Research in the 1950s by Harry Markowitz describes an "efficient frontier" to diversifying and trading risk for rewards. Basically, his research showed that there was a point at which you did not need to take on additional risk because the rewards you received for doing so did not justify taking on that extra risk. This research led to modern portfolio theory and much of the well-worn advice that financial planners trot out regarding investing in stocks and bonds.
Unfortunately, one mistake investors often make as they plan for retirement is failing to look beyond stocks and bonds, and take into account other sources of income when they make their investment allocations. However, new research by Dr. Wade Pfau, CFA, threatens to turn traditional advice about stock/bond allocations in retirement onto its head.
Dr. Pfau notes that people have two main goals in retirement: supporting lifestyle spending goals, or at least minimum spending needs, and maintaining a sufficient cushion of assets in reserve for unexpected expenses such as health issues, boomerang kids, and emergency repairs. Since most people do not have enough retirement savings to comfortably meet both goals, they have to make a tradeoff between one or the other—more income or more assets.
While he doesn't claim to allow people to have their cake and eat it too, Pfau suggests that it is possible to get more income in that tradeoff. His research suggests that, instead of investing exclusively in stock and bond allocations, people will be better off in investing in a combination of stocks and fixed annuities while avoiding bonds altogether.
You read that correctly. His research suggests not investing in bonds at all. The paper shows that people have their income spending needs met more fully by buying single premium immediate annuities (SPIAs) and then investing the remaining assets in stocks.
I was intrigued. My grandparents used to buy me Series EE savings bonds for my birthday as a way to save and invest. I had to cash them in to pay for repairs when my car managed to find its way into Mr. Kimble's passenger side door in high school, but boy, was I glad I had them. Surely bonds were part of any well-diversified portfolio, weren't they?
Fortunately, Dr. Pfau was kind enough to spare me some time for an interview. Some highlights:
- Dr. Pfau conducted a Monte Carlo analysis of 1,001 combinations of stocks, bonds, SPIAs, and variable annuities. In every case, the best outcomes for maximizing income and remaining assets came from an allocation of stocks and SPIAs. Based on these findings, Dr. Pfau asserts, “there is no need for retirees to hold bonds.”
- Annuities are like bonds with benefits. With a bond, you're going to receive a set amount of income payments over a fixed period of time and then receive your principal back. With a SPIA, you'll get a given amount of income payments for the rest of your life, but you get no principal back. Annuity providers use actuarial data to determine how much to pay you because a given percentage of people die each year. If you're a 65-year-old male, then, on average, you'll live another 17 years. So, the annuity provider can make payments as if you'd live another 17 years. However, some people will die earlier, and some will die later. If you die later, you have beaten the house and you get more money, but if you die earlier, the house wins. Because of this pooling of risks, annuities can pay a higher percentage return, and the tradeoff is that you don't get the money back at the end. If you're looking to meet income needs, then this is a great way to meet your goals because you can get more income for the same dollar.
- Traditional financial advice is based on a remarkable period in U.S. and world history. The returns and financial growth in the United States in the 20th century were abnormal and unprecedented. The advice that the financial planning industry developed about safe withdrawal rates in retirement and about asset allocation relies on historical performance that is unlikely to be repeated. A mix of stocks and annuities allows provides a floor for income needs while taking some upside risk with your stock investments. A way to think about it is this: the annuities can make sure that your day-to-day living expenses are met without requiring you to become a bag lady who eats cat food. The stock allocation allows you to take some shots higher returns to meet other goals, such as traveling around the world or leaving a bigger inheritance.
Regardless of where you are in life, you have to get a handle on your own situation before trying to take advantage of these new findings. If you want to convert some of your assets into annuitized income, then you need to have a good idea of what sort of income you need. Knowing your expenses, or having a good estimate of what your retirement expenses will be, allows you to determine how much in annuities you should be buying.
Pfau has some suggestions for what to consider when looking at a stock-and-annuity asset allocation:
- If you're at or approaching retirement age: Determine what your goals are with regard to balancing income desires and the desire to retain assets that you control. Once you buy a SPIA, you can't get that chunk of cash back, although you will get a stream of income payments for the rest of your life. If you have the financial wherewithal to do so, consider delaying annuity purchases until later in life, as you'll get an even higher stream of income due to the mortality credits of annuities.
- If you're younger: Again, get a good grip on your expenses so that you can have an idea of what sort of income you're going to need in retirement. Occasionally look at SPIA rates so that you can get an idea of what level of assets you'll need to replace your income with annuities. Don't get fixed on “the number.” It's not what you have, but what you can purchase that matters. As Dr. Pfau points out, “Somebody may look and say that they have $100,000 and think, 'Oh, I'm rich and that's a lot of money,' but…$100,000 may only support an annual income of $4,000 a year, and…that's going to be a reality check.”
Dr. Pfau's groundbreaking research provides more ammunition for economists who can't figure out the annuity puzzle, and shows that perhaps it's time to trade in the EE bonds for some SPIA annuities instead.
Jason Hull is a candidate for the CFP(R) Board’s certification, is a Series 65 securities license holder, and owns Hull Financial Planning.