Retirement finance has an accumulation stage and a decumulation stage. Accumulation gestates, hatches, and cooks your retirement nest egg; decumulation allows you to eat it. Accumulation commands the lion’s share of attention in popular finance, but decumulation, or distribution, is equally important. Understanding how to disburse wealth is just as important as understanding how to build it.
The Basic Problem
On retirement day, you possess a store of wealth built up throughout your working life. Stretched out before you is the rest of your life, of uncertain duration. You want to withdraw a sufficient quantity of wealth to finance a comfortable lifestyle, but not so much that you run out of money before you run out of life.
In order to make your problem manageable, you will probably choose to withdraw and consume a specified fraction of your wealth. If your chosen fraction doesn’t work well – either because you don’t have enough money to live on or because you are using up your wealth too rapidly – you may either choose a bigger fraction or a smaller one. You won’t, or shouldn’t, simply withdraw a random amount whenever the spirit moves you. That would leave you with almost no control over how fast your money is used up.
Your basic problem is choosing that fractional withdrawal, which is called the withdrawal rate and is expressed as a percentage. The optimal rate depends on subjective factors – your tastes and preferences, your need for security, and your tolerance for risk – as well as objective ones. Copious research has been devoted to identifying it. The most widely-cited studies focus on the question of how much can be safely withdrawn, and over what time period, without depleting the principal.
The Right Withdrawal Rate
Financial advisors can and should tailor their estimation of the right withdrawal rate to the particular circumstances, needs, and proclivities of each client. When asked to suggest a “rate of thumb,†however, they usually fall back on a conservative standard – a rate that will not deplete principal over a long retirement – or an even-more-conservative standard – a rate that will keep principal from declining.
The most widely-cited studies of this issue were conducted around the turn of the twenty-first century. They suggested that a withdrawal rate of 4-6% would probably not deplete principal, although the risk of doing so seemed to rise steeply once the rate reached 5%. (Another factor affecting the withdrawal rate is the rate of return earned in retirement, which depends on the allocation of retirement assets. The larger the equity allocation, the higher is the permissible withdrawal rate.) Today, 10 years later, financial advisors have lowered their sights markedly, picking 3-3.5% as the rate of thumb. What accounts for this change?
Over that 10-year interval, stocks have turned in their worst performance ever, with a negative rate of return. That has reduced the historical rate of return to equity, which in turn has driven down the highest permissible rates. The recent financial crisis has almost certainly exerted a downward psychological pull, leading planners to pull in their horns in case the recession stretches out over the next decade.
Other Important Parameters
Other parameters also affect the right withdrawal rate. Life expectancy at age 65 has increased dramatically over the last half of the twentieth century. All other things equal, a longer withdrawal period lowers the withdrawal rate consistent with non-depletion of principal.
Interest rates are a key determinant of the right withdrawal rate. Higher interest rates produce lower bond prices, reducing the value of a bond portfolio. This is a difficult parameter to gauge, however, since the higher rate will also increase the interest yield on both fixed-income and liquid assets.
Expenses in retirement can vary widely for different households. In particular, debt can eat up income otherwise available for consumption. The more debt (or other expenses), the lower is the permissible withdrawal rate.
How Do Annuities Fit Into This Picture?
After reading the foregoing, how much would you pay to simply forget about all potential complications and settle for a guaranteed income for life? That is the concept underlying most annuities. Its attractions obviously depend on the size of the guaranteed payment, as well as the solidity of its guarantee. Since the rate of return on an annuity varies directly with the length of the annuitant’s life, the trend toward increased life expectancy certainly favors the annuity.
Perhaps the biggest plus for annuities – especially equity indexed annuities – is the elimination of the need to guess about future stock prices, interest rates, and longevity. The world’s greatest experts cannot forecast these parameters with much precision. It is very likely that, in hindsight, there will be a particular allocation of stocks, bonds, and real assets that will outperform the annuity. The problem is that we cannot know this allocation in advance, so we cannot guarantee that it will find its way into our portfolio.
If we compare the annuity payout with an optimal withdrawal rate and asset allocation chosen after the fact, the annuity will likely come out second best. That is hardly a decisive argument against annuities, however, since there is no particular reason to believe that the choices we actually make will be the optimal ones. Annuities give us a reasonable outcome, guaranteed, compared to the prospect, but not the promise, of a better outcome if we make the right choices.
Annuities: The Dark Horse Choice
It is ironic that, given all the lip service paid to the concept of security, the only asset able to provide lifetime security of income is not even-better understood and utilized. The reasons for the dark-horse status of annuities are many and complex, but the fact remains that a life annuity is probably the best, most secure way to provide guaranteed income for life. The quickest way to realize this is to sit down and try to compute the right withdrawal rate on your retirement savings. Afterward, check out the best deal on a life annuity. Ask yourself if the incremental gain in income is worth sacrificing the security of the life annuity.
I think one of the biggest factors is the life expectancy rate that has increased to over 65.
Sometimes, with these things it seems as if you are screwed whichever way you turn. That’s one of the frustrating things about life that I’ve never learn to come to grips with.
An Explanation of the Operation of a Legal Reserve Life Insurance Company, underwriters of Annuities.
Through devastating world wars, financial recessions and depressions, sweeping epidemics, earthquakes and fires, inflation and deflation, the life insurance industry has protected people to a degree unmatched by any type of financial institution in the history of the world.
Today the life insurance industry provides more than a trillion dollars of death protection to American consumers.
The financial reliability of the life insurance industry, even in times of financial panic, was demonstrated convincingly during the Great Depression of 1929-38 when some 9,000 banks suspended operations while 99% of all life insurance in force continued unaffected. Reinsurance, acquisitions, and mergers protected virtually all policyowners in the affected companies against personal loss.
Unlike most industries where size is a major measure of financial stability, life insurance’s unique series of safeguards can make even the smallest company a tower of strength. In 1949 Mr. Leroy A. Lincoln, then president of the world’s biggest life insurance company, Metropolitan Life of New York, stated: “You’re as safe, as well protected and the cost is just as cheap if you buy from a small insurance company as from the largest.”
The State Insurance Department
The State Insurance Department is a most vital department in each of our fifty states. Acting on its own state’s insurance laws and regulations, it supervises all aspects of an insurance company’s operation within that state. In addition, the State Insurance Department licenses all companies and agents to sell insurance within its boundaries. It must also approve all policy forms and in some cases, sales materials before they can be offered to the public. The Departments review complaints from consumers and mergers of companies which do business within its boundaries.
Required Reserves Ensure Payment of Policyholder Benefits
A large percentage of each premium dollar calculated by actuaries for each company goes into the policyowner’s reserve fund. This policy reserve (Legal Reserve) fund is a liability to the life insurance company. The fund is established as a way of determining or measuring the assets the company must maintain in order to be able to meet its future commitments under the policies it has issued.
The reserve liabilities are established as financial safeguards to ensure the company will have sufficient assets to pay its claims and other commitments when they fall due. These assets are kept intact for payment of living and death benefits to the insureds. Life companies that comply with the legal reserve requirements established by the state insurance laws are known as legal reserve life insurance companies.
Periodic Company Examinations
Every year all legal reserve life insurance companies submit annual statements to the insurance departments of each state in which they are licensed to do business. The format and contents of the forms used are prescribed by the State Insurance Commissioners and they are a detailed report of an insurance company’s financial status that is important in evaluating the company’s solvency and compliance with the insurance laws. Every few years, depending on a company’s home state law, all companies operating in more than one state undergo a detailed home office zone examination of its financial position. This audit is conducted by a team of State Insurance Department Examiners representing the various zones in which the company is licensed to do business. Companies licensed in only one state are subject only to an annual home office examination by their State Insurance Department.
Additional Security Safeguards
1. Reinsurance: Nearly every legal reserve life insurance company further protects its policyholders by reinsuring part of the coverage with a life reinsurance company. This is done when the company will not or cannot undertake a risk alone. Reinsurance prevents relatively sizable claims from depleting a company’s policy holder reserves. The amount reinsured depends on many factors such as the size of the individual claim and the number of claims a company can expect.
2. Surplus: The surplus is the amount by which a company’s assets exceed its liabilites. The surplus protects the policyholders and third parties against any deficiency in the insurer’s provisions for meeting its obligations. The determination of the optimum amount of surplus that a company will retain must be based on experience, current conditions, and an awareness of the primary goal of maintaining a strong company that is always able to pay claims as they arise.
Mergers
In the unlikely event that a company’s annual statement or its own examination reveals possible financial weakness, one of several avenues is open to the company: (1) Produce additional operating capital; (2) Sell its business to another life company; (3) Merger into another financially stable life company. A legal reserve life insurance company simply does not close its doors and go out of business declaring that all policies are null and void. Legal reserve life policyholders enjoy personal security safeguards unknown by other types of business.
Yours for Life
Another unique advantage of legal reserve life insurance is that if one company is purchased or merged into another, there is no change whatsoever in the policy benefits or premiums. Legal reserve life insurance companies have established a public responsibility to respect both the letter and the spirit of laws and regulation so the interest of their policyholders are always protected.
Policyholders Protection Comes First
Today, as has been the case for many years, it is unlikely for the policyowner of legal reserve life insurance companies to lose their policy benefits. Through strict state insurance department regulations, the establishment of many state insurance guaranty associations and because of the insurance industry’s history of financial stability and public responsibility to operate in a manner not detrimental to the welfare of the community, your policy is secured by industry safeguards.
The main risk about annuities (which nobody mentions BTW) is that the insurance companies you bought them from goes bust. It has happened in the past as other insurance companies buy up existing policies. This is obviously done out of self interest because if policy holders get wiped out, no one would end up buying them. But you never know what happens when all insurance companies end up in trouble!