It’s one thing to advise a client that annuities are an important part of their retirement portfolio. Proving that the annuity recommendation will improve the client’s situation appears to be more difficult, but it need not be that way.
The existing approach to advising clients about annuities — matching essential expenses — diminishes the power of annuities.
The most commonly practiced approach by advisors is to meet the client’s essential expenses using annuities. It is reasonable to expect that the retiree should have essential expenses covered by guaranteed sources, but using that as the only argument to justify the proposed annuity purchase diminishes the power of annuities in many ways.
Besides missing the point that income from annuities can also be used for discretionary expenses, such a view ignores a holistic picture of the client’s situation. For example, the match essentials approach pulls the annuity away from the most powerful lever to help a retiree: Social Security claim deferral.
The advisor may think that an increase in the Social Security benefit through deferral will provide higher essential expense coverage and thus correspondingly decrease the amount of the annuity sale. In reality, the opposite is true — Social Security claim deferral strongly increases the case for annuity purchase, and a deferral-with-purchase approach dramatically improves the client’s situation. To explain how, I will introduce an alternate approach.
An Alternate Objective Holistic Approach
Consider an alternate approach that is based on analyzing the client’s complete retirement situation. This would include all their retirement expenses and all their cash flow sources, as well as their current investments and annuities. The agent uses software to simulate two alternative income strategies that generate the same desired retirement income, considering all income sources and under the same set of forward-looking investment returns and inflation assumptions (Monte Carlo simulation). The agent then compares the strategies on the following measures:
Shortfall risk: The probability of the client experiencing a shortfall in meeting the desired retirement income because the investment portfolio is exhausted while the client is still alive.
Shortfall $: Total amount of dollar shortfall experienced in one of the near-worst cases.
Average legacy: The average amount left as a bequest at the end of the plan.
Let me explain these metrics as part of a retirement income analysis framework.
I’ll use a hypothetical case of Peter and Lisa, who are 65 and 64 years old, respectively. They have $540,000 of retirement assets. Peter is retiring now. Lisa will work for another year, earning $41,500 and saving $4,000 of it. Peter collects a monthly pension of $1,000 that has a 100 percent survivor benefit. Peter’s Social Security monthly benefit at his full retirement age of 66 is $1,800, and Lisa’s Social Security monthly benefit is $800. It is expected that Peter will live to age 94 and Lisa will live to age 97.
They are looking to generate $70,000 of inflation-adjusted annual retirement income annually. This is tiered down, based on existing research, to 87 percent after Lisa turns 75 and to 83 percent after Lisa turns 85.
A fixed indexed annuity (FIA) and a single-premium immediate annuity (SPIA) are considered for the analysis. The FIA has an immediate credit enhancement of 2 percent, an interest rate cap of 2.8 percent and guaranteed growth of 8 percent simple interest rate in income base over 10 years, after which it provides a 6 percent lifetime withdrawal rate. Here is what we determined.
The chart above illustrates two different retirement income strategies and their performances.
Client Defaults represents the default strategy that the client wishes to pursue, which is to claim Social Security at the beginning of the plan and invest all their money in a conservative inflation-protected allocation (no annuity purchases are made).
The Max Confidence plan represents an optimal income strategy that is based on Peter deferring his Social Security claim to 70 and Lisa claiming her Social Security at 66, switching to a higher spousal benefit when Peter has filed and then switching to a survivor benefit upon Peter’s death. The plan is based on purchase of an FIA and a SPIA, each using 20 percent of the assets, and then balancing 60 percent of the assets invested in a moderate inflation-protected portfolio.
The relative superiority of the optimal strategy is clearly demonstrated by the 28 percent point reduction in the chance that the client faces a shortfall, the reduction of $250,000 in the cumulative shortfall in the near-worst case scenario, and the increase in the average bequest (the portfolio value at the end of the plan, measured in today’s purchasing power) of $204,000. The optimal strategy fared well on all fronts. That goes against the conventional wisdom that by buying annuities one is trading off against the bequest motive.
How is one recommendation so dramatically better than the other? It is because of the synergies brought about by Social Security, investments and annuities. Using the same case, this chart shows the amount of cumulative retirement income provided by each source over the course of Peter and Lisa’s retirement. Here is how this works.
Obtaining an additional $170,000 in Social Security retirement benefits over a lifetime through deferred claiming reduced the amount of total income funded by retirement assets. That in itself reduces the Shortfall Risk and it also makes the combination of annuities and investments even more potent.
By moving $216,000 of retirement assets into annuities that provide $293,000 of real retirement income (purchasing power measured in today’s dollars; nominal inflation adjusted payouts are higher) over their lifetime, the remaining investment balance of $324,000 needs to provide only $362,000 of real retirement income over 33 years of retirement. That dramatically reduces the Shortfall Risk. The Shortfall $ also is reduced because of the increased Social Security benefit and lifetime guaranteed annuity payouts. Best of all, the synergies that create less in total withdrawals from the investment portfolio result in a higher Average Legacy, so the client wins on all fronts.
Since the baby boomer generation has undersaved for retirement, many will need to consider longevity risk pooling through annuities; self-insuring their longevity is not a viable option for them. A transparent, objective analysis, as featured above, demonstrates you are acting in the client’s best interest despite the agent’s variable compensation. Transparency builds trust, brings more referrals, increases the retirement income business for advisors, and provides much-needed guidance and security for the baby boomers’ retirement.