We advocate a Safety First (or Liability-Driven) Investment strategy for retired households which anticipates the use of relatively low-risk investments to fund future Essential Expenses (the Floor Portfolio) and higher-risk investments to fund future Discretionary Expenses (the Upside Portfolio). The non-risky assets/investments we advocate for the Floor Portfolio include:
- Social Security benefits
- Pension benefits
- Lifetime income annuities (SPIAs and DIAs)
- Tips ladders, and
- Non-lifetime fixed annuities
The first three items above (including deferring commencement of Social Security benefits) can be considered as lifetime income products for the purpose of this post.
We are not big fans of using bonds for funding the household Floor Portfolio as they are generally subject to interest rate risk. We will also push back on those who argue that bonds are more liquid than lifetime annuities by noting that if you are going to fully fund your Floor Portfolio to pay future essential expenses, you are committing to keeping it funded, so the extent of perceived bond liquidity may be illusory.
Lots of our readers disagree with us and for whatever reason believe that bonds are just fine for funding their Floor Portfolios. Further, many of our readers would simply never even consider buying an annuity from an insurance company. We will once again take this opportunity to remind our readers that we aren’t in the business of selling any products (nor do we make any money from visits to our website or from any activity related to our website).
Many, if not most, of our readers plan to live longer than their life expectancy. Some even override the 25% probability of survival default lifetime planning period assumptions in our workbooks (Actuarial Financial Planner) because they want to assume that they or their spouse will live to age 100. We have no problem with being conservative and agree that most retirees should plan to live longer than their life expectancy.
If you plan to live longer than your life expectancy when determining the present value of your essential expenses, however, you should consider buying or investing in lifetime income products instead of buying bonds because acquiring lifetime income will generally increase the present value of your Floor Portfolio assets and your Funded Status, all things being equal.
We have spoken with readers (and some experts) who plan to live longer than their life expectancy when determining their spending liabilities in retirement, but they then argue that they don’t want to buy an annuity (or other lifetime income product) because they fear they may die early. This doesn’t make a lot of sense to us. When planning, you should presumably use the same LPP assumptions for determining both your assets and your spending liabilities, and you should presumably select investments that maximize returns for a given level of risk.
Readers may wish to read Dr. Wade Pfau’s paper, Determining an Efficient Frontier for Retirement Income, in which he compares the efficiency of various stock/bond portfolios with various stock/SPIA portfolios. He concludes that the stock/SPIA portfolios are much more efficient.
