This post is a follow-up to our post of December 22, 2019 in which we said,
“We here at “How Much Can I Afford to Spend in Retirement” won’t tell you how much you should spend in retirement or how to spend it. We do understand, however, that the many uncertainties involved in retirement planning can and do lead to anxiety, stress and sub-optimal decisions. Managing uncertainty is an area where we believe we can help. And while our Actuarial Approach to personal financial planning will not eliminate uncertainties and retirement risks, it can give you robust tools and processes to manage these risks, calm your retirement spending fears and help you make better spending decisions.”
Motivation for this follow-up post comes from the June 7, 2021 Advisor Perspectives article, “Be Afraid, Very Afraid, of Retiring in the 2020s” by John Robinson. In his article, Mr. Robinson says,
“Most retirement planning software uses data or assumptions that will lead to unrealistically optimistic outcomes, considering our low-interest-rate environment.” and
“Our own latest research effort concurs with their general view [of Drs. Blanchett and Finke] that consumers who are retiring in the 2020s should indeed be afraid. Very afraid.”
We thank Mr. Robinson for noting, as we have for years, that the investment return assumptions frequently used in retirement planning software tend to be much more optimistic than interest assumptions used to price guaranteed lifetime income insurance products that we recommend to use in building your Floor Portfolio. We also share Mr. Robinson’s concerns that financial advisors who knowingly or unknowingly use assumptions based on historical experience in retirement planning software may be misleading their clients.
We disagree, however, with Mr. Robinson’s main conclusion that new retirees (or even older retirees) should be very afraid. We also disagree with Mr. Robinson’s defense of financial advisors and others who continue to promote software that utilizes overly optimistic historical return assumptions in today’s low-interest-rate environment; particularly those who are unaware of the assumptions actually built into the models they use. Finally, we also disagree with Mr. Robinson’s derision of including life annuities in retiree Floor Portfolios. We discuss these items in the sections below.
Facing Fears in Retirement with a Robust Plan
There are many financial risks in retirement that should be of concern to retirees. Instead of living in fear of these risks, however, we encourage retirees to either take steps to manage these risks and/or to determine in advance how they will cope if a specific risk materializes in the future. This can be done using our Recommended Retirement Planning Process, which involves establishing a Floor Portfolio to fund essential expenses (including adequate insurance to protect significant assets) and an Upside Portfolio to fund discretionary expenses (which may be reduced if necessary).
These risks include:
- Investment
- Inflation
- Longevity
- Cognitive decline
- Reduction in sources of income (such as Social Security benefit reductions)
- Unexpected loss of assets (such as destruction of your home or other assets)
- Unexpected medical, long-term care or other expenses
As noted above, many of these risks can be managed by building a Floor Portfolio of low-investment risk assets (like Social Security, pensions and life annuities) and through the purchase of insurance. For other risks, retirees may decide that they can reduce specific discretionary spending if necessary (for example if inflation exceeds expectations). Having a robust plan is an important step to facing the fears of the unknown.
Advisors using a model they don’t fully understand
In his article, Mr. Robinson says,
“Of course, there is likely some contingent of the financial planning/wealth management community that is either unaware that the default expected return and standard deviation assumptions in most simulation software may be unrealistically high or that may not have had the academic exposure to econometrics and statistics necessary to understand the limitations of the software.” and
At present, no academic background in finance, accounting, or economics is required to become a financial planner (“Certified” or otherwise).
Now, if we did find something to be very afraid of in Mr. Robinson’s article, it was his defense of those who use modeling tools that they don’t fully understand. We believe it is critical for professionals who use modeling tools to understand the limitations of the assumptions built into the model.
“Dismay and Derision” Expressed toward Life Annuity Products
We view Single Life Annuities and Deferred Life Annuities as legitimate low-risk guaranteed income products that may be used to fund your Floor Portfolio. We are not pushing these products and we are certainly not pushing these products for funding of all your future expenses as implied by Mr. Robinson. Like fire insurance or medical insurance, these products provide insurance. In this case, longevity and guaranteed investment insurance. And yes, in this low-interest rate environment, these products can be expensive. We suggest that Mr. Robinson and interested readers read the excellent recent Advisor Perspective article, The Valid and Not-So-Valid Reasons for Rejecting Annuities by our actuary friend Joe Tomlinson to educate themselves on when including annuities in a retirement plan can be the right thing to do rather than simply rejecting annuities out of hand.
In his article, Joe tackles some of the “not-so-valid” reasons in a point/counterpoint discussion organized by arguments frequently made against annuities. For example, he notes:
- Lack of Liquidity—"Many people have sufficient funds and don’t need 100% of their financial products to be liquid, and the illiquid annuity products such as SPIAs and DIAs provide the largest benefits from pooling mortality risk.”
- Unexpected Mortality (hit by a bus)--“Annuitization simply provides mortality pooling – those with short lives subsidize those with long lives. It’s not a case of ‘the insurance company wins.”
- Asset-to-Income translation—"It is worthwhile to compare annuity payout rates to the cash flow that can be generated from bond ladders with a maturity set at an assumed maximum age at death. With today’s pricing, the bond ladder might be 40% more expensive that a SPIA generating the same payouts.”
- Stocks versus fixed income—"It makes a difference whether stock-return forecasts use historical data for returns or the premium over fixed income returns, which are significantly lower today in both real and nominal terms than historical averages. Also, it’s necessary to recognize the greater downside risk in a heavy reliance on stocks to support retirement.”
Finally, Joe concludes, “There are indeed positives [for purchasing life annuity products], but they tend to be different in character than the negatives. The positives relate to how annuities fit into a full financial plan and how they mitigate risk.” We agree.
Summary
While we agree with Mr. Robinson that new (and old) retirees should be concerned about investment risks in this low-interest-rate environment, they should also be concerned about other potential risks as well. In order to face these risks and avoid losing sleep, however, retirees need to develop and use a robust plan based on reasonable assumptions about the future. We believe our Recommended Financial Planning Process is a reasonable approach for this purpose.
