Your Clients' Toughest Retirement Decision
September 18, 2012
by Wade Pfau
Want to trigger an impassioned debate? Ask a group of advisors about the choice between systematic withdrawal plans (SWPs) and single-premium immediate annuities (SPIAs). Fee-only advisors are loath to cede control of client assets to an insurance company that might someday default, while annuity advocates fire back that only their strategies provide a lifetime income guarantee.
While I’m not taking sides in this feud, I would like to highlight some of the key issues that divide these opposing camps. These include the value of the historical record, the validity of research assumptions, biases in advisor recommendations, the role of fraud and cognitive decline, taxes, and the potential for self-annuitization.
A client following an SWP invests her assets at the start of retirement and withdraws funds over her lifetime. The key determinants of whether such a plan will succeed – meaning that the client will not outlive her funds – are the rate-of-return on the invested assets and the rate at which the client withdraws funds. By contrast, a retiree could instead purchase a SPIA from an insurance company and receive known payments for the rest of his life.
The basic case for systematic withdrawals is that, by calibrating a client’s withdrawal rate to what would have always worked in the past, a client can obtain a sustainable income stream for life similar to what SPIAs currently provide. Even better, systematic withdrawals allow clients to maintain control over and flexibility of their assets, and they retain the ability to bequeath any remaining assets. More often than not, using a safe withdrawal rate will allow a client’s wealth to continue multiplying throughout retirement, except in the unfortunate case when that client’s portfolio suffers a sharp decline shortly after the onset of retirement, which is the absolute worst-case scenario for such investors.
Michael Kitces of the Pinnacle Advisory Group recently emphasized in an important blog entry that safe withdrawals rates also provide a floor-with-upside approach, with the potential for greater spending or a growing legacy. What’s more, aside from the uncertainty of health expenses, which complicate any strategy, available evidence suggests that discretionary expenses decrease with age. With some flexibility to make mid-course spending adjustments, systematic withdrawals from a well-diversified portfolio should safely support a spending plan without wealth depletion while also preserving the client’s liquidity and upside potential.
As for SPIAs, each client only gets one opportunity to enjoy a sustainable retirement, and averages are irrelevant when dealing with volatile investments. With an SWP, one may hope for a risk premium from equities, but there is no guarantee that markets will comply. Especially when considering basic spending needs, relying on withdrawals from a volatile SWP portfolio exposes retirees to greater market risk than they may realize. The U.S. record is much too short to have any confidence about a safe withdrawal rate, uncertainty that is amplified in today’s low interest rate environment. The consequences of being unable to meet basic needs because of a bad sequence of market returns could be severe.
While systematic withdrawals force retirees to plan for a longer lifespan than average, the mortality credits provided by annuities (those who die sooner subsidize the payments to those who live longer) allow for payouts to be connected to life expectancies. Annuities provide a risk management tool that helps to protect clients from sequence-of-returns, longevity and market risk.
So there are countervailing benefits to each approach. The question, I’d argue, is not whether to annuitize, but how much to annuitize. Most Americans will find that the optimal answer is not 0% or 100%, but somewhere in between.