July 27, 2010
As we might expect, the annuity looks less attractive relative to the SWP when the risk of default in the annuity increases. Other work has demonstrated this result with more depth.
Conversely, the annuity looks more attractive if the default risk is zero:
Overall, these results suggest that even with considerable uncertainty in the risk of default by the seller of the annuity, annuities still make a great deal of sense as one component of the portfolio.
As I noted earlier, however, the size of the annuity investment will depend on the specifics of an investor’s risk tolerance, wealth level, and goals.
Discussion
Planning for the decumulation phase of life will receive increasing emphasis as the first wave of self-directed, defined-contribution plan investors enters retirement. Annuities provide important benefits as one component of the long-term portfolio. The fraction of wealth that an investor may consider for an annuity purchase depends on a range of factors. Wealthier individuals may be able to afford to self-insure by drawing small fractions of their portfolios as income or by living on the portfolio yield alone. Investors who are at risk of not having sufficient sustainable income in retirement should consider a higher level of annuitization. Investors who are more risk-averse are likely to annuitize a larger fraction of their portfolios, and those who have a strong desire to leave an estate to their heirs or charity should annuitize a smaller fraction of their portfolios.
Partial or total annuitization is a cheaper way to protect against longevity risk than an SWP alone. This finding is consistent over a substantial range of assumptions about default risk in the annuity. My results are consistent with other research demonstrating that annuities can be an effective tool to manage longevity risk.
Moshe Milevsky, a pensions expert, has coined the term ‘product allocation’ (as opposed to asset allocation) for the process of choosing how much of a portfolio will be in a SWP and how much will be in annuities and other financial products, in order to help investors more directly manage longevity risk. In coming years, we will see considerable attention given to product allocation decisions.
Geoff Considine is the author of a new book, Survival Guide for a Post-Pension World, as well as a book on the use of options strategies in wealth management. More information is available at www.quantext.com.
Geoff’s firm, Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors.
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