Investing for Retirement: SPIAs, TIPS, Stocks and the 4% Rule
Relying only on stocks and bonds to fund a decumulation strategy may no longer be feasible, given today’s low interest rate environment and the prospect of muted returns from the equities market. Investors should instead consider using single-premium immediate annuities (SPIAs) to fund at least a portion of retirement needs.
The potential role of SPIAs has begun to get attention as numerous recent articles and blog posts have questioned the viability of the 4% rule for retirement withdrawals. For two contrasting views, Bill Bengen's article, "How Much is Enough," in the May Financial Advisor supports continued use of the 4% rule, perhaps with some investment strategy tweaks, while a blog post by Wade Pfau last month shows how failure rates could rise with lower future investment returns.
This article is certainly not the first research on full or partial use of annuities. A classic study was a 2001 paper by Ameriks, Veres, and Warshawsky, "Making Retirement Income Last a Lifetime," in the Journal of Financial Planning. (Note: the linked article is available only to members of the Financial Planning Association.) Moshe Milevsky and Peng Chen have also done work in this area in the past few years, including in chapters of two books by Milevsky – "Are You a Stock or a Bond?" and "Pensionize Your Nest Egg," which he co-authored with Alexandra Macqueen.
This article will examine the issues raised in these earlier studies, in light of the current investment environment. Before projecting outcomes for various SPIA strategies, I'll first propose a specific downside risk measure to use in the analysis, and also discuss how TIPS, which have been touted as a safe retirement investment, may come up short compared to SPIAs.
A better downside risk measure
Evaluating investment strategies for retirement involves balancing upside prospects – projected bequest values or the possibility of increased spending – against the downside risk of depleting savings while still alive. The most popular downside-risk measure is the probability of running out of money. Monte Carlo simulations are typically used to estimate the percentage of failures, given various retirement durations. However, this measure gives an incomplete picture of risk, because it doesn't address the magnitude of failure. For example, living to age 95 and running out of money at 75 is much worse than running out of money at 94½.
For this article I will use a different measure, which takes into account both the probability and magnitude of failure, which I will take a moment to explain briefly. To get my measure, I ran Monte Carlo simulations and allowed both investment performance and longevity to be variable. For those cases in which savings run out before death, I calculated the equivalent of a "negative bequest” – the amount of outside funds from relatives, charities, or the government that would be necessary to continue withdrawals at the target level until death. For example, if an individual is withdrawing a level $20,000 per year, and runs out of money 5 years before death, the negative bequest is $100,000.
For a whole set of Monte Carlo simulations, I have calculated the average negative bequest among those cases where the portfolio fails. I then multiply the failure percentage by the average negative bequest to produce a measure that combines the likelihood of failure and the average magnitude. Going back to the example, a 20% chance of losing an average of $100,000 would be equivalent to a 10% chance of losing an average of $200,000. In the analysis that follows, I'll use this combined risk measure, but I will also show its components – probability of failure and average negative bequest in the event of failure – because the probability of failure is the more familiar risk measure for most planners.