The analysis was authored by Michael Finke, professor and director of retirement planning and living at Texas Tech University; and Wade Pfau, professor of retirement income, American College.
The researchers, who produced the paper in partnership with Northwestern Mutual, argue volatility and longevity “are the two big question marks in retirement.” At the same time, deferred income annuities (DIAs) are specifically tailored to mitigate these risks, the pair explains, and should be at least considered, if not implemented, as part of any retirement planning strategy.
“We can’t predict how the market will perform leading into and continuing through retirement, or how many years we will live in retirement, so it’s important that retirement planning uses both offensive and defensive strategies to position individuals for financial security,” explains David Simbro, senior vice president, life and annuity products, Northwestern Mutual.
Most DIAs purchased today have a relatively short deferral period before annuity payments begin, the analysis finds, suggesting that these short-deferral DIAs are particularly appealing to clients nearing retirement who value the ability to plan on a fixed nominal income stream after retirement. Unlike advanced life deferred annuities, known as ALDAs or longevity insurance, which are meant to provide late-in-life income primarily to protect against tail longevity risk, DIAs are products offered by insurance companies that provide for steady guaranteed income payments much earlier in retirement, and so they can be used to pre-fund retirement spending over the entire retirement lifecycle. DIAs are not market investments and as such do not fluctuate with market ups/downs. Generally they do not have a cash value and the guarantees are backed solely by the claims-paying ability of the issuer.
The research finds that DIAs “help to mitigate uncertainty and reduce the cost of retirement.” For purposes of the paper, the “cost of retirement” includes the actual cost of generating a given income in retirement in the face of unknown variables such as longevity and asset returns.
“When a retirement plan allocates a portion of assets to a DIA, the average cost of retirement is reduced by softening the financial blow of a long lifetime or poor market returns by guaranteeing a portion of retirement income,” the pair finds.
One implication of this is that investors who use DIAs can carry more equity risk past the retirement date. “Setting aside assets before retirement to buy a DIA places a portion of the retirement portfolio into a bond-like asset,” the researchers notes. “With a level of income guaranteed, individuals can then invest the rest of their assets more aggressively while maintaining the same risk profile.”
The research also suggests that innovative DIA products can provide an important advisory practice value-add, given the low-interest rate environment, as they may allow clients to achieve greater potential payout increases over time via dividends, while also providing protection against inflation and longevity.
One important caveat is that the research paper is based on a Monte Carlo analysis that simulates how an investment portfolio designed to provide $100,000 of real lifetime income behaves, both with and without the use of a DIA. The team ran more than 50,000 simulations and adjusted for longevity, stock and bond market performance and inflation—giving an impressive amount of data to back up their claims. However, $100,000 in guaranteed retirement income represents a significant amount of money that only the highest income earners will likely be able to save before retirement. It’s less clear, then, that the findings would hold lower down on the income scale, where people depend on Social Security to replace more of their income and don’t always have sufficient assets to make annuitization attractive.
As Simbro concludes, “There are no silver bullets for retirement planning—that’s why it’s so important to work with an experienced financial professional who can tailor a plan to meet an individual’s unique circumstances. The ultimate goal is to build a lifetime income, and DIAs can be one of the financial tools to help do just that.”
Northwestern Mutual has made the full paper available for download on its website.