RETIREMENT INCOME INSURANCE:
How to Make the Key Factor More Than Just a Guess
“What’s my number? – That is, how much do I need to retire?”
These are pressing questions for individuals whose major financial objective is saving for retirement. And no matter how complex and sophisticated the process used to answer these questions, every retirement projection has at its core a calculation of Present Value. Interestingly, most of the time, the critical factor in the generation of a Present Value calculation is nothing more than a guess.
Present Value (PV) is defined as “the amount of cash today that is equivalent in value to a payment, or to a stream of payments, to be received in the future.” If most people kept their retirement savings in a mattress, calculating Present Value would be easy. For example, if a person wanted to be assured of receiving $1,000 a month for 35 years (i.e. 420 months), the amount of cash needed today to be present in the mattress would be $420,000.
But very few individuals will put their money in a mattress; instead they will place the unused principal in a financial vehicle with the intention of earning a return – through interest, dividends, capital gains, etc. – which can be added to the accumulation. And this is where PV becomes a guessing game; how do you choose a rate of return that will reflect the future performance of your savings?
The projected rate of return – the present value factor – is the one component of a PV calculation that impacts everything else. Higher PV factors result in lower PV calculations, and vice versa. Using numbers from BTN Research, here is an example of a Present Value Retirement Calculation, the type that might be part of a moderately sophisticated retirement plan.
Suppose an individual wants to determine the lump sum amount required to fund a 30-year stream of retirement distributions. The annual income will begin at $100,000, and to maintain purchasing power, the income will increase 2.5% each year to keep pace with the historical rate of inflation. What’s the PV number? It depends…
• If the assumed annual rate of return is 5% for each of these 30 years, the amount needed is $2.21 million.
• If the assumed annual rate of return is 6% for each of these 30 years, the amount needed is $1.96 million.
• If the assumed annual rate of return is 7% for each of these 30 years, the amount needed is $1.75 million.
A fair number of financial experts would probably consider present value factors between 5-7% to be “reasonable” expectations; based on historical rates of return, these numbers aren’t outrageous projections that require risky investments to pay off. But note the Present Value amount required with a 5% projection is 26 percent greater than the PV with a 7% projection. That’s quite a difference. So which number should you choose? You can’t know for sure.
When the assumed rate of return on your retirement accumulation is just a guess, there is a ripple effect of uncertainty. First, since the present value factor is speculation, you really don’t know your “number.” And even if you feel confident about your projections, there’s the issue of how to handle deviations from your projection that might occur in the future. Because if the earnings from your retirement accounts under-perform the target rate of return at any time during retirement, you are facing either a reduction in annual income or the prospect of running out of money.
But what if you could make your present value factor a guarantee instead of a guess?
A Present Value Factor with Guarantees
One of the practical challenges for individuals approaching retirement is identifying financial products that can deliver a reliable and consistent income over an extended period. There are some debt instruments that promise regular payments over longer time periods, but for the past hundred years, the principal long-term retirement income products have been annuities.
With an annuity, an individual gives an insurance company a lump sum in exchange for a guaranteed stream of payments. These payments can be guaranteed for specified periods of time, including periods that last as long as the annuity holder is alive. The present value factor used by the insurance company will depend on the type of payment the prospective annuity buyer is seeking, but the key element is this: the insurance company has now assumed the risk of making sure the payments are made. For the individual, the guesswork and uncertainty of the PV calculation has been eliminated.
“Okay, I like the idea of guaranteed retirement income, but…”
In August and September of 2011, Synovate Research conducted a retirement survey of 1,000 non-retired Americans. When asked which factors related to creating a more secure retirement, 86 percent of the respondents chose “having a guaranteed stream of income in retirement.” In the press release accompanying the survey results, Allianz Life Insurance Company, the sponsor of the survey, noted:
Especially in an environment where equity markets – and therefore 401(k) balances – can swing wildly within a week or a day, it is not surprising to see Americans expressing far more interest in the need for guaranteed retirement income versus the balance of their retirement account.
But even though almost 9 out of 10 Americans want retirement security, the press release also acknowledged this reality:
Although the idea of a guaranteed stream of income continues to resonate with Americans, most pre-retirees don’t own annuities or are apprehensive about adding one to their retirement plan.
Economists call this the “annuity puzzle” – even though they want the features of an annuity, most Americans don’t buy them. Why? According to Richard Thaler, a prominent financial behaviorist and author of “Nudge,” the problem is how annuities are “framed,” i.e., how they are presented. Even though annuities are a form of insurance, “most people seem to consider buying an annuity as a gamble, in which one has to live a certain number of years just to break even.” Writing in a June 4, 2011, New York Times column (“The Annuity Puzzle”), Thaler enumerates several advantages that annuities have over other retirement alternatives:
Using standard assumptions, economic studies (going back to the 1960s) have repeatedly shown that buyers of annuities are assured more annual income for the rest of their lives, compared with people who self-manage their portfolios. One reason is that those who buy annuities and die early end up subsidizing those who die later.
Annuities provide clear information about when to retire. An annuity quote translates a lump sum into a monthlyincome, allowing individuals to determine whether they have accumulated enough to stop working.
Not having an annuity (specifically fixed immediate annuities, not variable annuities) adds layers of complexity to people’s financial lives. Retirees who choose not to annuitize must acquire the knowledge and assume the risk of investment managers, making allocation decisions and calculating the optimal drawdown rate over time. And since most of their decisions will be based on guesses/assumptions, Thaler’s research shows that many retirees actually tend to underspend in retirement.
When it comes to providing income security in retirement, Gary Bhojwani, Allianz president and CEO declares: “the simple fact is that annuities are the only retirement income products that pool risk, and thereby can guarantee that all annuity owners will have income for the rest of their lives, regardless of how long they live.”
If you want security in retirement, it is prudent and logical to consider the income insurance that only annuities can provide.
DOES YOUR RETIREMENT PROGRAM INCLUDE AN ANNUITY?