Income in Retirement - Integrated Approach Part 2
In the second part of this exceedingly sexy series on retirement income, I’d like to cover why it makes sense to mesh together multiple types of retirement income devices for most people.
To those of you still tuning in at this point - congratulations! Alas, you have confirmed your status as nerds, but on the bright side you're set up for much more success in retirement compared with your sitcom-watching, Cheeto-eating peers.
If you missed the first article, catch up here. We talked about two popular retirement income strategies - investments and actuarial products (annuities & insurance).
Each of those strategies has very real advantages and disadvantages but, like peanut butter and jelly, they work best when smushed together. Used in concert, the strategies have synergy and are complementary; many of their inherent disadvantages are neutralized.
"The Integrated Approach" - what does that mean?
As I said in the first article, when asked about retirement planning, most folks will respond with something about their 401k, IRA or other qualified retirement plan. The “investment” world (correctly) occupies most of our mind-space when it comes to retirement planning. Most of our growth potential and inflation-beating power comes from this side of the planning world.
However, by integrating one or more actuarial products along with your investment program, you will dramatically increase the both the odds of success and the cumulative amount of income you receive from your plan.
Ok, so down to brass tax: this means we’re going to take part of the money you’re saving towards retirement and commit it to an actuarial product like life insurance or an annuity. As a percentage of your retirement contributions, the actuarial products should remain in the minority; the lion’s share of your retirement savings should still be directed into the investment world.
Again, it’s nearly impossible to craft a retirement income strategy (or any other financial strategy) which is dominant in all situations for all people. The intent here is to lay the framework of a strategy which should be appropriate for most retirees.
We should take a moment here to choose our measuring stick(s). As you saw in article one, its easy to draw an inappropriate conclusion by evaluating either the wrong or not enough data. Like, if we just choose the strategy that projects the most income without considering the probability of failure. Not good...
So, how do we decide what makes for a "better" retirement income strategy? Perhaps more importantly, how should you define success? This is a crucial hurdle in selecting the right strategy.
For the purposes of our article, we’re going to measure a particular strategy three ways: probability of success, risks eliminated and cumulative income received at an age of normal life expectancy. When we get into a couple of case studies in part three of this series, you’ll be able to see examples of what the integrated approach looks like when the rubber meets the road.
Reduction of Risks
Let’s start with the risky stuff. As I mentioned, integrating a fixed-income actuarial component (immediate annuity) into your investment program actually helps neutralize some of the risks. Remember from part one of this series that our primary risks in the investment world (when it comes to retirement planning) are:
- Sequence Risk
- Longevity Risk
Our primary risks in the actuarial world were:
- Inflation Risk
- Liquidity Risk
Immediate annuities help reduce both sequence and longevity risk. Think about it this way - sequence risk basically means you don’t want to have to pull your money out of the market when its in a downturn. You want to hang tough during that time and let it recover. If you have an alternative source of income (and hopefully an appropriate amount of short term savings), you ideally have enough cash to weather the storm and defer withdrawals from your investment accounts.
For a married couple, including another actuarial product - a life insurance policy insuring the spouse with the shorter life expectancy - improves the situation in several ways. First, the income from the immediate annuity will be higher since it only needs to be tied to one life - the same partner we insured with the life insurance. This substantially increases the annuity income stream for a married couple. At the death of the first partner, the income stream will cease but a whole life death benefit is paid and a second income stream will be created.
Second, the life insurance policy has an investment component which will typically generate a bond-like return. This adds to the pot of money you’re accumulating and also allows the money you’re directing into the investment component of your plan to be invested more aggressively. In the integrated approach, we are reducing the bond component of the regular investment program to maintain correct overall balance; otherwise, by including the insurance, we’d make the overall retirement pot too conservative. In turn, the more aggressive posture in the investment account should create a bigger pot of investment dollars over the long term.
A side benefit of substituting the insurance cash values for the bond component is reduced correlation risk - insurance cash values have extremely low correlation with the stock market. On the flip side, bonds often do become correlated (move in step with) the stock market in times of extreme market stress (like a 2008).
The disadvantages of the actuarial products are also mitigated by their investment counterparts. Since we’re counting on our investment funds to beat inflation and we’re still directing the majority of our retirement dollars into those investment plans, we don’t get so concerned about the returns of those actuarial products.
Furthermore, since the investment dollars are immediately liquid, our concerns over liquidity from the actuarial products are reduced as well. Contrast this with a retiree who’s primary plan is an annuity/life insurance contract and the integrated approach is vastly superior.
All of these factors - the guaranteed income stream, death benefit, bond-like returns on the insurance values, and more aggressive allocation in the investment side combine to reduce longevity risk. You have a guaranteed paycheck no matter how long you live and you have (hopefully) a good pot of investment money to supplement and fight inflation.
I will demonstrate this with some hard numbers in the next & final article in this series.
When we’re comparing strategies, our second measuring stick will be the amount of income generated for the retiree. As you’ll see in part three, the investment only approach has the potential for the most income. If you happen to have very strong investment returns for your particular time frame, its entirely possible that an investment-only approach would create the most income. Oh, if we only knew!
We should briefly touch on a concept called “Prospect Theory”. This is a behavioral finance term coined by Daniel Kahneman (who won the Nobel Prize for it) which suggests that people feel losses and gains differently. Basically, it suggests that the pain of loss is much “bigger” than the enjoyment we have from additional “gains”.
This also coincides with an economic theory called “Marginal Utility”, which basically says that, once we get to a certain level, additional gains just don’t provide much additional enjoyment.
I remember my high school economics teacher, Mr. Culp, illustrated this very well by using pizza (the man loved to eat; most of his illustrations incorporated some sort of food):
If you’re starving and someone offers you a slice of pizza, you will gratefully accept and gobble it down. You’ll probably ask for another. The “value” or “utility” of that first slice of pizza is very high for you.
Conversely, if you’ve already had 3-4 slices and someone offers you another piece, you’re likely to decline. You’ve already had to unbuckle your belt and the “utility” of an additional slice is very low.
This is “marginal utility”, a.k.a. “diminishing returns”.
I say all this to point out that, while the investment-only approach may offer higher overall income- you reach a point where the "value" or “utility” of that added potential income is actually much smaller than the risk of loss you’ve assumed for using an investment-only approach. Furthermore, since we know losses "hurt" more than the additional utility of those potential added gains, taking on an investment-only strategy is likely a losing bet for most.
Yeah, I know I just got all academic with you there and you're probably falling asleep. If you remember any of that, just remember the pizza part.
Probability of Success
I’ve saved this for last as its possibly the most important. It was the great Mike Tyson who said “Everyone has a plan until they get punched in the mouth”. Or something like that.
We can’t call a strategy “good” if it won’t stand up to adversity. The likelihood of any particular strategy succeeding will be one of its most important facets. Going back to the investment only approach - the “outlier” outcomes on the positive side might look enticing, but learning that you have a 25% chance of failure takes a lot of the shine off.
Luckily, in 2018, advisors have amazing tools to help quantify this for our retirees.
As I’ll show in more detail on the next article, the integrated approach offers a much better likelihood of success as compared with relying on investments alone.
Importantly - not only is the likelihood of succeeding higher, but the most probable range of outcomes shows a higher cumulative income for the retiree under an integrated approach.
So, what is success? Pretty simply - not having to drastically cut your income later on in retirement, or, even worse, not running out of money. Duh. Also, success might mean being able to accomplish the travel, the charity work or the dream car. For some, success will also mean leaving a legacy for their heirs.
I’m going to wrap it up here for the second part of our series. Hopefully we’ve laid enough groundwork to be able to look at a couple of useful examples in part three.
Again, in article three, we’re going to rely on something called “Monte Carlo” analysis to help us see which strategies will produce the best result - investment only or integrated. This will help us understand what the most likely result is, as well as what the “tail” results are (the outliers - the not-as-likely good or bad results).
We’ll do a couple of examples in article three to show how the integrated approach produces the most income most of the time, while also dramatically reducing the downside risks of an investment-only approach. As always, the advice in this article is general in nature and may or may not apply to your individual circumstances. I’m happy to connect at any point to discuss you personal financial situation.