Reducing volatility risk prior to retirement

bostonerimus

Linton said:

bostonerimus said:

Deleted_User said:

bostonerimus said:

Many studies (admittedly US based) have shown that keeping a high percentage of relatively risky equity funds in a retirement portfolio leads to better income producing outcomes than annuities or portfolios with high percentages of bonds. Of course you don't get the guarantee of lifetime income that an annuity gives, but right now annuities are very bad value for money so a cash buffer and a Total Return strategy seems sensible. You could also insure against longevity risk by deferring state pension.

Here is a set of US studies, which shows that having a portion of your portfolio in annuities leads to a better set of outcomes, including the ability to spend more in the early years and potentially higher inheritance at the end. 

https://www.amazon.ca/Safety-First-Retirement-Planning-Integrated-Worry-Free-ebook/dp/B07X2TW623

Pfau receives some of his funding from the insurance industry...but I'm a big fan of the "safety first" approach where you guarantee a base level of income. That could come from DBs, SP or annuities. Right now locking in low interest rates with a lifetime annuity will be a losing proposition for most people over simply putting the money into a savings bond ladder where you can benefit from any increases in interest rates. I think the chance of rates increasing is higher than them decreasing. So only the irrational optimist who is convinced that they will live far longer than an average lifespan would buy one. Of course if you risk that capital in the markets you could lose a lot; but that isn't safety first. If you want to insure agains longevity risk the best option now is to defer SP.

I agree very much with the safety-first approach for basic expenditure though I would like to go rather further than "basic".  Being able to sleep at night is more important than the possibility of extra income beyond normal day to day needs.  However unless one has a good DB pension the necessary amount of guaranteed income may be difficult to achieve.

The best value option is as you say to defer SP.  However the gain from deferring for 5 years is only about £2.5K/year which may be useful, but it is far from life-changing.  The best approach I have found is to take income from dividends and bonds and keep 25-30% of my investments in cash and Wealth Preservation funds. These steps cover the gap between "basic" and "normal" to a degree sufficient to meet the sleep at night requirement.

Having a good level of guaranteed income is great, but that is increasingly the luxury of the people with large pots who can afford to put a fair chuck of their money in low risk, low (or negative) returning places. So the exact plan will vary quite a bit according to your circumstances and stomach for risk, but right now I find it difficult to see where an annuity would figure. Most people just can't afford them and it's rare for people to live comfortably on natural yield even including SP so they have to include capital gains and also eat some principal. Now that we have the flat rate pension people on low incomes might find working a couple of extra years and deferring SP very worthwhile to get a few thousand more in lifetime annual income.

My approach was to take a final full time job with a DB pension and a long time before that I'd bought a rental flat for retirement income and also paid into both US and UK SPs. Forward planning can help a lot. Additionally, at age 25, for my first pension I naively bought a variable annuity with a minimum guaranteed annual growth rate of 3%. It has chugged along between 7% and 3% for that past 30 odd years, so I lucked out I suppose. This year the rate is 3.6% and I can take that out without touching principal, but you can't buy this old annuity anymore.

[Deleted User]

Linton said:

Deleted_User said:

DairyQueen said:

Deleted_User said:

bostonerimus said:

Many studies (admittedly US based) have shown that keeping a high percentage of relatively risky equity funds in a retirement portfolio leads to better income producing outcomes than annuities or portfolios with high percentages of bonds. Of course you don't get the guarantee of lifetime income that an annuity gives, but right now annuities are very bad value for money so a cash buffer and a Total Return strategy seems sensible. You could also insure against longevity risk by deferring state pension.

Here is a set of US studies, which shows that having a portion of your portfolio in annuities leads to a better set of outcomes, including the ability to spend more in the early years and potentially higher inheritance at the end. 

https://www.amazon.ca/Safety-First-Retirement-Planning-Integrated-Worry-Free-ebook/dp/B07X2TW623

I suspect that when the next prolonged bear hits, and despite their perceived poor value, annuities will regain popularity.

Even if the prolonged bear does not come for a while, partial annuities still allow retirees to be far more comfortable and aggressive with the rest of their portfolio and to spend more.

There is a contradiction between people here saying “I can only safely spend 3% per year” and then saying that annuities are bad value. 

The current rate for an RPI linked single life annuity at 60 is about 2%, which could reasonably be considered bad value compared with an SWR of 3%.

The key words are “RPI linked”.  Its a niche instrument with very little competition and therefore yes, you get poor value. Thats not how most annuities are sold. 

[Deleted User]

bostonerimus said:

Deleted_User said:

bostonerimus said:

Deleted_User said:

Drawdown or not, poor sequence of return is a very serious risk to people immediately prior and soon after retirement.  The risk is that as portfolio is depleted during the lean years, it may never recover and the pension may run out of money too early.  

You can deal with it by having more fixed income.  That could include DB pensions, bonds or various types of annuities. 

The DB pension is becoming a rare luxury and annuities are such bad value for money now that I wouldn't look at them until relatively late in life, so cash and very short term bonds seem to be the best things to mitigate sequence of return risk.

Most of us have some DB, such as state pension. 

Disagree on annuities.  Its a complex tool with many options, but as per above comment, they provide much better value than cash or bonds (any duration) if used correctly. 

Cash = guaranteed loss in real terms. Short term bonds = guaranteed loss too.  Bonds are a problem for retirees because you need to align duration with unknown retiree’s duration to minimize risk and maximize return.  Insurance companies which issue annuities have very long durations and can pool between investors maximizing bond returns for you. On top of that you get a significant benefit as you get older and the other annuitants of your age die off.  And thats true for 60 and 65 year olds as well as someone in his 80s.  And then you can buy an annuity now which will start paying until after 80, benefiting from other annuitants dying, but also from investment returns between your current age and 80. 

Annuities tend to get bad rap here. Unfairly so. 

I looked at the rates for an annuity on the H&L site and 100k will buy a single life, level annuity for a 65 year old of 5k/year. If you put that 100k in a 5 year savings bond ladder and lets say rates stay at a pessimistic 1% then you can withdraw 5k for 22 years and the annuity will only win out at age 87...when the majority of people will be dead and won't get the full advantage of that mortality credit. 

Average life expectancy for a 65 year old is 20 years. So, you are right about “the majority” but only just. Imagine you are that bond person running out of money in his 80s. Not a nice feeling, huh? Even if you are “lucky” to die at 87.  In practice poor sod wouldn’t dare to actually spend 5k/year. Meanwhile your annuity person can spend 5k very comfortably without a second thought about the risk of dying  a few years after the money runs out.  So he’ll lead a wealthier life in his 60s. And perhaps that person will live beyond average life expectancy just because there is no need to fret about income running out.

I’d say  your example illustrates why annuities can be an excellent value right now. Of course there are other options. Could be a delayed annuity or a fixed term one (with proceeds used to buy bonds).  

bostonerimus

Deleted_User said:

bostonerimus said:

Deleted_User said:

bostonerimus said:

Deleted_User said:

Drawdown or not, poor sequence of return is a very serious risk to people immediately prior and soon after retirement.  The risk is that as portfolio is depleted during the lean years, it may never recover and the pension may run out of money too early.  

You can deal with it by having more fixed income.  That could include DB pensions, bonds or various types of annuities. 

The DB pension is becoming a rare luxury and annuities are such bad value for money now that I wouldn't look at them until relatively late in life, so cash and very short term bonds seem to be the best things to mitigate sequence of return risk.

Most of us have some DB, such as state pension. 

Disagree on annuities.  Its a complex tool with many options, but as per above comment, they provide much better value than cash or bonds (any duration) if used correctly. 

Cash = guaranteed loss in real terms. Short term bonds = guaranteed loss too.  Bonds are a problem for retirees because you need to align duration with unknown retiree’s duration to minimize risk and maximize return.  Insurance companies which issue annuities have very long durations and can pool between investors maximizing bond returns for you. On top of that you get a significant benefit as you get older and the other annuitants of your age die off.  And thats true for 60 and 65 year olds as well as someone in his 80s.  And then you can buy an annuity now which will start paying until after 80, benefiting from other annuitants dying, but also from investment returns between your current age and 80. 

Annuities tend to get bad rap here. Unfairly so. 

I looked at the rates for an annuity on the H&L site and 100k will buy a single life, level annuity for a 65 year old of 5k/year. If you put that 100k in a 5 year savings bond ladder and lets say rates stay at a pessimistic 1% then you can withdraw 5k for 22 years and the annuity will only win out at age 87...when the majority of people will be dead and won't get the full advantage of that mortality credit. 

Average life expectancy for a 65 year old is 20 years. So, you are right about “the majority” but only just. Imagine you are that bond person running out of money in his 80s. Not a nice feeling, huh? Even if you are “lucky” to die at 87.  In practice poor sod wouldn’t dare to actually spend 5k/year. Meanwhile your annuity person can spend 5k very comfortably without a second thought about the risk of dying  a few years after the money runs out.  So he’ll lead a wealthier life in his 60s. And perhaps that person will live beyond average life expectancy just because there is no need to fret about income running out.

I’d say  your example illustrates why annuities can be an excellent value right now. Of course there are other options. Could be a delayed annuity or a fixed term one (with proceeds used to buy bonds).  

In my example straight cash at 1% annual interest rate beats a single life annuity for most people. Of course you are buying the annuity to insure against longevity risk and those that need that insurance will be glad of it. However, I think it's a good bet that you will get better than 1% from your cash in the next 20 or so years. So what about 2%, the annuity wins only if you live to 90 and 3% takes that up to 95. Anyway, most 65 year olds simply can't afford to put 100k into a level annuity paying 5k a year or an index linked one paying 2k, or put that much cash into long term saving account ladders. They need their money to generate more income and for it to rise with inflation, so they are almost forced to take on more risk or keep working longer.

[Deleted User]

If you want to bet then just put everything into equities and take your chances.  Of course then people are talking about “SWR” of 3% rather than guaranteed 5% from an annuity and the 3% isn’t actually “safe”. Thats a massive difference in spending cash. 

The problem with your last scenario is that you keep talking about “most people” and “bets”. Many don’t want to play Russian Roulette when the losers get to beg for food in their twilight years. A 5% chance of that happening is way too high in my book, let alone 45% in your example. And life expectancy for someone who lives to 85 years is 7 years. Thats a nightmare scenario you’ve just drawn for that person. 

So in practice whether your cash returns 1% or 2% (a bet), to have the ability to spend 5K at 65 your poor sod needs more than 100k. So, he’ll tie more of his money into a god awful “investment” which will include government bonds.  A 10 year bond in the UK gives you 0.5%, so your 1% is very optimistic, let alone 2%. 

Seems to me that a risk averse 65 year old who buys a 5% annuity to cover the delta between his DB income and minimum needs, and still has a sizeable stock portfolio to deal with the inflation, “extras” and legacy might well buy both peace of mind and more spending money than your betting person. He can afford to take lots of risk with the remaining liquid portfolio vs a person who has to worry about providing for his very basic needs. So based on “betting” he might come out ahead as well. An annuity would provide a great value to him/her. 

Linton

Deleted_User said:

If you want to bet then just put everything into equities and take your chances.  Of course then people are talking about “SWR” of 3% rather than guaranteed 5% from an annuity and the 3% isn’t actually “safe”. Thats a massive difference in spending cash. 

The problem with your last scenario is that you keep talking about “most people” and “bets”. Many don’t want to play Russian Roulette when the losers get to beg for food in their twilight years. A 5% chance of that happening is way too high in my book, let alone 45% in your example. And life expectancy for someone who lives to 85 years is 7 years. Thats a nightmare scenario you’ve just drawn for that person. 

Seems to me that a risk averse 65 year old who buys a 5% annuity to cover the delta between his DB income and minimum needs, and still has a sizeable stock portfolio to deal with the inflation, “extras” and legacy might well buy both peace of mind and more spending money than your betting person. He can afford to take lots of risk with the remaining liquid portfolio vs a person who has to worry about providing for his very basic needs. So based on “betting” he might come out ahead as well. An annuity would provide a great value to him/her. 

Agree with the general principle apart from one detail - a 5% annuity would be fixed rate that is 99.9% guaranteed to reduce in real value over time whereas a 3% SWR (3% is lower than most people quote) is by definition 100% inflation linked so the two are not comparable.   Fixed rate income is high risk in my view unless you have a low risk strategy to replace it in later years.

michaels

Linton said:

Deleted_User said:

If you want to bet then just put everything into equities and take your chances.  Of course then people are talking about “SWR” of 3% rather than guaranteed 5% from an annuity and the 3% isn’t actually “safe”. Thats a massive difference in spending cash. 

The problem with your last scenario is that you keep talking about “most people” and “bets”. Many don’t want to play Russian Roulette when the losers get to beg for food in their twilight years. A 5% chance of that happening is way too high in my book, let alone 45% in your example. And life expectancy for someone who lives to 85 years is 7 years. Thats a nightmare scenario you’ve just drawn for that person. 

Seems to me that a risk averse 65 year old who buys a 5% annuity to cover the delta between his DB income and minimum needs, and still has a sizeable stock portfolio to deal with the inflation, “extras” and legacy might well buy both peace of mind and more spending money than your betting person. He can afford to take lots of risk with the remaining liquid portfolio vs a person who has to worry about providing for his very basic needs. So based on “betting” he might come out ahead as well. An annuity would provide a great value to him/her. 

Agree with the general principle apart from one detail - a 5% annuity would be fixed rate that is 99.9% guaranteed to reduce in real value over time whereas a 3% SWR (3% is lower than most people quote) is by definition 100% inflation linked so the two are not comparable.   Fixed rate income is high risk in my view unless you have a low risk strategy to replace it in later years.

Agree, compare apples with apples; age 55,index linked annuity 1.6% vs swr 3.5% - problem is that is historically safe rather than guaranteed safe.

bostonerimus

Deleted_User said:

If you want to bet then just put everything into equities and take your chances.  Of course then people are talking about “SWR” of 3% rather than guaranteed 5% from an annuity and the 3% isn’t actually “safe”. Thats a massive difference in spending cash. 

The problem with your last scenario is that you keep talking about “most people” and “bets”. Many don’t want to play Russian Roulette when the losers get to beg for food in their twilight years. A 5% chance of that happening is way too high in my book, let alone 45% in your example. And life expectancy for someone who lives to 85 years is 7 years. Thats a nightmare scenario you’ve just drawn for that person. 

Seems to me that a risk averse 65 year old who buys a 5% annuity to cover the delta between his DB income and minimum needs, and still has a sizeable stock portfolio to deal with the inflation, “extras” and legacy might well buy both peace of mind and more spending money than your betting person. An annuity would provide a great value to him/her. 

That 3% is index linked so you need to compare it with the 2% index linked annuity. 

I agree that running out of money is bad, but you have to understand the risk involved and so a grasp of the probability is required to make that decision. A 5% chance of failure will be too much for some people and ok for others.

The person who has enough to buy a 100k annuity and lock in 5k for the rest of their life with no inflation adjustment and has money left in a stock portfolio is starting out from a strong position. I would not lock in today's historically low annuity rates. I would annuitize later on if necessary. Also what would it cost to buy a deferred annuity right now for a 65 year old starting in 20 years? That would be interesting to know. But whenever you deal with an insurance company you need to understand the contract and watch out for the fees.

Thrugelmir

Linton said:

Deleted_User said:

If you want to bet then just put everything into equities and take your chances.  Of course then people are talking about “SWR” of 3% rather than guaranteed 5% from an annuity and the 3% isn’t actually “safe”. Thats a massive difference in spending cash. 

The problem with your last scenario is that you keep talking about “most people” and “bets”. Many don’t want to play Russian Roulette when the losers get to beg for food in their twilight years. A 5% chance of that happening is way too high in my book, let alone 45% in your example. And life expectancy for someone who lives to 85 years is 7 years. Thats a nightmare scenario you’ve just drawn for that person. 

Seems to me that a risk averse 65 year old who buys a 5% annuity to cover the delta between his DB income and minimum needs, and still has a sizeable stock portfolio to deal with the inflation, “extras” and legacy might well buy both peace of mind and more spending money than your betting person. He can afford to take lots of risk with the remaining liquid portfolio vs a person who has to worry about providing for his very basic needs. So based on “betting” he might come out ahead as well. An annuity would provide a great value to him/her. 

Agree with the general principle apart from one detail - a 5% annuity would be fixed rate that is 99.9% guaranteed to reduce in real value over time whereas a 3% SWR (3% is lower than most people quote) is by definition 100% inflation linked so the two are not comparable.   Fixed rate income is high risk in my view unless you have a low risk strategy to replace it in later years.

By whose definition?  

[Deleted User]

Linton said:

Deleted_User said:

If you want to bet then just put everything into equities and take your chances.  Of course then people are talking about “SWR” of 3% rather than guaranteed 5% from an annuity and the 3% isn’t actually “safe”. Thats a massive difference in spending cash. 

The problem with your last scenario is that you keep talking about “most people” and “bets”. Many don’t want to play Russian Roulette when the losers get to beg for food in their twilight years. A 5% chance of that happening is way too high in my book, let alone 45% in your example. And life expectancy for someone who lives to 85 years is 7 years. Thats a nightmare scenario you’ve just drawn for that person. 

Seems to me that a risk averse 65 year old who buys a 5% annuity to cover the delta between his DB income and minimum needs, and still has a sizeable stock portfolio to deal with the inflation, “extras” and legacy might well buy both peace of mind and more spending money than your betting person. He can afford to take lots of risk with the remaining liquid portfolio vs a person who has to worry about providing for his very basic needs. So based on “betting” he might come out ahead as well. An annuity would provide a great value to him/her. 

Agree with the general principle apart from one detail - a 5% annuity would be fixed rate that is 99.9% guaranteed to reduce in real value over time whereas a 3% SWR (3% is lower than most people quote) is by definition 100% inflation linked so the two are not comparable.   Fixed rate income is high risk in my view unless you have a low risk strategy to replace it in later years.

SWR isn’t actually anywhere near as “safe” as annuity income whether its 3% or not. Perhaps 3% is too high in my example.  It is true that inflation linked annuities provide poor value. In my example you deal with inflation by leaving some of your portfolio in 100% stocks and using annuity for the FI portion of your portfolio.  The other point is that statistically  people tend to spend less as they grow older. Perhaps inflation isnt an issue?  Not sure about that.