Tuesday, March 30, 2021

Safety-First Retirement Planning

An alternative to managing a portfolio of stocks and bonds through retirement is to use insurance company products such as annuities and whole life insurance to get more predictable outcomes.  Mixed approaches are possible as well.  Wade Pfau, a professor of retirement income, makes the case for income guarantees in his book Safety-First Retirement Planning.  The book is a dry read, but it’s thorough in its explanation of insurance company products.  Pfau’s intent is to persuade the reader that annuities and whole life insurance can help build a better retirement, but the book had the opposite effect on me.

Any reader looking for a deep understanding of income annuities, variable annuities, fixed-index annuities, and whole life insurance along with the vast array of bells and whistles available on these products will find it in this book.  Income annuities are simple enough, but the other insurance products have so many small variants that it seems impossible to compare the products of different insurance companies without a retirement researcher at your side.  “Prospectuses about variable annuities can be hundreds of pages long.”

With so much variation in available products, you may wonder how the author is able to make any general claims about how to use these products well.  The answer is that he made many simplifying assumptions.  The biggest assumption is that the insurance products are “competitively priced.”  This assumption is so at odds with some practices in the real world that the chapters on variable annuities and fixed index annuities begin with disclaimers.

Pfau limits his discussion to “good” variable annuities whose “fees are not excessive” and whose complexity is not used to “hide a lack of competitiveness in the pricing.”  He limits his discussion of fixed-index annuities similarly and further assumes they are “not being sold by an unscrupulous financial advisor only to generate a commission.”

My personal experience with variable annuities and fixed index annuities is limited, but I have waded through the rules for a few of them.  In every case, it was clear to me that the products were not “good.”  They were overpriced and their income guarantees were highly vulnerable to inflation, even if inflation stays at low levels.  I’m not optimistic about finding a “good” variable annuity or fixed index annuity of the theoretical types described in this book.

The only insurance product I’ve ever seriously considered is an income annuity indexed to the Consumer Price Index (CPI), but these seem not to be available in Canada.  I might consider an income annuity without inflation protection late in life when I’m less concerned about inflation uncertainty over decades.  The author hasn’t given me a reason to change my mind on these points.  But this isn’t so much a problem with the book as it is a sign that Pfau’s presentation is thorough and unbiased.

One of the side effects of considering theoretical versions of insurance products showed itself in one example comparing a simple income annuity to managing a portfolio of stocks and bonds.  The conclusion was that the annuity allowed higher retirement spending, but this conclusion depends on being able to buy an annuity for the price Pfau calculates.  I don’t know if that is possible in the real world.

For anyone considering whole life insurance, Pfau makes it clear that you should think of it as a replacement for the bonds in your portfolio.  Further, the main value of whole life insurance is the tax deferral, so it makes most sense for someone who has already maxed out tax-advantaged retirement accounts, but still wants more fixed-income investments.

My expectation before reading this book was that it would cover how to decide on portfolio allocation to stocks, bonds, and annuities based on annuity prices and stock and bond future return expectations.  However, the final chapters on pulling everything together didn’t really cover this.  Any rational means of deciding how much to spend on an annuity would be sensitive to the annuity’s price.

Pfau admits that his “discussion has been based on a simplified model in which future inflation is fixed and known.  There was no possibility for unexpectedly high inflation.”  This is why his analyses don’t call for using annuities whose income guarantees are CPI-adjusted.  But in the real world, decades of inflation uncertainty make annuities with fixed income guarantees much riskier than they appear.

The author attempts to partially justify the lack of focus on inflation-protected income guarantees by observing that “inflation-adjusted spending for many retirees can be expected to decline with age.”  The implication of observing that the average retiree spends less with age is that we should plan our retirement assuming we’ll do the same.  This is like observing that the average adult carries a few thousand dollars in credit card debt, so we should all do the same.  Why should we emulate the behaviour of the average retiree when we know that some retirees overspend early and later have to cut spending?

Overall, this book gives a thorough, unbiased explanation of retirement insurance products.  I’m left with a much better understanding of annuities and life insurance.  In theory, retirees could benefit from certain types of fairly priced annuities and life insurance.  In practice, what I learned only solidified my reasons for avoiding most insurance company retirement products.


  1. I agree with your 5th paragraph kindly summarizing that in general most annuities are "not good". I feel the negatives outweigh the positives, except maybe if one has no trustworthy family and their cognitive thought declines to a point where they can no longer maintain a simple etf portfolio, then maybe these turnkey products make more sense.
    If someone needs to turn up some monthly income and not lock up their money in an expensive annuity, they could consider putting a percentage of their investments in the most solid of covered call ETF's that provide a slightly higher monthly income, but don't grow much in share value or lose any over the long term. (BMO has a few of these) There stated goal is to crank out a steady high distribution and have down market protection built in. It's not a recommendation, but IMO an alternative to a high priced annuity that leaves nothing behind when you pass away to loved ones.

    1. Hi Paul,

      I could see possibly getting an income annuity later in life when there's not so much time for inflation to erode the value of payments. I'd sooner own an asset allocation ETF with a bond component than a covered call ETF.