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...

I was listening to Episode 89 of the Rational Reminder podcast , an interesting interview with Wade Pfau who is an expert on retirement income. Much of the discussion was on annuities. This made me reflect on the challenges of using annuities in Canada. Pfau speaks highly of Moshe Milevsky, and both have done work showing how retirees can use their portfolios more efficiently in retirement if they put some of their money into annuities. Another expert in the same camp is Fred Vettese who advocates buying an annuity with about 30% of your savings. The math checks out on the work these experts have done to show that you can spend more from your portfolio with less risk of ever running out of money if you use annuities. However, the underlying assumptions need to be examined. Pfau says investors just don’t like handing a big chunk of their money over to an insurance company, even though buying an annuity is very helpful for dealing with longevity risk. It’s quite true that some...

A big challenge in retirement is spending enough to be happy without running out of money. The main problem is not knowing how long you’ll live. This is called “longevity risk.” We are forced to plan for a long life whether we’ll live long or not. One way to eliminate longevity risk is with an annuity. The idea is to hand your money over to an insurance company, who then promises to pay you monthly, even if you live much longer than they expect. According to Meir Statman in his book Finance for Normal People , “people are reluctant to annuitize, a reluctance we know as the ‘annuity puzzle.’” Statman identifies a number of “behavioral impediments to annuitization.” We are averse to “transparent dips in capital.” Seeing your portfolio take a big drop hurts, even knowing that you’ll get lifetime income in return. Also, the “money illusion” makes “a lump sum of $100,000 seem larger than its equivalent as a $500 monthly annuity payment.” “Availability errors deter people from...

There are two central messages of the book Pensionize Your Nest Egg , by Moshe Milevsky and Alexandra Macqueen. The first is that having assets saved for retirement is not the same as having a pension. The second is that you can turn assets into a pension with the right insurance products. Both are true, but I have serious reservations about the variable annuities the authors recommend. To a first approximation, the authors say that if there is a nontrivial chance that you’ll run out of money in retirement, then you don’t have a pension. Any attempt to manage your asset allocation through bucketing or other means can leave you vulnerable to the risks of living long, inflation, getting poor investment returns, or having poorer returns early in retirement that deplete your nest egg. The authors do a good job of explaining each of these risks. The offered remedies for all of these problems are various types of annuities sold by insurance companies. The authors offer a process fo...

To me, the most interesting observation Frederick Vettese makes in his book The Essential Retirement Guide is what to do with the bond allocation of your portfolio at retirement. “It makes sense to liquidate these fixed income investments and buy an annuity.” This seems so logical, but it had never occurred to me before. The main advantage of an annuity is that it eliminates longevity risk. When the insurance company sets your annuity payments, it can do so based on average lifespans. However, if you invest your money yourself, you have to account for the possibility that you’ll live to be very old. The main disadvantage of an annuity is that its returns are based on long-term bond returns; you can’t get the higher expected returns and inflation protection that stocks provide. Vettese isn’t the first person to suggest putting part of your nest egg into an annuity. However, what is new to me is the direct comparison to a bond portfolio. To maximize your spending from the fix...

If you buy an annuity for $100,000, and it pays $6000 per year, that seems like a 6% return. But that’s not actually the interest being paid. Most of each payment is just your own money returned to you. Here I try to work out what interest rate an annuity actually pays. To do this, I worked out what interest rate the insurance company would have to make to exactly cover all the payments to a large group of people who buy the same annuity. For that I needed actuarial tables that predict how many people will live to each age. I used data from Statistics Canada. Note that this is not the same as just using average life expectancy; I actually assume the insurance company keeps making payments to remaining survivors each year. There are many types of annuities. Here I focus on the simple case where there is no guarantee period, which means that the payments stop when you die, even if that happens shortly after buying the annuity. I also looked only at single person annuities wit...

The idea behind annuities sounds great. You get a predictable income for the rest of your life no matter how long you live. This frees you from worries about how much you can safely spend each year. Rob Carrick’s recent article covered many important details concerning annuities. However, he left out a very important part of the discussion. The elephant in the room with annuities is inflation. Canadians like to complain that their CPP (Canada Pension Plan) and OAS (Old Age Security) payments are too small, but at least they are indexed to inflation. Imagine how small these payments would look if they never changed for 25 years. An ancestor of mine held a senior position and retired decades ago with what was considered to be a very generous pension. However, the payments weren’t indexed to inflation. By the time he died 23 years later, his monthly pension payments had dropped in value by nearly a factor of 3. Take your current income, divide it by 3, and imagine trying to ...

Update: Annuity payment rates for one insurer are at the end of this post. The Canada Pension Plan (CPP) is essentially a CPI-indexed life annuity. Your CPP benefits are determined based on your contributions during your working life, and once payments start they rise with the consumer price index (CPI) each year. CPP payments may not be large, but their purchasing power remains constant for the rest of your life. This brings considerable peace of mind. For people who have built their own savings over the years without the benefit of an employer defined-benefit pension plan, it’s natural to consider turning a large lump sum of savings into a CPP-like CPI-indexed life annuity. This would eliminate having to worry about investing and would eliminate concerns about outliving your money or losing ground to inflation. I wouldn’t want to tie up all my savings in an annuity, but I can see the appeal of allocating a portion to an annuity so that the combination of CPP and annuity pay...

The idea of dedicating a portion of your retirement savings to an annuity can be appealing. Imagine that at retirement you buy an annuity guaranteeing payments of $3000 per month for the rest of your life. This would bring some peace of mind. You could then use what is left of your retirement savings for extras. The big problem that could upset this tranquil scene is inflation. If the first ten years of your retirement are like the period from 1973 to 1983 in Canada, the purchasing power of your $3000 per month will drop to only $1220 per month! Suddenly, the annuity is bringing much less peace of mind. By not taking into account inflation, retirees with fixed-payment annuities are effectively overspending in the early part of their retirements, possibly without realizing it. It is possible to get an annuity whose payments rise by some fixed percentage each year (at the cost of much lower starting payments), but this requires guessing at the rate of inflation. If inflation ...

A reader had some thoughtful comments and questions about my analysis of the Manulife IncomePlus annuity . Here are his comments (edited for brevity) followed by my thoughts. 1. You describe the worst case scenario in which an investor makes withdrawals beginning in the first year. The product is best suited to the investor who leaves cash in the investment for at least 15 years so that the guaranteed income grows at 5% per year (albeit simple rather than compounded) for that period. An example will help here. Our investor Ida puts $400,000 into IncomePlus. In my earlier analysis of IncomePlus , I focused on the case where Ida draws a guaranteed income of 5% or $20,000 per year for the rest of her life. But, suppose that Ida is only 50 years old and doesn’t need any extra income until she is 65. IncomePlus rules permit Ida to defer payments for 15 years and then collect a guaranteed $35,000 per year for the rest of her life. This figure came from increasing the $20,000 by 5...

Recent stock market declines forced Manulife Financial to borrow $3 billion from the Canadian banks. This brings to mind one of the risks of buying any type of annuity including IncomePlus: default by the insurance company. The main drawback of IncomePlus is the high fees and the likelihood of not keeping up with inflation . On the positive side is the protection from a prolonged decline in stock prices. If stocks perform poorly for a long time, customers of IncomePlus will get a steady income eroded by inflation, but at least it wouldn’t drop in absolute terms. But if this doomsday scenario for stocks plays out, all IncomePlus customers will be leaning on the insurance guarantee all at once. What happens if Manulife runs out of money? Existing regulations require Manulife and other insurance companies to maintain certain financial reserves, and this was the reason for the $3 billion loan. If stock prices really do decline for a long time, creditors will eventually stop lend...

A member of my extended family I’ll call Don has been hit with a hard sell to buy into a Manulife Financial’s IncomePlus annuity. IncomePlus is essentially a portfolio of mutual funds with very high MERs combined with an insurance component that adds even more fees. For an overall cost of about 3.5% each year, Don is guaranteed payments each year for the rest of his life of at least 5% of his original investment. For the first 20 years, this is just a guaranteed return of his inflation-ravaged capital. If Don’s portfolio happens to grow despite the 5% withdrawal and 3.5% fee each year, there are defined times every three years when the portfolio locks in the gains, and Don’s guaranteed yearly income rises to 5% of the new portfolio size. Don would be counting on such gains just so that his income would keep up with inflation. For Don’s income to match inflation, the mix of investments in his mutual funds would have to grow in value each year by inflation plus the 5% withdrawal...

Unlike most investing products, life annuities actually solve a problem that do-it-yourself investors have difficulty handling on their own: longevity risk. By controlling my own investments with low-cost index ETFs, I can beat most professionally-managed mutual funds. However, when it comes to my retirement years, it will be hard to decide how much money it’s safe to spend because I don’t know how long I’ll live. If you control your own investments, the only practical approach in your retirement years is to spend little enough that your money will last to the end of a very long life. Just because the odds are only, say, 50% that you’ll make it to age 80, that doesn’t mean that you can get away with saving only half a year’s worth of spending money for your eighty-first year. If you make it to age 80, you’ll need a whole year’s worth of money. Life annuities are an insurance product designed to solve this problem. The insurance company takes a lump sum of money from you and pa...