The following section references the study "Investing your Lump Sum at Retirement". We will provide quotes and commentary. The quotes in blue and/or red stem directly from the study conducted by David F. Babbel, Fellow, Wharton Financial Institutions Center, Professor of Insurance and Finance, The Wharton School, University of Pennsylvania, and Craig B. Merrill, Fellow, Wharton Financial Institutions Center Professor of Finance and Insurance, The Marriott School of Management, Brigham Young University. The commentary in black is provided by Steven S. Delaney, President of American Annuity Advocates.
"Imagine sitting down on the day of your retirement to plan your financial future. You know what your annual expenses have been and you want to maintain your current standard of living. So, you consult a recent mortality table and find that if you’ve made it to your 65th birthday, you can expect to live to 85 years old. You perform a little calculation and find that, together with your Social Security monthly payments, you have just enough savings to maintain your current standard of living and spend al of your savings and future expected earnings by the time you die at the age of 85. But, what if you live longer? Will you be reduced to eking out an existence on Social Security alone? Where will the additional money come from? What if future investment returns are not what you anticipated at the start of your retirement? These questions are increasingly urgent in America today, as forces are combining to make planning for outliving your resources more important than it has been in the past. Old rules of thumb for spending your assets in retirement, called decumulation, need to be reconsidered."
The study “Investing your Lump Sum at Retirement” from the University of Pennsylvania’s Wharton Business School points to the wisdom in utilizing safe, fixed annuities in your retirement planning. The study will focus on the allocation of your lump sum, your 401-k, your accumulated savings at retirement, and making your money last as long as you do. It will discuss what many financial planners, journalists, and talking heads, are not prepared to talk about. “Why is that?” you may ask. The answer may lie in their lack of perspective, relative experience, pertinent research, and/or, perhaps their subjective orientation.
If you take the time to read what some of the brightest minds in financial planning are telling you, professors and economists from A to Z, you will come to understand why “American Annuity Advocates” supports the use of annuities in retirement planning. With new information comes new understanding, hence, you are likely to question the validity of some of the information and advice, you have been given in the past by other sources.
This research paper is a “must read” for financial planners and consumers. Below is a mix of highlights and commentary on this research paper. You will have the ability to download the entire research paper at the end of this section.
It is important for you to understand that some financial advisors with a strict stock market orientation may contend that stocks and bonds are still the best way to prepare for income needs in retirement. They are correct in the sense that a mix of stocks and bonds in a client’s portfolio, depending on one’s tolerance for risk, may in fact be a fine method for the accumulation phase of one’s nest egg. However, The Wharton Business School essay “Investing your Lump Sum at Retirement” is about the “decumulation” phase of one’s nest egg, and it provides the research, the evidence if you will, that advisors who maintain that a mix of stocks and bonds, for the purpose of providing income in retirement, are simply incorrect.
The Wharton Business School study talks about the advantage of having a guaranteed income in retirement provided by an annuity. “Trying to replicate this advantage of a secure lifetime income, but without the risk-pooling of a life annuity, will cost you from 25% to 40% more money, because you would need to set aside enough money to last throughout your entire Possible lifetime, instead of simply enough to last throughout your expected lifetime.”
Essentially, the research indicates this: You could place a hypothetical $200,000 into an annuity which would provide a guaranteed lifetime income of $1572 a month to a 70 year-old-male- but would need 25% to 40% more to accomplish that same goal with a mix of stocks, bonds, and/or mutual funds. In other words, you would need $250,000 to $280,000, rather than your original $200,000. Would you rather put $200,000 into an annuity for a guaranteed lifetime income of $1572 a month or invest $250,000 to $280,000 into an investment vehicle that may not last as long as your lifetime?
The study discusses the need to partially liquidate your nest egg, in order to provide you with a guaranteed income stream that you cannot outlive. In reading this essay, you will come face to face with your financial future, the genuine risks within, and the decisions that you must face when approaching retirement. The essay will provide the research that leads to the prescription for securing your retirement. That prescription is annuitization, a guaranteed income stream. American Annuity Advocates contends that no decision should be made without first examining this essay, and then reviewing the ‘investment versus savings’ choices available along the spectrum of risk and return.
“You should begin by annuitizing enough of your assets so that you can provide for 100% of your minimum acceptable level of retirement income. Annuitization provides the only viable way to achieve this security without spending a lot more money. The economic models invariably attest to this fact – that the cost of not being able to cover basic expenses far exceeds the potential upside of taking on additional equity exposure. In calculating how much to annuitize privately, subtract from what is needed each month from the amount you will be getting from Social Security and any pension benefits you may have accrued.”
The “incorrect” view held by some advisors regarding real market risks along with the overall costs associated with market sensitive investments, stems from the fact that advisors are often products of their environment. This “incorrect” view is promulgated by an industry that lives off of the “frictional costs” to the consumer, in the form of loads, fees, charges, and/ or expenses. In addition, some financial advisors are in the habit of routinely spouting “the stock market historically returns 10%”. Consumers need to be aware that this is a myth, as evidenced by the research of Jeremy Graham when he illustrates the historical P/E (price to earnings) ratios relative to actual stock market performance. The point is, when advisors say the stock market will earn 10% over time, this leads to false expectations by the consumer. Projections of a 10% return in the stock market by any financial advisor should not be permitted.
Unfortunately, such views may lead not only to a warped perspective on stock market returns, but a warped perspective on market risks as well. As market oriented advisors are often said to be “playing with your money”, they may be taking risks too lightly, and concern for the costs attributable to the consumer may become secondary.
“In another recent study, we re-examined the unique features of annuitization and showed that people who place their retirement wealth in mutual funds of stock, bonds, the money market, or some combination thereof are subjected to greater risk, often higher expenses, and returns that are unlikely to keep pace with annuity returns, especially when risk is taken into account.”
“Why Don’t More People Annuitize - Reasons and Excuses (or, Annuity Myths)”
“While public and private annuitization (i.e., Social Security and pensions) were heavy in the past, relatively few Americans not covered by pensions today have chosen to annuitize their wealth through private annuity purchases. Given the alarming confluence of economic and demographic changes occurring today, the number of people choosing life annuities should be larger than ever.”
“Many market participants believe that “stocks for the long run” is the way to go. But our study showed that over the long haul, unless stocks achieve excess returns above Treasury bonds at least twice as high as they are generally expected to generate, it often makes more sense to annuitize most of one’s wealth at retirement. So why don’t more people annuitize? Here are some common myths about annuities.”
“Isn’t it cheaper to use some sort of homemade strategy that mimics the behavior of life annuities? That way I can cut out the insurer!”
“This would be nice, but it is a fantasy. We don’t notice people doing this with life insurance. Why not? Because it takes an insurer to assemble a large pool of thousands of people, to fund the payments that go to people who die prematurely. A large pool is also needed to provide predictability and efficient pricing to the provider of insurance, as well as to the consumer. The same pooling principle is behind life annuities, and allows insurers to offer monthly payments throughout your life, no matter how long you live. It is difficult to form a viable pool size if you try this at home on your own!”
“That hasn’t stopped financial economists from experimenting with close to a dozen different investing and budgeting plans to see if mimicking the desirable attributes of life annuities can be done successfully. Thus far, each one exposes the retiree to the possibility of suffering sustained periods of inadequate income, at times even below survival income level. Financial planners sometimes say that a particular favored system may give you a good chance of significantly higher investment returns if your savings are placed in equities or some other favored investment. That may be true. But such homemade systems also carry a risk of running out of income long before one runs out of life. Their sponsors may counter that the risk of such an eventuality, if everything goes according to assumptions and the plan is followed tightly, may be only 15%. That is roughly equivalent to the 16.7% odds of losing in a game of Russian roulette, and few people are prone to participate in such games!”
“If I put all of my money in a life annuity, will there be anything left for my kids?”
“There are several levels upon which this valid question can be answered. First, assume that you put all of your money in life annuities (which we do not advocate). If you have enough money to give some to your heirs, yet place it all in life annuities, the monthly payments will likely be more than you need to maintain your lifestyle. Therefore, the excess could be saved and passed on to them. The longer you live, the more excess will be available for your heirs.”
“If I purchase an irrevocable life annuity at retirement, don’t I lose control over those funds? “
“Yes. And thankfully, so do your kids! One of the most difficult situations in which older people find themselves occurs when there are many people trying to get their hands on your hard-earned money. Let’s face it. Some of us get rather feeble as we age, and our judgment sometimes lapses. We become vulnerable to impassioned pleas from others to “ante up” our savings to them. How many aged people have lost everything in such situations, sometimes even to well-intentioned recipients? Moreover, it also greatly reduces the risk of us overspending.”
“Conclusion”
“When individuals consider the list of positive attributes associated with life annuities, i.e., guaranteed payments you cannot outlive, low cost, access to invested capital, and reasonably priced features such as inflation adjustment and legacy benefits, the argument for this income solution in retirement is compelling.”
We gave you some highlights, but we hope that reading “Investing your Lump Sum at Retirement”, in it’s entirety, will further your ability to determine both your willingness to accept risk, as well as, which investment or savings options may be best for you. All of us are faced with the following decision; should we invest our lump sum in the stock market, should we be placing our lump sum in a safe, guaranteed annuity, or should it be some combination of both ideas?
In order to take make the right decisions for you and your family, you must base your decision upon your ability to live with risk, and consider what percentage of your nest egg should be allocated to market sensitive investments, and what portion of your nest egg should be allocated to fixed, guaranteed savings products. By educating yourself on this website you are clearly separating yourself from the masses who may, unfortunately, find themselves less prepared for retirement.
All foot notes and sources are noted on the original document “Investing your Lump Sum at Retirement”.
To download “Investing your Lump Sum at Retirement” from the University of Pennsylvania’s Wharton Business School. Click here
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