By Horizon Investments

For years, conventional wisdom has held that individuals nearing retirement should increase their fixed income allocation to protect assets and generate income.

But there are indications that view of retirement planning is changing. Low-interest rates and longevity risk are among the factors leading investors and financial advisors to reconsider the strategies required to provide for a comfortable retirement. New research continues to demonstrate the potential benefits of maintaining a more substantial equity position in a portfolio throughout the retirement years.

Equity exposure can provide growth across an extended retirement, but what about the need for income? In a recent research paper (Improving Outcomes for Retirement Income Solutions by Combining Managed Money and Annuities), we examined a new approach to retirement planning using managed money and a simple annuity strategy to provide both an income stream and protection against longevity risk (this could be thought of simply as “outliving your money”).

Rising rates favor the use of annuities

Annuities are an insurance contract in which the investor provides either a lump sum or a series of payments to the insurer in return for an income stream, typically guaranteed for life. The nature of those payments is determined by a number of factors, including prevailing interest rate levels that impact the rate of return provided by the insurance company, and the life expectancy of the contraction. The internal rate of return (IRR) tends to rise (and fall) with interest rates, with higher rates resulting in a higher IRR. As such, annuities can offer a compelling way to generate income and to protect against loss of principle during a period of declining bond prices and rising interest rates.

Annuities have long been recommended by advisors as a standalone vehicle for generating guaranteed income. However, little research exists that examines the dynamic of combining an allocation to an annuity with managed money. In our study, we used a type of annuity known as a Single Premium Immediate Annuity (SPIA), which is typically funded with a single payment from the investor. We examined the impact of replacing a moderate portion of an investor’s fixed income allocation with a SPIA, and the balance of the portfolio invested in a mix of stocks and bonds. We then analyzed the results across a broad range of portfolio allocations, market conditions, longevity scenarios, and lifestyle requirements.

Among the findings:

  • Adding annuities may immunize against interest rate risk, as annuity payments tend to rise with interest rates.
  • The biggest potential benefit accrues to those who live beyond the median life expectancy, where the rate of return on the annuity generally exceeds the “risk-free” return available in the market, defined as the yield on 30-year US treasury bonds.
  • The income “guarantee” provided by the annuity may allow for a larger allocation to equities in the remaining portion of the portfolio. This, in turn, increases the likelihood of achieving the desired retirement savings outcome without increasing spending failures even in “worst case” scenarios.
  • The value of annuity allocation increased as assumed market returns fell.

Increased equity exposure can improve outcomes

When it comes to considering withdrawal rates, the so-called “4% rule” continues to dominate the planning process. This ubiquitous rule of thumb was established in a 1994 paper by William Bengen that looked at all rolling 30-year retirement horizons starting in 1926 and a 50/50 stock (S&P 500 Total Return) and bond (Intermediate Term Government bonds) portfolio. In each starting year he computed the maximum initial portfolio withdrawal rate, that when adjusted for actual inflation each year thereafter, could have been withdrawn from the portfolio without depleting all the assets over the 30 years. In general, 4% was found to be a workable withdrawal rate for most of the periods measured.

A lot has happened in the 25 years since that study was published. We have experienced an extended period of historically low interest rates, impacting the ability of the bond side of the portfolio to generate income. At the same time, Individuals are living longer and often spending more years in retirement. Therefore, they need to sustain the ability to spend over longer periods of time. As a result, researchers have taken a fresh look at the 4% rule and, in particular, its 50/50 stocks/bonds allocation. There is a common conclusion in the withdrawal rate literature: more equity exposure typically can allow for higher rates of success.

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