Friday, October 19, 2012

Efficient Frontiers: Inflation Assumptions, Fixed SPIAs, & Inflation-Adjusted SPIAs

The other day, I posted about a new research paper called, "An Efficient Frontier for Retirement Income." This paper provides a framework for retirees to choose how to allocate their retirement assets between stocks, bonds, inflation-adjusted SPIAs, fixed SPIAs, and VA/GLWBs.

In the case study used the article, a 65-year old heterosexual couple requiring a 4% withdrawal rate to meet their lifestyle goals (and whose minimum spending needs were set equal to the lifestyle goal) was best served by combinations of stocks and fixed single-premium immediate annuities (SPIAs). At current product pricing levels, there is little need for bonds, inflation-adjusted SPIAs, or immediate variable annuities with guaranteed living benefit riders (VA/GLWBs).

I’ve received lots of great feedback and am now in the process of working through a variety of issues, one by one, to demonstrate about the robustness of these results to different assumptions and retiree situations.

Today, one of the results that really caught me off guard was that fixed SPIAs performed so much better than inflation-adjusted SPIAs. I was naturally more of an inflation-adjusted guy. In hindsight, though, the reason is obvious. I made a table to demonstrate why. I used commercially available SPIA rates that were available in April 2012 (this is a while ago, but I just haven’t gotten around to updating what I use). Those rates are at the top of the table:
 Comparing Fixed and Inflation-Adjusted SPIAs
Fixed SPIA Rate (%)
Inflation-Adjusted SPIA Rate (%)

Expected Inflation Rate (%)
Number of Years For Real SPIA Income to Match the Fixed SPIA

An important point to note is that the initial retirement date payout is 51% larger for the fixed SPIA than the inflation-adjusted SPIA ((5.84-3.875) / 3.875). After retiring, the fixed SPIA amount will always stay at the same nominal amount, whereas the nominal amount of the real SPIA increases along with the sequence of inflation experienced after retirement. For my simulations, I did have inflation fluctuate randomly around an average inflation rate of 2.1%, which represented the breakeven inflation rate expected by the markets as determined by comparing Treasury yields with TIPS yields.

If inflation is fixed at 2.1%, the table shows that the actual income amount provided by the real SPIA would not start to exceed the fixed SPIA amount until the 20th year of retirement. That’s a long time to wait. Granted, after 20 years, the real SPIA will continue providing a larger amount of income forever, but it is a long time to wait for that to happen. That is the fundamental intuition about why fixed SPIAs beat real SPIAs in my simulations

Granted, a very important point is that many people are worried about higher inflation in the future. The markets currently don’t expect that, but if you disagree, then you might like to use a higher inflation rate for your calculations about whether a real SPIA is worth the cost. What is important here is how long it will take for cumulative price increases of 51% to happen. If inflation averages 3%, then the real SPIA would provide more income starting in the 14th year of retirement. If inflation is 4%, then it would only take 10.5 years.

Your views about future inflation are quite important to this decision.
Note that higher inflation would also hurt the performance of the VA/GLWB strategy since its guarantees cannot be expected to keep pace with inflation, and it would also hurt bond mutual funds since the interest rate increases accompanying higher inflation would result in capital losses.

Higher inflation will not completely overturn the idea that the efficient frontier consists of stocks and SPIAs, but it could influence the result about whether the appropriate SPIA choice is a fixed SPIA or a real SPIA. Interestingly, it also allows some role for bonds especially in the portfolios on the frontier leaning more to the side of leaving a larger bequest.

Here is a figure of the baseline case for a 65-year old couple with lifestyle 
spending needs equal to 4% of retirement date assets. Everything is the same as in my original article, except that now the average inflation rate is 4% instead of 2.1%. Now, the frontier consists of combinations of stocks, bonds, and real SPIAs: