Friday, November 23, 2012

Important New Research Results from IFID Centre Conference

I'm writing from Toronto, where I attended the 2012 Annual IFID Centre Conference orgazinized by Moshe Milevsky and his colleagues. There were four speakers at the conference, each of whom provided research results which have a direct bearing on retirement income strategies. The real mind blower for me was the fourth and final presentation, so don't click away yet.

I was the first speaker. I spoke on my most recent research article, "An Efficient Frontier for Retirement Income." As this is a research area pioneered by Moshe Milevsky in the first place, I was nervous about doing this. But I think things went well. I've discussed this paper here before. At the conference I also showed results from further case studies which I had been meaning to write about at my blog but haven't gotten around to yet. These include looking at different measures of success for meeting lifestyle spending goals, assuming a smaller equity risk premium of 3% (which Robert Kirchner had encouraged me to do), and also trying a more optimistic scenario for stock and bond returns to make sure that my previous findings are not only a result of my pessimistic assumptions about market returns. In all the cases, the general shape of my efficient frontier holds up, which is that retirees may be best served by combinations of stocks and fixed SPIAs. A part of the frontier I hadn't discussed also does include that particularly risk averse retirees may benefit instead from combinations of real SPIAs and fixed SPIAs. These results do appear relatively robust. The big takeaway for me from the participant comments is that I should try including life insurance as another potential "asset class" for the analysis. 

The second speaker was Anthony Webb from the Center for Retirement Research at Boston College, who spoke on his research article, "Should Households Base Asset Decumulation Strategies on Required Minimum Distribution Tables?" I recently discussed research from Morningstar about optimal withdrawal strategies, and their optimal strategy is rather complex. Webb and co-author Wei Sun limit their analysis to "rule of thumb" style strategies which can be more easily followed by households, such as the 4% rule, and other related strategies. They find relatively robust results that a good "rule of thumb" strategy is to spend any interest and dividends received plus a percentage of principal equal to the amount calculated by the IRS for the required minimum distributions from tax-deferred accounts. I discuss those RMD distributions and provide a table of them here. My only concern about this strategy is that it provides a variable and unpredictable income which is highly dependent on market returns, but Anthony Webb's intuitive response is that: if you don't want to accept variable income, you shouldn't be investing in the stock market in the first place. That's a safety-first idea

The third speaker was Marie-Eve Lachance from San Diego State University. She focused on how to optimize between traditional IRA (backloaded taxes) and Roth IRA (frontloaded taxes) accounts in light of unknown future tax policies and the complications arising with other parts of the tax code, in particular the fact that traditional IRA distributions count as income for whether Social Security is taxed, while Roth IRA deductions (currently) do not. Conventional wisdom is that people should contribute to tax deferred savings accounts first with the idea that taxes will be lower post retirement. But this result does not always hold up, and college educated readers (implying a higher salary level) may benefit more from frontloaded tax approaches. Here is a link to her rather theoretical article on this subject.

Finally, Thomas Salisbury of York University spoke on work-in-progress research by him, Moshe Milevsky, and Huaxiong Huang. This is the presentation which I found myself most fascinated by and took copious notes. Though it is still a work in progress, I received permission to write about it. The maestro himself, Moshe Milevsky, will also write a column about it early next year for Research Magazine, and the authors, of course, will be sending their research paper to an academic journal as well. So definitely watch for that (I will surely provide a link when it comes out), but you are hearing about it here first :)

What is the issue? Well, it is a rather specialized topic and may not be relevant for many readers. But for those of you for whom it matters, this is a big deal. And I know some of you care, because I've received emails with questions about this issue and I didn't know a good answer. If you would like a general introduction to what I am talking about here, I provided an overview of GLWBs in a recent column at Advisor Perspectives.

The question is: suppose you own a deferred variable annuity with a GLWB rider and you have not begun taking guaranteed withdrawals yet. You are still in the deferral phase, but you are specifically wondering when you should stop deferring and start taking guaranteed income. These co-authors worked through the mathematics about this and found that the general answer is simple: start taking guaranteed income ASAP. There are some exceptions, but most of the exceptions are not very realistic for being actual possible scenarios for people. The one exception which may matter is that if you are within a couple of years from reaching an age where the guaranteed withdrawal rate will jump up (such as from 4% to 4.5%) then it could be worthwhile to wait for that. Their research paper will provide the exact parameters about when this wait is worthwhile. But otherwise, generally speaking, if you are thinking about whether you should start taking guaranteed income, the answer is going to be that you should start taking guaranteed income now

They investigate this question from the perspective of what is the worst thing a GLWB owner can do from the perspective of the insurance company. In turns out that especially in the past, many GLWB products seem to have been designed to be lapse-supported. This means that the GLWBs actually offered pretty valuable guarantees, but the saving grace for the issuer is that most of the owners would let the product lapse or would roll over to a different annuity before the insurance provider ever found themselves on the hook for supporting guarantees. This all changed with the financial crisis in 2008, after which a number of companies have dropped their GLWB lines as owners found out that they now owned valuable guarantees that were in the money (the guaranteed benefit base exceeds the contract value of remaining assets) and were not lapsing at the rate the insurance companies expected. Compounding the trouble for the insurance companies was that with interest rates falling so low, it was becoming increasingly difficult for them to hedge the risks related to the guarantees they had made. 

And so suppose you own a GLWB in the deferral phase and are thinking about starting income. The intuition for why you should start income now is rather elegant. GLWBs are complicated, but they can be thought of simply as a combination of an investment account and a deferred annuity. As long as the assets in the VA account are bigger than zero, then withdrawals do not cost the insurance company anything. You are taking back your own funds. The GLWB becomes costly to the insurer (which is good for you) in the case that the contract value of your assets reaches zero. Then you still receive an income for life and this is the expense which the insurance company needs to be hedging against with the income they receive from the guarantee rider they charge you. So from the insurance company's perspective, they want you to delay. And they provide a lot of incentives to do this, such as the opportunity for growing your benefit base if your investments do well, the opportunity to get a higher payout rate if you wait to start at a higher age, or even some companies provide guaranteed growth for your benefit base if you delay. 

But the opportunity to grow your benefit base by delaying guaranteed income just isn't worth it (except for that issue where you are just a couple of years away from getting an age-based increase in your payout rate). Think of it this way. Suppose you delay taking $100 for one year and this lets your benefit base grow by enough so that your subsequent guaranteed income will be $105. Assuming that the interest rate for discounting future income is zero, how long do you have to wait for this deferral to pay off? Well, it doesn't pay off until the contract value of assets hits zero. Suppose that takes 25 years to happen. Then the deferred annuity begins which is $5 more per year than otherwise. Then, it takes another 20 years to get that $100 of income back that you had delayed. You are now looking at a 45 year period to breakeven on your delay. With a positive interest rate, the breakeven point would be even longer. It just isn't worth it. 

I think this result is so powerful because it is not intuitive beforehand, but makes a lot of sense once you hear it. Do note that this issue is different from whether or not you should buy a GLWB in the first place. The matter is what to do if you happen to already own one. And the answer is: start income withdrawals!

Attending the conference was a great experience. It is held annually on US Thanksgiving Day.