Optimizing a Retirement Portfolio Using Annuities
Nov 14, 2022
Blueprint Income Team
If one's goal is to avoid running out of money in retirement while leaving the largest possible legacy behind at death, then income annuities play a crucial role. In Blueprint Income's recent white paper, we demonstrate that portfolios made up of just stocks and annuities produce the best outcomes.
- Blueprint Income's white paper on how to optimize a retirement portfolio using annuities is available here
- For someone who wants to limit the risk of running out of money while maximizing their legacy, a portfolio of stocks and annuities is most efficient
- A good rule of thumb for buying annuities is to have 50% of your bonds replaced by annuities 10+ years from retirement and 100% replaced by retirement
The following is an excerpt from Blueprint Income's white paper "Optimizing A Retirement Portfolio Using Annuities" written by Lauren Minches, FSA (actuary). The full paper is available for free download via this link.
A pre-retiree heads into retirement with many goals, some at odds with others. Often these goals include: maintaining a high standard of living, not running out of money, leaving a legacy after death, etc. But, a retiree’s number one goal must be to not run out of money. In reality, having the right financial situation such that one can continue living without work and not run out of money is the definition of retirement.
This is becoming increasingly difficult in today’s retirement landscape where the decline in pensions has transferred market and longevity risks onto the individual, leaving them far more susceptible to running out of money (i.e. having no personal savings or income streams other than Social Security, which is generally not enough to live off of, forcing a reduction in one’s standard of living). And, because the mutual fund industry via 401(k)s and IRAs currently dominates retirement planning, most conversations around money in retirement are about accumulating wealth to then support some level of retirement spending, instead of talking directly about locking in one’s ability to spend. Mutual funds and other market investments offer individuals the opportunity to take risk, not to eliminate it like pensions and annuities do.
The dominance of the mutual fund model, along with human tendency to under-insure, has left the majority of Americans unprepared for retirement and concerned about running out of money. As a Fellow of Society of Actuaries and an employee of Blueprint Income (digital annuity platform), this problem has been a focus of my professional career.
Annuities, whether purchased individually or in group format as with some pensions, along with Social Security, exist to help individuals avoid running out of money in retirement. Because of the pooling of longevity risk across participants, annuities are able to offer “mortality credits” which result in them outperforming bonds with respect to the goal of not running out of money. In this paper, and relying heavily on the good work done before me by retirement income experts, I demonstrate how adding annuities to one’s retirement portfolio reduces the risk of running out of money. Moreover, I provide a new model for optimal asset allocation that goes beyond stocks and bonds to include annuities.
Summary of Results
To minimize the risk of running out of money in retirement while maximizing the legacy one leaves behind at death, annuities play a crucial role in a retirement portfolio. The least efficient portfolios are those with stocks and bonds but without annuities. The most efficient portfolios are those with stocks and annuities but without bonds. (Efficiency captures the portfolio’s ability to best accomplish the goals stated with the minimum level of risk necessary.)
This conclusion holds true before retirement as well, suggesting that retirees should be replacing their bond allocations with annuities and pre-retirees should be doing the same with at least a portion of their bond allocation (with annuities providing income starting at retirement).
Although not yet proven via modeling, initial analysis suggests that the most reasonable execution plan is to trade half of one’s bonds in for annuities 10+ years from retirement and then increase the allocation year-by-year such that at retirement all bonds have been replaced.
Download and read the paper to understand:
- The Goal of Retirement Income Planning: Thinking in terms of income instead of assets & building a "decumulation" plan
- The Structure of an Annuity: How mortality credits provide longevity protection that bonds do not
- The Efficient Frontier: The risk/return maximizing concept that underlies modern portfolio theory and the "120 minus your age" rule-of-thumb
- The Retirement Income Efficient Frontier: How the standard efficient frontier needs to be modified for retirement
- The Retirement Income Efficient Frontier Pre-Retirement: How the results change when you model a 50-year-old instead of a 65-year-old's portfolio
- Drawing a Conclusion About Annuities in Retirement Portfolios: Spoiler alert - they're very useful!
- Study Limitations & Areas for Future Analysis: We didn't consider taxes, correlations among assets, future changes in annuity rates, etc.
- Creating a Rule of Thumb for Annuities in Retirement Portfolios: Replace 50% of your bonds with annuities before retirement and replace 100% in retirement
Blueprint Income Team
We are a team of finance, insurance, and actuarial professionals working to make it easier for everyone to achieve a steady and comfortable retirement. We write about annuities (the good and the bad) and provide strategies to help Americans prepare for retirement.