Of course, the 4.5% income guarantee is not like the 4% rule,
since it does not provide a stable after-inflation income throughout retirement. As an example, one simulated retiree got somewhat lucky as their income grew to just over $5,000 by year 5, but
they also lived long enough to see the real value of their after-inflation income fall below $3,000. GLWB riders provide some random
upside to lucky retirees and guaranteed income for life, but they
don’t take away purchasing power risk for a long-lived retiree.
Sharpe’s conclusion is that the peculiar income ratcheting
characteristic of GLWBs means that they are not any more
efficient than the fixed withdrawal strategy. Many simulations
result in low incomes that decline in purchasing power. But
this isn’t because of greedy insurance companies.
On average, the present value of fees on GLWB VAs is only
3.3% of the initial value invested. And only 5.5% goes unspent
to the couple’s estate, meaning that more of the initial nest egg
ends up being spent. Unfortunately, the downside of the product structure is that the range of income paths might not provide
the highest expected welfare to the couple who aren’t willing to
accept the wide range of lifestyles offered by the GLWB.
Maximizing Retirement Efficiency
How does a retiree choose the right balance of lifestyle and
risk? What combination of investments and insurance products provides the best solution? How does a retiree eliminate
the risk of ruin that comes with an investments-only fixed
withdrawal approach, protect against inflation, and take an
appropriate amount of investment risk?
One approach is to place the majority of retirement savings
in an income floor. The floor should optimally be constructed
by purchasing an inflation-protected annuity (a rare beast) or
through a ladder of Treasury Inflation Protected Securities
in which a portion of value at maturity can be spent and the
remainder can be used to purchase a ladder of annuitized
nominal income. For example, a retiree can invest in 20-year
TIPS that will grow by 1% above inflation at today’s rates that
at maturity are used to purchase an annuity whose value will
not have been eroded by inflation over time.
The remainder could be invested in a leveraged equity ETF.
If the leveraged equity portfolio rises beyond the initial allocation to risky assets (say 15%), then the surplus can be used to
add income to the riskless floor. If the leveraged strategy fails,
the retiree will simply live on the income floor. An unleveraged
portfolio would allocate a higher percentage to equities but
follow the same approach of gradually building the guaranteed
income floor over time.
This strategy may be complex for retirees and even advisors
to implement. Ideally, innovation in financial products will
allow advisors to build a retirement income investment plan
using more efficient products that provide the greatest income
security with the right amount of upside potential.
It took decades for Sharpe’s vision of a low-cost internationally diversified market portfolio to gain wide acceptance.
Hopefully, it won’t take decades for the industry to build a
more efficient and simple retirement income solution.
Michael Finke is Chief Academic Officer of The American College of
Financial Services and a regular contributor to Investment Advisor.