Most investors are familiar with the benefits of diversification and the concept of the efficient frontier for portfolio management.
The normal efficient frontier highlights the best combination of assets (stocks and bonds) to balance expected returns against the risk of capital loss (due to market volatility).
Because retirement is more concerned with cash flows, the frontier should consider these measures to be relevant for retirees.
When you construct an efficient frontier for retirement that creates a trade-off between income to the retiree and the estate balance, it is clear that annuities provide a superior outcome to standard bond investments.
The efficient frontier
The concept of the efficient frontier for retirement income was developed by US academic, Professor Wade Pfau.
His 2013 Journal of Financial Planning article, “A Broader Framework for Determining an Efficient Frontier for Retirement Income”, focuses on how best to meet the two competing financial objectives for retirement: satisfying lifetime spending goals and preserving financial assets.
The frontier highlights the potential outcomes from the combination of stocks, bonds and annuities.
Other assets can be added, but it is the contrast of combining annuities with stocks against the results from combining bonds with stocks that is most interesting.
The chart below highlights the two trade-offs. Both start with 100 per cent stocks in the upper left of the page.
Increasing the allocation to either bonds or annuities reduces the expected balance to an estate.
Stocks have the highest expected return, so the expected final balance will be lower if you are not invested completely in the risky asset.
The trade-off for this is an increase in the amount of income that will be received over a lifetime.
To capture the risks, this income is measured at the 90th percentile. That is, the income will be provided at least nine times out of 10.
Using annuities provides a clear advantage. For any reduction in the estate balance, there is a much larger increase in the income available to the retiree.
Trading off the potential estate using annuities provides more income to the retiree than if they use bonds in retirement.
The efficient allocations will do a better job at meeting both of the lifetime objectives by including annuities.
The example in the chart is based on a single Australian retiree.
She is assumed to have $500,000 available and is looking to spend $43,000 a year, approximating the Association of Superannuation Funds of Australia (ASFA) comfortable standard for a single retiree.
The income calculations include the Age Pension and the chart illustrates the proportion of target income (the $43,000) that will be received over her lifetime.
Two thousand scenarios have been used to calculate the frontier using investment data from Willis Towers Watson and variable mortality conditions from ALT2010-12, with the Australian Government Actuary’s 25-year mortality improvement data.
Designed for income
A lifetime annuity is designed to provide a stream of income payments for an individual retiree’s uncertain lifespan.
The annuity provider can manage a large portion of this risk through pooling with other lives, which will be of differing lengths on either side of the expected average.
The result is a higher income payment to retirees overall, as opposed to the self-insurance route.
Bonds, on the other hand, are useful in adding capital stability during accumulation.
Generating cash flows from bonds, either via direct investment or bonds funds, means realising them at variable prices over time.
The result is a lower level of income to achieve the same estate balance.
Another advantage of having a focus on providing income is that other financial assets can be used to focus on other objectives.
Having risks managed by the lifetime annuity means that a retiree can spend more of their risk budget on other investments.
This can be used to target higher expected returns, which will, for the same income to the retiree, lead to a higher expected estate balance.
Protecting the estate from a premature death
Many retirees worry that a possible premature death will leave their estate short of the capital they put into their annuity.
Most lifetime annuities sold in Australia include a withdrawal guarantee, so an early death does not necessarily leave beneficiaries in any worse shape.
A 15-year withdrawal guarantee provides enough time for retirees to ensure they get value out of the annuity, but it is not very costly as most retirees will live well beyond this period.
It helps provide confidence for clients to develop a sustainable retirement income plan.
The bottom line
Annuities are designed to provide income in retirement. When used as part of a diversified portfolio, they actually provide a better outcome for retirees than can be achieved by stocks and bonds alone.
With modern annuities, retirees can have the benefit of securing income and retaining peace of mind to maximise the benefits for their estate.
Aaron Minney is the head of retirement income research at Challenger.
