|
 Published
Monday, November 12, 2007
 Print
Friendly Version Email
This
An actuarial look at investing
by Stephen Butler
Is there a clairvoyant actuary in the house? Professional actuaries
predict life expectancy. We could turn to one to help us search
for guaranteed retirement income that we won't outlive.
As a start, let's look at three possible approaches. Two have
been around forever, and one is brand new.
Of the two that have been around forever, one has been sold aggressively
and the other amounts to a cost-effective "do it yourself"
approach to supplying retirement income.
For the brand new candidate, we have Fidelity's so-called "Income
Replacement funds."
Immediate fixed annuities guarantee a payment stream for the
rest of your life.
To illustrate a simple example, for a male age 65, a deposit
of $100,000 in a competitively priced contract generates a fixed
income stream of $8,000 per year.
Once you sign up, you give up the $100,000 and you can't rescind
the contract. Your heirs or favorite charities will never get
the money. In this example, the so-called embedded yields of the
investments are estimated to be about 5.5 percent to 6 percent.
Earning this much on the money plus chewing into the principal
to average life expectancy is what justifies the 8 percent payment
amount.
All these numbers are fixed. The only thing changing their effective
value over time is the rate of inflation that will reduce the
payments' buying power as the years go by.
A variable annuity will use rate-of-return numbers based on past
stock market performance (instead of the embedded fixed return
mentioned above.)
Under these circumstances, it is easy to make the case that there
will always be plenty of money to support a variety of generous
payout amounts. Only a clairvoyant actuary will be able to tell
us whether the stock market performance will be positive enough
to generate the promised payments.
Variable annuity proposals can only be hypothetical, so they
are sprinkled with all kinds of disclaimers suggesting that nothing
is guaranteed.
However, the optimistic misleading numbers are what sell these
plans to the unsuspecting.
A "do it yourself" approach on the same $100,000 would
be a 50/50 combination of some bond funds and a value-oriented
large cap index fund that pays dividends.
Three bond funds in equal amounts including a high-yield fund,
Ginny Mae (mortgage) fund and a short-term bond fund will generate
an average dividend yield of about 6 percent today.
If the other half of the fund is in a stock-oriented fund, with
a 2 percent stream of dividends, the average payout of the entire
$100,000 account would be 4 percent, or $4,000.
If the stock fund is appreciating at a conservative rate of 8
percent per year, this would allow us to access principal at a
rate of 2 percent per year and still leave 6 percent for growth
to combat inflation on this $50,000 half of the account.
Remember, only half of our entire account is in this stock fund,
so the growth of 6 percent here amounts to only 3 percent of the
entire account (the other half of which includes the bond funds
that are not appreciating). The average rate of inflation is 3
percent.
Bottom line: We have a fund combination generating an income
of 5 percent and keeping pace with a 3 percent inflation rate.
The 5 percent income stream may be 3 percentage points less than
the 8 percent fixed annuity, but we maintain control of the principal,
we have some protection against inflation and our children or
charity will get the $100,000 (plus some appreciation on the $50,000
in stocks).
The 3 percent income difference, after taxes, would have looked
more like only 2 percent anyway -- a cheap price to pay for keeping
our options open on that $100,000.
What we have just described, fundamentally, is the component
mix of the new Fidelity Income Replacement product.
The difference is that the Fidelity approach assumes a greater
erosion of the $100,000 than just the rate of 2 percent per year
outlined above. By something called the "horizon date,"
all the money will be gone and the payments stop.
The horizon dates are all based on historical rates of return
of different asset classes used in the investment mix, and this
can be a mistake if we think that the past 20 spectacular years
will repeat themselves.
Fidelity uses a 20-year compound rate for the S&P 500 index
of about 11.4 percent. I assumed 8 percent in the do-it-yourself
version above. What looks like an income stream on the Fidelity
"thumbwheel" that lasts for 20 years might only last
for about 12 at my 8 percent estimate.
There are disclaimers everywhere, but who pays attention to them?
Moreover, in an exercise where every full percentage point of
return is critical, the ongoing expense ratio of these income
replacement plans is more than 1 full percentage point per year.
In the end, I may decide to die broke, which is certainly one
retirement strategy, but I want it to be on my terms as part of
an informed decision with eyes wide open.
|
