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.