Journal of Financial Planning: July 2016
Harold Evensky, CFP®, AIF®, is chairman of Evensky & Katz/Foldes Financial in Coral Gables, Florida, and Lubbock, Texas. He frequently speaks on investment and financial planning issues, and is author of Wealth Management and co-editor of The Investment Think Tank.
With the political primaries, the announcement of the Department of Labor’s fiduciary rule, and lackluster market returns dominating the professional media, research articles probably have not been on any practitioner’s list. However, for the long-term it’s those research articles that may have the most important impact on practitioners and our clients. The good news is, good research continues. Here I provide some of the major takeaways for some of these papers.
Retirement Income Research
“How Risky Is Your Retirement Income Risk Model?” by Patrick Collins, Huy Lam, and Josh Stampfli (Financial Services Review, Fall 2015). Comparing eight different risk models, the authors conclude that oversimplified models may distort the risks retired investors face. Incorporating in their analysis investment cost, advisory fees, and mortality, they find a difference in sustainability rates projected by different models from a 4 percent failure rate at the low end to a 49 percent failure rate the high end. They conclude:
- A normal distribution is not a good fit for most financial asset return series, as it does not capture asymmetry of returns for the magnitude of tail-risk events.
- Success or failure should never be evaluated in terms of a single model or a single metric.
- Although they may not be the best alternative, advisers tend to use models commonly used in the profession. The authors hypothesize, “The mere thought of making choices of consequence under conditions of ambiguity and ignorance calls out for company.”
“The Efficacy of Publically Available Retirement Planning Tools,” by Taft Dorman, Barry Mulholland, Qianwen Bi, and Harold Evensky (Social Science Research Network, SSRN.com, February 2016). This paper so echoes the prior work (and I am a co-author), I couldn’t resist including it. Based on an intensive review of 41 publically available programs, the conclusion says it all: our results are generally consistent with prior research that the available tools provide highly variable results.
However, with “conclusions” ranging from, “Congratulations! It appears that you saved enough to meet your goal. In fact, it appears that at age 90 you may still have $2,777,469 in your retirement accounts,” to “The client will run out of money by age 89. The client needs $1,268,208 at retirement age,” we conclude that the available offerings are not only misleading but in most cases potentially dangerously misleading. As many of these tools are offered by well-known and respected organizations, we believe that in light of the issues raised by this study, a serious review of current offerings is in order.
“The Perfect Withdrawal Amount: A Methodology for Creating Retirement Account Distribution Strategies,” by E. Dante Suarez, Antonio Suarez, and Daniel T. Walz (Financial Services Review, Winter 2015). The authors argue that the traditional approach for developing withdrawal strategies is heuristic in that “these approaches typically start with an idea that ‘makes sense’ intuitively and then test it to see if improvement was indeed attained.” As an alternative, they introduce an analytical solution called the “Perfect Withdrawal Amount.” The results of their research are two strategy alternatives to the familiar 4 percent rule: the “Sticky Median with 70-point Tolerance and Recentering,” and the “Sticky First Quartile with 30-point Tolerance and Nudging.”
Investors looking to provide withdrawal stability would use the 4 percent rule, although it may result in a terminal value far in excess of the client’s goals. Investors looking to maximize income would look to the “Sticky Median” strategy, although it risks major adjustments to withdrawals over time. For those primarily concerned with safety, flexibility, and consistent cash flow, the “Sticky First Quartile” strategy would be the choice and would be expected to provide a rising withdrawal path.
Contrary to conventional wisdom, the authors conclude the best level of failure risk is 50 percent. That would result in half the retirees being able to maintain their projected cash flow or more. The other half would avoid depletion through timely warnings that the payouts needed to be decreased.
“Distribution Methods for Assets in Individual Accounts for Retirees: Life Income Annuities and Withdrawal Rules,” by Mark Warshawsky (The Journal of Retirement, Fall 2015). Warshawsky’s paper compares the popular 4 percent rule to a strategy incorporating an immediate annuity. The comparison looks at income and risk. The two methods are compared using historical simulations of asset returns, interest rates, and inflation. The author finds:
Life annuities are effective instruments for retirement cash flow, however they are subject to inflation risk and are illiquid. Given the diverse needs of households, the optimal strategy is most likely to be a combination of traditional investments with life annuities. However, in those cases where there is no bequest goal, the optimal strategy is to place all retirement assets in life annuities.
Delaying the annuity purchase to an older age may make sense as mortality credits increase with age.
Given the uncertainty regarding future interest rates and mortality, using a laddering strategy of purchasing annuities gradually over many years during retirement may be the optimal strategy.
Although inflation indexed immediate annuities are theoretically attractive, there are very few products of this nature currently being offered and the income from traditional fixed immediate annuities is about 40 percent higher than the initial payment for an inflation indexed income annuity.
Deferred income annuities (DIAs), referred to as longevity insurance, are also viable complements to a retirement income strategy; however there are indications that the load on this product is larger than immediate annuities and hence they require careful evaluation.
Because there are usually economies of scale for living expenses, it may not be necessary for a couple to purchase an immediate annuity for both lives, but rather a joint and 2/3rd to survivor annuity.
At age 70, income from the life annuity almost always exceeds the 4 percent rule and often by significant amounts.
The paper concludes: “... in light of the results presented and given that the retirement plan’s or account’s main purpose is to produce lifetime income during retirement, it is hard to argue against a significant and widespread role for immediate life annuities in the production of retirement income.”
“Allocating to a Deferred Income Annuity in a Defined Contribution Plan,” by David Blanchett (The Journal of Retirement, Spring 2015). In this study, Blanchett considers the use of deferred income annuities (DIAs), products that were made viable with the July 2014 Treasury release of regulations regarding the use of DIAs in defined contribution pension plans, also referred to as qualified longevity annuity contracts (QLACs).
We learn several things about DIAs in this study, including:
Due to the use of unisex pricing, there is an additional cost for male purchasers.
Cost may be minimized by purchasing contracts with earlier income start dates and adding benefits such as return of premium and cash refunds. This is not a free lunch, as it may result in the reduction of the income payment by approximately 10 percent.
Attributes that tend to favor the use of DIAs include: being younger, having an earlier income start date, having less existing guaranteed income, being less funded for retirement, having a lower bequest preference, and having a longer life expectancy.
DIAs can generally provide lower effective cost than traditional immediate annuities.
The approximate breakeven nominal return required of a traditional investment portfolio is 4 percent. If an investor expects 4 percent portfolio return, they would be indifferent between purchasing a DIA and generating income from a traditional portfolio.
The breakeven return for someone with a below-average life expectancy is 2.2 percent, versus 5 percent for someone with above-average life expectancy.
Potential negatives include: irreversibility and illiquidity of the investment, negative mortality weighted net present value for the average investor, potentially high cost, and the risk of “buying low,” given the expectation of rising interest rates in the future.
The optimal DIA allocation varied significantly over almost 80,000 simulations; however the average allocation was 30.52 percent. Although allocations are lower for males due to unisex pricing, the analysis suggests they can still be a valuable form of guaranteed income for males.
Portfolio Protection and Downside Hedging
“Quantifying the Value of Downside Protection,” by Jerry Miccolis, Gladys Chow, and Rohith Eggidi (Journal of Financial Planning, January 2016).
This paper addresses the issue of portfolio protection in a down market. The traditional use of fixed income allocations to buffer equity risk is, according to the authors, “highly improbable” over the next decade or so. Liquid alternatives are challenged, as the returns have been mediocre as competition has increased and correlations with equity markets have increased. In addition, investors may be impatient with investments that consistently underperform headline S&P 500 returns as they have over the last several years.
An alternative is to manage equity risks directly within the equity investment, a strategy the authors term “risk-managed investing,” or RMI.
RMI strategies incorporate tactical rotation out of equities, low- or minimum-volatility or risk-controlled funds, quantitative momentum-based strategies employing moving average or other algorithms to signal market moves, tail-risk hedging overlays using equity options, and/or combinations of the above.
Although RMI strategies may solve the equity risk problem, they come at a cost that, over market cycles, may outweigh the benefit. Despite the cost, however, RMI strategies may provide significant emotional value and peace of mind. RMI strategies also provide a quantitative benefit reduction in “volatility drag,” and the mitigation of sequence return risk.
Implemented successfully, the RMI strategy could result in a portfolio with a 75 to 80 percent equity allocation being safer in down markets and better performing enough markets with the traditional 60 percent equity allocation.
“Improving the Outlook for a Successful Retirement: A Case for Using Downside Hedging,” by W.V. Harlow and Keith C. Brown (The Journal of Retirement, Winter 2016). In the same theme but providing more specificity regarding implementation, Harlow and his co-author develop implementable strategies they refer to as downside hedging (DH).
The goal of DH is to alter the risk of extreme negative tales by truncating that risk. The paper considers two specific strategies: the “cost less collar,” or the purchase of put options to limit the downside financed by the sale of call options’ equivalent value; and the direct purchase of put options without the sale of call options.
The authors find the use of DH strategies provides “valuable risk mitigation around the critical retirement date as well as an effective hedge against sequence risk.”
Thoughtful Concepts
A few additional papers that provide thoughtful concepts for practitioners include:
- “Do Fundamental Index Funds Outperform Traditional Index Funds?” by Edward C. Chang and Thomas M. Krueger in the December 2015 issue of the Journal of Financial Planning.
- “Two Determinants of Life Cycle Investment Success,” by Jason C. Hsu, Jonathan Treussard, Vivek Viswanathan, and Lillian Wu in the Spring 2015 issue of The Journal of Retirement.
- “Investor Sophistication and Target-Date Fund Investing,” by Michael A. Guillemette, Terrence K. Martin, and Philip Gibson in the Spring 2015 issue of The Journal of Retirement.
- “Reexamining ‘To vs. Through’: What New Research Tells Us about an Old Debate,” by Matthew O’Hara and Ted Daverman in the Spring 2015 issue of The Journal of Retirement.
I hope you have a great summer, and I’ll “see” you again in a few months.
Learn More
Love New Research?
If you’re looking for cutting-edge research that will impact how you practice financial planning, you’ll find it at the FPA Annual Conference—BE Baltimore, Sept. 14–16, 2016. Respected academics from some of the top financial planning schools will present unpublished research as part of the research track brought to you by the Journal of Financial Planning and the Academy of Financial Services.
Each piece of research presented was selected through a blind peer review process, and cash prizes will be awarded onsite for the best theoretical and best applied research presented at the conference.
Learn more at FPA-BE.org/Academics