This Annuity Helps Retirees Outperform 4% Withdrawal Rule: RetireOne

According to the paper, a given investor may draw income from the covered asset at a defined payout rate according to a benefit base that is typically guaranteed to not be less than the initial investment. Crucially, this benefit base can grow as the portfolio grows, and withdrawals continue until the covered assets are depleted, at which time the issuing insurance company continues the income payments.

“The annuity, then, is contingent upon asset depletion, and deferred until such time,” Richter-Gordon explains. “As mentioned above, CDAs are cancellable with no surrender charge; one implication of this benefit is that, if portfolio values rise to a point where the investor no longer worries about safely generating income for life, the CDA option can be dropped, and costs saved accordingly.”

The Potential Benefit to Retirees

To demonstrate the benefits of this approach, the analysis considers a theoretical 60-year-old couple with $1 million in retirement savings. The couple intends to start drawing income from their portfolio when they turn 65, and their income target is 4% of their portfolio’s value at the time income commences.

In the scenario, the couple would like to target increasing this spending amount by 2% a year to help offset the impact of inflation on their lifestyle, while their portfolio remains allocated 55% to equity and 45% to fixed income instruments during a 30-year retirement period.

According to the paper, running a traditional Monte Carlo assessment of this couple’s retirement prospects (defining failure as missing the income target by 10% or more in any given year) results in an “unacceptably high” 44% failure rate, and the spread of potential outcomes on both the upside and the downside is vast.

According to Richter-Gordon, using a more sophisticated flexible spending approach that sees retirees adjust their spending depending on market conditions can meaningfully reduce failures in the Monte Carlo projection. Such strategy, however, can result in a degree of annual income variability in unfavorable market scenarios that is not tolerable to many clients.

Part of the benefit of leveraging a CDA, the paper explains, is that it allows the client to embrace a higher equity exposure. In the theoretical example above, by purchasing a CDA to cover half the portfolio, the couple can bump its equity allocation up to 75% without meaningfully increasing the risk of failure, given the annuity-based income backstop.

Importantly, with a CDA, the consumer’s upfront commitment is modest — an annual fee, collected quarterly in arrears, that is similar in magnitude to an advisory fee.

“This low commitment allows the client to make not a one-time, but rather a continuous decision to continue paying for an income guarantee, or to terminate the guarantee if it no longer proves valuable to them,” Richter-Gordon explains. “The CDA allows the client and advisor to retain control of the allocation of assets, including equity exposure, and allows them to avoid the higher fees often associated with deferred annuities with secondary guarantees.”

In the event of a poor sequence of returns, the contingent deferred annuity solves for longevity risk by providing a guaranteed income stream for life, even when the asset is exhausted. In the absence of a market shock early in retirement, this form of portfolio income insurance can also help create more predictable and stable income streams, offer the opportunity to benefit from risk premium, and ultimately provide a better net economic benefit than unprotected withdrawal strategies.

“Based on the above analysis comprising 1,000 Monte Carlo simulations, a portfolio with 50% of assets covered by a CDA offers significantly better outcomes in terms of net economic benefit vs. an unprotected portfolio utilizing RMD-inspired withdrawal patterns,” Richter-Gordon concludes.

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