Dr. David F. Babbel
Professor Emeritus, The Wharton School
University of Pennsylvania
Senior Advisor, Charles River Associates
Frequently I have been asked to explain my approach to dealing with the daunting challenges we face in today’s retirement climate. I am questioned because it is an area I have studied deeply. My approach reflects my own low tolerance for risk and my own circumstances. It is neither a perfect nor a foolproof plan, yet it is the best that I could come up with for my wife and me and it might have some applicability for others who face similar circumstances.
As I get closer to retirement age the investment world is undergoing a transformation that makes it most difficult to plan. I have only a small pension from Berkeley ($900 per month, complete with the full faith and credit of California standing behind it!) as well as the university equivalent of a 401(k) from Wharton, where I served for 19 years. I also have Social Security, a system that has been skewed to subsidize the poor.
Although I have built up a reasonably gracious lifestyle, to maintain it in retirement requires supplemental savings. There is no consensus among my academic and Wall Street colleagues who specialize in investments about what should be done. Many colleagues are just as bewildered as I. As I consulted with other investment professionals, I found their suggestions didn’t address the main problems that I faced in a manner consistent with my low tolerance for risk. At their core, the suggestions amounted to risky bets on interest rates, the value of money, precious metals, real estate, junk bonds, hedge funds, private equity, mutual funds, ETFs, stock market bubbles or bursts, foreign exchange rates, and so forth. I felt I had accumulated sufficient savings that I shouldn’t need to take risky bets and relegate their outcome to luck.
I will briefly discuss ten of the most important financial challenges to funding retirement and then my strategy to address them:
- Uncertain Longevity
- Insolvency Risk of Institutions Backing Retirement
- Personal Cost of Living
- Liquidity Sufficient to Cover Extraordinary Events
- Tax – Confiscation of Wealth
- Litigation Risk
- Diminished Investment Capacity
- Protection from the Kids
None of the traditional retirement strategies covers all bases.
My personal approach to addressing these risks includes deferred and immediate annuities in an innovative and responsive, albeit simple way. I hope my approach offers elements that might be useful for your own client’s situation. My approach is prone to leaving some money on the table, but it allows me to sleep at night. I have no interest in keeping up with the Joneses, who might well surpass me if their stock or precious metals bets turn out right; rather, I have an interest in maintaining my lifestyle as long as practically possible, and not imposing on my children the costs of my retirement — nothing more, nothing less.
I should disclose here that I have no products to sell and never have. I don’t endorse any particular investment or insurance companies, brokers, agents, or specific products. I do not engage in any personal consulting on these issues.
The most daunting risk facing retirees is the uncertainty regarding the length of life they will need to fund.
Fortunately, with ordinary fixed annuities, you can provide level income for your maximum lifespan for about 40% less than it would take to provide the same level of lifetime income security using noninsurance vehicles. However, that leads us to our second challenge.
Insolvency risk of institutions backing retirement
If we leave our money invested in the market, whether stocks or long-term bonds, we are subject to crippling losses of 10% to 60% in any given year. If we give our money to a bank or insurer, it too may suffer losses and become insolvent.
The average length of retirement for a healthy person retiring at age 65 is about 20-23 years, depending on gender. About half of those people will die before they reach that average; the rest will live longer, and many much longer. Actuaries estimate that about 25% of couples who are healthy at 65 will have at least one member live longer than 97 years.
Over every 20-year period since 1971 when the U.S. eliminated dollar convertibility into gold (e.g., 1/1972 – 1/1992, 2/1972 – 2/1992 … 7/1992 – 7/2012), the dollar lost from 36 to 70 percent of its purchasing power by the end of 20 years, depending on when you happened to retire. Do you expect that the dollar will lose value within that same range over your first 20 years of your retirement? Neither do I. When considering the profligate deficit spending combined with unprecedented monetary expansion that we have seen over the past several years, I along with many other economists expect that this will all come home to roost, but who really knows?
Therefore, if you are striving to maintain purchasing power over your remaining lifespan, you might want to consider keeping a goodly portion of your wealth in reserve rather than annuitize most of it at the outset. Alternatively, you could annuitize the bulk of it but save much of your monthly income for the first 10 or so years so that those savings can supplement an eroded annuity payment later. However, this would expose you to the uncertain lifetime predicament, and your supplemental savings might run out before you do. Another alternative is to purchase an escalating annuity that provides higher payments over time.
Two kinds of such escalating annuities are available. The first is one where you choose an annual escalation factor, such as 1%, 2%…up to 6%. This is meant to cover increasing costs of living over time. But if there is very low inflation or even deflation, you would forego a lot of current consumption to cover an inflationary scenario that might not emerge to the degree predicted. Economists have a rough time predicting inflation more than a year or two away, much less 20 years.
The other kind of escalating annuity is indexed to the CPI, although it is common to have a maximum annual adjustment capped at 4% or 6% or some other number that could prove inadequate if we have another bout of inflation like the early 1980’s, or worse. Moreover, our CPI index keeps getting “refined” (i.e. “reduced”). Using the method employed in the early 1990s would reveal a 3% higher annual rate than what we report today. Using the method from the mid-1980s and before would reveal a 7% higher rate per year than what we report today, which is only around 2.5%. There is even a plan to “refine” the calculation methodology once again this year, which will slice off another portion of the reported inflation rate.
The implications: Even if you could accurately forecast inflation over the length of your retirement, or alternatively, acquire an inflation-indexed annuity fully linked to the adjusted and readjusted CPI, without any imposed caps, you may not be covering the true value erosion that ensues. (Note that a fully inflation-indexed annuity begins with annual payments approximately 25% to 30% lower than a level-payment annuity.) But suppose that these alternatives get you pretty close. That leads to the fourth challenge.
Your cost of living versus the CPI
The CPI measures the change in a general basket of consumer goods. Currently, that basket contains about 200 categories of goods and services comprising 80,000 items. That basket used does not track the basket of a typical retiree, and more importantly, does not track your particular cost of living. The components and, more importantly, the weights applied to those components of the general basket of goods and services used to measure inflation differ significantly from the typical retiree’s basket. Moreover, a retiree’s relevant basket changes considerably over time, and your particular basket may not correlate well with that of the average retiree.
Many retirees want to leave a bequest. Many simply leave what remains, if anything, after expending what is needed during their remaining lifetimes. This sets up a potential conflict of interest. Those heirs who are sacrificing and providing significant assistance to you in your senior years will likely receive less and less the longer you live, and perhaps may even wind up paying for your living and burial expenses when you run out of money. This is particularly likely if you follow a retirement strategy without lifetime income guaranties of annuities, because you and they will be much more exposed to the risks of you outliving your income.
On the other hand, if you annuitize the bulk of your wealth, there probably won’t remain anything for them at all unless you get a lifetime annuity with a “period certain” payout of say, five, ten or twenty years. In that case, your heirs may receive something, but probably not if you survive the stipulated period. Moreover, you will receive significantly lower monthly payments during the rest of your life for having opted such a period certain payout provision, especially if you select a period certain longer than ten years.
Liquidity sufficient to cover extraordinary events
To the extent your monthly income is generated from pensions and annuities, it will be essentially level, for all practical purposes. However, living expenses are not level at times, so you will need to set aside additional funds to handle such expenses. Those funds must be available when needed, and not subject to significant losses occasioned by the caprices of the marketplace.
Tax – confiscation of wealth
The Federal income tax has morphed into a wealth tax in some ways. I’ll discuss the tax implications of my strategy later.
If you have accumulated a reasonable sum of money to fund your retirement, you are also a target for someone else – a person or an institution – to try and transfer it to them. This often occurs through litigation. Even if you prevail in a lawsuit, the costs of litigation can take a sizable chunk out of your retirement savings.
Diminishing investment acumen with age
Studies have documented the decreasing investment acumen that we suffer as we age. A recent study showed that people over the age of 60 average about 3% to 5% lower returns on their investment portfolio each year than those younger, even after adjusting their portfolios to the same risk levels and taking into account experience. Performance deteriorates especially quickly after age 70. I recognize that as I age, I too am likely to succumb to diminished investment prowess. Besides, I do not wish to spend my retirement years pouring over company financials and reports of dubious value.
What about the kids?
One of the most difficult situations in which older people find themselves occurs when there are others trying to get their hands on your hard-earned money.
Let’s face it. Some of us get rather feeble as we age, and our judgment sometimes lapses. We become vulnerable to impassioned pleas from others to “ante up” our savings to them. This vulnerability is particularly strong in connection with our caregivers who often are members of our own family. How many aged people have lost everything in such situations, even to well-intentioned recipients? Whatever portion of your wealth is annuitized becomes less prone to these kinds of incursions. Moreover, having full access to all of your wealth at once greatly increases your risk of overspending.
Our Retirement Funding Strategy
Our personal strategy is to get on base, not swing for the fences. (Too many of my colleagues have done the latter and are back in the dugout, or worse.) It addresses each of the aforementioned retirement risks in various ways. None of our approaches is without at least some risk, of course.
Our strategy is simple, and one that I should be able to easily manage as I age. Our qualified assets (tax-deductible savings) are mostly in two asset classes: TIPS and Stable Value Funds. The TIPS grow each year by their stated coupon rate as well as inflation. We also have saved a lot in Stable Value Funds, which maintain their values and feature good yields. We are not taxed on either until we begin to withdraw for consumption purposes. These two asset categories allow us to handle extraordinary expenses, such as a new car, new roof, as well as unforeseeable expenses. We also have small positions in equities and high-yield debt, but if we lose it all, we won’t be hurting.
The bulk of our savings is in unqualified assets. Most is in deferred fixed annuities – 13 in all. Two are in indexed annuities that provide an annual floor return of 0%, but also give a limited upside based on how the stock market behaves, subject to an annual cap. What is less common, however, is how we have structured them.
We handle the insolvency risk in three ways. First, the annuities that we have purchased are all from companies with superior credit ratings. Second, they are diversified across many companies so that our exposure to any one company is limited. Third, most of them are in amounts below the Pennsylvania Life and Health Insurance Guaranty Association limits. Depending on the state in which you live, this guaranty is limited to between $100,000 and $500,000 per policyholder.
My wife and I purchase most of our annuities separately, thereby doubling the amount covered within the guaranty limits. She will inherit all annuities that are not in payout status if I go first, as well as have sufficient life insurance to augment her assets, if necessary. That will compensate for the fact that some of the annuities in payout status expire when I do, but in the interim, we get about 15% more income than if they were in joint payout status.
Half of them will be annuitized when we retire, providing us with lifetime income sufficient to maintain our lifestyle. The other six will continue to be held in deferral, exchanged upon maturity into other deferred annuities. However, at any time they can be either liquidated (in the unlikely event that our extraordinary expenses exceed TIPS and Stable Value assets) or annuitized only when necessary, due to the erosion of the purchasing power of the level payment stream generated by the seven annuities in payout status.
Inflation risk is the second most important risk for most retirees who live beyond a few years. We handle it in five ways.
- Only one of our annuities has a remaining maturity beyond six years. Surrender fees are quite low and for any rise in interest over 1%, we can pay the surrender fee and redeploy those assets into any other deferred annuity offering higher yields. While we could lose money on the transaction, it will quickly be made up with the new annuity. Also, yields received in the interim on the deferred annuities greatly exceed what is offered on money market funds.
- The annuities in deferral continue to grow tax deferred. Most grow at 3% to 6.5% per year.
- Our primary inflation hedge is that for each year they remain in deferral, we get not only a higher amount to eventually annuitize, if needed, but because of our increasing ages we also receive higher “mortality credits” – the repayment of principal baked into the payout rates that are designed to return all of your principal over your expected remaining lifetime. If my wife or I live beyond our expected lifetime, the mortality credits come from someone else who logged off early. If I exit early and leave some mortality credits on the table from those annuities already in payout status under my name, I will not have any remorse. I will be dead! My wife will be able to quickly make up for any income insufficiencies with the annuities remaining in deferral, along with my whole life insurance policy. These mortality credits are substantial, and grow quickly with age. Together with the interest credited annually to annuities in deferral, they are able to serve as an excellent income hedge against all but the worst kind of inflation. The lifetime annual payout rate can grow by 10%, 15%, and 20%. When added to the increased annuity value that accrues during the deferral period, a relatively small annuity can dwarf the size of payments from those already annuitized.
- Recall that all of our qualified savings are in TIPS, which keep pace with officially reported inflation, and Stable Value Funds that are not subject to capital losses when inflation rises, because we can withdraw them at book value at any time.
- Finally, we won’t access Social Security until I reach age 70, allowing us to have the highest basis subject to annual inflation adjustments throughout out lives.
I call our approach “staggered annuitization” rather than “laddered annuitization,” which is an approach already well understood. The reason not to ladder annuities is that we cannot predict our personal cost of living very well. Remember that hedging against general inflation is not really the goal here. We need to hedge against our personal cost of living. Because mortality credits grow at an increasing rate as we age, there is a built-in incentive to delay annuitization of our remaining annuities until we simply cannot maintain our desired lifestyle anymore without turning on another annuity.
The annuities address the bequest challenge in three ways. First, by foregoing the annuitization of half of our annuities, the remaining six are all inheritable, as well as our TIPS and Stable Value Funds. Second, by having a plan that will provide increasing income through our lifetimes, we are able to transfer funds to our children prior to our demise. Third, they are unlikely to ever have to sacrifice their own needs to cover for our poor planning.
As for taxes, we handle that in several ways. Our annuities grow tax deferred, as do our qualified Stable Value assets and TIPS. When the annuities are converted into payout status, 40% to 85% of the income is excluded from tax, depending on their basis. This will help keep us below the maximum tax rate thresholds.
In most states, annuities are not subject to attachment or confiscation in litigation. Some states have high limits for this protection, others have unlimited protection.
We are also sensitive to our likely diminishing investment acumen over time, but have set things up in such a way that the performance of the various asset classes we have chosen will not depend much upon any further choices that we make. The only real susceptibility we will be exposed to is in the selection of replacement annuities when the annuities in deferral mature. But we have help there too. The annuities we have chosen are plain vanilla fixed deferred annuities, except for the two indexed annuities that we purchased.
The other main choice that my wife and I will have to make going forward is how long we can continue to maintain our lifestyle before annuitizing another one of our remaining annuities. Our monthly budget numbers will guide us. Also, there is no reason for us to necessarily convert the remaining annuities into a life annuity. For example, if we learn that we are subject to a terminal illness, we might choose instead to annuitize over a period certain, the residual of which our heirs could inherit. This would also provide accelerated income over our remaining lifetimes.
As for protection from the kids, fortunately we don’t have those kind of kids! They are the most loving and supportive children and sons-in-law that one could ever want. They understand and enthusiastically support our strategy, and especially appreciate getting some of their legacy at the time of their greatest need. But even if they were the kind of children to be concerned about, the difficulty of accessing and liquidating the deferred annuities gives some additional measure of protection, and they simply cannot access the annuities in payout status.
For the complete version of Dr. Babbel’s article with greater detail and ideas on how to put the “Staggered Annuity” concept into your practice please visit