Written by John Spitzer, Ph.D. and Todd Houge, Ph.D., CFA
In a recent advice column**, two professional financial advisors addressed the following situation: An 83 year-old widow in OK health recently sold her home and moved into an apartment at a senior residence facility. Including proceeds from the sale, her savings total $500,000. Her monthly expenses are $3,500 of which $800 is covered by Social Security. How should she invest the $500,000?
Both advisors recommended that she hold 2-3 years of expenses or about $100,000 in a liquid account, despite low current yields, to provide for unforeseen circumstances. So the remaining $400,000 must generate $2,700 per month or $32,400 annually. Both advisors were in a quandary over how to achieve the required 8.1% annual return.
Money markets, Treasury securities, and investment grade bonds are out, as their current yields are nowhere near the 8% level. That leaves stocks and other higher risk investments, but both advisors acknowledged that this elderly woman is not in a good position to assume substantial risk. Neither advisor provided a working solution to the problem.
We can identify two fairly simple solutions. A mediocre solution (but still better than merely hoping for the best) is to try to schedule withdrawals of principal so the portfolio provides adequate income over a period exceeding the widow’s life expectancy. We consider this approach mediocre because it poses major difficulties in its implementation.
One major problem is that you must make an assumption about how long the client will live. If the assumption is too aggressive, the client outlives the funding. A common tactic is to choose an age of 105 or 110. But even using an age of 105 does not work very well here.
Let us assume the widow’s advisor expects that she will live to age 105 (a 0.34% probability). Given her funding needs, this goal requires her portfolio to earn more than 5% annually, without anything extra to keep up with inflation. (You can use a mortgage calculator to determine the required fixed-rate yield here – put in $400,000 as the mortgage amount, 22 years term, and have it calculate the rate. We get 5.863%.)
Given current yields, this earnings requirement implies holding investments with significant risk, and thus the possibility of negative returns. With bad luck she could run out of money well before age 105, particularly if the portfolio experiences negative returns in the early years.
A better solution is to buy an immediate annuity from an insurance company. In exchange for a one-time, up-front investment, the annuity would pay her a steady stream of cash for as long as she lives. In essence, she would be buying a pension – ensuring that she cannot outlive her money. Importantly, she can also purchase an annuity that offers protection against inflation.
What would it cost this 83-year old widow to buy an annuity that would pay her $2,700/month, with a 3% annual increase for inflation protection, for the rest of her life? To answer this question, we used the lifetime annuity calculator in NewRetirement.com. The inputs to the calculator are the client’s birthdate (we put in January 1928), gender (female), individual or joint with a spouse (individual), date to begin receiving the annuity (we put June 2011), and investment amount (using trial & error, we put in $320,000).
The calculator returns the lifetime monthly income the client would receive for various options. One of the options is for lifetime income with a 3% increase every year. For this option, the annuity would pay her $2,715 per month in the first year, and then the payment would increase by 3% during the next year, and so on. (If the client were to take the option to receive a fixed monthly payment for life, without any annual increase, the monthly payment would be $3,262.) So the 83-year old widow could buy an annuity for $320,000 that would meet her monthly income needs with a 3% annual increase for inflation. If she purchased such an annuity, she would still have $80,000 in her portfolio to invest in stocks or other higher-risk securities.
We understand why neither advisor mentioned the mediocre solution of withdrawing principle to meet expenses. That’s not a great solution. But why did neither financial advisor mention immediate annuities? Could it relate to the way financial advisors charge for their services? We think it’s possible.
Many advisors charge clients an annual fee as a percentage of the assets under management. Suppose the widow engages an advisor who charges a 1% annual fee. If she does not consider an annuity, the advisor’s fee is 1% of $500,000 or $5,000 annually. If she purchases the annuity, the assets under management are reduced to $182,000, and the annual fee drops to $1,820. The financial advisor has an incentive to avoid recommending the annuity because it will result in lower annual compensation from the client.
There are many good financial advisors who place their clients’ interests first and will not be influenced by incentives that would reward themselves to the detriment of the clients. We know financial advisors who do recommend immediate annuities. But incentives can influence behavior, sometimes unconsciously, and it is important to know how incentives may influence the advice you are given.
(A shorter version of this article appeared in the Spring 2011 Corridor Business Journal Magazine)