Academic journal article Financial Services Review

A New Strategy to Guarantee Retirement Income Using TIPS and Longevity Insurance

Academic journal article Financial Services Review

A New Strategy to Guarantee Retirement Income Using TIPS and Longevity Insurance

Article excerpt

Abstract

Retirees investing their savings in stocks and bonds face the risk of financial ruin even when withdrawing as little as 4% annually. This paper proposes a new investment strategy using Treasury Inflation Protected Securities and longevity insurance that would guarantee real annual withdrawal rates in excess of 5% without any risk of financial ruin. The strategy can be implemented at minimal cost by retirees and their financial advisers. Institutional providers can use this strategy to offer products that would provide inflation adjusted lifetime incomes and allow retirees to retain control over most of their savings in retirement.

© 2009 Academy of Financial Services. All rights reserved.

JEL classification: D14 (personal finance), G22 (Insurance)

Keywords: Retirement planning; Withdrawal rates; TIPS; Longevity; Financial ruin

1. Introduction

The search for the optimal withdrawal rate, the rate that minimizes the prospect of either having too small a retirement income or running out of money in retirement, is an ongoing quest for retirees and their financial advisers. The current consensus in the literature suggests that retirees can expect to withdraw at a real rate of about 4% of their initial savings by investing in portfolios of stocks and bonds, though even at this rate they face a small risk of financial ruin or running out of money in retirement. The risk of financial ruin increases significantly with higher withdrawal rates.

Economists have long contended that retirees can get higher withdrawal rates and lifetime protection from ruin by buying immediate lifetime annuities with their entire savings, rather than investing in securities and living off the income and principal. However, for reasons discussed later, immediate lifetime annuities have not been popular with retirees; it is estimated that less than 2% of retirees annuitize their retirement savings. On the other hand, the need for assured lifetime incomes has become more acute as life expectancies increase and has spurred demand for annuities such as 'longevity insurance' or deferred annuity products.

In this paper, I propose a new financial strategy using a combination of inflation protected securities and longevity insurance (or deferred annuities) that would allow retirees to enjoy real withdrawal rates substantially higher than the 4% suggested above. More significantly, the strategy would allow the retiree to earn these higher rates without any risk of financial ruin. The retirees would be assured a predetermined lifetime real income, similar to the income from social security and most defined benefit pension plans. In addition, the strategy would allow retirees to maintain discretionary control over a large part of their savings in retirement.

This new investment strategy does not require active portfolio or withdrawal rate management. The annual withdrawal or income over the retiree lifetime would be determined at retirement, based solely on the prevailing prices for inflation protected securities and longevity insurance products, and would not be affected by subsequent changes in asset prices and returns over the retirement period. The strategy is relatively easy to adopt and can be managed by retirees and their financial advisers. It can also be used by institutional providers as the basis for products that would package investment management and longevity insurance and provide lifetime incomes to retirees without requiring them to buy an immediate annuity with their entire savings.

2. Literature review

The early literature on determining sustainable withdrawal rates starts with the assumption that retirees prefer to adopt a passive approach in managing their retirement portfolios; that is, they select a fixed withdrawal rate (based on their aversion to financial ruin), make the appropriate asset allocation, and then receive an income stream over a fixed number of years, say 20 to 35 years. …

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