By Clayton Browne. Originally published at ValueWalk.
Why Bond Funds Don’t Belong In Retirement Portfolios
August 4, 2015
by Wade Pfau
Income annuities provide payments precisely matched to a client’s longevity while stocks provide opportunities for greater investment growth. The question remains whether clients should hold bond funds in their retirement income portfolio.
To answer that question, I will first look at the role income annuities play in a retirement plan and then see whether bond funds can fulfill that need equally well.
I will use the term income annuities to include single-premium immediate annuities (SPIAs) and other similar products, some of which provide inflation protection.
Managing retirement risks with income annuities
Income annuities can be viewed as a type of coupon-paying bond that provides income for an uncertain length of time and does not repay the principal value upon death. Much like a defined-benefit pension plan, income annuities provide value to their owners by pooling risks across a large base of participants. Longevity risk is one of the key risks that can be managed effectively by an income annuity. Investment and sequence risks are also alleviated through the more conservative investing approach for the underlying annuitized assets. Income annuities support longevity through risk pooling and mortality credits rather than through seeking outsized investment returns.
Longevity risk relates to not knowing how long a given individual will live. But while we do not know the longevity for a particular individual, actuaries can accurately estimate the longevity patterns for a large cohort of individuals. The “special sauce” of the income annuity is that it can provide payouts linked to the average longevity of the participants, because those who die early will subsidize the payments to those who live longer.
Meanwhile, sequence risk relates to the amplified impact that investment volatility has on a retirement-income plan sustaining withdrawals from a volatile investment portfolio. Even though we may expect stocks to outperform bonds, this amplified investment risk also forces a conservative individual to spend less at the outset of retirement in case their early retirement years are hit by a sequence of poor investment returns. As I discussed in an earlier column, many retirement plans are based on Monte Carlo simulations that produce a high probability of success, which implicitly assumes lower investment returns. An income annuity also avoids sequence risk because the underlying assets are invested by the annuity provider mostly into individual bonds, which create income that matches the company’s expenses in covering annuity payments.
In hindsight, those who experienced either shorter lifespans or who benefited from retiring at a time with strong market returns would have preferred if they had not purchased an income annuity. But income annuities are a form of insurance. They provide insurance against outliving one’s assets. In the same vein, someone who purchased automobile insurance might wish they had gone without if they never had an accident. But this misses the point of insurance. We use insurance to protect against low-probability but costly events. In this case, an income annuity provides insurance against outliving assets and not having sufficient remaining income sources.
There is still an important benefit from income annuities even to those who do not survive long into retirement, especially for those who are particularly worried about outliving their assets. That benefit can be seen by comparing it to the alternative of basing retirement spending strictly on a systematic withdrawal strategy from an investment portfolio. In order to “self-annuitize,” a retiree has to spend more conservatively to account for the small possibility of living to age 95 or beyond while also being hit with a poor sequence of market returns in early retirement.
The income annuity supports a higher spending rate and a license to spend more from the outset of retirement.
With regard to sequence risk, those seeking to “self-annuitize” have two options for deciding how to spend from their investments. They could spend at the same rate as the annuity with the hope either of dying before they run out of money or that their investments earn strong enough returns to sustain the higher spending rate indefinitely. This approach requires acceptance of the possibility that one’s standard of living may need to be cut substantially later in retirement should the hopes for sustained investment growth not pan out. The alternative is to spend less early on and increase spending later if good market returns materialize. The problem with this intention to increase spending over time is that it is the reverse of what most people generally wish to do: spend more early in retirement.
Earmarking assets to fund spending with income annuities
The four financial goals for retirement are lifestyle, longevity, liquidity and legacy. I have just discussed how an income annuity potentially enhances lifestyle from the starting point of retirement. As well, longevity is the fundamental reason to partially annuitize assets. But what about liquidity and legacy?
Income annuities do not provide liquidity or legacy without adding costly provisions that reduce the value of the mortality credits. Intuitively, if you are not willing to subsidize the payments to others in the event you die early, then you have no right to earn the subsidies from others in the event
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