Forget fund values – income is all that matters, and it should and can be delivered through scalable annuitisation and drawdown strategies tailored to the individual’s needs, without the necessity of delivering full financial advice. ...
Confusing the need for a pot of money with the need for income can lead to very expensive mistakes. “You cannot say wealth goals are approximate to income goals. Imagine you are a 45 year old and you are going to retire at 65. In returns of income, what is the risk free asset? It is an asset, fully guaranteed, that 20 years from now starts paying you a level income for the rest of your life, corrected for inflation. I created one of those, called a real annuity, and from 2003 to 2012 I ploughed the monthly returns and we saw swings of -17 per cent and +15 per cent, on a risk-free asset. Yet when you measure this asset in terms of income, there’s no risk. So when someone says we can approximate an income goal with a wealth goal, as a practical matter, it doesn’t even come close,” says Robert Merton.
Merton argues that the culture of interpreting pensions in terms of fund values has developed because the Defined Contribution retirement sector has emerged from the mutual fund industry. “The government benefit doesn’t give you a pot. The most intuitive thing for people is income. Income correlates with standard of living, in every aspect. Even in Pride and Prejudice, when Jane Austen evaluates Darcy and all the other men, she didn’t say he was worth £200,000. She said he was worth £10,000 a year,” he says.
Merton envisions a DC retirement system whereby the focus is shifted towards achieving the real, inflation-corrected retirement income that retirees need. That means a move away from the risk concept typical in current DC schemes of investment risk or capital loss and the volatility of returns, towards income outcomes.
Individuals’ own tailored strategies can be assessed by asking four key questions – what is your desired income target; what is the minimum income that would be acceptable if you do not reach your desired target; how much money are you willing to contribute on top of employer contributions and when do you plan to retire.
Forget fund values – income is all that matters, and it should and can be delivered through scalable annuitisation and drawdown strategies tailored to the individual’s needs, without the necessity of delivering full financial advice. ...
Confusing the need for a pot of money with the need for income can lead to very expensive mistakes. “You cannot say wealth goals are approximate to income goals. Imagine you are a 45 year old and you are going to retire at 65. In returns of income, what is the risk free asset? It is an asset, fully guaranteed, that 20 years from now starts paying you a level income for the rest of your life, corrected for inflation. I created one of those, called a real annuity, and from 2003 to 2012 I ploughed the monthly returns and we saw swings of -17 per cent and +15 per cent, on a risk-free asset. Yet when you measure this asset in terms of income, there’s no risk. So when someone says we can approximate an income goal with a wealth goal, as a practical matter, it doesn’t even come close,” says Robert Merton.
Merton argues that the culture of interpreting pensions in terms of fund values has developed because the Defined Contribution retirement sector has emerged from the mutual fund industry. “The government benefit doesn’t give you a pot. The most intuitive thing for people is income. Income correlates with standard of living, in every aspect. Even in Pride and Prejudice, when Jane Austen evaluates Darcy and all the other men, she didn’t say he was worth £200,000. She said he was worth £10,000 a year,” he says.
Merton envisions a DC retirement system whereby the focus is shifted towards achieving the real, inflation-corrected retirement income that retirees need. That means a move away from the risk concept typical in current DC schemes of investment risk or capital loss and the volatility of returns, towards income outcomes.
Individuals’ own tailored strategies can be assessed by asking four key questions – what is your desired income target; what is the minimum income that would be acceptable if you do not reach your desired target; how much money are you willing to contribute on top of employer contributions and when do you plan to retire.
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
1.The problem is that by focusing solely on income you can end up buying products that have a negative total return and in the long run that isn't sustainable.
Reply 1: Merton is talking about retirement income outcomes, which doesn't necessarily mean investing in income investments before retirement.
2. Even in Pride and Prejudice, when Jane Austen evaluates Darcy and all the other men, she didn’t say he was worth £200,000. She said he was worth £10,000 a year,” he says.
Reply 2. Throughout Europe in the 18th and 19th century immediate annuities could protect from a humiliating descent into poverty. It helped protect royalty from poor investments in other markets and from huge gambling losses. I am looking for more of number 1 and 2 and less of number 3 per the full article. Thanks for your research again, Bob.
"Let us endeavor, so to live, that when we die, even the undertaker will be sorry." by Mark Twain.
Reply 2.1 The big problem with looking at income is inflation.
Living on £10,000 a year is now living in poverty.
I don't have a good answer but both steady income and investment growth are probably needed.
3. Hi Bob,
The problem is that it's really hard o predict with any accuracy what level of income may be required. What if you or your spouse have substantial medical expenses that aren't covered by Medicare or other insurance, or need LTC? OK, in an ideal world you would buy insurance to convert all of these risks into predictable expenses, but that may not always be possible or practical. So you may just need a big pile of money, just in case.
In any event, it's very easy to convert account value into income--just sell some of it off. One thing that an annuity does solve is longevity risk. So it's probably worth converting some of your assets into an annuity at retirement. But I don't think that implies that an income stream is all that matters.
Brad
Most of my posts assume no behavioral errors.
4. Re: It’s the income, stupid!
Post by VictoriaF » Wed Aug 21, 2013 7:20 am
The word "stupid" in the title is an insult. A more accurate expression would be "It's the income, biased!" In fact, the widespread preference for assets over income is a manifestation of common cognitive biases.
To be clear, financial advisers and money managers prefer their clients to have assets. After all, they are paid for the assets under management (AUM), not for the income under management. Ironically, the clients also tend to overestimate the value of assets.
Behavioral economists have uncovered many happiness biases:
i. Experiences make people happier than possessions, and yet people tend to overspend on things.
ii. People are notoriously bad predictors of how miserable a major disaster (or how happy a major achievement) would make them feel.
iii. Experiments show that people are more happy when good things are split into small portions and spread over time than when they receive it all at once. Similarly, they are happier when a major calamity takes place in one installment and is not delivered in pieces. Yet, people persistently choose the opposite of what would make them happy.
The last item (iii) explains why income makes people happier than assets, and why most people resist it.
Victoria
Behavioral economists have uncovered...
3. Experiments show that people are more happy when good things are split into small portions and spread over time than when they receive it all at once.
When giving me a cash gift, my dad would alway say "Don't spend it all in one place." And my mom would say "Don't let the money burn a hole in your pocket."
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
4. 
bertilak wrote:
Bobcat,
Thanks for the link. I agree that income is king to a retiree and believe Merton et. al. (and their predecessors) are making an important point. I myself repeat the "worth $XXX per year" story.
One thing that is new to me: The idea that one can do something about this well BEFORE retirement. I had always looked at it as how to apply one's accumulated nest egg DURING retirement and that this was a different consideration than how to build that nest egg. I was hoping to see something to tell me about that. Even though I am already retired it could give me some insight and it would be nice if younger accumulators heard about better ways to prepare for retirement.
But, the article is short on practical advice. It seems more like an advertisement for DFA. ...
Reading on, there isn't really much said that is actionable...
The practical advice.
Assuming you plan to retire in your mid-60s then sometime between the ages of 40 & 50 you need to seriously plan for retirement. You pick two retirement income goals. An aspirational level of real retirement income and a lower floor level of real retirement income. Price both income goals by using the price of real annuities at your retirement target age, e.g age 65. Fund the floor income level with TIPS that mature when you are 65 and I-bonds. This is a TVM problem.
TIPS maturing at age 65 you hold now and Ibonds you hold now is PV.
FV is level of TIPS maturing at age 65 plus Ibonds held at age 65.
PMT is amount you intend to save each year in TIPS maturing at age 65 and Ibonds
i is real interest rate on TIPS & Ibonds
n is # of years until retirement
Adjust PV & PMT to reach FV goal.
Adjust above each year for changes in annuity prices caused mainly by changes in real interest rates and changes in longevity at age 65.
Manage the remainder of your retirement portfolio so that its expected value gets you from the floor income to the aspirational income goal. If the rest of the retirement portfolio does better than expected, then take the windfall and move it to safe assets to raise the safe retirement income floor. If the rest of the portfolio does worse than expected, you will need to save more, retire later, take more risk, or lower the aspirational retirement income goal. :(
For most Americans SS will provide roughly 50% of their aspirational retirement income goal. Their personal investments need to supply the other half. The safe floor might be something like SS and 20% more with the remaining AA of retirement assets getting them to 100% of the aspirational retirement income goal. Safe retirement income can come from TIP ladders and Ibonds as well as annuities. Not all retirement income needs to come from safe assets. But at a minimum your retirement income floor goal should be met with safe assets.
BTW this DFA plan is not available to individuals. It is only available to participants in 401k plans, 403b plans, 457 plans etc. that are managed by DFA.
BobK
before there were defined contribution (DC) retirement plans there were company pension plans that provided known (defined benefit) retirement income streams. Since DC retirement plans are dominated by mutual fund companies, the focus has shifted from retirement income to the level of financial assets at retirement. Defined contribution retirement plans (401ks, 403bs, 457s, IRAs, etc.) are a misnomer. A better description would be self-directed pension plans. That description would put the focus back on retirement income, where it belongs.
History of Annuities
Although annuities have only existed in their present form for a few decades, the idea of paying out a stream of income to an individual or family dates clear back to the Roman Empire. The Latin word "annua" meant annual stipends and during the reign of the emperors the word signified a contract that made annual payments. Individuals would make a single large payment into the annua and then receive an annual payment each year until death, or for a specified period of time. The Roman speculator and jurist Gnaeus Domitius Annius Ulpianis is cited as one of the earliest dealers of these annuities, and he is also credited with creating the very first actuarial life table. Roman soldiers were paid annuities as a form of compensation for military service. During the Middle Ages, annuities were used by feudal lords and kings to help cover the heavy costs of their constant wars and conflicts with each other. At this time, annuities were offered in the form of a tontine, or a large pool of cash from which payments were made to investors. As investors eventually died off, their payments would cease and be redistributed to the remaining investors, with the last investor finally receiving the entire pool. This provided investors the incentive of not only receiving payments, but also the chance to "win" the entire pool if they could outlive their peers. European countries continued to offer annuity arrangements in later centuries to fund wars, provide for royal families and for other purposes. They were popular investments among the wealthy at that time, due mainly to the security they offered, which most other types of investments did not provide. Up until this point, annuities cost the same for any investor, regardless of their age or gender. However, issuers of these instruments began to see that their annuitants generally had longer life expectancies than the public at large and started to adjust their pricing structures accordingly.
Annuities came to America in 1759 in the form of a retirement pool for church pastors in Pennsylvania. These annuities were funded by contributions from both church leaders and their congregations, and provided a lifetime stream of income for both ministers and their families. They also became the forerunners of modern widow and orphan benefits. Benjamin Franklin left the cities of Boston and Philadelphia each an annuity in his will; incredibly, the Boston annuity continued to pay out until the early 1990s, when the city finally decided to stop receiving payments and take a lump-sum distribution of the remaining balance. But the concept of annuities was slow to catch on with the general public in the United States because the majority of the population at that time felt that they could rely on their extended families to support them in their old age. Instead, annuities were used chiefly by attorneys and executors of estates who had to employ a secure means of providing for beneficiaries as specified in the will and testament of their deceased clients. Annuities did not become commercially available to individuals until 1812, when a Pennsylvania life insurance company began marketing ready-made contracts to the public.
THE EARLY HISTORY OF ANNUITIES
Not surprisingly, since uncertainty about length of life is a ubiquitous source of risk, financial contracts similar to annuities have a long history. James (1947) reports that ancient Roman contracts known as annua promised an individual a stream of payments for a fixed term, or possibly for life, in return for an up-front payment. Such contracts were apparently offered by speculators who dealt in marine and other lines of insurance. A Roman, Domitius Ulpianus, compiled the first recorded life table for the purpose of computing the estate value of annuities that a decedent might have purchased on the lives of his survivors.
Single-premium life annuities were available in the Middle Ages, and detailed records exist of special annuity pools known as tontines that operated in France during the 17th century. In return for an initial lump-sum payment, purchasers of tontines received life annuities. The amount of the annuity was increased each year for the survivors, as they claimed the payouts that would otherwise have gone to those who died. When the second-to-last participant in a tontine pool died, the sole survivor received the entire remaining principal. The tontine thus combined insurance with an element of lottery-style gambling.
During the 1700s, governments in several nations, including England and Holland, sold annuities in lieu of government bonds. The government received capital in return for a promise of lifetime payouts to the annuitants. Murphy (1939) provides a detailed account of the sale of public annuities in England in the 18th and early 19th centuries. Annuities initially were sold to all individuals at a fixed price, regardless of their age or sex. As it became clear over time that mortality rates for annuitants were lower than those for the population at large, a more refined pricing structure was introduced.
In the United States, annuities have been available for over two centuries. In 1759, Pennsylvania chartered the Corporation for the Relief of Poor and Distressed Presbyterian Ministers and Distressed Widows and Children of Ministers. It provided survivorship annuities for the families of ministers (see James 1947). In Philadelphia in 1812, the Pennsylvania Company for Insurance on Lives and Granting Annuities was founded. It offered life insurance and annuities to the general public and was the forerunner of modern stock insurance companies.
That life annuities were often purchased from the government instead of insurance companies in the 18th and 19th century does not change the fact that life annuities could be purchased in Europe during that time period.
BobK[/quote]
Not the point.
Life estates in property were well known in the law. But these were simple annual payments not modern annuities. You can call a tail a leg but it does not make it one.
annuities at that time grew out of Tontines. The relationship between tontines and Modern annuities is explored in a recent article. http://ir.lawnet.fordham.edu/cgi/viewco ... ntext=jcfl
This is silly. Life and casualty insurance did not exist 200 years ago exactly as they do now. Neither did stock or bond markets or life annuity markets. But in all cases there were something like today's markets operating. The oldest of all these were the life annuity markets, which have been around since the Middle Ages - long before European stock markets.
It wasn't just actuarial science that was in its infancy 200 years ago. The same can be said for all of finance.
BTW you can purchase life annuities today that make annual rather than monthly payments.
BobK
I like the part of the article where Merton and Greenwood talk about current DC retirement plans.
They obliquely note that when a provider discusses the hi-lites of a DC plan what is talked up is how much you can contribute, the company match, the tax advantages of the plan, and the return rates you 'may' get. What is rarely mentioned is the output of the plan in retirement. :wink:
It is as though providers and policymakers are scared to tell people just how little they are going to get for fear they will leave their scheme immediately.
This approach, says Merton, is not only misguided, but also dishonest and irresponsible. “From a regulator, politician or employer’s point of view there will never be a time when it’s a good time to tell them the truth,” he says. ...
He argues a dose of honesty might not be as unpleasant as we might think. “For young people who say they don’t want to save now, the message is that one way or another they are going to have to pay for their retirement, so they may as well start early and make the most of tax breaks and employer contributions. That way they will have more to spend in your thirties, forties and fifties.” ...
“All these people coming to pensions for the first time are virgins. That is a good thing because you can take them and say what income they are going to get. Yes there is a page saying what the fund is worth if they liquidate it, but that is at the back, not at the front. “Take these virgins and don’t let them learn bad habits. Particularly for the groups that matter most, talk to them about income. If you don’t do this right, everything you have to do is going to be an uphill battle.
The government taxes income not assets, so assets are better than income in that regard.
6. evett wrote:
The title of the piece echoes a very famous piece of advice James Carville gave to William Jefferson Clinton: "The economy, stupid." The advice is just as useful now.
The phrase has become a snowclone repeated often in American political culture, usually starting with the word "it's" and with commentators sometimes using a different word in place of "economy." One of my favorite uses of this snowclone is a health economics paper.
From the conclusion.
In 2000 the United States spent considerably more on health care than any other country, whether measured per capita or as a percentage of GDP. At the same time, most measures of aggregate utilization such as physician visits per capita and hospital days per capita were below the OECD median. Since spending is a product of both the goods and services used and their prices, this implies that much higher prices are paid in the United States than in other countries. But U.S. policymakers need to reflect on what Americans are getting for their greater health spending. They could conclude: It’s the prices, stupid.
7. Well, for me they'll be inadequate for my goals, and what will compensate for that is my elective retirement savings that I control. If my elective retirement contributions are forced into essentially the same system, it's unclear to me the results will be substantially different. I have nothing against annuities per se, but aside from SS and noncontributory employer plans, I prefer them to remain an option in terms of when and how much I choose to participate, not what some professor somewhere thinks is best for me, or even worse, some politician. :)
Don't do something. Just stand there!
8. What matters is the risk to your standard of living, not the risk to your portfolio. Your standard of living is mainly determined by your income. The problem with using assets as a proxy for income is that a given level of assets will produce wildly different income flows depending on the level of real interest rates and other factors.
9. Well, for me they'll be inadequate for my goals, and what will compensate for that is my elective retirement savings that I control. If my elective retirement contributions are forced into essentially the same system, it's unclear to me the results will be substantially different. I have nothing against annuities per se, but aside from SS and noncontributory employer plans, I prefer them to remain an option in terms of when and how much I choose to participate, not what some professor somewhere thinks is best for me, or even worse, some politician. :)
Reply 9. There is nothing in the plan Merton is discussing that forces you to annuitize. You are encouraged to annuitize at least part of your 401k at retirement, but you are not forced to annuitize anything. The main point is that the plan assesses the adequacy of your retirement planning by how much income you can expect in retirement. This is ascertained how much income you would have by annuitization at retirement - not by the expected level of financial assets you will have acquired at retirement.
Once you have determined your retirement income goal the plan is developed so that your savings, portfolio risk level, and retirement date are adjusted over time to keep you on track to reach your retirement income goal.
Confusing the need for a pot of money with the need for income can lead to very expensive mistakes. “You cannot say wealth goals are approximate to income goals. Imagine you are a 45 year old and you are going to retire at 65. In returns of income, what is the risk free asset? It is an asset, fully guaranteed, that 20 years from now starts paying you a level income for the rest of your life, corrected for inflation. I created one of those, called a real annuity, and from 2003 to 2012 I ploughed the monthly returns and we saw swings of -17 per cent and +15 per cent, on a risk-free asset. Yet when you measure this asset in terms of income, there’s no risk. So when someone says we can approximate an income goal with a wealth goal, as a practical matter, it doesn’t even come close,” says Robert Merton.
Merton argues that the culture of interpreting pensions in terms of fund values has developed because the Defined Contribution retirement sector has emerged from the mutual fund industry. “The government benefit doesn’t give you a pot. The most intuitive thing for people is income. Income correlates with standard of living, in every aspect. Even in Pride and Prejudice, when Jane Austen evaluates Darcy and all the other men, she didn’t say he was worth £200,000. She said he was worth £10,000 a year,” he says.
Merton envisions a DC retirement system whereby the focus is shifted towards achieving the real, inflation-corrected retirement income that retirees need. That means a move away from the risk concept typical in current DC schemes of investment risk or capital loss and the volatility of returns, towards income outcomes.
Individuals’ own tailored strategies can be assessed by asking four key questions – what is your desired income target; what is the minimum income that would be acceptable if you do not reach your desired target; how much money are you willing to contribute on top of employer contributions and when do you plan to retire.
Forget fund values – income is all that matters, and it should and can be delivered through scalable annuitisation and drawdown strategies tailored to the individual’s needs, without the necessity of delivering full financial advice. ...
Confusing the need for a pot of money with the need for income can lead to very expensive mistakes. “You cannot say wealth goals are approximate to income goals. Imagine you are a 45 year old and you are going to retire at 65. In returns of income, what is the risk free asset? It is an asset, fully guaranteed, that 20 years from now starts paying you a level income for the rest of your life, corrected for inflation. I created one of those, called a real annuity, and from 2003 to 2012 I ploughed the monthly returns and we saw swings of -17 per cent and +15 per cent, on a risk-free asset. Yet when you measure this asset in terms of income, there’s no risk. So when someone says we can approximate an income goal with a wealth goal, as a practical matter, it doesn’t even come close,” says Robert Merton.
Merton argues that the culture of interpreting pensions in terms of fund values has developed because the Defined Contribution retirement sector has emerged from the mutual fund industry. “The government benefit doesn’t give you a pot. The most intuitive thing for people is income. Income correlates with standard of living, in every aspect. Even in Pride and Prejudice, when Jane Austen evaluates Darcy and all the other men, she didn’t say he was worth £200,000. She said he was worth £10,000 a year,” he says.
Individuals’ own tailored strategies can be assessed by asking four key questions – what is your desired income target; what is the minimum income that would be acceptable if you do not reach your desired target; how much money are you willing to contribute on top of employer contributions and when do you plan to retire.
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
1.The problem is that by focusing solely on income you can end up buying products that have a negative total return and in the long run that isn't sustainable.
Reply 1: Merton is talking about retirement income outcomes, which doesn't necessarily mean investing in income investments before retirement.
2. Even in Pride and Prejudice, when Jane Austen evaluates Darcy and all the other men, she didn’t say he was worth £200,000. She said he was worth £10,000 a year,” he says.
Reply 2. Throughout Europe in the 18th and 19th century immediate annuities could protect from a humiliating descent into poverty. It helped protect royalty from poor investments in other markets and from huge gambling losses. I am looking for more of number 1 and 2 and less of number 3 per the full article. Thanks for your research again, Bob.
"Let us endeavor, so to live, that when we die, even the undertaker will be sorry." by Mark Twain.
Reply 2.1 The big problem with looking at income is inflation.
Living on £10,000 a year is now living in poverty.
I don't have a good answer but both steady income and investment growth are probably needed.
3. Hi Bob,
The problem is that it's really hard o predict with any accuracy what level of income may be required. What if you or your spouse have substantial medical expenses that aren't covered by Medicare or other insurance, or need LTC? OK, in an ideal world you would buy insurance to convert all of these risks into predictable expenses, but that may not always be possible or practical. So you may just need a big pile of money, just in case.
In any event, it's very easy to convert account value into income--just sell some of it off. One thing that an annuity does solve is longevity risk. So it's probably worth converting some of your assets into an annuity at retirement. But I don't think that implies that an income stream is all that matters.
Brad
Most of my posts assume no behavioral errors.
4. Re: It’s the income, stupid!
Post by VictoriaF » Wed Aug 21, 2013 7:20 am
The word "stupid" in the title is an insult. A more accurate expression would be "It's the income, biased!" In fact, the widespread preference for assets over income is a manifestation of common cognitive biases.
To be clear, financial advisers and money managers prefer their clients to have assets. After all, they are paid for the assets under management (AUM), not for the income under management. Ironically, the clients also tend to overestimate the value of assets.
Behavioral economists have uncovered many happiness biases:
i. Experiences make people happier than possessions, and yet people tend to overspend on things.
ii. People are notoriously bad predictors of how miserable a major disaster (or how happy a major achievement) would make them feel.
iii. Experiments show that people are more happy when good things are split into small portions and spread over time than when they receive it all at once. Similarly, they are happier when a major calamity takes place in one installment and is not delivered in pieces. Yet, people persistently choose the opposite of what would make them happy.
The last item (iii) explains why income makes people happier than assets, and why most people resist it.
Victoria
Behavioral economists have uncovered...
3. Experiments show that people are more happy when good things are split into small portions and spread over time than when they receive it all at once.
When giving me a cash gift, my dad would alway say "Don't spend it all in one place." And my mom would say "Don't let the money burn a hole in your pocket."
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
bertilak wrote:
Bobcat,
Thanks for the link. I agree that income is king to a retiree and believe Merton et. al. (and their predecessors) are making an important point. I myself repeat the "worth $XXX per year" story.
One thing that is new to me: The idea that one can do something about this well BEFORE retirement. I had always looked at it as how to apply one's accumulated nest egg DURING retirement and that this was a different consideration than how to build that nest egg. I was hoping to see something to tell me about that. Even though I am already retired it could give me some insight and it would be nice if younger accumulators heard about better ways to prepare for retirement.
But, the article is short on practical advice. It seems more like an advertisement for DFA. ...
Reading on, there isn't really much said that is actionable...
The practical advice.
Assuming you plan to retire in your mid-60s then sometime between the ages of 40 & 50 you need to seriously plan for retirement. You pick two retirement income goals. An aspirational level of real retirement income and a lower floor level of real retirement income. Price both income goals by using the price of real annuities at your retirement target age, e.g age 65. Fund the floor income level with TIPS that mature when you are 65 and I-bonds. This is a TVM problem.
TIPS maturing at age 65 you hold now and Ibonds you hold now is PV.
FV is level of TIPS maturing at age 65 plus Ibonds held at age 65.
PMT is amount you intend to save each year in TIPS maturing at age 65 and Ibonds
i is real interest rate on TIPS & Ibonds
n is # of years until retirement
Adjust PV & PMT to reach FV goal.
Adjust above each year for changes in annuity prices caused mainly by changes in real interest rates and changes in longevity at age 65.
Manage the remainder of your retirement portfolio so that its expected value gets you from the floor income to the aspirational income goal. If the rest of the retirement portfolio does better than expected, then take the windfall and move it to safe assets to raise the safe retirement income floor. If the rest of the portfolio does worse than expected, you will need to save more, retire later, take more risk, or lower the aspirational retirement income goal. :(
For most Americans SS will provide roughly 50% of their aspirational retirement income goal. Their personal investments need to supply the other half. The safe floor might be something like SS and 20% more with the remaining AA of retirement assets getting them to 100% of the aspirational retirement income goal. Safe retirement income can come from TIP ladders and Ibonds as well as annuities. Not all retirement income needs to come from safe assets. But at a minimum your retirement income floor goal should be met with safe assets.
BTW this DFA plan is not available to individuals. It is only available to participants in 401k plans, 403b plans, 457 plans etc. that are managed by DFA.
BobK
History of Annuities
Although annuities have only existed in their present form for a few decades, the idea of paying out a stream of income to an individual or family dates clear back to the Roman Empire. The Latin word "annua" meant annual stipends and during the reign of the emperors the word signified a contract that made annual payments. Individuals would make a single large payment into the annua and then receive an annual payment each year until death, or for a specified period of time. The Roman speculator and jurist Gnaeus Domitius Annius Ulpianis is cited as one of the earliest dealers of these annuities, and he is also credited with creating the very first actuarial life table. Roman soldiers were paid annuities as a form of compensation for military service. During the Middle Ages, annuities were used by feudal lords and kings to help cover the heavy costs of their constant wars and conflicts with each other. At this time, annuities were offered in the form of a tontine, or a large pool of cash from which payments were made to investors. As investors eventually died off, their payments would cease and be redistributed to the remaining investors, with the last investor finally receiving the entire pool. This provided investors the incentive of not only receiving payments, but also the chance to "win" the entire pool if they could outlive their peers. European countries continued to offer annuity arrangements in later centuries to fund wars, provide for royal families and for other purposes. They were popular investments among the wealthy at that time, due mainly to the security they offered, which most other types of investments did not provide. Up until this point, annuities cost the same for any investor, regardless of their age or gender. However, issuers of these instruments began to see that their annuitants generally had longer life expectancies than the public at large and started to adjust their pricing structures accordingly.
Annuities came to America in 1759 in the form of a retirement pool for church pastors in Pennsylvania. These annuities were funded by contributions from both church leaders and their congregations, and provided a lifetime stream of income for both ministers and their families. They also became the forerunners of modern widow and orphan benefits. Benjamin Franklin left the cities of Boston and Philadelphia each an annuity in his will; incredibly, the Boston annuity continued to pay out until the early 1990s, when the city finally decided to stop receiving payments and take a lump-sum distribution of the remaining balance. But the concept of annuities was slow to catch on with the general public in the United States because the majority of the population at that time felt that they could rely on their extended families to support them in their old age. Instead, annuities were used chiefly by attorneys and executors of estates who had to employ a secure means of providing for beneficiaries as specified in the will and testament of their deceased clients. Annuities did not become commercially available to individuals until 1812, when a Pennsylvania life insurance company began marketing ready-made contracts to the public.
THE EARLY HISTORY OF ANNUITIES
Not surprisingly, since uncertainty about length of life is a ubiquitous source of risk, financial contracts similar to annuities have a long history. James (1947) reports that ancient Roman contracts known as annua promised an individual a stream of payments for a fixed term, or possibly for life, in return for an up-front payment. Such contracts were apparently offered by speculators who dealt in marine and other lines of insurance. A Roman, Domitius Ulpianus, compiled the first recorded life table for the purpose of computing the estate value of annuities that a decedent might have purchased on the lives of his survivors.
Single-premium life annuities were available in the Middle Ages, and detailed records exist of special annuity pools known as tontines that operated in France during the 17th century. In return for an initial lump-sum payment, purchasers of tontines received life annuities. The amount of the annuity was increased each year for the survivors, as they claimed the payouts that would otherwise have gone to those who died. When the second-to-last participant in a tontine pool died, the sole survivor received the entire remaining principal. The tontine thus combined insurance with an element of lottery-style gambling.
During the 1700s, governments in several nations, including England and Holland, sold annuities in lieu of government bonds. The government received capital in return for a promise of lifetime payouts to the annuitants. Murphy (1939) provides a detailed account of the sale of public annuities in England in the 18th and early 19th centuries. Annuities initially were sold to all individuals at a fixed price, regardless of their age or sex. As it became clear over time that mortality rates for annuitants were lower than those for the population at large, a more refined pricing structure was introduced.
In the United States, annuities have been available for over two centuries. In 1759, Pennsylvania chartered the Corporation for the Relief of Poor and Distressed Presbyterian Ministers and Distressed Widows and Children of Ministers. It provided survivorship annuities for the families of ministers (see James 1947). In Philadelphia in 1812, the Pennsylvania Company for Insurance on Lives and Granting Annuities was founded. It offered life insurance and annuities to the general public and was the forerunner of modern stock insurance companies.
That life annuities were often purchased from the government instead of insurance companies in the 18th and 19th century does not change the fact that life annuities could be purchased in Europe during that time period.
BobK[/quote]
Not the point.
Life estates in property were well known in the law. But these were simple annual payments not modern annuities. You can call a tail a leg but it does not make it one.
annuities at that time grew out of Tontines. The relationship between tontines and Modern annuities is explored in a recent article. http://ir.lawnet.fordham.edu/cgi/viewco ... ntext=jcfl
This is silly. Life and casualty insurance did not exist 200 years ago exactly as they do now. Neither did stock or bond markets or life annuity markets. But in all cases there were something like today's markets operating. The oldest of all these were the life annuity markets, which have been around since the Middle Ages - long before European stock markets.
It wasn't just actuarial science that was in its infancy 200 years ago. The same can be said for all of finance.
BTW you can purchase life annuities today that make annual rather than monthly payments.
BobK
I like the part of the article where Merton and Greenwood talk about current DC retirement plans.
They obliquely note that when a provider discusses the hi-lites of a DC plan what is talked up is how much you can contribute, the company match, the tax advantages of the plan, and the return rates you 'may' get. What is rarely mentioned is the output of the plan in retirement. :wink:
It is as though providers and policymakers are scared to tell people just how little they are going to get for fear they will leave their scheme immediately.
This approach, says Merton, is not only misguided, but also dishonest and irresponsible. “From a regulator, politician or employer’s point of view there will never be a time when it’s a good time to tell them the truth,” he says. ...
He argues a dose of honesty might not be as unpleasant as we might think. “For young people who say they don’t want to save now, the message is that one way or another they are going to have to pay for their retirement, so they may as well start early and make the most of tax breaks and employer contributions. That way they will have more to spend in your thirties, forties and fifties.” ...
“All these people coming to pensions for the first time are virgins. That is a good thing because you can take them and say what income they are going to get. Yes there is a page saying what the fund is worth if they liquidate it, but that is at the back, not at the front. “Take these virgins and don’t let them learn bad habits. Particularly for the groups that matter most, talk to them about income. If you don’t do this right, everything you have to do is going to be an uphill battle.
The government taxes income not assets, so assets are better than income in that regard.
6. evett wrote:
The title of the piece echoes a very famous piece of advice James Carville gave to William Jefferson Clinton: "The economy, stupid." The advice is just as useful now.
The phrase has become a snowclone repeated often in American political culture, usually starting with the word "it's" and with commentators sometimes using a different word in place of "economy." One of my favorite uses of this snowclone is a health economics paper.
From the conclusion.
In 2000 the United States spent considerably more on health care than any other country, whether measured per capita or as a percentage of GDP. At the same time, most measures of aggregate utilization such as physician visits per capita and hospital days per capita were below the OECD median. Since spending is a product of both the goods and services used and their prices, this implies that much higher prices are paid in the United States than in other countries. But U.S. policymakers need to reflect on what Americans are getting for their greater health spending. They could conclude: It’s the prices, stupid.
7. Well, for me they'll be inadequate for my goals, and what will compensate for that is my elective retirement savings that I control. If my elective retirement contributions are forced into essentially the same system, it's unclear to me the results will be substantially different. I have nothing against annuities per se, but aside from SS and noncontributory employer plans, I prefer them to remain an option in terms of when and how much I choose to participate, not what some professor somewhere thinks is best for me, or even worse, some politician. :)
Don't do something. Just stand there!
8. What matters is the risk to your standard of living, not the risk to your portfolio. Your standard of living is mainly determined by your income. The problem with using assets as a proxy for income is that a given level of assets will produce wildly different income flows depending on the level of real interest rates and other factors.
9. Well, for me they'll be inadequate for my goals, and what will compensate for that is my elective retirement savings that I control. If my elective retirement contributions are forced into essentially the same system, it's unclear to me the results will be substantially different. I have nothing against annuities per se, but aside from SS and noncontributory employer plans, I prefer them to remain an option in terms of when and how much I choose to participate, not what some professor somewhere thinks is best for me, or even worse, some politician. :)
Reply 9. There is nothing in the plan Merton is discussing that forces you to annuitize. You are encouraged to annuitize at least part of your 401k at retirement, but you are not forced to annuitize anything. The main point is that the plan assesses the adequacy of your retirement planning by how much income you can expect in retirement. This is ascertained how much income you would have by annuitization at retirement - not by the expected level of financial assets you will have acquired at retirement.
Once you have determined your retirement income goal the plan is developed so that your savings, portfolio risk level, and retirement date are adjusted over time to keep you on track to reach your retirement income goal.
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