Envestnet Whitepapers

Annuities as an Asset Class for Fee-Based Advisors l 9 © Envestnet 2022 Stocks Alternatively, one could seek an investment return higher than 0 percent by including stocks. With a fixed annual investment return of 3.1 percent, the retiree could support the 5 percent spending rate for thirty years. With a 4.2 percent investment return, spending could be supported for forty years. The question then centers around how likely it is for the portfolio to earn these higher rates of return through a stock-heavy focus. Bonds Suppose a retiree wants to stretch the nest-egg over twenty years and will earn 0 percent returns by investing in bonds. We could assume higher bond returns, but that would simply complicate the math without changing the intuition behind the example. Since insurance companies also invest in bonds, higher interest rates would increase the annuity payout rate as well. With 0 percent returns, these bonds allow for spending at 5 percent of the initial portfolio balance—the sustainable spending rate—every year for twenty years. With this spend rate, bonds will leave nothing to support spending beyond year twenty. Income Annuities Now suppose life expectancy is twenty years and longevity risk is added to the equation. Some will not make it twenty years; others will live longer. With the 0 percent returns the annuity provider earns from bonds, the provider could still support this 5 percent spending rate through risk pooling and mortality credits no matter how long the annuitant survives. "Self-annuitization" Now suppose the retiree "self-annuitizes" instead by managing this longevity risk without insurance. This requires picking a planning age one is unlikely to outlive. Suppose the retiree decides to plan under the assumption that retirement will last for thirty years. In this case, to spread assets out over thirty years with a 0 percent investment return, the spending rate must fall to 3.33 percent. Note as well, the spending rate could only be 2.5 percent to support expenses for forty years. In this situation, there is a direct relationship between a longer life and a lower rate of spending. Retirees are forced to spend less to the extent they worry about outliving their portfolio. In terms of an unintended legacy, if one did live for twenty years, then a third of the assets would remain with a thirty-year plan, or half of the assets would remain with a forty-year plan. Compared with an annuity, using bonds leads to a lower than possible retirement lifestyle and potentially an unintentionally large legacy, but with risk for shortfalls for an even longer than planned lifetime. Let us consider a simple example with four different approaches. With the basic understanding in place, we can then dig in deeper.

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