The conventional wisdom, espoused by the popular financial press, is that people should invest the bulk of their retirement savings in mutual funds that invest in stocks and bonds. Over time, the only adjustment said to be necessary is to change the mix, so that it's more heavily weighted toward bonds.
In reality, however, there are a number of reasons why people end up pursuing a different strategy as they approach and enter their retirement years. This alternate strategy often relies upon products with more principal protection.
A less risky approach
One significant reason for this is that the average person cannot tolerate the risks that come with investing in securities. The DALBAR Quantitative Analysis of Investor Behavior examined annualized returns of both stocks and bonds over the last twenty years, a generally favorable period for both, and found that the average investor's realized return lagged the major market indices by more than 5 percent annually. The reason? Poorly timed decisions, often motivated by emotion, regarding when to buy and sell.
Over time, as people age, they tend to become more risk averse. A key reason for this is that, after they retire, the safety net of being able to earn a salary goes away. Thus, they become increasingly aware of their vulnerability, relying upon a finite amount of retirement savings when there are many unknowns. These unknowns include:
- How long will they live? According to the Society of Actuaries' 2000 Annuity Mortality Table, if a husband and wife are both healthy at age 65, the chance that at least one of them will live more than thirty years is greater than 30 percent. Very few people enter retirement with enough savings to support their existing lifestyle for that long.
- What rate of return will they earn? A financial advisor may expect that a mix of stocks and bonds will realize a specific level of investment return in the future. But, no matter what level of return the advisor expects, a retiree cannot rely upon it, because the future may end up looking quite different from the past.
- When will bear markets occur? A key risk that increases after retirement is the sequence of returns. One way to have an 8 percent return over three years is to have a return of 8 percent each year. Another way is to have a 20 percent drop in year 1, followed by a 25 percent gain in each of years 2 and 3. If your clients are leaving their retirement money untouched, they should be relatively indifferent about these two scenarios. However, if they are withdrawing funds annually, the scenario with the fluctuating annual returns is much worse for them. So, the timing of bear markets is an increased risk in retirement.
- What will happen with inflation? If inflation averages 5 percent and one of the retired couple lives for more than 30 years, they would be dealing with prices for everything (including housing, utilities, food, medicine, travel and entertainment) that are four times as high as they are paying today.
- What medical and long term care expenses will they need to cover? Fidelity Investments estimates that a couple retiring this year will need $230,000 to pay for medical expenses throughout retirement, not including any costs associated with nursing home care.
The annuity safety net
Risks like these often cause people to decide to put their money into products that provide safety of principal, with the intent of living off their interest earnings. This, however, has proved to be hard to sustain as interest rates have dropped. For example, the average interest rate on a 3-month bank certificate of deposit has dropped from over 5 percent in January 2008 to less than one-third of 1 percent today.
Thus, we are now seeing many clients flock to the relative certainty of the guaranteed lifetime income benefits available on annuities. The great advantage of these products is that clients can transfer some of the risks that they face to the issuing insurance company. The insurer effectively takes on the longevity and investment risks. Similarly, there insurance products allow customers to transfer — at least to some extent — the inflation, medical expense and long-term care expense risks to insurers.
The heightened risks that clients face during retirement makes them less willing to stick with the conventional wisdom espoused by the popular financial press. This, combined with our current low interest environment has consumers seeking new solutions. Insurance carriers willing to address these risks are finding an eager customer base.
Chris Conklin is a licensed agent and principal and actuary of Insurance Insight Group and MyAnnuityTraining.com. He can be reached at 801-290-3320 or [email protected].
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