The Benefits Of Partial Annuitization Using A Single Premium Immediate Annuity (SPIA)
The seminal paper demonstrating the benefits of annuitizing a portion of a retiree's portfolio was "Making Retirement Income Last A Lifetime" by Ameriks, Veres, and Warshawsky in the Journal of Financial Planning in 2001. Building from the roots of Bill Bengen's "safe withdrawal rate" approach, the researchers examined the benefits of partially annuitizing 25% or 50% of the client's portfolio into a single premium immediate annuity SPIA), versus just holding a stock/bond allocation, assuming a 4.5% withdrawal rate (deliberately selecting a withdrawal rate that would have at least some risk of failure, to see if annuitization enhanced the results).
The approach in the research was fairly straightforward - retirees would rely on the annuitized funds for spending cash flows in the early years, and only increase withdrawals from the portfolio as necessary in later years to keep up with inflation. Accordingly, the portfolio would not need to be tapped as much for distributions in the early years, which would allow the retiree to defend against liquidating during a potentially unfavorable sequence of returns in the early years (as an extended period of mediocre returns in the first half of retirement while ongoing withdrawals are occurring is the primary risk for a retiree ).
The results were rather striking; on a Monte Carlo basis, the 4.5% withdrawal rate for a moderate growth portfolio had a 12.6% risk of depletion, while annuitizing 25% of the assets dropped the risk of failure to 7.8% and annuitizing half the portfolio dropped it down to only 3.3%. Similar results were seen whether the time period was shorter or longer (though obviously, the longer overall time period, the greater the probability of failure across all approaches). In fact, over long time horizons, the results were so favorable that not only were the probabilities of success higher, but for conservative portfolios the median wealth was actually slightly higher in the annuitization scenarios than the non-annuitization scenarios; in other words, even though the retirees surrendered the liquidity of their annuities up front, if their retirement lasted long enough the non-annuitized half of the conservative portfolio actually grew larger than if the retiree just kept the entire conservative portfolio invested and taking withdrawals in the first place! (Though for the aggressive growth portfolios, median wealth was higher by just investing it all.)
The results of Ameriks et. al. were hailed as a major breakthrough supporting the value of partial annuitization; Google Scholar notes that the paper has been cited at least 68 times since it was published. On the one hand, the conclusions seemed almost intuitively obvious: supporting retirement with annuitization in the early years so that the portfolio only had to support material withdrawals in later years was essentially a bucketing approach that reduced exposure to sequence risk for the portfolio investments, while racking up mortality credits from the SPIA along the way. On the other hand, though, the reality is that relying on the fixed portion of the portfolio in the early years doesn't necessarily require using a SPIA in the first place, and it wasn't entirely clear how much was due to SPIA mortality credits, and how much was just a creative liquidation strategy!
The Flaws Of SPIA Partial Annuitization Research
Viewed from a total wealth perspective, the reality of the Ameriks et. al. study (and others like them) is that as withdrawals are funded by a SPIA in the early years while the portfolio is allowed
to grow, the retiree's asset allocation actually shifts over time. For instance, imagine a simplified scenario where Investor A holds $500,000 in stocks and $500,000 in bonds, while Investor B holds $500,000 in stocks and puts the other $500,000 into a SPIA. According to the Ameriks research, Investor B should come out with a more sustainable retirement income, due in large part to the fact that withdrawals from equities will be diminished during the early years, as the SPIA covers most of the withdrawal needs. Yet if we advance this scenario forward by 15 years, the equities will have likely risen (with long-term growth investments and a relatively small level of ongoing withdrawals), while the implied value of the SPIA will have declined (as the value goes down when the retiree doesn't have as many remaining years to live and receive payments); thus, if the portfolio is up to $700,000 (given some growth but some withdrawals), while the remaining payments of the SPIA are only worth $300,000, then the client's asset allocation is actually now 70/30 (where the 70% is liquid stocks and the 30% is the present value of the remaining annuity payments). The end result: the stocks/SPIA scenario may have started out as being 50/50, but the asset allocation has shifted up to 70/30 due to the liquidation strategy, while the 50/50 portfolio was assumed to remain at 50/50. As the years go by, the percentage of total wealth allocable to stocks would continue to rise, as shown below.
The reason this matters is that, for the purely-portfolio-based retiree, there's no reason why the same strategy couldn't be implemented without a single premium immediate annuity. In other words, if there's a benefit to disproportionately liquidating bonds in the early years and letting the stocks run, and then liquidating the stocks later, this could be done simply by using a generic 50/50 portfolio that automatically takes/most all of its withdrawals from the bonds in the early years and allows its equity exposure to rise steadily over time, mimicking the total wealth asset allocation shown above, but without actually annuitizing a portion of the wealth. Accordingly, in a new working paper that we've just posted to SSRN. retirement researcher Wade Pfau and I sought to study this exact issue, and try to determine whether or to what extent the benefits of partial annuitization are actually attributable not to the SPIA itself, but simply due to the bucketing-based declining-fixed-and-rising-equities liquidation strategy that it indirectly produces.
The results, shown in the table below, were somewhat surprising: for a 65-year-old couple at a 4% withdrawal rate, the failure rates of just taking systematic withdrawals from a portfolio that mimics the implied glidepath of a stock/SPIA portfolio were actually superior to using the inflation-adjusted (real) SPIA! In fact, the rising equity glidepath approach was so effective, it was superior to stock/SPIA portfolios and superior to fixed 50/50 portfolios! It wasn't until extreme longevity scenarios, where the 65-year-old married couple sustains withdrawals for 35+ years (beyond age 100) that the stock/real-SPIA scenarios were superior to the glidepath scenario, such that we could actually attribute the benefits of a SPIA's mortality credits to improving the outcome. And when used a fixed SPIA (not adjusting for inflation), even after 40 years (where the couple lives beyond age 105!) there was still virtually no improvement to using a SPIA over just implementing a glidepath portfolio! (For further details on the assumptions underlying this table, see the original paper .)