Many of those in the financial world talk about the concept of retirement ruin. As commonly used, retirement ruin means running out of retirement income before one is dead. In the investment world it has come to be defined as odds that a pile of assets will produce a given percentage of income for a certain number of years. In practice, the advisor will enter details about the consumer’s assets, withdrawal percentage and number of years the income is needed into a software program, and a software program spits out an answer showing the probability that the assets will last. The pronouncement is made saying something like “There is a 90 percent probability of receiving this percentage payout for the next 30 years.” And yet, it is readily apparent that many of those relying on the probabilities produced by the model have given little thought to whether the basic assumptions are accurate or can even be supported. 

My main problem with the models is they use limited data and attempt to apply it to the future. A recent article by Professor Moshe Milevsky¹ does a great job of summarizing the fascination that many have with the concept of retirement ruin, even though they don’t have the “mathyness” to understand what they are looking at, and adds a third reason why this concept is misapplied.

1) Too few data points.
A Martian landing in Duluth on the first day of June and leaving after Labor Day would have over 100 data points for Twin Ports weather. The only conclusion you could reach from the data points is the average temperature in Duluth is 71 degrees and it never gets below 55 degrees. Many in academia and Wall Street act as if their extremely limited number of data points, representing less than a century of modern financial market history, can show all of the possible outcomes in the financial markets.

2) Beware Soothsayers & Prophets  
When it comes to computer predictions of retirement ruin, seldom has GIGO (garbage in-garbage out) seemed more appropriate. I’m unaware of any investment algorithms made in the 1990s that had predicted even a one percent probability of a three-year bear market followed by a 50 percent market crash within the same decade. I’m unaware of any past model that assumed an extended period of near zero T-bill rates.  

Addressing these financial engineers, Milesky states “Your black box is subliminally forecasting how interest rates, stock prices, inflation and mortality will evolve over the next 50 years and how they will co-vary with each other. Can you justify these assumptions to your clients? Do you even know these assumptions?”

3) Beware the standard deviation.  
Let’s say that Portfolio A and Portfolio B each have a 90 percent probability of being able to pay out an income for 30 years. Based on that fact alone we should be indifferent to using either one, if our goal is a 90 percent probability of getting 30 years worth of income. However, let’s say the worst case scenario for Portfolio A is that the income lasts 28 years and the worst case scenario for Portfolio B is that the income lasts 16 years. Are you still indifferent?

A large standard deviation (or a lopsided deviation where there’s a bunch of short year run-outs) means that if you are in that 10 percent ruin group that doesn’t make it to 30 years, the number of years short could be huge. However, I almost never see the variance of the suggested portfolios discussed. 

Annuities Are Not Perfect but…
If you buy an annuity guaranteeing a lifetime income you are protected from the retirement ruin…unless the insurance company making the guarantee fails. Although infrequent, annuity carriers have failed in the past, but fixed annuities have actual safeguards that don’t apply to those fantasy retirement ruin portfolio models. One safeguard is carrier financial strength, which is dynamically watched over and regulated by state insurance departments. A long period of low bond yields and rising longevity will be like watching the approach of a very slow moving train—the regulators have sufficient time to switch the train to a different track. Guaranty associations providing a minimum level of coverage are another safeguard, but it needs to be stated that if several annuity carriers go belly-up it could be years before an annuity owner would get their covered payment.

Even though the reality is that getting a life income from an annuity does not give you 100 percent protection from retirement ruin because we can’t predict the future, the annuity comes a whole lot closer to 100 percent than anything else out there. And you don’t need a degree in mathyness to understand that.  ïƒ¾

Footnote:
1. Moshe Milevsk, “It’s Time to Retire Ruin (Probabilities),” Financial Analysts Journal (March/April 2016): 8-12.

Jack Marrion

Jack Marrion provides research and consulting services to insurance companies and financial firms in a variety of annuity areas. He also serves as director of research for the National Association for Fixed Annuities and as a research fellow for Webster University.

In 1994 he wrote a book to help banks market investment and insurance solutions to their small business clients. In 1996 he produced the first independent hypothetical return monthly publication comparing all index annuities on the market, and in 1997 created the first comprehensive report of index annuity sales, products and trends, “Advantage Index Product Sales & Market Report” (quarterly).

His insights on the annuity and retirement income world have appeared in hundreds of publications. In 2006 the National Association of Insurance Commissioners asked him to address their annual meeting and teach regulators the realities of index annuities. He was invited back in 2009 to talk to the NAIC about the effects of aging on senior decision-making. He is a frequent speaker at industry functions.

Prior to forming Advantage Com­pen­dium, Marrion was president and owner of an NASD broker/dealer with offices in nine states. Previous to that he was vice president of a life insurance company and vice president of an NYSE investment banking firm. He has a BBA from the University of Iowa, an MBA from the University of Missouri, and a doctorate from Webster University.

Marrion can be reached at Ad­van­­tage Compendium. Telephone: 314-255-6531. Email: ­[email protected].