How to Transfer the Risk of Running Out of Money
Thursday, July 10, 2014

If you had the ability to transfer the risk of running out of money before you die to a third party, would you do it? It’s an interesting question since everyone but the very affluent face longevity risk. Furthermore, longevity risk is a wildcard from the standpoint of financial planning. If we knew in advance when we were going to die, we could adjust our allocations, savings rates and spending patterns accordingly. We don’t know, however. Our best guesses are dependent on actuarial tables, which come with a margin of error at the individual level.

One product the financial industry has created to help investors cope with this uncertainty is a longevity annuity. Also referred to as an advanced life deferred annuity (ALDA), this product begins paying a stream of income after a prespecified age has been reached. You pay $X amount up front in exchange for the guarantee of receiving income from the time you reach age Y until the day you pass. In addition to any Social Security benefits or pension payments you are eligible for, you will be guaranteed a stream of income late in life regardless of what happens to the rest of your savings. (The amount of annuity income paid is dependent on the size of the contract purchased and the rate of return.)

Economists like annuities because they transfer uncertainty from the investor to a third party. Many investors are less excited about annuities because they lock up money and are expensive to get out of. Plus, annuities don’t have the best reputation. Many advisers don’t fully understand them, have misrepresented them and/or have improperly sold them. This is unfortunate because annuities are good products when used correctly based on an investor’s specific needs.

I’m discussing annuities because last week the Treasury Department and the Internal Revenue Service finalized rules to make longevity annuities accessible to 401(k) plans, other similar types of retirement plans and IRAs. The new rules allow up to 25% of the account balance or (if less) $125,000 to be used to purchase a qualifying longevity annuity without the investor having to worry about running afoul of the required minimum distribution (RMD) rules. If the investor dies before the reaching the age when payments are scheduled to start, the contract can allow for the premiums paid to be returned to his or her account. (The Treasury Department’s website has a press release announcing the new rules.)

It’s a potentially positive step for investors looking to offset longevity risk. Terms and costs will vary. It may well turn out to be that the longevity annuity offered by your 401(k) plan or your adviser—if you work with one—is not the best offering, so make sure you shop around. Also be cognizant of interest rate risk. You may be better off purchasing a series of annuity contracts over a period of time than buying a single contract today. This statement applies to all types of annuities, including longevity and immediate annuities.

I also want to emphasize that longevity annuities are not your only option for coping with longevity risk. A properly diversified portfolio combined with a sound withdrawal strategy and a variable spending plan can give you enough financial security to make owning an annuity unnecessary. A bond ladder (a portfolio of bonds with different maturity dates) can be used in lieu of an annuity. You can take out a reverse mortgage or continue to work in retirement to realize extra income. Long-term care insurance can be used to offset some of your late-in-life expenses. In other words, you have options as long as you have a well-thought-out financial plan and the discipline to stick to it.

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The Week Ahead

I will speak to our San Francisco chapter about smart investing on Saturday, July 19. Click here for more information and to register for the meeting.

Dow components Johnson & Johnson (JNJ), JPMorgan Chase & Co. (JPM), Goldman Sachs Group (GS), and Intel Corp. (INTC) will report earnings on Tuesday.  On Thursday, UnitedHealth Group (UNH) and IBM (IBM) will report, and Friday will feature General Electric (GE).  Joining them will be about 60 fellow members of the S&P 500.

This week’s first economic reports will be June retail sales, the July Empire State Manufacturing survey, June import and export prices and May business inventories. All four will be released on Tuesday. On Wednesday, the June Producer Price Index (PPI), June industrial production, the July National Association of Home Builders' housing market index and the periodic Federal Beige Book will be released.  Thursday will feature June housing starts and building permits and the July Philadelphia Fed survey. The week will finish with the preliminary University of Michigan's consumer sentiment survey for July on Friday. 

Federal Reserve Chair Janet Yellen will give her semiannual monetary policy testimony to Senate and House committees on Tuesday and Wednesday, respectively. St. Louis president James Bullard will speak in Kentucky on Thursday. 

July options will expire on Friday.

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AAII Sentiment Survey

Pessimism about the short-term direction of stock prices is at its highest level in two months, according to the latest AAII Sentiment Survey. Neutral sentiment is at a four-month low, while optimism is only slightly lower than a week ago.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 0.9 percentage points to 37.6%. Optimism is below its historical average of 39.0% for the 15th time in the past 17 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, plunged 5.4 percentage points to 33.7%. This is the lowest neutral sentiment has been since March 13, 2014. Even with the decline, neutral sentiment remains above its historical average of 30.5% for the 27th consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, jumped by 6.3 percentage points to 28.7%. This is the largest amount of pessimism recorded by our survey since May 8, 2014. Even with the rise, bearish sentiment remains below its historical average of 30.5% for the 12th straight week and the 35th out of the last 39 weeks.

Though there was a significant weekly increase in pessimism and a decrease in neutral sentiment, the changes simply moved each measure of sentiment closer to its historical average. The shifts occurred as the S&P 500 index fell 1.1 percentage points over two consecutive trading sessions during the survey period and tensions in the Middle East escalated. These two events, combined with concerns about prevailing valuations, likely caused more investors to fret about the potential for a downward market move occurring over the short term.

At the aggregate level, some AAII members are optimistic about sustained economic growth, the market’s upward trend, and the Federal Reserve’s tapering of bond purchases. Others are concerned about the pace of economic growth, prevailing valuations, events in the Middle East and Ukraine, and frustration with Washington politics.

This week’s special question asked AAII members how the complexity of the way market orders are processed is affecting their attitude toward investing. The majority of respondents (60%) said the complexity is having no effect. An additional 16% of respondents said the complexity is only having a small or a limited impact. Only 12% of respondents said they felt as if they were at a disadvantage or say their attitudes are adversely affected by the manner in which orders are processed.

More than 10% of all respondents clarified their responses by describing themselves as long-term investors, not traders. Another 8% of respondents said they are using limit orders instead of market orders.

Here is a sampling of the responses:

  • “Since I do very little short-term trading, the complexity of the buy and sell process impacts my attitude towards investing quite minimally.”
  • “Not at all. I am a long-term investor and don’t think that the effects of the process are very significant for the long-term results.”
  • “Not at all. I know I lose, but not too much each time.”
  • “A small effect, but I’ve changed to using limit orders where possible.”
  • “It makes me feel as if ‘the deck is stacked’ against small retail investors.”


This week’s Sentiment Survey results:

Bullish: 37.6%, down 0.9 points
Neutral: 33.7%, down 5.4 points
Bearish: 28.7%, up 6.3 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!


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