How can you build the ideal portfolio? For many advisors, the answer can be summed up in one word: Markowitz.
In the 1950s, Harry Markowitz changed the financial world by describing how diversification could help investors control risk and achieve maximum returns. But in recent years, some academics have identified a problem with the modern portfolio theory developed by Markowitz and others: Retirees who diligently follow the theories could wind up broke.
To appreciate the problem, consider a 35-year old who is saving for retirement at 65. Through market ups and downs, the saver maintains an optimized portfolio and achieves his expected returns. But look, something troubling happens when he retires: Since his life expectancy is 83, he sets a time horizon of 18 years. Rebalancing the portfolio according to modern portfolio theory, he begins taking withdrawals. The portfolio works perfectly — but the man lives to 92, spending his last days in poverty.
The 92-year old has become the victim of what academics call longevity risk. Though the modern portfolio theory examined market risk, it did not address the problem of retirees who live too long.
For the Rest of Your Days
Now academics are stepping forward, seeking to describe portfolios that will produce maximum returns while ensuring that retirees don't outlive their assets. A leader in the field is Moshe Milevsky, a professor at York University in Toronto. Milevsky argues that all portfolios should consider longevity risk. For wealthy people with small living expenses, the danger is minimal. By maintaining a diversified portfolio and withdrawing less than 3 percent of assets a year, a rich retiree may never come close to exhausting assets. But other savers should consider purchasing some kind of immediate or payout annuity that guarantees the retiree a lifetime income.
“Bill Gates does not need an annuity, but many other people should seriously think about them,” says Milevsky.
For instance, a 65-year old who pays $100,000 for a fixed annuity could receive monthly payments for life of about $700. That could be enough to guarantee that an elderly person would never lose his house. But there are some downsides to the use of annuities. In return for the income stream, the annuity purchaser pays fees and may give up the right to touch the principal or leave it to heirs. In addition, the value of the fixed monthly payments can be eroded by inflation.
Because of the tradeoffs, investors seeking to use an annuity must consider a series of questions: What percentage of assets should go into the annuity? Should the investor rely on a fixed annuity or a variable instrument that could produce market-related gains? To help address the sticky problems, Milevsky designed a model along with Peng Chen, research director of Ibbotson Associates, the Chicago market researcher. To use the model, an advisor would plug in data, including the client's age, risk tolerance and life expectancy. The model also accounts for a variety of factors, like how much current income the client needs and whether he wants to give some assets to heirs.
It is impossible to know how long the client will live, but by using thoughtful estimates, advisors can use the model to sort through a variety of alternatives. A client with a low risk tolerance and little interest in making bequests should put a lot of assets in fixed annuities, the model suggests. By contrast, someone who wants to make big bequests should buy mutual funds, instead of locking assets into annuities.
The Next Markowitz
In one example, the model considers a 60-year-old male who expects to live 20 years and wants to leave 20 percent of his assets to heirs. The model suggests putting 16 percent in fixed annuities, 8 percent in variable annuities and the rest in a mix of stock and bond investments, such as mutual funds. This portfolio would provide diversification as well as a guaranteed income.
Annuity experts praise the model, saying that it makes a contribution by underlining key questions. But so far, few advisors have raced to adopt payout annuities.
“We have avoided them because of the fees,” says John Sterba, president of Investment Management Advisors, a registered investment advisor in New York.
Ibbotson's Chen says that the fees, which can amount to less than 1 percent of the assets annually, may be worthwhile.
“You should think of annuities as insurance,” he says. “Home insurance can be expensive, but people buy it because they figure it is worth the cost.”
Some boosters of annuities put more emphasis on fixed instruments than Chen does. Retirees should start by calculating how much their necessities cost, says Michael Lane, director of advisor services for TIAA-CREF, the big pension provider. Say a retiree has $1 million in assets, Lane says. To cover necessities, the retiree would need to spend $600,000 on a fixed annuity. The retiree should buy the annuity and put the rest of his assets in equities and other variable investments. “After retirement, should you run some risks in order to cover expenses, or should you take zero risk?” Lane asks. “Many retirees should avoid risks altogether.”
While Lane's approach has won some support, the bulk of retirees have not been converted to annuities, according to studies by researchers at the Department of Labor. The researchers looked at retirees that participated in defined contribution plans. When they retired, the employees had a choice: They could take their pensions in lump-sum payments or could convert the cash into annuities that would provide lifetime security. Only 4 percent elected to annuitize.
The data indicate that the industry must do a better job of persuading advisors and clients about the virtues of annuitization, says Dean Jarnow, director of annuity product development for American Express Financial Advisors. Jarnow says that academics have made important strides in highlighting the value of annuities, but there is a need for more research.
“We need the next Markowitz who can help us find the right way to handle the whole retirement distribution issue,” he says.