Have you considered your retirement income model?

Many retirement planners abide by what they call the "4% rule," which holds that if a retiree invests in a moderately risky portfolio of 60% stocks and 40% bonds, s/he can initially withdraw 4% of the assets to provide income, increase that amount in subsequent years to keep pace with inflation, and still have what is claimed to be a 90% probability of not running out of money over a 30-year retirement. Even though its proponents assert that this approach is a conservative one, it has three major flaws.

1. Losses in the early years tacked on to the regular withdrawals raise the chances of failure dramatically. T. Rowe Price has done some good research in this area, based upon a 55% stocks/45% bonds portfolio and 4% annual withdrawals, rising with inflation. The study concludes that with negative annualized returns for the first five years of retirement, there is a whopping 57% chance of running out of money within 30 years. Moreover, such significant losses are not as aberrational as some might think:

"Even in large portfolios, high standard-deviation events tend to occur far more often than a normal distribution suggests. This seems especially true on the downside, which will call this variable excess risk 'iceberg risk,' because it is mostly hidden from view but threatens major damage. It might also be called 'Noah risk,' after the proverbial flood that drowned the world.... Also, in the Biblical story, the world was amply warned about the flood but refused to listen. In contrast, icebergs reflect a type of risk that people look for but may not see."

Kent Osband, Iceberg Risk: An Adventure in Portfolio Theory (2002).

When these "black swan" events happen early-on during retirement in an individual retiree's portfolio which is also providing income, the personal costs are often catastrophic. The crucial risk to investing in stocks isn't the chance that a retiree's rate of return might vary from historical averages; it is the possibility that stocks might wipe him or her out. That risk never goes away, no matter how long the investor stays in the market. A longer horizon provides more opportunities to recover from "extreme market conditions," but it also provides more opportunities to experience them.

2. With people continuing to live longer and longer, the assumption of a 30-year retirement is a dangerous one. Today there is a 23% chance that at least one member of a 65-year-old couple will live to age 95. And with improving health care, even more people will live to 95 and beyond in the future, according to the Society of Actuaries. Indeed, a recent analysis of data from more than 30 developed countries reveals that death rates among people older than 80 are still falling. In 1950, the likelihood of survival from age 80-90 was 15-16% for women and 12% for men, compared with 37% and 25%, respectively, in 2002, and there's no sign of this longevity growth slowing down.

3. As has been reported by The Wall Street Journal, among others, the Monte Carlo simulations upon which the 90% success rate is claimed tend to underweight the risk of failure, often dramatically. "I take whatever probability of failure that comes out of your Monte Carlo simulation and add 20 percentage points," noted William J. Bernstein, author of The Four Pillars of Investing.

It's when the hypothetical becomes real that the magnitude of the problem becomes especially clear. Working with portfolio probabilities is fine — until the negative and failure statistics have names and faces.

A recent article from Kiplinger's looks at these issues from an interesting perspective. Although not typically a friend to annuities, Kiplinger's offers a twist on the traditional risk pyramid (see above). With a traditional risk-pyramid model, the safest investments — such as annuities and bank deposits — are used to build the foundation of the portfolio, with riskier investments layered on top, adding (in order) bonds and various types of stock funds until the riskiest assets (alternative investments) are placed on top. Significantly, this diversification spreads the risk, but it doesn't guarantee that the portfolio won't lose money.

The article describes the twist as follows. "By flipping the risk pyramid on its side, you can align your retirement timeline with your investment strategy. Fund your immediate income needs with risk-free investments, such as...an immediate annuity, and gradually increase the risk (and potential return) of other investments."

It's significant that even Kiplinger's recognizes the need to structure retirement planning with an annuity foundation. Income annuities (whether an immediate annuity or the annuitization of a deferred annuity) are an incredibly powerful tool for managing income needs and are almost surely the most underutilized asset in the financial world today. As reported by The Wall Street Journal, "income annuities can assure retirees of an income stream for life at a cost as much as 40% less than a traditional stock, bond and cash mix." What that efficiency means is that retirees who need a nest egg of, say, $1 million, can live the same lifestyle with as little as $600,000 in an income annuity.

As stated by Prof. David Babbel of Wharton:

"I have reviewed over 70 academic studies that have appeared since 1999, analyzing lifetime income annuities vs. other alternatives, and coauthored another major study. (Most of these are included in the reference section to this paper, as well as a handful of earlier academic studies, each marked with an asterisk.) The consensus of the literature from professional economists is that lifetime income annuities should definitely play a substantial role in the retirement arrangements of most people. How great a role depends on a number of factors, but it is fair to say that for most people, lifetime income annuities should comprise from 40% to 80% of their retirement assets under current pricing. Generally speaking, if a person has no bequest motive, or is averse to high risk, the portion of wealth allocated to annuities should be at the higher end of this range.

"Lifetime income annuities may not be the perfect financial instrument for retirement, but when compared under the rigorous analytical apparatus of economic science to other available choices for retirement income, where risks and returns are carefully balanced, they dominate anything else for most situations. When supplemented with fixed income investments and equities, it is the best way we have now to provide for retirement. There is no other way to do this without spending much more money, or incurring a whole lot more risk coupled with some very good luck."

Annuities provide a powerful foundation for any portfolio and are crucial for providing guaranteed retirement income in an efficient manner. Good financial planning demands that we use them routinely.