Embracing the Financial Mixed-Marriage

Applying insurance concepts in guiding retirement spending from investments

by Gary Baker

Mr. Baker leads the U.S. Operation of CANNEX Financial Exchanges. CANNEX provides a central exchange for guaranteed product data, illustrations and analytical tools in the U.S. And Canada. Connect with him by e-mail: [email protected]

How many investors or advisors have an established process to monitor and adjust withdrawal rates frequently over the course of time in retirement? Chances are that those with limited retirement income planning experience may rely on general rules and guidelines centered on withdrawing a fixed percentage of assets regardless of an individual’s longevity or attitudes toward risk.

A rule of thumb, like the “4% Rule”, provides a simple frame of context for anyone considering the dimension of retirement spending. However, it provides little in the way of a practical plan. Today there seems to be general acceptance that a marriage between investment and insurance concepts is necessary to help guide the appropriate allocation of products in support of financial needs in retirement – primarily around spending and estate planning.

Early in one’s lifecycle (i.e., during the earning years) investment strategies and insurance strategies can be conveniently compartmentalized into two distinct camps – savings optimization and household protection. But as needs shift going into retirement, the wall dividing these two camps breaks down and the concept of allocation graduates to a new level that not only considers equities vs. bonds, but also investments vs. annuities/insurance.

A Matter of Trust

Truth is that the behavioral desire for control over one’s assets is a very strong force and typically only those who work with (and trust) a financial advisor will yield to consultation that advocates the purchase of an annuity as part of an allocation strategy with a nest egg.

“Do It Yourself” investors along with those who agree with some of the negative press and perceptions of annuities will sacrifice a certain level of estate and pension-like guarantees in return for absolute control over their portfolio. Although these investors forego the benefits of insurance pooling, they can still apply some basic principles of actuarial science to optimize the withdrawal rates from their portfolio during retirement.

ome investment management firms have recognized the relevance of this approach and have developed payout funds to simulate the nature of a guaranteed cash flow with the illusion of control. With or without annuities, developing and evaluating a retirement income plan by using both investment and insurance concepts is not necessarily an intuitive approach. For example, the notion of a “present value” of an asset is converted to an “actuarial present value”.

Not only do you have to take into account an assumed discount rate for the valuation, but you would also apply an assumed mortality structure (or table) that adjusts the valuation based on the probability of survival for each year into the future. To that end, there are three fundamental insurance principles that can be applied when managing the continuous evaluation and adjustment of an investment portfolio withdrawal rate specific to an individual in retirement:

1. Planning Horizon and your Probability for Survival
Today, many retirement tools and processes force the user to determine a specific planning horizon. For the 65 year old, this typically translates to a time frame anywhere between 25 to 35 years. However, one of the biggest risks you have to address with your spending plan is the uncertainty of how long you will live.

Today there seems to be general acceptance that a marriage between investment and insurance concepts is necessary to help guide the appropriate allocation of products in support of financial needs in retirement

The time horizon is fluid – not static. Managing your withdrawal rate in proportion to your survival probability (as provided by mortality tables) theoretically provides a better opportunity to manage and optimize your retirement spending – assuming that you also adjust your spending based on the current state of capital markets. This also provides the advantage of not being forced to choose an arbitrary date in the future of when you might pass away (not only can this be difficult but also uncomfortable).

2. Longevity Risk Aversion
Whereas financial risk aversion relates to the level of tolerance an investor can stomach in a fluctuating market, longevity risk aversion relates to the personal belief or attitude of how long you think you will live as well as how much you initially spend.

There is a theory that these risks are somewhat correlated. Someone who is risk adverse will most probably choose a conservative portfolio of investments while anticipating lower market returns. As a result, the rate of spending from that portfolio will tend to be lower as well. Similarly, someone who believes they will live a long time will also spend less early in retirement knowing that their portfolio has to last for quite some time. Intuitively, they may also plan to reduce their spending over time, if necessary, in relation to their evolving attitude and beliefs about their own mortality.

Therefore, on a general level, your preferences for investment allocation may mirror what your view is of your own longevity. Regardless of how you choose to correlate these different risks, in practice there may be other financial planning factors that influence your allocation decisions separate from your spending behavior not to mention your lifestyle and longevity beliefs.

3. The Impact of Existing Guaranteed Income
While Longevity Risk may cause you to adjust your withdrawal rate downward, the amount of guaranteed lifetime income you already receive may allow you to increase your spending. If you already receive a decent sized pension from an old employer along with Social Security, you essentially have a guaranteed floor of income which provides you with a little more discretion to increase the withdrawal rate from your portfolio.

If you do not receive a pension, and depending upon the size of your portfolio, you can always annuitize a portion of your assets to create a meaningful floor and experience the same fundamental effect. Putting it all together, the assumption here is that an optimal portfolio withdrawal rate:

  • Depends on adjustments overtime based on your survival probabilities and existing capital markets and
  • Can be further adjusted based on your attitudes relative to your longevity risk aversion as well as the level of pre-existing guaranteed lifetime income.


 Note: Last year, The QWeMA Group (a division of CANNEX) received a U.S. patent for the method and system to determine optimal spending rates using this methedology which can be incorporated into existing planning processes, tools and calculators as well as educational programs. Ultimately, processes that combine investment and insurance concepts will continue to evolve around the market as financial advisory firms continue to improve their expertise and ability to support more advanced retirement income methodologies.