Explore the application of Modern Portfolio Theory to retirement income planning and the benefits of implementing in-plan annuities to address financial risks in retirement.
In a previous blog post, I discussed the application of Modern Portfolio Theory (MPT) to retirement income planning. This involves replacing investment returns with income as the reward on the y-axis of the risk-reward spectrum and using Monte Carlo analysis and the Probability of Success as the definition of risk on the x-axis. This allows us to create an "efficient income frontier" that shows how much income a participant can take for a given level of risk, and then identify interventions to help them take more income.
To test the resiliency of a participant's portfolio to unforeseen risks, we can introduce different risk scenarios as part of this analysis. In today's economy, which is marked by areas of uncertainty despite several positive indicators, having a strategy that includes buffers against risks is crucial.
One such intervention is recommending an in-plan annuity with increasing income potential. These products can improve the probability of success and address unforeseen financial risks in retirement, such as equity returns risk, market shock risk, longevity risk, and inflation risk.
While these risks are not the only risks retirees face, we can use quantitative methods to demonstrate the impact of an annuity on a portfolio in these risk scenarios. In this blog, I will focus on these risks and use the "efficient income frontier" to visualize the impact of adding an in-plan annuity to a portfolio.
Establishing a baseline
Before considering risks, let's see how an annuity affects your baseline scenario (assuming everything goes according to plan). Introducing an annuity can shift the "efficient income frontier" upward and to the left. This means you can achieve a higher desired income level with the same level of risk, or achieve the same income level with a higher probability of success. For example, with an annuity allocation, you might increase your probability of success by 13% for the same desired income goal of $24,000 (as shown in the analysis below).
Risk scenario #1: Equity returns risk
The first risk that we’ll look at is equity returns risk. This is the risk that equity markets underperform. To illustrate this risk, we consider a scenario where equity returns are 6% rather than the originally assumed 7%. In this case, the probability of success of the portfolio with the annuity is 19% higher than the portfolio without the annuity for an income goal of $24,000 – assuming 6% equity returns. It’s also 8% higher than the portfolio without the annuity and 7% returns.
Overall, offering a guaranteed level of income in retirement reduces reliance on unpredictable market performance – lowering the sensitivity of the portfolio and providing a layer of security for participants at or nearing retirement.
Risk scenario #2: Market shock risk
Assets invested in equity markets are also vulnerable to sudden market downturns, which can be particularly devastating early in retirement. In a scenario where the equity market drops by 25% and the bond market drops by 10% during the first year of retirement, this can have significant impacts on the value of retirement savings. For instance, the introduction of a shock of this magnitude would decrease a participant’s probability of success by 22%, from 79% to 57%, in a portfolio without an annuity for an income goal of $24,000. If the participant did have a portion of their portfolio protected in an annuity, their probability of success for the same income goal only drops by 10% from 92% to 82%, which is still higher than the portfolio without the annuity before the shock.
It’s also important to note that in a shock like this, it would be typical for a participant to adjust their income goal. In this example, if the participant adjusts their income goal from $24,000/year to $21,000/year, they are able to maintain a 92% probability of success in the shocked portfolio with the annuity compared to a 70% probability of success in the shocked portfolio without the annuity.
While the stock market has demonstrated long-term growth in the past, it is important to recognize that a scenario where equity returns decline by 25% and bond returns decline by 10% is not uncommon. This situation is similar to returns observed during the 2008 financial crisis and more recently the COVID-19 pandemic.
Risk scenario #3: Longevity risk
With increasing life expectancies, longevity risk is a real risk that participants face in retirement. If we consider a situation where a participant lives beyond their planning age (age 95) to age 100, having an annuity in a portfolio can yield significant benefits. Even when planning for a longer lifespan (age 100), the probability of success for an income goal of $24,000 in the portfolio with the annuity is still quite high at 90% compared to the portfolio without the annuity, which drops to 71% in the age 100 scenario – 19% lower than the portfolio with the annuity.
Annuities offer clear benefits for individuals concerned about outliving their retirement savings. With a guaranteed income stream for life, annuities provide a reliable source of income, no matter how long one lives. This is especially important for those who want to ensure that they have a predictable stream of guaranteed income that can be used for essential living expenses.
Risk scenario #4: Inflation risk
As retirement approaches and portfolios become more conservative, traditional fixed-income options like bonds become vulnerable to inflation risk, as rising inflation often corresponds with higher interest rates, which can lower the value of fixed-income investments. Consider a scenario where a participant needs to increase their withdrawals by 2.5% instead of 2.0% due to inflation.
In this example, the portfolio with the annuity has a 16% higher probability of success than the portfolio without the annuity (85% vs. 69%) for an income goal of $24,000. Note: Our analysis used the Allianz Lifetime Income+® Annuity, which is a fixed index annuity that offers increasing income potential through its Lifetime Income Benefit. The potential for increasing income is a key differentiator that can help hedge against inflation risk and may provide more cumulative income over life expectancy than in-plan income products that lack such features.
Compounding complexity of financial risks
Further, it’s important to note that financial risks rarely operate independently and often impact each other. Longevity risk becomes more concerning if a participant needs to withdraw more due to inflation, and high equity returns in portfolios may increase the likelihood of income lasting throughout retirement, but they also heighten market shock risk.
In today's unpredictable and increasingly complex economic climate, including an annuity in an employer-sponsored retirement plan can therefore provide a valuable layer of security. It can help participants achieve their desired income level, protect against market downturns, and ensure a steady income stream throughout retirement, even if a participant lives longer than expected.
Next steps
Retirement income planning requires a strong risk management strategy. Our framework helps you identify the impact of potential threats and explore solutions like annuities. We can walk you through a personalized Portfolio Impact Report (PIR) analysis based on your unique assumptions; email our team.
In addition to these quantitative outcome improvements, it is important to consider the emotional components of retirement and how specific product features cater to different participant needs and how those needs evolve over time. Get additional insights on how to consider risk holistically in our latest white paper and other insights on Insights and Education.
Assumptions used for analysis
Results presented in this blog are based on the Portfolio Impact Report, a calibrated Monte Carlo engine developed by Allianz Investment Management U.S. LLC (AIM US) that uses model hypothetical portfolios and over 20,000 simulations to assess the likelihood of achieving retirement goals. Our assumptions are listed below. These assumptions are hypothetical and do not represent an actual participant.
| Product assumptions | Capital market assumptions | Participant assumptions | Asset allocation assumptions |
|---|---|---|---|
| Product: Allianz Lifetime Income+® Annuity | Equity Total returns: 7.00% Volatility: 16.00% |
Current age: 55 | No annuity: 60% Equity and 40% Bond |
| Fees: 0.50% | Retirement age: 67 | ||
| Income begins at retirement age | Bond Yield: 3.00% Volatility: 5.00% |
Planning age: 95 | |
| Annual cap: 5.00% | Retirement assets: $250,000 | Annuity: 40% Equity, 30% Bond and 30% Annuity |
|
| Protection of principal: 100% | Correlation -15.00% |
Contributions: $12,000/year | |
| Personal lifetime withdrawal rate: 5.50% | Income inflation: 2.0%/year |
Methodology and assumptions used in simulations
- S&P 500® Index used as a proxy for U.S. large-cap, BBgBarc US Agg Bond Index used for U.S. bonds.
- Success is measured as having the desired legacy wealth at the end of the stated investment horizon. This goal increases annually with inflation.
- Hypothetical outcomes were derived from 20,000 Monte Carlo simulations.
- No advisory fees or taxes are reflected.
- Bond yields are mean reverting.
- Equity dividends are reinvested continuously.
- Bonds are zero-coupon with a constant 7-year maturity.
- Monthly income goal is not changed as account balances decrease.
- Annuities are given first priority as an income source, followed by the sales of securities.
- Securities are sold in proportion to asset class account values.
