A pioneering researcher on the role of human capital in financial planning, the importance of biological age to retirement planning, the role of annuities and tontines in hedging longevity risk, and more.
Our guest on the podcast today is renowned retirement researcher Moshe Milevsky, who has conducted research on a broad range of topics, including pensions, annuities, investment strategies for people approaching retirement, and asset allocation over the human lifecycle. A prolific writer and researcher, Milevsky is also the author of several books, including Are You a Stock or a Bond?, The 7 Most Important Equations for Your Retirement, and The Calculus of Retirement Income. His recent books include King William's Tontine: Why the Retirement Annuity of the Future Should Resemble Its Past and The Day the King Defaulted: Financial Lessons from the Stop of the Exchequer in 1672. He's served as a professor of finance at the Schulich School of Business at York University for the past 25 years. He received his bachelor's degree in physics at Yeshiva University, his master's degree in mathematics and statistics at York University, and his doctorate in finance at York University's Schulich School of Business.
Background
Moshe Milevsky's home page
Milevsky's Twitter account @retirementquant
Moshe Milevsky Books
The 7 Most Important Equations for Your Retirement
The Calculus of Retirement Income
King William's Tontine: Why the Retirement Annuity of the Future Should Resemble Its Past
The Day the King Defaulted: Financial Lessons from the Stop of the Exchequer in 1672
Human Capital
"The U.S. Labor Market During and After the Great Recession: Continuities and Transformations," by Arne Kalleberg. The Russell Sage Foundation Journal of the Social Sciences, Vol. 3, No. 3, April 2017.
"No Portfolio is an Island," by David Blanchett and Phillip Straehl, Financial Analysts Journal, Vol. 71, issue 3, May/June 2015.
Longevity Risk
"Forget Your Real Age: Plan Your Retirement Around Your 'Biological Age'," by Lewis Braham, Barron's, Jan. 27, 2019.
"Retirement Spending and Biological Age," by Huaxiong Huang, Moshe Milevsky, and T.S. Salisbury. Journal of Economic Dynamics & Control, September 2017.
"The Utility Value of Longevity Risk Pooling: Analytic Insights," by Huaxiong Huang and Moshe Milevsky, North American Actuarial Journal, Feb. 8, 2019.
Annuities and Tontines
"Valuation and Hedging of the Ruin-Contingent Life Annuity (Rcla)," by Huaxiong Huang, Moshe Milevsky, and T.S. Salisbury, Journal of Risk and Insurance, Vol. 81, No. 2, May 2014.
"Pros and Cons of 2 Key Annuity Types," by Christine Benz and David Blanchett, Morningstar.com, Oct. 18, 2014.
"Could a Tontine Be Superior to Today's Lifetime Annuity Income Products?" by Michael Kitces, Nerd's Eye View, Feb. 3, 2016.
"Estimating the True Cost of Retirement," by David Blanchett, Morningstar Investment Management, Nov. 5, 2013.
Retirement System and Planning
Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar, Inc.
Jeff Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Benz: Our guest on the podcast today is renowned retirement researcher Moshe Milevsky. Dr. Milevsky has conducted research on a broad range of topics including pensions, annuities, investment strategies for people approaching retirement, and asset allocation over the human lifecycle. A prolific writer and researcher, Professor Milevsky is also the author of several books, including Are You a Stock or a Bond?, The 7 Most Important Equations for Your Retirement, and The Calculus of Retirement Income. His recent books include King William's Tontine: Why the Retirement Annuity of the Future Should Resemble Its Past and The Day the King Defaulted: Financial Lessons from the Stop of the Exchequer in 1672. He's served as a professor of finance at the Schulich School of Business at York University for the past 25 years. He received his bachelor's in physics at Yeshiva University, his master's degree in mathematics and statistics at York University, and his Ph.D. in finance at York University's Schulich School of Business.
Dr. Milevsky, welcome to The Long View.
Moshe Milevsky: Thank you.
Benz: So, before we get into retirement planning, and we'll spend the bulk of our discussion there, I wanted to talk about asset allocation generally. You wrote a book about the importance of human capital when thinking about your retirement plan. And the concept was determining whether your human capital is more equity-like or more like a bond. Walk us through an example of someone with equity-like human capital, what makes them equitylike and then let's discuss the implications for their portfolio and their financial plan.
Milevsky: Sure. The idea actually goes back generations. If you read Adam Smith carefully, he talks about what is the value of the individual and the risk characteristics in the individual. But what you're referring to is work that I did about 10 or 15 years ago, starting with Roger Ibbotson, who I'm sure you know …
Benz: Yes.
Milevsky: And basically, we went through different professions, careers, jobs that people have, and we tried to classify them based on their sensitivity to the equity markets. If you are a tenured professor at a university like I am and obviously, like Roger is, or if you are a fireman, or a police officer or a teacher, or a federal employee with a high degree of job security, you're looking at what's happening now in the stock market and it's painful, but your job isn't at risk. Your earnings aren't at risk. Your salary, your wage, your compensation is not affected. So, I would say, you're more bond-like. On the other hand, the students that I was teaching this morning, who are in the business school or in the business program, they're all trying to find jobs when they graduate at the end of this year--they are fourth-year students--they've seen a slowdown, almost a halt, in job offers, in outreach and interviews because everybody's trying to evaluate now how many employees am I going to need if there's a slowdown in the economy? They are stocks, their human capital is stocks. And then, anything in between--you work in the real estate sector, your human capital is real estate, you're a real estate agent, you make earnings from commissions, then your human capital is real estate. Make sure you don't have that in your portfolio.
So, this isn't just about classifying people's job. This isn't about going to a zoo and saying, that's a monkey, that's a zebra, that's a rhinoceros. It's about saying, look, because of the fact that you're a zebra, make sure your 401(k), IRA looks very different than the rhinoceros. So, that's the importance of it. And that's what it means to have human capital that's a stock or a bond.
Ptak: So, you gave the example of your students being stock-like in terms of their human-capital profile, but I would imagine they're also young and we tend to think of young investors as wanting to take on as much equity risk as prudently possible. Yet, I think what you described is that you want to think about your human-capital profile in concert with your financial-capital profile. So, how should a young investor approach that?
Milevsky: I think that there's two competing effects there. On the one hand, you have what many practitioners call time diversification, which is this idea that, if you have a very long time in the stock market, you can afford to take on more stock-market risk, defined in different ways. On the other hand, you have human-capital theory, which suggests that your human capital has very certain specific risk characteristics, and your portfolio has to balance them. So, in some sense these are competing interests, and it depends on your situation. But if your job is sensitive to the state of the economy, this might have long-term implications. There's research that shows that people that joined the labor market in '08 and '09 during the crisis have suffered long term in terms of their career prospects. They're not being promoted as quickly, their opportunities aren't as high. So, in some sense, if I had to balance the two, if you're a 25-year-old student, I would say that your human-capital riskiness might actually trump the time-horizon effect.
Benz: So, that would call for a more conservative investment portfolio to the extent that they have investment assets?
Milevsky: I think that we simplified a little bit too much when we talk about conservative and safe. I mean, there are certain industries that are being decimated in the market right now. And those industries, it's not that they're stock-like, it's not that they're high beta, it's that people that work in those industries should not have exposure to that in their portfolio. So, I'm an advocate of going to your company 401(k) and carving out the exposure to things in that industry. If you work for Coke or Pepsi, you should carve out consumer discretionary from your investments because there's a very good chance that if your human capital suffers, your financial capital suffers.
So, Christine, to answer your question, it's not about conservative versus safe. It's about what sort of risks should you be taking and what factors of the economy should you link to. If there's 9 or 10 or 11 sectors of the S&P, which ones should you extract from your investment portfolio because your human capital is sensitive to it? I think David Blanchett has wrote about this as well.
Benz: Right. So, let's talk about the challenges of planning for retirement financially. That's been a big focus of your research over the years. So, let's start with the big challenges. We don't know how long we'll live. We don't know how the market will perform over our particular accumulation time horizon or our decumulation time horizon. We may not even know when specifically we will retire. Am I missing anything big when we're thinking about the big challenges that make retirement planning so hard?
Milevsky: I think it's a pyramid and you certainly started at the top of the pyramid. I think longevity uncertainty, there's just this uncertainty about how long it's going to be and in what state we will be. It drives a lot of the other sources of uncertainty. Financial markets drive a lot of the uncertainty. I mean, there's personal preferences that change over time. What you like now and the things you enjoy doing now may not be what you would enjoy doing 10 or 15 or 20 years from now. The evidence I have are colleagues of mine that are suddenly getting grandchildren now and whereas, three years ago, they didn't seem to have any interest at all in that aspect of life. And now, I have a tough time scheduling meetings with them because the grandchildren are visiting. So, that's a preference that just wasn't there that suddenly they want to spend money on. So, there's a whole bunch of portfolio of uncertainties that you face going into retirement, which I believe makes it a much, much more difficult problem than simply accumulating wealth, or figuring out how much to save or what the right portfolio is. I think it's a much larger order of magnitude.
Benz: You've said that the term retirement doesn't mean anything anymore. What did you mean by that?
Milevsky: Well, there's a distinction between stopping to work and bringing your human capital, as we discussed, to a value of zero and starting to withdraw money from a portfolio or a collection of accounts. We used to think of those two events as being synonymous. So, I retired and now I'm in drawdown mode. And I think we're seeing more and more people where there's a gap of five to possibly 15 years between those two events, in either direction. So, they may continue working at a reduced rate, which means that their income is much lower. They're still working, they haven't retired, but they need to withdraw money from their portfolio to live off because they need to supplement the difference. In the other direction, we have people that have retired, they are not generating any labor income, they still don't need to tap any other sources of income and then the age of 71 or 72 comes along and it's time to tap RMDs and where do I invest it and how do I allocate? So, I don't think the word retirement really captures the complexity of this. It doesn't really capture a stage of life anymore. Unfortunately, we all use it to describe a field and we have no choice. So, I have at least three books with the word retirement in the title, even though I don't really like it.
Ptak: A lot of your work is centered around managing longevity risk. How do you define it?
Milevsky: So, longevity risk is about the uncertainty in how long you're going to live. I view longevity risk as the standard deviation of your remaining lifetime. If you think about how long people live, some people make it to the age of 90, 95, 100, possibly beyond; other people only make it to the age of 70, or 75, or 80. So, if you take a look at a collection of people in retirement and how long they lived, and you computed the mean, the arithmetic mean, the average, you'd get about 20 years. On average, we spend 20 years in retirement or in that stage of our life. But if you were to take the standard deviation or the volatility or any measure we use with portfolios, you'd see that there's quite a bit of dispersion there. And as a percentage, it's a vol, or an implied volatility, of about 45% to 50%. Meaning, the uncertainty about how long that's going to be is on the order of 50% of the mean. The mean is 20. But some people can live as high as 30. Other people might live as low as 10 years. So, that's a 50% variability. That's longevity risk to me.
Benz: So, you've written that age is a very crude way of measuring longevity risk. In fact, one of your books is specifically about how to be more sophisticated about measuring life expectancy, getting beyond age and trying to measure longevity risk. So, what is what you call biological age and how should we calculate ours?
Milevsky: Yeah. Well, we're really covering a lot of ground here. We're jumping from one … I feel like this is that old TV show: This is your life Mr. Milevsky, and we're just going through every … So, biological age is another issue and that is the awareness that the number of times you've circled the sun, your chronological age, really doesn't reflect the number of years that you have remaining. So, you can be 55 years old chronologically, and I can be 55 years old chronologically, but that doesn't really tell us a lot about how long we still have to spend in the life cycle. And there are tests that are being developed and there are controversial methodologies, but there are tests that are being developed that use blood and saliva and other biomarkers of aging to tell you what your true age is.
So, for example, in my case--I had mentioned this to a reporter at The Wall Street Journal a couple of weeks ago--my wife gave me a birthday present when I turned 50, which to me was a big chronological milestone. And this birthday present was a test where I would send a little bit of saliva and six weeks later, they send you back a report. This isn't DNA testing or genetic. This is simply what your chronological age is versus your biological age. To make a very long story short, even though I had turned 50 chronologically, the report came back and said that I was 42 years old biologically that I was eight years younger. And this isn't about patting myself on the back and saying I'm in good health. This is about saying that the tests could not determine what my true age was. There was nothing in me biochemically that would be able to date me, like a carbon-14 testing, that I'm actually 50 years old. As far as they're concerned, they could not determine me as being different from 42.
And when I looked into that--to me it was a novelty--when I looked into that, there are other testing companies. I did this once or twice. They all didn't come back with the same number. There's obviously heterogeneity there. But the point is that your body really ages at a different rate depending on various factors. And the number of times you've circled the sun, your chronological age, has become a very convenient way to compare yourself, but it doesn't really mean very much. So, that's what I mean by biological age versus chronological age. And my point is that that has enormous implications for retirement planning, because you might think you're 62 and entitled to take early Social Security and I might be 62, but your 62 might actually be 70 biologically. You should be getting full retirement benefits. My 62 chronologically could be 55 biologically and someone at the Social Security administration should be saying, Mr. Milevsky, go home, you're not really 62. So, that's sort of the implications for retirement planning.
Ptak: Do you think there's actually a public policy implication, for instance, where we get to a point where two people with the same chronological age, but different biological ages would receive different Social Security or annuity payments?
Milevsky: I do. And I think that's where we're headed. I know a number of countries that are starting to think that way. And to be perfectly honest, we may not have a choice. With the entitlements and the discussion around Social Security reform--and it's not just in the U.S., anywhere. I mean, right now I'm in Canada. There's discussions about what the appropriate payout rate should be. We have to start thinking very carefully about this uncomfortable fact that wealthier people with higher incomes live longer, which means that we're going to be transferring wealth in the exact opposite direction we want from people that aren't going to live very long, that aren't going to get the benefits for very long to people that are getting the benefits for much longer, and yet they're contributing almost the same rate from a payroll perspective.
So, I know we're getting very far away from portfolio construction and annuities, and how to mix stocks and bonds. But the answer to your question is, absolutely, this does have public policy implications.
Benz: So, in the meantime, do you think it's a good idea for people to use these tests, or maybe use some sort of longevity calculator online to try to get their arms around what their actual life expectancy might be?
Milevsky: Well, I think it's part of an intelligent approach to retirement-income planning. As you're getting closer to it, you investigate many facets of your retirement and you take questionnaires to determine what it is that you want to do in those years and you talk to friends and family about where they're going to live so that you do it appropriately. Part of that preparation is to get a better handle on how old are you really.
Now, I'm not a big fan of the web-based calculators. I think that unless they take fluids, it's not very reliable. I mean, you do really have to prick yourself a little bit to get a better sense of what that number is, but it's certainly a beginning. Just because your birth certificate or your drivers license says a number doesn't mean you should be using that for retirement-income planning.
Benz: So, let's say, I've run the numbers, used one of these tests, or whatever I've done and determined that I have a concern that I might outlive my money. What are the products, investment types, what should be in my tool kit when I'm trying to think about my retirement portfolio and protecting it against this risk of outliving my money?
Milevsky: Yeah. So, if I can back up a bit, what worries me isn't so much living a long time and running out of money. To be perfectly honest, I don't mind living to 100 if my portfolio has done well. I'm sure that if I live to 100, and the Dow or the S&P goes up 15% a year for the next 20 years, I'll be okay because of the fact that I'll be able to drawdown that money from the portfolio. In some sense, I'm worried about two events occurring at the exact same time--living a very long time and at the same time markets not doing well. It's like saying to someone, you're concerned about two things when you're driving and you're in an accident. Number one, you hit something and there's damage. It's not just about the hitting, there has to be damage. So, you buy insurance, not about being in an accident, but about causing damage. And I think the same thing applies when it comes to retirement income planning. You have to concern yourself with the joint occurrence of those two events. And in response to your question, Christine, there are products out there that protect you. And that's that whole family of annuity products, that whole universe of annuity products that I think should be in the tool kit, in the discussion, certainly something you should investigate as you get into those years if you don't have a lot of pension income already.
Benz: So, you talked about that convergence of living a long time and encountering a weak market environment over that time horizon. Is that top of mind for you right now? I don't need you to make a market call or anything like that, but have you been thinking about that in the context of the fact that we have had such a long running strong equity market, bond yields are very low today? What's your take on that question?
Milevsky: It's an easier conversation to have in the last few weeks than it was in the last few years. I do a lot of public speaking seminars, academic conferences, speaking to practitioners, even client events, you know, it's stuff to get them excited about downside protection. When they continue to see markets outperform averages, I'll tell financial advisors, you can't assume a geometric mean of 6%, reduce it to 4%. And they say, Oh, come on, but historically, the S&P – I hate to say this, I'm suffering as much as anyone else. But it's good to see these sorts of corrections, it makes my job easier.
Benz: So, let's talk about spending less as maybe a risk mitigator if someone encounters a weak market environment. Is that a potential tool that someone could use? I mean, it's not necessarily palatable, but it's certainly something that someone could use to help protect against running out of money.
Milevsky: Yeah, it's not so much a tool that someone can use. But it's a question that you get asked a lot, how do I respond to the drop? So, the issue becomes, somebody set up a spending plan under the assumption that they would earn certain returns in their portfolio, and for the most part they have, but now we wake up and March 2020, and the markets are down. So, they're saying to me, my portfolio is down 20%, how should I adjust my spending? So, that's where you can have an intelligent conversation of whether it should be reduced by only 15% or maybe you should be reducing it by 10%. So, if someone says upfront, I can never--will never be able to reduce my spending, they are candidates for some of the guaranteed income products, but if they say, yes, I could adjust--so, I won't take a cruise if the market goes down. We tell them, well, here's the good news. The market goes down and there are no cruises to take because they've shut down for a couple of months. So, in some sense, you do have to have those conversations with people before they make their withdrawal plans. But it's really about how do I adapt to what just happened? How do I modify my plan? And if you are able to modify that gives you some flexibility, you can be more aggressive early on.
Ptak: I know we wanted to talk some more about annuities with you. But before we did that I wanted to shift gears a bit and talk about Social Security and pensions if we can. My question is delayed filing, is that usually the best first step to take before someone considers an annuity product essentially enlarge that lifetime payout first?
Milevsky: So, there's this nice benefit to that, you know, still on the books, we don't know how long it's going to last, that if you delay taking Social Security to an advanced age, you get more than you should. And there's no other way to describe this, you get more than you should, in the sense that if we used realistic investment rates or interest rates, which are now basically negative on the real curve, and we use realistic mortality, your mortality, you should not be entitled to get that large increase. I think it's important to explain this to people. You're getting more than you should. And whenever somebody offers you more than you should, you have to stop and say, you know what, maybe I should take it, it's more than I deserve.
If that ever gets adjusted, and they start to reduce that amount that they increase your benefit, we will say, well, now it's kind of fair and maybe you shouldn't. The way the current situation is, the way the current rules are, I think you're getting more than you should. For most people delaying makes a lot of sense, and they will be essentially replicating their own annuity at home. You may not want to buy an annuity. Here's another way to manufacture it that might be more palatable, wait until the very end, you'll get a higher payment.
Benz: So, let's talk about the type of people, the profile for whom an annuity is a good fit. Would that be people without pensions? I would guess people with pensions wouldn't need to augment their plans with annuities, would they?
Milevsky: The term that I like to use is, in order to answer that very good question, you have to take a look at what fraction of your balance sheet right now, what fraction of your entire personal balance sheet, is pension-ized? And by pension-ized I mean, that part of the balance sheet is sitting in a defined benefit pension, Social Security, guaranteed lifetime income product. So, the way you would do this mathematically, and I don't want to get too complicated, is you would add up all the income sources that you're entitled to, that are guaranteed for the rest of your life, Social Security, corporate pensions, maybe annuities that you have already, and then you would compute their present value, you'd add them up and say, well, what are they worth today in the open market, you'd add that to your liquid assets, 401(k)s, IRAs, taxable accounts. And you'd say, okay, that's my total balance sheet, my pension stuff and my liquid investable stuff and you would then figure out what fraction the pension stuff is from the total balance sheet. So, that's the fraction of your balance sheet that's pension-ized. And what I would say is, if that fraction is greater than 70% or 80%, if that's greater than 70% or 80%, which means you have a lot of pension income already, I would say, do not buy any more annuity income. You are overly annuitized. Please, you have enough. There's no need. So, that's it, that sort of upper end.
Benz: Right.
Milevsky: On the bottom end, anybody that says, Moshe, I just did this calculation. I added up my pensions, my wealth, and as a percent, the percent that's fractionalized is only--pension-ized is only 10%. I do not have a guaranteed pension. All my money is sitting in an IRA, 401(k). So, it's less than 10% that's pension-ized, I would say run quickly to an annuity salesperson, you got to talk to them about annuities. So, those are the endpoints. Less than 10%, gets yourselves some more; more than 70% or 80%, you have more than enough.
Anywhere in between this sort of 20% and 70%, I would say, it kind of depends on preferences, and when you want to do it and whether you're comfortable with the idea, do you want to leave a legacy. But that's sort of the way I think about who needs more and who does not need anymore.
Benz: So, the SECURE Act passed by the U.S. Congress at the end of 2019 would allow more defined contribution plans, like 401(k)s, to offer an annuity option to participants. I'd like your take on whether that's a good idea. I'm guessing you'll say it is. And do you think plans will add them?
Milevsky: So, it's tough to answer your second question, you know, is the safe harbor that's been provided going to be enough to prompt companies to do this? Also, even on the first question, I don't think everybody needs more annuity income. I think there's groups out there, as I said earlier, that already have a lot. They don't need more. But generally, what I like about this SECURE Act, you know, what I read in it is that it forces people to think about what matters, which is the income your account generates, as opposed to the size of the account.
Benz: Right.
Milevsky: One of the provisions in there is that at some point, the Department of Labor is going to tell you that you have to convert the account balance into some sort of income and put it on the statement so that people can see that at the end of the quarter or at the end of the year, if part of that is offering annuities that would provide those income sources, that's great. My point is, what I like about the SECURE Act is, yes, it's nice that they're going to be these annuities on the menu. But what I really like about it is the fact that it's forcing people to really treat this as a retirement income vehicle as opposed to an accumulation vehicle.
Ptak: What types of products would make sense to be included in, say, a 401(k) plan?
Milevsky: Something that protects you against these two risks that I alluded to earlier. So, I don't necessarily want to see SPIAs and DIAs, single premium income annuities and deferred income annuities. Especially in today's rate environment, it's very difficult to make a case for them. What I would say is we want products that convert into that if certain triggers are achieved. So, I like market contingent annuities. I like annuities that--we call them in the academic literature ruin contingent annuities. If an account is ruined, they continue to pay contingent deferred annuities, certainly, variable annuities with living benefits. But just because it's called an annuity, I wouldn't put it on the shelf. One of the problems is that an annuity is more of a legal definition or an insurance definition as opposed to an economic definition. You could have 100 economists in the room, and they'll probably agree that certain things that are annuities have nothing to do with annuitization. So, the response to your question is products that guarantee me income for the rest of my life if certain events happen.
Benz: So, I guess a good thing to look at would be the 403(b) space where annuities have been allowable for a long time and a lot of participants have had a really terrible outcome. They've been in these terribly high cost products. So, how can we help ensure that we don't send 401(k) participants hurtling down a similar path?
Milevsky: So, the disclaimer I always say when I talk about the benefits of certain things, I'm a big fan of ETFs. In fact, for the most part, I only own ETFs. But if an ETF provider would charge me 250 basis points for the privilege of having an ETF, I would say that's atrocious. I wouldn't say ETFs are horrible. That is a fee issue. And we've got to ensure that the fees and the compensation and the distribution, and how do we incentivize people to explain these things are all done in a fair manner. But what we can do is we can't tarnish the entire product because of the fact that in some sectors, the fees are very high.
So, I'm not sure if I'm answering the question. I do understand the concerns that have been expressed about these products. But I think it's very, very important to understand that the concern wasn't with what the product does, but the cost of the product. That's a separate matter. This is very different than telling someone, you know what, you need much more life insurance. You should buy a lot of life insurance, and then it turns out they have no beneficiaries, they have no children, they have no grandchildren. Why did you sell them life insurance? They didn't need it. Shame on you. Why did you sell them life insurance?
That's not what we're talking about here. We're talking about people that do have a need for the longevity insurance. But I would agree, they seem to be paying more than the fair economic value of what they're receiving, you know, maybe some regulation, maybe what we need is more transparency, maybe financial literacy, I think will help as well so that everybody in the food chain understands what is being paid, but I don't think we should tarnish the product class.
Benz: So, Jeff and I have talked to several retirement researchers who favor the very vanilla low-cost, single-premium annuities, deferred income annuities. You discuss variable annuities as being beneficial. Let's just walk through the thesis about why you think that the variable products might be preferable at least in some situations.
Milevsky: Yeah. So, first of all, I do have to disclose I own two of them, not just one of them now. I own a variable annuity with a guaranteed living withdrawal benefit. If I take a look, I did before I sit up for this interview, the guaranteed withdrawal base which in plain English is the account value as far as income is concerned, right now is probably 40% higher than the account value from a market perspective, which means that the income that I receive will probably be double what it would have been had I annuitized my account value. So, I don't know if this answers your question, but the reason I'm a fan of them is because they provide protection against market declines and the SPIA and the DIA they provide longevity insurance, but I believe that a lot of people don't need that type of longevity insurance. They need protection against the joint occurrence of markets as well as longevity.
I'm also concerned about the mortality tables that are baked into them and how many people are buying this not knowing that their longevity prospects aren't anywhere near what the annuity pricing is assuming. So, you're buying an annuity. You're very proud because you read in some academic paper that academics like immediate annuities, but then you realize that you're paying the price as if you were 50-years-old when in fact you're 65, you know, going back to the biological and chronological discussion.
So, let me try to summarize it this way. I don't know – I'm sure you've heard of the debate whether people should buy term insurance and invest the difference …
Benz: Yes.
Milevsky: … or whether they should buy whole life and universal. I mean, this is a debate that went back to the 60s. I remember, when I was in graduate school in the 1990s, going to the library and seeing debates in the 1950s about that, buy term and invest the difference, say the purists and then the insurance industry says, no, whole life, you will. I think we're in the same situation right now. The purists saying only buy DIAs and SPIAs, and then people coming in with nuances. There are tax reasons. There's permanence. There's hedging. And I'm very much not a believer of, well, buy term and invest the difference. Don't do anything else. I think there are many circumstances where you want other than term because of very well-defined arguments about taxes, well defined arguments about insurability, uncertainty about human capital. And I think it's the same thing with annuities. They're good. I'm not bashing them. My point is, you have to open up the door to other ones as well.
Benz: So, if I'm a consumer, and I'm interested in this kind of product, what are the key things that should be on my checklist? Because I think it's just a terribly opaque universe. People have a hard time knowing what they're getting, what they should be looking for. What would you coach people to look for if they wanted to seek out such a product?
Milevsky: Yeah. So, the first thing I would coach them to not do is Google the word.
Benz: OK. People hate the word, don't they?
Milevsky: Yeah. I mean--and it's not just that, you know, you get all bunch of misinformation. I would say find a fee-only financial planner. I know do-it-yourself people don't like to hear that. Look, go talk to somebody who's spent hundreds of hours thinking about this and let them direct you to a product, an annuity that would make sense for you given your circumstances, explain the pros and the cons. The 2000-page prospectus or disclosure document is insurmountable to a non-lawyer, I mean, even to a lawyer. How am I supposed to find all the gotchas in this 2000-page document and all the clauses that would allow them to declare force majeure and not guarantee the base? You need to talk to people that this is what they specialize in. They specialize in annuity type products and they have a transparent discussion about compensation. But unless you have a lot of time, trying to figure this out yourself is, it's not going to be easy.
Benz: But that's part of the problem too, finding a fee-only financial planner who knows anything about these products. I mean, I think at least in the U.S. there's been kind of a bifurcation where variable annuities are the domain of insurance people for the most part and fee-only planners don't want much to do with them.
Milevsky: No, I know. There really is a stigma attached to them. But I am seeing more products that are not designed to be commissionable product. There are asset-based fees on it. Some of them are no commission at all. I'm seeing more of it. Because the insurance industry is seeing what you've just described, which is the RIAs saying we don't like these things, we don't understand them. They're very, very opaque. And we certainly don't want the commission version. So, create something that does what you've just described, guaranteed lifetime income, contingent on markets, but not the structure that you have right now. So, I do think that there's change and I think the bigger manufacturers and carriers are aware of it.
But I completely agree. I mean, the current situation has to change because not everybody has a PhD in finance and through PhD students to sit through a prospectus and figure out what's really going on like I did before I bought some of them.
Ptak: A big question that investors grapple with in the annuity space is how much of a portfolio to allocate to one. How would you suggest that investors approach that question? You've suggested 20% to 40% of assets. How did you arrive at that?
Milevsky: Yeah. So, that gets back to the pensionization argument I described a few minutes ago where you add up all the assets on your balance sheet and you add up the entitlements to income and you compute one as a fraction of the other. So, that's sort of where it comes from. It's sort of economic theory that describes what's the optimum risk/return trade off.
To do it less mathematical, I would say, what other guaranteed sources of income do you have? How does it relate to what it is that you're trying to achieve? What is it that you want to withdraw? And at the very least you want 80% or 70% of that that comes from guaranteed sources. Back that out and we get to the 20% or 40% of the balance sheet number that you've just described. So, let me say that again. When I say 20% to 40%, I mean of your balance sheet, not sources of income. I'd like to see a higher percentage in terms of guaranteed sources of income.
It also depends on a spouse, if they have guaranteed sources already, then the family is going to be more secure. So, I would say the number should be lower. People that have very strong legacy and bequest motives, maybe the number should be lower as well.
I also find it interesting that--I think that everybody should have a diversified portfolio at retirement, no different than a nutritionist saying that for breakfast you should have an assortment of products. But everybody wants me to talk about the same thing. Zinc is just one element of the minerals and vitamins you should have every morning. But for some reason I've become the zinc expert and that's all I end up talking about. So, people think this guy thinks that all we can survive on is zinc. No, it's part of a well-balanced diet. There should be many other things like fixed income and real estate and long-term care and some sort of insurance policy, nursing home coverage. You also should invest in family. I mean, treat them nicely, because they are going to pay dividends over time. And I mean that seeing in society what happens to the people that didn't really invest in societal relationships and what it does in terms of depression and what it does in terms of social cohesion. So, there's a whole portfolio of things you need to invest in when you get close to retirement. Annuities are one of them, but please don't spend more than 5% of your retirement income conversation on those things.
Benz: So, you mentioned long-term care risk, which is another huge risk factor for many people's plans. Let's talk about how you would coach people approaching retirement or people, say, in their 50s about how to tackle that issue, given the changes we've seen in that marketplace, how the pure long-term care insurance market is, in many ways, kind of a broken market. How would you suggest people attempt to troubleshoot that risk factor?
Milevsky: Yeah, it's an it's an industry in flux, it's products flux, the number of people that are getting notices saying that their premiums are going to go up or they can lapse, but if they want to keep the coverage, companies that are no longer offering coverage. So, this is one of those where you want to pay very close attention to what's happening and keep the flexibility in whatever it is that you're doing. I'm more of a fan not necessarily of the stand-alone products, but products that you can convert into long-term care, product that give you protection against a bunch of triggers. If you need long-term care, you move into a nursing home. If you can't do four of five activities of daily living, or you happen to be alive at the age of 95, we will pay you this amount, combination products that intrinsically underwrite each other because the risks are somewhat offsetting.
So, the way I would approach that is not necessarily by buying a product that's triggered by one nursing home or a long-term care event, but a product that's kind of part of something more comprehensive, maybe a life insurance policy back to whole life where there is a rider in there that if you need to take some of the death benefit or cash value and convert it into nursing home, you'd be able to do it. Those would be the products I would consider. The toaster and the fax machine and the microwave all in one even though you're thinking why should I mix them because of some of the factors that you discussed and the problems in the industry.
Benz: The hybrid products are what you're talking about.
Milevsky: The hybrid products.
Benz: How about the annuity long-term care hybrids? Do you like those products or do you like that idea, at least?
Milevsky: Yeah, so if it's a true annuity long-term care--you know, some of them say, well, if you have to move into a nursing home, we'll double the payout rate. But that's still my money; you're giving me my money back. That's not insurance. You're just saying you're going to release some of the liquidity. If I get a nursing home or a long-term care trigger event, and I get to take a lot more than I put in, yes, I'd be a big fan of that because of those offsetting risks. My point is, a lot of things are called long-term care riders; they have nothing to do with long-term care.
Benz: So, going back to zinc, as you said, I wanted to talk a little bit about tontines, because you've written about financial history of annuities and tontines. So, let's talk about what is a tontine just so everyone is following.
Milevsky: Yeah, I'm getting more and more requests to chat about that. I find that appealing. 10 years ago, when I was in the archives doing this, people thought I was nuts. But historically, 300 years ago, the way governments raised money – we're talking about before long-term bonds, before the Bank of England. Bank of England was founded in 1694. So, even before that, the way governments raised money for wars mostly, wars were very expensive, is they would go to a syndicate of people, wealthy people, and they would say, look, we need, 100, 1000, GBP 100,000 from you and we will give you every year a coupon of 8% or 10% interest payments. And people would say, okay, that's nice, but we want something more than that. And they would enhance it by saying that if you survived, you would get the 8% or 10% coupon. But if you didn't survive, you as a member of the syndicate, your syndicate members would get your coupons instead.
So, the way this works is, if at the end of the year the entire syndicate is still alive, everybody gets their 10% interest. But if say, half the pool is gone in a few years, everybody would be getting 20% interest because they'd be getting their 10% and somebody else's 10%. And if a couple of years later, a quarter of the pool is left, everybody is getting four times as much interest, 40%. This obviously has a gambling element. It's a speculative element. It sounds kind of crazy. The last survivor gets this huge interest. But this was the way governments borrowed money before long-term bonds. And the reason I mentioned this is because they were extraordinarily popular as a way of financing income in your retirement years, because people were aware of the fact--this is well before pensions--that if you live a long time, it's expensive. You need people to take care of you. And this instrument, even though it wasn't really designed that way, would create an increasing income over time, possibly keeping up with inflation, long-term care costs, expensive costs in the 17th century. So, people found this very appealing as a self-made pension. And they became very popular tontines in France and England. I've learned recently after attending a number of conferences that these were popular all over the world. They just had different names. And this became the way people borrowed money, tontines and the way people invested to create an income in retirement. This all unraveled over time. I don't have the time to go through the whole history. And they almost disappeared from the scene other than the occasional Simpsons episode or Agatha Christie story or a movie.
But now there's this awareness that maybe we should bring back tontine elements, not the products themselves. Obviously, we've evolved in 300 years. Because what this does is it enables us to share longevity risk with a pool without getting an insurance company involved. And that's the appeal to many people, such as the RIAs, registered investment advisors, that just don't like insurance to begin with. They say, this sounds like something that we could create with a large enough book of investors without involving an insurance company and capital requirements and insurance regulation and insurance commissioners. It sounds like we'd be able to create income without needing all of that. And that's why there's resurgence of interest. I hope I've explained them and that sort of gives us a sense of why these are becoming important.
Benz: Definitely. I guess the question is when you think about retiree spending, and our colleague David Blanchett has done some interesting research on that sort of the trajectory of retiree spending, who wants their income to trend up as they get older. It seems like people spend more avidly when they are younger and want less income as they get older.
Milevsky: Absolutely. So, the original tontine design from the 17th century had the income growing over time, and I agree. What 97-year-old really wants millions of dollars a year, right, and how many of them will even be aware of the fact that they just got it, right, I mean, thinking about the fact that they are 97. But the modern design, modern tontine thinking would say, well, here's what we're going to do with this syndicate. Early on, we are going to give you 15% or 20%; later on, we're going to give you much less so that we balance out what you've just described. There's no reason at all that the interest rate to the syndicate is a constant 10% forever. What we could so is, we could start off and give you very large income, so buy--think of zero coupon bonds that mature in a year, we buy a lot of those for the first few years, because as David points out, people want to spend more early on. Later on, the payment would go down, but at least you're guaranteed an income for the rest of your life as long as you live. No retiree, even if they say I want to spend less when I'm 90, no retiree wants to be told, by the way, if you get to 93, there will be no more money at all because you will have run out. They all want some guarantee that no matter how long they live and that's where the tontine would come in. But I completely agree with you. We're not resurrecting the 17th century version.
Benz: OK. Let's talk about the retirement system in the U.S. You hinted that potentially Social Security reform to address the fact that wealthier folks are living longer maybe on the horizon. What other things do you think could help make retirement preparedness better in the U.S. as more and more people get into retirement without the benefit of pension?
Milevsky: So, I'm a big fan of the work I'm sure you know of Olivia Mitchell on financial literacy and the work she has been doing on what is it that we need to teach people early on in the life cycle so that they can make more intelligent decisions around Social Security and how do we educate people about this sustainability of the systems so that when we go with a plate and say, we need to collect more from you, we need more in order to finance that people will appreciate the benefit of it. So, I think a big part of it is, let's get the financial literacy right and let's make sure people understand how expensive it is to give people an inflation-adjusted income for the rest of their lives. The present value of their Social Security benefit is hundreds of thousands of dollars. Let's tell them that early on. I think that that would be number one.
I think number two is just a general awareness of the transfer that's taking place as we have more mortality heterogeneity, we know that there are people that are not living as long as other to be clear on where that transfer is and have an open political debate about whether we're happy with that, with the person that's claiming at the age of 70 who is going to live for 30 more years is being subsidized by somebody who isn't and a discussion around is that the way we want to do it. So, those would be some of them. None of them involve tinkering with the system. This is just explaining, persuading, certainly having an open debate.
In terms of technical fixes, you know, I'm not a U.S. Social Security expert, but if you adjust the index, not for wage inflation but for price inflation, you're going to reduce a large fraction of the unfinanced or the unfunded liability. And if we increase the cap so that people have to pay into this up to 300,000 versus 130,000, you can fix some of it. So, those are technical fixes in order to bring this on to a stronger footing and I'm sure technical committees will be created to fix that. But I think that even beyond that we need the public to appreciate the value of what they are receiving.
Ptak: Do you think a defined contribution driven system like we have here in the U.S. now is essentially putting retirees to be in a position to succeed? I think that we've talked to a number of speakers and they have indicated that there's a real tension there that while they can be accountable for the investment decisions that they make in their retirement plans, it may not necessarily would be putting them in a position for retirement readiness.
Milevsky: You know, unfortunately--and today is a good day to remind people of that, Jeff, this all depends on how things turn out in the market 15 or 20 years from now. If Jeremy Siegel is right and in the long run equities are going to bail us out of all our problems, then DC is the path to success, because DC for the most part means these accounts where you invest in the markets. But I'm concerned what if this persists for 10 years? I mean, we had that from 2000 to 2010. I'm also concerned about people that are automatically being put into fixed income right now simply because of target date and life cycle funds where the bond by definition cannot yield more than zero because the yield is close to zero already and the mathematics of bonds being what they are means that you are not going to earn very much.
So, in some sense, the answer depends on the future and I don't really know the future.
Benz: What about the virtue of doing my accumulation outside of the confines of an annuity, so just using plain-vanilla stocks and bonds and then as decumulation comes close, transferring then to some sort of an annuity product and maybe getting away from some of the costs during my accumulation years?
Milevsky: There's certainly a consideration. That's a spreadsheet problem where you have to tell me how old you are. You know, you're 30; you are looking at paying 150 basis points a year for the next 30 years. Will that be worth it versus the risk of buying the annuity in 30 years and there's a very good chance that when you spread sheet it, my answer would be, you are absolutely right, don't buy it now, wait. It depends on where interest rates are and what the annuity is going to cost. Annuities today are extraordinarily expensive because interest rates are so low. By annuities I mean the real thing, the income annuity, the economist annuity, the SPIA. Anybody that took your strategy for the 10 years and said, you know what, I like annuities, I'll buy it in 10 years. So, now, I'm going to manage a portfolio of stocks and then, in retirement I'll buy the annuity. Well, they have faced a double whammy. Depending on where the market goes, their portfolio could not be worth what they thought it would be. And right now, immediate annuities are extraordinarily expensive. They are historically low rates simply because bond yields are at historically low rates.
So, you're timing the bond market with your strategy, if you're comfortable doing that, if you are professional bond trader, go ahead.
Benz: So, your research has addressed a lot of different facets of retirement planning. Are there any areas that you expect to work on further that you think need to be addressed and that we should expect to be seeing in your research in the years ahead?
Milevsky: I think I've gained a greater appreciation over time for almost anthropologist that goes to live amongst the gorillas in Africa and studies them and talks about what they do in practice versus what in theory they should be doing. And I'm gaining a great appreciation for how people actually manage their retirement in practice versus how you tell them to do it and the resilience and how people adapt to their income regardless. So, I would say if I had to predict 10 years from now what I'm doing, it's hanging around nursing homes and seeing what people do.
Benz: Well, Dr. Milevsky, this has been a great conversation. Thank you so much for taking time out of your day to talk to us. It's been super illuminating for me. I appreciate your efforts and your time today. We both do.
Milevsky: My pleasure.
Benz: Thank you so much.
Ptak: Yeah, you are great. Thank you.
Benz: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts. You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.
Benz: Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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