Happiness Is a Reliable Income Source

June 6th, 2010

The content of human happiness is a subject for never-ending speculation and wonder. One aspect of this picture seems to have clarified, however. Retirees consistently say that they are happier when they have a reliable source of income than when they don’t.

Unfortunately, retirement is, by definition, that time of life when earned income ceases. How, then, should a prospective retiree find a reliable income source?

What is a Reliable Source of Income, Anyway?

Surveys of retirees are valuable but potentially misleading. Reactions to the phrase “reliable source of income” will vary not only because people have different needs for security and growth, but also because people will define the word “reliable” differently. For our purposes, call a “reliable source of income” one that is stable and secure. That is, the amount of monthly income doesn’t decline (it may increase if indexed to inflation) and payment of the money is virtually certain.

The Usual Suspects: Social Security and Company Pensions

A snapshot of Americans’ balance sheets would reveal that about 40% of retirement income is projected to come from Social Security payments. These are based on the number of covered quarters of employment and the amount of income earned. Enrollees can discover their projected benefits as of today by consulting the Social Security Administration.

Company pensions are regular lifelong payments made by businesses to their employees. These are generated by contributions made by employees during their working lifetime. (Although contributions may be attributed to the business, this is misleading – just as it is with Social Security “contributions.” The company’s contributions are actually made by the employee in real economic terms, since the wage paid is lower than it would be without the employer’s contribution.)

At one time, Social Security payments would have been considered the most stable and secure income source for retirees.  Repeated studies have shown that the actuarial unsoundness of the Social Security program has continually increased for over a decade. Eventually, the system will need outright subsidies from general revenues. That is a political decision that will require Congressional approval and Presidential signature. Thus, an opinion about the reliability of the system today depends on a political judgment about how likely lawmakers and executives are to approve those subsidies.

Company pensions were likewise considered as good as gold for many years. In recent years, various high-profile companies have succeeded in shedding their pension liabilities. Moreover, studies show that company pensions are underfunded in the aggregate. To the extent that a pension is dependant on the financial solvency of the sponsoring company, the pensioner’s income-security eggs are heavily concentrated in that particular basket. This level of risk may violate our virtual-certainty criterion for security.

The “Riskless Asset” – U. S. Government Securities

Fixed-income securities are longtime mainstays of retirement investment because they primarily offer income rather than growth. This fits the needs of retirees. For well over a century, the prototypical “riskless asset” was U.S. government bonds. If a bond is held to maturity, its only risk is default by the issuer. U. S. government bonds were backed by a taxing power wielded over the world’s most prosperous economy. Default was therefore considered unthinkable.

That has changed somewhat, and only time will reveal the magnitude and permanence of that change. The staggering budget deficits – both current and projected – recently rung up by the Bush and Obama administrations have led Moody’s, the most prestigious bond-rating agency, to threaten a downgrade of the government’s credit rating. Although the default risk of U. S. government securities is still considered very small, this tiny crack in the budgetary dam is ominous.

Corporate Bonds

There are many corporate bonds to choose from, even if the investor is restricted to the safest, “investment-grade” securities. By holding corporate bonds to maturity, the investor can escape reinvestment risk. The failure of bond-rating companies to foresee the risks of excess leverage has cast some doubt on the value of their ratings. This has driven corporate-bond investors to bond funds, which diversify away most default risk. This risk-reduction has a price – namely, the “interest-rate risk” borne by holders of long-term debt.

Corporate bonds can provide stable income, but their security is somewhat in doubt. The same is true – for different reasons – of bond funds.

“Blue-Chip” Stocks

At one time, the stocks of the largest and most secure firms were referred to as “blue chips.” They were highly prized by retirees because of their longstanding record of paying dividends. Although stock dividends are residual income rather than contractual promises, the blue-chip companies guarded their dividend-payment records almost as jealously as they did their bond ratings.

That day has gone and will not return in the foreseeable future. The tax system is heavily biased against dividends; they are taxed once as corporate income and again as personal income. This has gradually changed corporate policy in favor of income-retention for growth purposes and against dividend distribution. Growth accumulates untaxed until the stock is sold – quite possibly in retirement – while dividends are exposed to current taxation as personal income to the shareholders.

This bias affects capital budgeting as well as dividend policy. Corporations choose debt finance rather than equity because interest payments are deductible while dividends are not. (Most economists regard this as a flaw in the tax structure.)

The upshot of all this is that blue-chip stocks are no longer a reliable source of retirement income.

Mutual Funds

It is possible to avoid both the Scylla of corporate default and the Charybdis of low income payout by continuing mutual-fund investment into retirement. Diversification would remove most bankruptcy risk, while the investor can withdraw dividends and sufficient additional principal to meet income needs. In fact, many financial advisors are recommending mutual-fund investment as part of a “mixed strategy” of retirement investing.

Unfortunately, mutual funds are not a panacea for retirees’ income problems. The large variance in share prices and growth means that retirees cannot withdraw a sizable fraction from the fund and still expect to maintain principal intact. (Current suggested withdrawal rates hover in the range of 3-3.5%.) Consequently, the mutual funds’ role in the strategy is growth-oriented rather than income-oriented. For a reliable source of income, mutual funds must be supplemented with another income source. Increasingly, that income source is annuities.

Annuities

After a long time in the shadows of retirement investing, annuities are beginning to come into their own. This is due less to changes in annuities themselves than to relative changes in competing sources of income. Social Security and company pensions have become riskier income sources. After recent financial-market and ratings-agency scandals, corporate bonds are also riskier than before. Bond funds carry inherent interest-rate risk. Mutual funds cannot satisfy retirees’ income needs on their own.

Annuity risks have not changed much in the absolute sense, but the heavier risks of alternative investments have made annuities less risky relative to other assets. The growing popularity of no-load, low-cost and inflation-indexed annuities has helped to increase the popularity of annuities. The net effect of these changes has been to revive interest in annuities.

Annuities meet the standard of income-reliability reasonably well. They offer the option of annuitization via a life annuity, which provides a guaranteed source of level, lifelong payments. While it is perfectly correct that the security of these lifelong payments is only as good as the issuing company’s financial strength, life-insurance ratings by the large ratings agencies allow the potential annuity purchaser to evaluate the company’s financial status. Because of the diversified range and conservatism of their investments, insurance-company investments bear less risk than do those of ordinary companies.

Academic research strongly suggests that annuities become more valuable as investors’ risk aversion increases. The recent financial-market meltdown may have effected a sea change in investor attitudes toward risk. Increasing life expectancies have also bolstered the case for annuities, since the rate of return on an annuity payout improves as the annuityholder’s age increases.

The Bridge and the River

An old adage contrasts different ways of coping with the risk of flood to a bridge – either raise the bridge or lower the river. The status of annuities as reliable income sources in retirement has changed in ways analogous to these. Refinements to the annuity product have “raised the bridge,” while increases in the risk of alternative investments have “lowered the river,” relatively speaking. This combination of changes has made annuities the most reliable current source of retirement income.

Category: Annuities, Economic Analysis, Fixed Annuities, Indexed Annuities, Investment Strategy, Retirement Planning, Risk | Tags: , , , , , ,

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