New ways of creating personal pension type retirement income producing portfolios

Invitation to a conference dealing with annuities and optimal allocation in retirement provides an opportunity to evaluate two special calculators, one (from a major Canadian insurer) kept for financial advisors and insurance agents/brokers, while the other freely available for anyone on the web. Both have advantages over most of the other available retirement planning tools, but there are significant differences between these two as well. The exercise illustrates some of these differences and gives weight to the claim that inherent conflict of interest situations practically all service providers are in can be seriously at the detriment of clients who seek individualized pension type life-long retirement income streams that are to keep pace with inflation. The exercise helps to understand the nature of depletion or distribution portfolios, and the merits and limitations of guaranteed income providing annuities and doubly-insured mutual funds (so called Guaranteed Minimum Withdrawal Benefit Plans or GMWBs).


  • The Problem
  • Explanations?
  • What are annuities anyway?
  • Two special calculators
  • The three slide-shows
  • What did we learn?
  • Addendum, on Aug 28, 2009
  • The problem

    Recently, I got invited to a “unique one-day conference to discuss and debate what role income annuities should have in retirement income portfolios and what constitutes an optimal allocation in retirement“. Yes, the topic is unique indeed. While annuities are part of the curriculum leading to perhaps any kind of financial designation or license, there has been hardly any mentioning of this income generating investment form by insurance companies, advisors, or financial magazines in the last several years. (There has been one exception, the so-called ‘insured annuity’ concept, to which I’ll return elsewhere.) The keynote presentation at this conference is promised to address the situation that is characterized this way: “For many decades, a major divergence between the central role that life annuities play in theoretical portfolio models and the virtual absence of voluntarily purchased life annuities from the actual portfolios of real retirees has persisted.” The question of ‘Why has this been the case?’ immediately crops up in one’s mind.

    The organizers of this conference seem to see the problem in terms of consumers ‘not getting it’, or perhaps even actively resisting professionals’ attempts to explore how annuities could help income security in retirement. Picking ‘Understanding why consumers are not acting in their own best interests‘ as the first of three declared focuses of the conference clearly suggests this approach. I will argue, and show evidence, in this post that the undeniably unfortunate situation of downplaying the role of annuities may be caused directly not by resistance of consumers, but mainly by ignorance by almost all involved, and poor service by financial service providers, both companies and individuals. Of course, we have to dig deeper and find the forms of and reasons for that ignorance and poor service.



    I’m sure the whole aura of hyper expectations in the financial markets in the last 2-3 decades contributed to both the complacency feeding the ignorance and the provision and acceptance of the poor service, by showing annuities as mundane, boring, not ‘sexy’, low-return options. Recent sobering experiences have probably started to change somewhat this general attitude shared by many consumers and service providers. Interestingly though, the change in service offerings is still hardly noticeable, and I guess the explanation is mainly in the incentives of service providers, namely the inherent conflict of interest situations most service providers are in regarding giving the best advice to clients.

    First, annuity products are offered by insurance companies only, since their ‘manufacturing’ requires the kind of expertise (actuarial calculations) that others are not trained for and entitled to offer. At the level of advisors or sales people, similarly, only those who have an insurance sales license can offer annuities to consumers. In other words, a bank, a mutual fund company, a discount broker, or an advisor without an insurance license is not simply not having a stake in exploring annuity options, or educating clients about them; rather, as long as they are compensated by commission on a transaction basis or even according to assets under management (AUM) in a fee-based arrangement, they have a strong interest in not even mentioning it because this is something that can potentially take away a lot of business from them.

    [As an insurance-licensed person, I’m in a conflict of interest situation too, although in exactly the opposite sense. I could get out of it only by giving up that license, … but it wouldn’t really help clients, since they simply cannot buy these insurance products without the involvement of someone compensated by commission; that’s how the playing field is set up. It’s different with non-insurance products, therefore I gave up my mutual funds sales license. Being straightforward and transparent regarding the issue, communicating meaningfully and with detailed, real arguments both for and against various options, and being open even about compensation differences between alternatives shown to clients are the ways in which I stick to my professional principles and address this unfortunate conflict of interest trap.]

    Second, even for insurance companies and insurance agents or brokers, offering annuities has not been a very exciting option, compared to other insurance-industry-provided products. Whole life and universal life insurance policies, as well as segregated funds all offer much higher commissions than annuities, … not to mention the lack of further ongoing compensation with annuities, while that’s a major factor with the previous ones. It’s likely not just the individual sales people though: insurance brokerages and perhaps even the insurance companies themselves are not really excited about annuities either, on a similar basis: there is much more money in promoting other products.

    Third, I think it’s much more than direct (immediate and on-going) compensation that is the issue here. Selling an annuity to a client can be seen as, in a sense, losing that client, … which is a big issue in a relationship-based business. As long as the client has a product that requires ongoing service, the relationship is alive, and – especially if it’s well cultivated – it can lead to further connections and product sales, … bringing additional compensation. Thus, from a sales point of view, it’s better to have a client with whom the relationship is ongoing and alive – because if this ongoing service, … renewals, portfolio adjustments, additional deposits, etc. – than another who paid into a life annuity and that’s perhaps the end of the story, so to speak, as for the service is concerned. That latter client will have a stream of income, and there may be no need or even opportunity ever to take further actions with that sale. It goes against the widely accepted and promoted industry logic of ‘building a fence around clients’ (sic!; sorry if the metaphor offends you, … it’s not of my invention or guide) by offering more products and ongoing services. It’s also less likely to get referrals from someone who bought an annuity from you several/many years ago, than from someone who bought some product at the same time, and has been in regular meaningful contact with you ever since.

    All these points are generalizations, of course, allowing exceptions. However, I think it’s problematic if one has to be an exception to be able to serve clients’ interest best. Furthermore, even with the best intentions and willingness to go against one’s own financial interest if the client’s interest demands so, an advisor has to be on alert and cautious with what the product provider companies offer as solutions and seemingly useful tools. I will demonstrate here via a specific example what I mean, but let’s sum up first what the main characteristics of annuities are.


    What are annuities anyway?

    The distinguishing feature of annuities in designing retirement portfolios is that they can address one big unknown, the length of our life span, accurately. Moving into more conservative investments when approaching and while in retirement is practiced by many. The main issue with most retirement plans is to ensure that there will be sufficient income coming from the portfolio if the client lives long, even if much longer than statistical life expectancy. In the most basic form, when you buy an annuity, you give a lump sum to the insurance company and they, in return, will pay you a contractually guaranteed income for life, … whether it means two years or fifty years. Under this basic variant, that’s their only obligation, … what you gave to them is theirs now, you cannot change your mind, you cannot withdraw a lump sum, and even if you happen to die prematurely, there is no money left for your heirs. In addition to addressing the unknown life span issue, non-registered annuities are remarkable from taxation point of view as well: a part (in most cases a major part) of annuity income is considered return of capital, therefore flows tax free to the annuitant.

    Annuities are simple to understand, they don’t demand ongoing managing, and they have a few variants beyond what I described as the base variant here. These variants (deferred [that can be superior to GICs], guaranteed term, indexed, guaranteed payment period, accelerated payment, cash-back death benefit, etc.) make annuities flexible to adjust to individual circumstances. Just like they appreciate the slowly disappearing defined benefit pension plans from employers, people would appreciate these annuity features, were they well informed about them. They don’t, because they aren’t. To find evidence for this, it’s enough to look at the huge sales success by a few insurers with so-called Guaranteed Minimum Withdrawal Benefit Plans (GMWBs), after they were introduced about two years ago. The main attraction and novelty of these plans is an annuity-like feature, that is the guarantee of life-long income. More about them later.


    Two special calculators

    The most important part of this post is the conclusions from the comparative assessment of two relatively new software tools. Their common unique feature, compared to the many available retirement or financial planning calculators, is that these two do optimization of retirement funds at a different level. Calculations by them include not only equities (stocks) , fixed income assets (GICs, bonds), and cash (money market funds or savings accounts), to mention just the main asset-allocation categories all the traditional calculators use, but also annuities and GMWBs.

    One of these software tools is available online, but ostensibly only for advisors. The best would be if I could show you here how it works, but it’s a tricky issue. While the special website where it is available is not part of the password protected advisors’ website of the company, while they showed the software on big screens to the public on the Financial Forum, e.g., and while many clients can see its website address if/when their advisor shows them what can be learned from it in their situation, still, there is no link to it from the public website of the company, … and even when I did a site search it didn’t bring up the page with the calculator. This ‘we don’t show it but we don’t really hide it either’ approach I find a bit disingenuous. There are even some strict legal conditions attached to its use, that I find puzzling. Here is the text I had to grudgingly accept to get access when I set out to evaluate how it works, and how useful it is:


    By clicking on the “ I Agree ” button, you attest and confirm that you are a Dealer, Broker or Advisor affiliated with [company name]. You also declare that you have read the information that follows and that you are acting in accordance with all legal and compliance requirements described below.

    You are acting in accordance with the [company name] Code of Business Conduct and Ethics, the [company name] Privacy Principles and Practices and your Producer’s Agreement.

    You have fully advised your existing and/or potential clients (the “Clients) how you will be collecting, using, and/or storing their personal information when accessing this website and/or utilizing any tools contained within (including any calculators and illustration systems). You have obtained the Clients’ explicit consent for the collection, use and storage of that information and have provided them with a copy of the [company name] Privacy Principles and Practices prior to accessing this website.

    All rights reserved. All information contained within this website is the property of [company name]. It may not be copied, transmitted or used without [company name]’s express written approval. It is strictly for information purposes only and is not intended to provide specific financial, investment, tax, legal, accounting or other advice and therefore, should not be relied upon in that regard. [company name] is not responsible for any damages or losses arising from any use of this information.



    I say ‘grudgingly’, because this text itself is very much against my principles and understanding of professionalism and responsibility. It’s one thing to decline responsibility for things outside our control (like future market returns., e.g.), but it’s another to do the same for what we do, offer, or show. Also, if it is not to be relied on at all (not even as a part of a set of tools and considerations), then why is it there, … and why can the advisor produce a nice personalized 14 page report to clients with it?

    Anyhow, even if I cannot show it, I will at least describe my experience with it, and then compare it with another widely available software tool. This second software tool I can name up front: it’s the same Otar Retirement Calculator (ORC) that I’ve used in previous posts. Anybody can download it from, and you don’t have to be an advisor to buy and use it. Now, you can download even Jim Otar’s soon-to-be-published book (Unveiling the Retirement Myth) from there. The book gives all the information (and most likely more!) that you need or want to be able to use ORC yourself, or communicate sensibly about these issues with your advisor.


    The three slide-shows

    The following three slide-shows give you the details of this comparative assessment. In the first one, you’ll get acquainted with the online Product Allocation Tool (PAT). In the second, we continue the exploration and focus on the case of a 60-year-old new retiree, trying to find the best solution that PAT offers. Finally, in the third slide-show, we repeat Case #2 step by step, but this time on ORC. It will be interesting to see where and how the two calculators are in concert, and where, how, and why they aren’t.

    To give you the punchline in advance: While you’ll see evidence that both tools can be superior for general retirement planning purposes to other more traditional calculators, you will also see why I prefer ORC, and why one has to be cautious with PAT. The slide-shows themselves are available outside this post as well, therefore you’ll find some repetition in what you hear and read. I hope you won’t find it boring; actually, it might be even useful, in case you have difficulties with my accent during the slideshows. 🙂


    What did we learn?

    According to Case #1 run on PAT, I think it’s fair to say that the introduction of income sustainability calculations using guaranteed income sources is an important positive step. On the other hand, we found that this PAT is at least as much of a shrewd sales tool as a seriously analytical one. It doesn’t show the detailed background calculations, the time horizon assumption is not disclosed, it tried to impress us with unnecessary animation, suggested moving assets when it was not warranted, didn’t let us try our own combinations in some situations, … and when we were free to do that then we could easily find solutions that were less costly and as good as, or even better than, the ones the software automatically suggested. We just had to disregard its warning that we shouldn’t move outside the suggested ranges.

    The potential seriousness of the inflation factor was demonstrated in a situation when seemingly all uncertainty was eliminated by relying only on annuities; when we examined it a bit more closely we discovered that level benefit paying annuity would not completely eliminate all the risks, and the need for managing investments even late in retirement.Because of all these, this tool can be used either decently, when figuring out individualized optimal solutions, or deceptively and mindlessly, when quick-sale cookie-cutter so-called ‘solutions’ are treated as acceptable or perhaps even desirable, from a sales point of view.

    The second case run on PAT didn’t invalidate any of our findings from studying Case 1. We had to use this PAT boldly and unrestrained, disregarding some warnings in the process. We achieved highest RSQ scores by applying more annuities and less GMWBs than the Model Product Allocation offered. There was a meaningful difference between running the same scenario for a male and a female client, which underlines again the importance of longevity / time horizon assumptions. We had to remind ourselves that RSQ calculation or income stream security, while very meaningful, in itself is not the whole story; to decide about portfolio allocations there are a few additional fundamental aspects to consider.

    Here is the last slide from Part 3 of the presentation (calculations for a 60-year-old for getting $13,000 annually for life from a $300,000 non-registered account):

    summary chart

    Perhaps putting a few key earlier charts side by side in this last slide is the most helpful way of seeing the tendency that we detected. These screen-captures from ORC show basically what RSQ is about in PAT: the likelihood at various ages (along the horizontal axis) of having various levels of income. (Green means full income, red means no income at all.) Those five charts on the top with some red in them represent the strategies that don’t use guaranteed income producing insurance products: annuities or GMWBs. Then (last chart in the 2nd row) we introduced these guaranteed (or pension-type) products, … first in the proportion that PAT offered as optimal. Since we were not too impressed, we went on exploring: We found that disregarding the PAT-offered allocation leads to a better outcome, … just like it did when we were experimenting with PAT. The major improvement came when we included inflation-indexed annuities, … products that were disregarded by PAT, … which is not a surprise if we consider that the company behind PAT doesn’t offer this kind of annuity. According to ORC’s transparent and unbiased calculations though, it’s exactly this kind of annuity that could most successfully address the potentially huge problem that retirees may have to face, namely: long term erosion of purchasing power of money by inflation.

    I made some critical comments here about PAT. It would be unfair to not acknowledge in the summary again that with all its problems, this tool is better for retirement planning than what most financial companies as advisors use. Creating it was not the first occasion when this unnamed company went ahead of the crowd. When I criticize how they present the calculator, how they even play this game of ambivalence with its availability, and how they seem to be more self-serving than professional, then I don’t try to make them seen any worse than any other financial company. Actually, they are probably better in some respect then many others, … but some skepticism and preparedness in dealing with them is as needed as ever.

    Some people may think that instead of inflation, it’s he opposite, that is deflation, that we can count on. It’s a good feature of inflation indexed annuity that even when price level decreases, the annuity income will not; it means that in those years the purchasing power of the income would not simply be preserved but increased. There is no such straightforward answer to two other related concerns regarding inflation: First, how accurately official inflation figures describe reality; second, how individual or personal inflation relates to national averages. As for the first issue, it probably makes sense to be a bit skeptical; if only half of what some people claim in this regard (see, e.g., for US data), namely that official inflation numbers are regularly understate reality, than you’ll be wise to adjust you expectations and plans accordingly. As for the second issue, one’s personal-level inflation depends on the ‘basket of products and services’ one pays for, as opposed to that statistical basket for average citizens or families. In other words, it’s partly a matter of lifestyle choices, and also influenced by circumstances, from place of residence to household arrangements to health status, etc.

    While in these comparative calculations we did not deal with it at all, it’s worth mentioning that there is another inexplicably neglected asset category that addresses directly the inflation issue: real return bonds. These are special fixed income assets providing a modest return, … but over and above inflation. One of the unique strengths of ORC is that with it one can run aftcast calculations with portfolios including real return bonds as well. Since PAT doesn’t do calculations with such assets, there was no point including them in the ORC calculations here either, … but it’s good to know that the opportunity is there.

    We had some uncomfortable issues with planning horizon (mostly because it was not clearly revealed) when we experimented with PAT; ORC is very straightforward and transparent in this regard as well, … and putting more emphasize on inflation-indexed annuity is probably the best way of tackling with the longevity challenge as well. While level-income annuities or GMWBs can address the longevity aspect itself, they are less secure (even the fixed percentage-indexed annuity version, I suppose) from an inflation-protection point of view.

    Closely linked to the time horizon question is the issue of gender. As we found, women can realistically expect a lower sustainable income than men from the same asset size, … whether we used PAT or ORC, the difference was about the same.

    The calculations here were done on relatively modest size retirement accounts and desired income levels. It would be a mistake to conclude from it that inflation-protection and life-long guarantees are for the not-so-wealthy, but less important for bigger accounts and higher income levels. The crucial issue is not the size of the account or that of the income, but the proportion of these two. Someone with a huge retirement asset base but with similarly high income needs or wants can benefit a lot from securing guaranteed income sources, while someone with the same initial account size but much lower income needs or wants, especially if s/he is not very risk-averse and is able and willing to deal with managing those assets, can completely avoid annuities, GMWBs, or real return bonds. (Remember how PAT disregarded this potentiality when we experimented with the desired income level? I think it’s the signal of problems when tools and service providers try to offer the same for quite different situations.)

    Finally, it’s important to emphasize again that while the focus of attention during the whole presentation was on lifelong income sustainability, in terms of purchasing power, retirement planning has other aspects as well that can be important to different extent and in different ways to different people. In other words, however useful these calculations may be (and it’s a ‘may be’ only, since we do not know for sure how useful exactly even the best lessons of history will turn out to be for us), they can be only part of the planning process, almost never the whole thing. ORC can be used for the analysis of some of the more personalized ‘what if?’ scenarios (we used only part of ORC’s power in this introductory exercise), but it’s the best – or even inevitable, depending on the specifics – to use other computer tools as well. Taxation, estate planning or insurance issues and calculations, e.g., are more or less outside the reach of ORC, … one needs additional tools and approaches for them. Similarly, from a goal-setting or creative vision making point of view – something the importance of which many people do not recognize anyway – ORC is not the best elicitor, not to mention PAT that is especially simplistic in this regard.
    While it is important to consider ORC as probably the most important piece in the retirement planning tool kit, it’s also important to recognize, I think, that is can be creatively used for planning for accumulation portfolios as well. In those situations, its role and usefulness is not as unique as with distribution portfolios, still its clear handling of data and secular cycles makes it an enlightening resource.
    One can triangulate forever with high tech tools, of course, but at the end of the day they will prove to be useful only when there is good handling of a very old low-tech tool as well: talking, … that is sharing thoughts, ideas, information, wishes, fears and intentions. All these tools and calculators are to enhance merely the art of planning, they cannot even promise more than that.


    Addendum, on Aug 28, 2009:

    If you go to Jim Otar’s website, you will find links to the recent article by Jonathan Chevreau in the Financial Post about Jim’s new book, and the two-part interview they did as well (here and here). I highly recommend these interviews. I also added my comment to Chevreau’s blog post about the huge response by readers to the article.


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