A Variant on Target Date Funds that uses Deferred Life Annuities

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Horton
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A Variant on Target Date Funds that uses Deferred Life Annuities

Post by Horton »

A recent National Bureau of Economic Research (NBER) working paper examines a variant on target date funds that uses deferred life annuities rather than bonds to reduce risk as retirement approaches. The abstract of the article is provided below.
This paper evaluates a new variant of the popular target date funds used in employer-based retirement savings plans. We call this new variant a “target retirement plan.” Instead of increasing the allocation to bond funds as retirement approaches, a target retirement fund gradually purchases deferred life annuities beginning at age 50. In the particular straw model target retirement fund examined in the paper, the defined contribution participant makes deferred life annuity purchases at ages 50, 52, 54, 56, 58, 60 and 62. We compare how a target retirement fund participant would fare compared with someone who stays with a traditional TDF until retirement and then buys an immediate life annuity. We examine 1,000 possible 30-year futures for stock returns, bond fund returns and Treasury interest rates. The main result from this paper is that buying a retirement annuity in advance (by accumulating deferred life annuities) is superior to sticking with a Target Date Fund until retirement and then buying an immediate annuity in most scenarios of future stock returns, interest rates and bond returns.
I found the article and it’s resulting to be interesting. That said, the authors do not mention any of the limitations of annuities. For instance, locking in an annuity at age 50 deferred to age 65 is likely to be unappealing to many given the irrevocable nature of annuities; most would prefer the flexibility of having capital that they can convert to income via a variety of methods later in life when they retire.

It’s also worth noting that many 401k plans do not even allow in-plan annuity purchases. As such, it wouldn’t be possible for an individual to purchase a deferred life annuity prior to age 59 1/2. That said, the target audience for this article is likely plan sponsors and investment companies building target funds, rather than individual investors.

Second, inflation is not explicitly mentioned, although I think it’s implicitly recognized in their results via the future stock returns, bond fund returns and Treasury interest rates that are used.

I anticipate that an individual could get similar results by beginning to build a non-rolling TIPS ladder 15-20 years before retirement. An individual could also use duration matched TIPS funds to accomplish this; the Dimensional Target Retirement Income funds provide an example glidepath that an individual could use. An individual could also convert these assets into annuities during retirement, if desired.

Last, it’s worth noting that the authors achieved better results using deferred annuities in their model (and using their assumptions), but the outperformance over traditional target date funds was not life-changing - it amounted to about 6-10 months of the individual’s salary before retirement. While potentially meaningful, I don’t think that this result would dramatically change one’s retirement plans.
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JoMoney
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by JoMoney »

I don't think it's a surprising result, every time I've looked at life annuity vs bond portfolio laddered to relative life expectancy table, the annuity offered a higher payout to the relative life expectancy (with the guarantee of lasting however long one lives, but nothing for beneficiaries if they pass earlier than expectation.)
What was surprising was the quoted statement,
... The main result from this paper is that buying a retirement annuity in advance (by accumulating deferred life annuities) is superior to sticking with a Target Date Fund until retirement and then buying an immediate annuity in most scenarios of future stock returns, interest rates and bond returns.
Specifically with regard to the stock return component, I would expect/hope that despite being a more risky holding, that in most scenarios holding stocks for a longer period would have resulted in a higher return in most scenarios (but the risk that in some it was worse.)
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by petulant »

It's hard to know how to take the results since it's clearly not apples-to-apples in the handling of stocks in the annuity-based plan versus the stock/bond portfolio plan. The former stays in stocks except for annuity purchases; the latter would start a transition that, I assume, includes rebalancing. On first reading, the glidepath for transitioning equity to fixed income seems to be mathematically distinct between the two options as well (i.e., are they just putting 10% of equity into bond funds at the same ages for the TDF?).

In discussing the deferred annuities, one noteworthy aspect that the authors discuss is the implied interest rate immunization from deferred annuities. A typical SPIA that covers only a portion of the monthly budget hedges duration on par with a bond ladder; the insurance company is handling its overall cashflow projections in a way that can tie bond maturities to the right year to meet liabilities (payment to the annuitant). SPIAs are technically better at this than bond ladders because they increase payouts relative to the bond ladder by also recognizing mortality experience (i.e., some will pass away by a certain point). Nevertheless, if you were to build a bond portfolio with funds and then convert some of that portfolio to an annuity at age 65, you may have a duration mismatch where you were reducing duration because you are retiring soon or because you are risk averse in a mixed stock/bond portfolio, and then you are increasing duration when purchasing the SPIA. Purchasing deferred annuities earlier actually prevents this potential mismatch and results in "correct" duration immunization for the annuitant--there is a rate or a curve of rates locked into the product that directly matches the inflow today to all future outflows needed. While this duration would result in more volatility for a bond fund, annuities can "hide" the volatility from the annuitant by quoting value based on the initial premium. (Again, here I am assuming that the size of the SPIA covers only a portion of the monthly budget; if the annuity is too large, some of its payments will become savings, which is not the same.)
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by bobcat2 »

Horton wrote: Sat Jan 21, 2023 8:01 amnflation is not explicitly mentioned, although I think it’s implicitly recognized in their results via the future stock returns, bond fund returns and Treasury interest rates that are used.

I anticipate that an individual could get similar results by beginning to build a non-rolling TIPS ladder 15-20 years before retirement. An individual could also use duration matched TIPS funds to accomplish this; the Dimensional Target Retirement Income funds provide an example glidepath that an individual could use. An individual could also convert these assets into annuities during retirement, if desired.
I agree.

Where deferred life annuities are really helpful before retirement is assessing how well you are doing in meeting your retirement income goals. Particularly, if the deferred annuitization explicitly takes into account inflation both before and after annuity payouts begin.

See The Crisis in Retirement Planning by Robert Merton

The risk-free portfolio.
Under the proposed scheme, the risk-free retirement asset is a bond-like security that makes no coupon payments until the date of retirement and then makes level payments, adjusted for inflation, each month for the rest of the retiree’s life. Because it is not feasible to purchase this security, called a deferred real annuity, until the employee is close to retirement, the fund manager creates a facsimile of the asset through a dynamic trading strategy that mixes U.S. Treasury Inflation-Protected Securities (TIPS) of various maturities to reflect the maturity structure of the employee’s target retirement income. This way of using financial technology to match the returns and cash flows of a reference security is called a replicating portfolio strategy and has been widely used for several decades, although only recently in this specific application. The idea is to ensure that the amount of money in the portfolio at retirement is sufficient to purchase the replicated deferred annuity, no matter what the interest rate may be at the time. The retiree is not committed to purchasing the annuity, however, and can use the funds any way he chooses.

Link to article - https://hbr.org/2014/07/the-crisis-in-r ... t-planning

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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by Bill Bernstein »

Thanks for pointing out the NBER paper.

Unfortunately, it assumes a 2% annual rate of inflation, in which case, no surprise, annuitization proves superior to a target date fund. Two percent inflation, though, is not a bet that I, for one, would want to make with my retirement.

The Merton paper simply makes the obvious point that retirees require an inflation-adjusted annuity, not a pot of assets. Here's the key passage:
My point is that the financial technology already exists to invest individual pension contributions in this way. Employees still get a pot of money upon retirement and thus retain the same freedom of choice over their retirement savings that they have under current defined-contribution arrangements.


Trouble is, that paper was written in 2014, and the technology he's talking about, namely inflation-adjusted annuities, disappeared in 2019. If you review the paper with that in mind, he's pretty positive on a TIPS ladder as a second best.

Which is exactly how he's designed the DFA TDFs: the duration exposure in those portfolios is almost entirely in TIPS; the only nominal component is the DFA one-year fixed fund, which is essentially a money market fund.

That should tell you what he thinks of nominal annuities, which are simply repackaged long-duration nominal bond portfolios with an additional mortality credit.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by nedsaid »

petulant wrote: Sat Jan 21, 2023 9:03 am It's hard to know how to take the results since it's clearly not apples-to-apples in the handling of stocks in the annuity-based plan versus the stock/bond portfolio plan. The former stays in stocks except for annuity purchases; the latter would start a transition that, I assume, includes rebalancing. On first reading, the glidepath for transitioning equity to fixed income seems to be mathematically distinct between the two options as well (i.e., are they just putting 10% of equity into bond funds at the same ages for the TDF?).

In discussing the deferred annuities, one noteworthy aspect that the authors discuss is the implied interest rate immunization from deferred annuities. A typical SPIA that covers only a portion of the monthly budget hedges duration on par with a bond ladder; the insurance company is handling its overall cashflow projections in a way that can tie bond maturities to the right year to meet liabilities (payment to the annuitant). SPIAs are technically better at this than bond ladders because they increase payouts relative to the bond ladder by also recognizing mortality experience (i.e., some will pass away by a certain point). Nevertheless, if you were to build a bond portfolio with funds and then convert some of that portfolio to an annuity at age 65, you may have a duration mismatch where you were reducing duration because you are retiring soon or because you are risk averse in a mixed stock/bond portfolio, and then you are increasing duration when purchasing the SPIA. Purchasing deferred annuities earlier actually prevents this potential mismatch and results in "correct" duration immunization for the annuitant--there is a rate or a curve of rates locked into the product that directly matches the inflow today to all future outflows needed. While this duration would result in more volatility for a bond fund, annuities can "hide" the volatility from the annuitant by quoting value based on the initial premium. (Again, here I am assuming that the size of the SPIA covers only a portion of the monthly budget; if the annuity is too large, some of its payments will become savings, which is not the same.)
Your comments about the duration mismatch are very interesting. This is a problem that the Dimensional Fund Advisors Target Date Retirement funds are trying to address. So for example, their 2025 fund is 2/3 in TIPS which have an average duration of about 14. Just guessing, I suppose the duration of the Bonds within my portfolio are about 7 or less. So the concept of duration matching has been new for me and hard to understand and hard to accept. It seems like a big increase in volatility for the fixed income part of a portfolio. Nevertheless, I am doing duration matching with a recent rollover with the idea of buying an annuity with the proceeds at a future date or at least keeping the option open.

The consequences of a duration mismatch that you describe are these: first, the near retiree had foregone a lot of interest over a lifetime by keeping durations too short; second. that the amount of income he or she could buy with an annuity bounces around with interest rates. In theory, if one had correct duration matching, you would know at any given time how much inflation protected income you could buy with the bonds within your portfolio, that is if you use TIPS.
If a near retiree did not duration match his or her bonds, then he or she won't really know how much income that an annuity will produce until the decision is made to make the purchase.

Am I getting this right?
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by bobcat2 »

Bill Bernstein wrote: Sat Jan 21, 2023 10:17 amTrouble is, that paper was written in 2014, and the technology he's talking about, namely inflation-adjusted annuities, disappeared in 2019. If you review the paper with that in mind, he's pretty positive on a TIPS ladder as a second best. That should tell you what [Merton] thinks of nominal annuities, which are simply repackaged long-duration nominal bond portfolios with an additional mortality credit.
From the Merton paper -
A graded annuity whose income payments grow at the expected rate of inflation can also be used when inflation-protection is not available.
Merton believes that the retiree should have both annuitized income, which is either fully COL adjusted if available, or partially COL adjusted if full not available, as well as duration matched real income from TIPS assets. In the DFA funds Merton designed the duration matched real income is produced by combination duration matched TIPS funds - not TIPS bond ladders.

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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by bobcat2 »

nedsaid wrote: Sat Jan 21, 2023 10:24 amThe consequences of a duration mismatch that you describe are these: first, the near retiree had foregone a lot of interest over a lifetime by keeping durations too short; second. that the amount of income he or she could buy with an annuity bounces around with interest rates. In theory, if one had correct duration matching, you would know at any given time how much inflation protected income you could buy with the bonds within your portfolio, that is if you use TIPS.

If a near retiree did not duration match his or her bonds, then he or she won't really know how much income that an annuity will produce until the decision is made to make the purchase.

Am I getting this right?
Yes.

For retirement income you want to measure in income units - not wealth units. The annuity price bounces around in wealth units but is steady in income units.

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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by bigskyguy »

The DFA Target Date Funds are, for us, the gold standard in decumulation planning, and I would gleefully move our IRA funds into them (Target Date 2020 for us) if it were not necessary to pay an advisor in order to do so. So we have instead (thanks to #Cruncher and kaesler) built a TIPS ladder that mirrors the Target Date 2020 percentage commitment to inflation-indexed bonds (approx. 75%), and placed the remaining 25% in DFAC/DFAX to mirror the global equity portion of Target Date 2020. And we employ the withdrawal calculator that Dimensional has on their website for Target Date withdrawals to guide our annual payouts. Now that I am in my 70s, and my spouse in her 60s, the simpler our portfolio the better.
I understand the place of advisors in designing and implementing a portfolio structure, and no doubt they have a valuable role to play. However, the rationale for an advisor when it comes to Target Date Funds escapes me.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by nedsaid »

Bill Bernstein wrote: Sat Jan 21, 2023 10:17 am Thanks for pointing out the NBER paper.

Unfortunately, it assumes a 2% annual rate of inflation, in which case, no surprise, annuitization proves superior to a target date fund. Two percent inflation, though, is not a bet that I, for one, would want to make with my retirement.

The Merton paper simply makes the obvious point that retirees require an inflation-adjusted annuity, not a pot of assets. Here's the key passage:
My point is that the financial technology already exists to invest individual pension contributions in this way. Employees still get a pot of money upon retirement and thus retain the same freedom of choice over their retirement savings that they have under current defined-contribution arrangements.


Trouble is, that paper was written in 2014, and the technology he's talking about, namely inflation-adjusted annuities, disappeared in 2019. If you review the paper with that in mind, he's pretty positive on a TIPS ladder as a second best.

Which is exactly how he's designed the DFA TDFs: the duration exposure in those portfolios is almost entirely in TIPS; the only nominal component is the DFA one-year fixed fund, which is essentially a money market fund.

That should tell you what he thinks of nominal annuities, which are simply repackaged long-duration nominal bond portfolios with an additional mortality credit.
Bill, I am getting closer to retirement and am still thinking over what my ultimate strategy will be. I thought about buying TIPS individually and laddering them with a Cash Balance Plan rollover but I couldn't get past the first rung of the ladder. I started running into $75,000 and $100,000 purchase limits at Fidelity. So I used the short Term TIPS that I bought and included them in a duration matching strategy that included Intermediate Term and Long Term TIPS ETFs.

I may duration match the rest of my TIPS funds at some point, I am using the rollover as an experiment to see if I can tolerate the additional volatility across my entire fixed income portfolio. Based upon your warnings regarding inflation and looking at the DFA 2025 fund, I have increased the TIPS allocation within my Fixed Income to 39%. So your writings are having an effect.

I am at 62% stocks now and am considering a Stocks to TIPS rebalance to get Stock allocation down to maybe 55% and eventually 50%. Crossing my fingers and hoping I can do this in the context of a big market rally and positive real yields on TIPS. Not sure that will ever happen, but I can hope. Were my portfolio much larger, I would probably have it look more like the DFA 2025 fund. In your parlance, I haven't quite won the game yet.

I had once considered annuitizing maybe 10% to 20% of my portfolio but with inflation running hot there is no way I would do that now. An annuity with annual adjustments at a fixed percentage rate every year is a possibility but I am nervous about even that.

So the dynamic has changed and I am having to rethink some things. I am doing a lot of analysis, last week I did a project comparing my portfolio with the various 2025 Target Date funds which included Vanguard, Fidelity, T Rowe Price, American Century, American Funds, and DFA. It was interesting to see the variation among the funds but a couple of takeaways. The more aggressive funds had 55%-56% stocks and the less aggressive funds were more like 42%-45% stocks, DFA the outlier at about 30%. DFA was the outlier with TIPS at 66%, T Rowe Price had a conservative Target Fund with 18% Short Term TIPS. It was interesting that T Rowe Price had a Target 2025 fund that was conservative and a Retirement 2025 fund that was more aggressive and in line with the Vanguard and Fidelity offerings. I was also interested to see the various levels of commitment to Foreign Bonds: Vanguard was the highest, T Rowe Price was second, and American Century in third place. It was an eye opener to do the Retirement Target Date Fund analysis.

As I explained in previous posts, I looked at annuity quotes to get an idea of what my funded ratio might be. I am getting close but I want more margin for error. I looked at annuities with 3% annual adjustments and found that it would take somewhere around 2/3 of my portfolio to annuitize the gap between desired income in retirement and what I would receive from Social Security. Not going to annuitize that much of my portfolio but it gives me an idea.

So I am writing this in hopes that others will read this and think about the types of analysis that they should be doing as they approach retirement. Takeaways, more TIPS and less stocks at some point. Annuitization would work as a partial solution if the CPI Adjusted Annuities would come back. Otherwise I am looking at a Sustainable Withdrawal Rate strategy and duration matching with Bonds.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by bigskyguy »

nedsaid wrote: Sat Jan 21, 2023 11:49 am
...I am getting closer to retirement and am still thinking over what my ultimate strategy will be. I thought about buying TIPS individually and laddering them with a Cash Balance Plan rollover but I couldn't get past the first rung of the ladder. I started running into $75,000 and $100,000 purchase limits at Fidelity. So I used the short Term TIPS that I bought and included them in a duration matching strategy that included Intermediate Term and Long Term TIPS ETFs....

...So I am writing this in hopes that others will read this and think about the types of analysis that they should be doing as they approach retirement. Takeaways, more TIPS and less stocks at some point. Annuitization would work as a partial solution if the CPI Adjusted Annuities would come back. Otherwise I am looking at a Sustainable Withdrawal Rate strategy and duration matching with Bonds.
For us, the approach taken by DFA with their Target Date Funds makes by far the most sense, for so many reasons that have been put forth on this forum. I would very strongly recommend that you read the segments on the Dimensional website that describes their thought process and methodology, read Merton's work, and then think about it all for a goodly amount of time. It took me a goodly while (measured in years) to come to the conclusion that DFA methodology is by far the most intellectually appealing and appropriate for retirement. We have chosen to self-construct our portfolios, rather than pay an advisor.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by Bill Bernstein »

A graded annuity whose income payments grow at the expected rate of inflation can also be used when inflation-protection is not available.
Yes, I saw that, and it gobsmacked me when I read it, since it ignores the most obvious tail risk that suffuses economic history, especially in the fiat money era, which is runaway inflation. With >$30T in national debt and another $100T in implicit commitments, if you're not worried about future inflation, you are willfully blind. Which is why I repeatedly bring up LTCM every time I see Merton mentioned in these threads: he may be a brilliant mathematician, but even a quarter century after his last major foray into money management, he still doesn't think as much as he should about the cruel mistress of history.

Yes, you'll probably be fine with a nominal annuity with or without an escalator in the same way that you're "probably" fine if you don't wear a seat belt.

His co-author, Zvi Bodie, understands this intuitively when he labels nominal annuities a speculation on inflation that prudent investors don't undertake.

Nedsaid: I agree. If you can't make a TIPS ladder work, then a mix of ETFs matched to your horizon is a decent substitute. For the retiree with a borderline burn rate, the modest extra effort of a two- or three-fund portfolio plus TIPS duration matched to your time horizon in any form is likely preferable to a target date fund.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by Bill Bernstein »

Again, in practice Merton favors TIPS over all but the shortest nominal bonds, and, implicitly, nominal annuities.

You could do worse than to recreate his DFA portfolios,

https://www.dimensional.com/us-en/funds ... arget+date

at a low-cost provider using the equivalent US and foreign total-market funds and TIPS/cash, either as a discrete ladder or in ETF form, which would be a tad cheaper than the DFA funds.

Since I last looked at these, for all but the shortest portfolios he seems to have replaced the one-year fixed fund with a mix of two slightly longer (2-3y) nominal bond funds.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by Silence Dogood »

The Vanguard Target Retirement Income Fund (VTINX) seems particularly vulnerable to high inflation:

Code: Select all

Fund:   											Allocation:
Vanguard Total Bond Market II Index Fund							37.40%
Vanguard Total Stock Market Index Fund Institutional Plus Shares				17.40%
Vanguard Short-Term Inflation-Protected Securities Index Fund Admiral Shares			16.80%
Vanguard Total International Bond II Index Fund							16.10%
Vanguard Total International Stock Index Fund Investor Shares					12.30%
Last year, Vanguard introduced a number of "Income and Growth Trust(s)" - but did not introduce a mutual fund version.

I would like to see Vanguard offer a "Target Retirement Income and Growth Fund" - with a 50/50 stock/bond asset allocation - and a small allocation to TIPS, I think that it would be an appropriate investment for a lot of people.

(See this thread for more information.)
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by nedsaid »

bigskyguy wrote: Sat Jan 21, 2023 12:09 pm
nedsaid wrote: Sat Jan 21, 2023 11:49 am
...I am getting closer to retirement and am still thinking over what my ultimate strategy will be. I thought about buying TIPS individually and laddering them with a Cash Balance Plan rollover but I couldn't get past the first rung of the ladder. I started running into $75,000 and $100,000 purchase limits at Fidelity. So I used the short Term TIPS that I bought and included them in a duration matching strategy that included Intermediate Term and Long Term TIPS ETFs....

...So I am writing this in hopes that others will read this and think about the types of analysis that they should be doing as they approach retirement. Takeaways, more TIPS and less stocks at some point. Annuitization would work as a partial solution if the CPI Adjusted Annuities would come back. Otherwise I am looking at a Sustainable Withdrawal Rate strategy and duration matching with Bonds.
For us, the approach taken by DFA with their Target Date Funds makes by far the most sense, for so many reasons that have been put forth on this forum. I would very strongly recommend that you read the segments on the Dimensional website that describes their thought process and methodology, read Merton's work, and then think about it all for a goodly amount of time. It took me a goodly while (measured in years) to come to the conclusion that DFA methodology is by far the most intellectually appealing and appropriate for retirement. We have chosen to self-construct our portfolios, rather than pay an advisor.
I am studying this, Bobcat2 has educated me on Dr. Merton's work and on the DFA Target Date Retirement funds. It does take some study and thinking through as these concepts are counterintuitive. I am doing the duration matching strategy with TIPS with a rollover and I want to see how it goes. I remember the Financial Advisor that I worked for getting annoyed with me talking about science experiences within a portfolio. What I meant is that you never know for sure how things will work until you try it out for yourself, I didn't mean taking outrageous risks within your portfolio.

The thing is, I could have read Dr. Merton's articles forever but not until I worked up a spreadsheet and put the ideas into practice with real money did the concepts really start to sink in. Otherwise, it is like playing Monopoly with friends and family with Monopoly money, there is really nothing at stake and probably not much to be learned.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by nedsaid »

Bill Bernstein wrote: Sat Jan 21, 2023 1:51 pm Again, in practice Merton favors TIPS over all but the shortest nominal bonds, and, implicitly, nominal annuities.

You could do worse than to recreate his DFA portfolios,

https://www.dimensional.com/us-en/funds ... arget+date

at a low-cost provider using the equivalent US and foreign total-market funds and TIPS/cash, either as a discrete ladder or in ETF form, which would be a tad cheaper than the DFA funds.

Since I last looked at these, for all but the shortest portfolios he seems to have replaced the one-year fixed fund with a mix of two slightly longer (2-3y) nominal bond funds.
Two possible critiques of the DFA approach is that they might be too light on Stocks. Also one could say that what he has done is transfer volatility from Stocks to Bonds with perhaps less return. My own opinion is that I am impressed with what he has done, not sure I could bring my Stock allocation that low. Like Alex P. Keaton, I came of ago in the early 1980's just
as massive Bond and Stock bull markets were starting. I suppose for that reason I have been more Stock heavy, even today
at age 63. During the 2010's, I just could not get excited about 2% yields on Bonds. Today, Bond yields are much higher but are below the inflation rate, I am even less excited about that. So TIPS it is for Bonds, I have upped my allocation recently and may do even more.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by PersonalFinanceJam »

nedsaid wrote: Sat Jan 21, 2023 3:54 pm
I am studying this, Bobcat2 has educated me on Dr. Merton's work and on the DFA Target Date Retirement funds. It does take some study and thinking through as these concepts are counterintuitive. I am doing the duration matching strategy with TIPS with a rollover and I want to see how it goes. I remember the Financial Advisor that I worked for getting annoyed with me talking about science experiences within a portfolio. What I meant is that you never know for sure how things will work until you try it out for yourself, I didn't mean taking outrageous risks within your portfolio.

The thing is, I could have read Dr. Merton's articles forever but not until I worked up a spreadsheet and put the ideas into practice with real money did the concepts really start to sink in. Otherwise, it is like playing Monopoly with friends and family with Monopoly money, there is really nothing at stake and probably not much to be learned.
It seems to make much more sense, maybe even becoming intuitive, once you start thinking about the desired income you expect from your portfolio. I’m grateful for bobcat2 for his continued posts in this regard and I think there should be many more threads on this at Bogleheads. The current discussion leads me to believe there is potential merit in what I have been thinking for a while. At a certain point one should start shifting their portfolio and little by little purchasing future income for their retirement. Instead of annuities it might make more sense to buy TIPS/TIPS funds as the bridge to social security. Whatever is leftover could be held in stocks or used to increase the safe floor of real income.

It would seem this approach also guides the asset allocation for the later portfolio. One doesn’t have to think about how to shift from 20% bonds to 40%, you just keep buying more TIPS/future income until you hit your desired targets. This might leave you with a smaller amount of stocks than expected but it shouldn’t matter as much because you’ve secured your future retirement income.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by nisiprius »

I am an investor and retiree, not a financial economist. It is not of much interest to me to read about hypothetical vehicles--such as Milevsky's "ruin-contingent annuities"--if there are no real-world products I can buy, and in many cases there don't seem to be.

Heck, there are even real-world products that puff out of existence, like the PIMCO RealIncome mutual funds, which were supposed to implement a TIPS ladder scheduled to pay out even inflation-adjusted monthly income until an target date when the portfolio would actually be exhausted, with a deferred annuity that was supposed to kick in and continue the payments after that date. As nearly as I can tell, they launched the funds, never got around to cutting the deal that was supposed to pair them with the annuities, and then liquidated the funds long before the maturity date.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by SteveinVanvcouverWA »

Bill Bernstein wrote: Sat Jan 21, 2023 1:08 pm
Nedsaid: I agree. If you can't make a TIPS ladder work, then a mix of ETFs matched to your horizon is a decent substitute. For the retiree with a borderline burn rate, the modest extra effort of a two- or three-fund portfolio plus TIPS duration matched to your time horizon in any form is likely preferable to a target date fund.
By "TIPS duration matched to your time horizon," does that mean until your average estimated age of death? Or the longest you expect you might live? Or halfway to your average estimated age of death?

I did a few calculations on the DFA Target Retirement funds. The average duration of the TIPS seems to be roughly half of the life expectancy of a male who retired at age 65 at the date of the fund.
For example, for the 2010 fund, assuming that someone holding the fund retired in 2010 at the age of 65, the average duration of the TIPS is 4.5 years, whereas the life expectancy of that same 78 yo male now is about 10 yrs (per SS actuarial tables).

Fund_______Ave Duration____Life expectancy__Current age
2010__________4.5______________10_____________78
2015__________6.2______________14_____________75
2020__________7.9______________17_____________68
2025__________9.4______________21_____________63

You can see my calculations here:
https://drive.google.com/file/d/1zkPtI7 ... sp=sharing
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by Horton »

Dimensional is likely determining the duration necessary for an equivalent annuity, which would be approximately half of life expectancy for a 78 year old.

For an individual not yet in retirement, the duration would be approximately:

# of years to retirement + life expectancy @ retirement / 2

Note: this is an approximation. When rates were zero, this was more or less correct. With positive interest rates, the duration is a little less than estimated above.
80% global equities (faith-based tilt) + 20% TIPS (LDI)
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by grabiner »

The theory makes sense. The expected present value of annuity payments should be slightly less than the expected present value of investing the same money in bonds yourself, since the annuity provider needs to make a profit. But the "expected" is important; if you buy an annuity, you will have more than the expected value if you have a long life, and thus will be less likely to exhaust your portfolio at the same withdrawal rate.

Therefore, if you want higher sustainable withdrawals for your own lifetime, buying an annuity is optimal; it reduces the expected amount you leave for your heirs, but increases your own ability to spend.
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Re: A Variant on Target Date Funds that uses Deferred Life Annuities

Post by Horton »

Agree, and this is where the optionality piece comes in. By duration matching, the value of the assets will closely approximate the cost of an annuity, regardless of how interest rates change. You can then buy annuities if/when you like.
80% global equities (faith-based tilt) + 20% TIPS (LDI)
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