April 24, 2012

Don't Play Russian Roulette With Your Retirement

I've talked about fixed annuities on and off in the past.   Generally I think that an immediate fixed annuity can be a pretty good way to provide some guaranteed income during retirement.

A lot of people are generally wary of annuities.   Sometimes people are legitimately worried about high fees or just confused about how annuities work.    Most people have an understandable cautious concern about handing over large amounts of their money to an insurance company and thus feel they are losing control of their finances.   However I also think a lot of people feel they can simply do better by managing their own money and investing in stocks and/or bonds.

Investing Your Lump Sum at Retirement, David F. Babbel and Craig B. Merrill,  August 2007

They made this analogy between investing your money for retirement and playing Russian Roulette :

"Financial planners sometimes say that a particular favored system may give you a good chance of significantly higher investment returns if your savings are placed in equities or some other favored investment. That may be true. But such homemade systems also carry a risk of running out of income long before one runs out of life. Their sponsors may counter that the risk of such an eventuality, if everything goes according to assumptions and the plan is followed tightly, may be only 15%. That is roughly equivalent to the 16.7% odds of losing in a game of Russian roulette, and few people are prone to participate in such games! Why, then, are people so prone to bet their own income security when it comes to retirement?"

What if I told you that you have an 85% chance of outliving your retirement funds if you self managed the money in stock/bond investments.   Doesn't seem too bad if you put it that way.   The vast majority of time people will do fine.

But the opposite of that is the 15% failure rate.   Which is quite close to the 1 in 6 chance (16.7%) rate of losing  a game of Russian Roulette.    Would you take those odds?

Of course I'm not saying that buying stocks is analogous to putting a gun to your own head.   But its an interesting way to think about the numbers.   When the negative consequences of failure are very high then it gives us much more compelling reason to take lower risks and seek a much higher success rate.    The consequences of running out of money in your old age are pretty bad if you ask me.

Note: The cynical side of me forces me to point out that the study in question is partially funded by an insurance company which makes profit off of selling annuities.   Which I think is bad cause peoples natural cynicism in distrusting studies funded by profit seeking companies can can undercut what is a very good retirement strategy.  


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