Pensionize Your Nest Egg

There are two central messages of the book Pensionize Your Nest Egg, by Moshe Milevsky and Alexandra Macqueen. The first is that having assets saved for retirement is not the same as having a pension. The second is that you can turn assets into a pension with the right insurance products. Both are true, but I have serious reservations about the variable annuities the authors recommend.

To a first approximation, the authors say that if there is a nontrivial chance that you’ll run out of money in retirement, then you don’t have a pension. Any attempt to manage your asset allocation through bucketing or other means can leave you vulnerable to the risks of living long, inflation, getting poor investment returns, or having poorer returns early in retirement that deplete your nest egg. The authors do a good job of explaining each of these risks.

The offered remedies for all of these problems are various types of annuities sold by insurance companies. The authors offer a process for determining how to split your nest egg across stocks, bonds, simple annuities, variable annuities, and various types of guaranteed income riders with these annuities. They call this “pensionizing” your nest egg.

There is no reason, in principle, why this can’t be great advice. Having an insurance company average out longevity risk across many retirees can benefit everyone. The problem I’ve seen is the sky high fees embedded in the complex annuity products I’ve examined. In one case, the guaranteed income looked good with the possibility of income increases if stocks performed well. But the rules for when these income increases would kick in combined with huge yearly fees made it very likely that few if any increases would occur. This would leave the retiree with income eroding with inflation each year.

The authors assert that “converting some of your initial nest egg into a stream of lifetime income by pensionizing it increases the amount you can spend at all ages, regardless of the exact cost of the pension annuity.” This is clearly false if the fees baked into annuities are too high. I can only assume the authors imagine the fees to be limited to reasonable levels.

The authors do compare the costs of annuities to the costs of other types of investments. However, the annual percentages given will mislead many readers. They say that the total annual fee of the typical Canadian mutual fund is 1.84%/year, and that variable annuities with lifetime income guarantees have annual fees in the 3-5% range.

This isn’t a fair comparison because some of the variable annuity fee exists to cover the cost of the income guarantee. Even ignoring this fact, to most people, the cost difference doesn’t look huge. However, suppose that the average dollar of your nest egg stays invested through 15 years of retirement. If we convert these annual costs to 15-year costs, the mutual fund costs 24%, and the variable annuity costs 37-54%! Even seemingly small increments in fees make a big difference.

The book’s table of costs also lists the fees for exchange-traded funds (ETFs). Strangely, though, it lists these fees as starting at 0.5%/year in Canada and the U.S. It’s not difficult at all to find index ETFs charging less than 0.1% per year.

Many commentators advocate a retirement strategy of owning more bonds and fewer stocks as you age and placing some fraction of your nest egg in a simple annuity when you reach 75-80 years old. As long as the stocks and bonds are invested in low-cost ETFs, I’m skeptical that the authors’ pensionizing strategy is superior. I’d have to see the numbers to be convinced otherwise.