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Welcome to personal finance for long-term investors, where we believe Benjamin Franklin's advice that an
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investment in knowledge pays the best interest both in finances and in your life. Every episode teaches you personal
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finance and long-term investing in simple terms. Now, here's your host, Jesse Kramer. Welcome to Personal
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Finance for Long-Term Investors, episode 131. My name is Jesse Kramer, and by day, I work at a fiduciary wealth
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management firm helping clients nationwide. You can learn more at bestinterest.blog. blog/work. The link
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is in the show notes. By night, I write the bestinest blog and I host this podcast. I also put out a weekly email
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newsletter. All those projects help busy professionals and help retirees avoid mistakes and grow their wealth by
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simplifying their investing taxes and their retirement planning. And I'm going
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to do a really quick review of the week and then dive right into the good stuff.
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The review is from LTI Wannabe Charlie. I think that's long-term investor. LTI.
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LTI Wannabe Charlie who says, "Truly the best. The world of finance, tax, and
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retirement planning can seem daunting, even intimidating. At least it did for me until I found Jesse. And I'm so
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grateful to have found him and this podcast. He's extremely knowledgeable, and his delivery of extremely difficult
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topics is superb. Jesse is able to make even the most complicated topics understandable and comprehensible to
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even those without the financial knowhow. I end each episode feeling empowered and ready to take on the
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world. Listen to his Q&A episodes. Listen to them all. You won't regret it.
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Thank you, Jesse. Well, thank you, Charlie. That was a very, very kind review. I'm very glad that you find this
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helpful and hopefully you leave today's episode a little more knowledgeable and
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empowered and ready to take on the world. Charlie, please email me jesseb bestinterest.blog and I'll get you
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hooked up with a super soft podcast t-shirt. Now, let's get to the good stuff. Whenever you start conversations
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about retirement and retirement planning, you can count on a few topics to come up. Investing, social security,
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RMDs and taxes, leaving money to your heirs. Now, income. Income is another pretty common topic. Where will my
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income come from? How will I replace my income? How will I build my paycheck? What if I don't have a pension? Should I
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own lots of bonds? They create income. Should I own dividend paying stocks? They create income, too. Should I
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purchase an annuity? That creates lots of income, too. Today, we're going to do
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a deep dive on that last one. We're going to do a deep dive on annuities. I've spent, you know, five or 10 minutes
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here or there to discuss why I don't like annuities. But because there are, you know, thousands of you listening and
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many of you have heard of annuities, are maybe intrigued by annuities. You might
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own an annuity or you're considering buying one. You've asked me about annuities before. And I wanted to devote
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some serious time to annuities today. And so that's what this episode is. Think of it as this hopefully evergreen
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long-standing episode that explains annuities in in pretty deep detail. But we're going to start with some of the
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the lighter details or some of the higher level stuff, right? An annuity is a contract with an insurance company
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where you pay them money. Usually, you pay them most of the money now, but sometimes you can pay them money over
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time. Either way, you're paying the insurance company a big lump sum of money. And in return, they promise to
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pay you a regular income stream, just like a paycheck, for a set amount of time or for in many cases for the rest
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of your life. So, a very common annuity might say you write the insurance company a million check today and then
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they start sending you $6,000 a month for the rest of your life. That is one example of how an annuity could work.
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Now, I'm going to start with a big picture statement with a little bit of backup about annuities. I do think there
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are more reasons to dislike annuities than to like them. And I think more retirees are worse off with annuities
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than they would be with the alternative options. Now, why do I say that? Well, let me give you what I believe to be a
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transparent but still a pretty simple pro versus con of annuities. Well, we'll
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start there. Just very high level pros and cons. The pros. Annuities provide longevity insurance. The longer you
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live, the better your annuity decision will have been in hindsight. Annuities create stable, predictable income, which
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is certainly a good thing inside of a financial plan. And it also really helps us, you know, behaviorally. It helps to
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have that steady income. Uh, it helps us make good decisions. Last, annuities provide simplicity. at least one type of
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simplicity. There's no rebalancing with an annuity. There's no withdrawal rate
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decision. There's no market timing anxiety. You simply collect the constant income stream just like collecting a
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paycheck. So in that way annuities can be thought of as simple and those are the pros. Those are you know in my
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opinion the main pros and so far that sounds pretty good right like with many things in the world we can't evaluate
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only the benefits. We need to consider what are the costs and in my view the actual costs and the opportunity costs
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of annuities are significant cons. The overwhelming majority of annuities are poorly designed and incredibly
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expensive. Variable annuities which we will explain the difference between variable annuities and fixed annuities
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in a minute but variable annuities can easily have fees exceeding 2% per year and that's on top of large commissions
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which are usually 5 to 10% of the upfront cost. Quickly a couple other major cons. Annuities are typically
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illquid and irreversible. It's a one-way decision, especially once the income
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stream is turned on. You basically never have access to your lumpsum ever again.
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Or if you do, you can buy something with a lot of annuity products called a writer or an add-on. If you happen to
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have an add-on that gives you access to your to your lumpsum after the fact, that's probably a very steep costing
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add-on. And that's really different from a traditional portfolio where you can
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live off of the income or growth of your traditional portfolio and then you still
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have access to all of the underlying investment. In annuity, you're giving up
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the investment itself. My last con of annuities is just the expected return. I've gone over that math many times here
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before, but I'm happy to do it again. In their best form, which I will talk about
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later, it's that whole variable versus fixed annuity conversation that I already mentioned once and we will we
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will get to it. In their best form, which I I will talk about later, at their very best, the long-term expected
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returns of an annuity are something like what I'm about to say. If if we look at
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say a healthy 60-year-old male, his uh payout rate in a very simple annuity product is probably going to be
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somewhere in the nature of 6 to 6 1/2%. So, you have to ask yourself, well, how many years of a payout at 6% do you need
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to have in order to get 100% of your money back? And you realize the answer is about 16 and 12 years. So in that
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case, his expected return for the first 16 and 12 years is technically negative because if he dies after 14 years, he
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hasn't even gotten his original money back. For a typical annuity, you might
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say year 15 or so is about where the break even occurs. Before year 15, it's
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essentially been a negative return. Once you've collected 15 years worth of uh
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payments, okay, you finally have positive nominal returns. And these are nominal returns, right? doesn't even
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count inflation, which would make the situation appear worse. Once you get out to 20 years, the expected return is
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somewhere in the order of 3% per year. After 25 years, maybe 4 1/2% per year. After 30 years, it's up to about 5 1/2%
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per year. And then once you get out to 40 or 50 years, that's when your return
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hits an asmtote at about 6 1/2% per year. So, if our 60-year-old male lives to be 100 years old, at that point,
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he'll see something like a 6 to 6 12% annualized return. But if he only lives
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to 75, he'll see a 0% return. If he lives to 85, he'll see something in the
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realm of a 4 to 5% return. And I just don't like those returns, right? If I'm
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investing for a 20, 25, 30-year timeline, I want something better than a nominal four or 5% return. So anyway,
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that's the big con for me or one of the big cons is just that the returns are
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not attractive enough. But before I go further, let's do some definitions. I
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used the terms variable annuities and fixed annuities before. Let's define those. Fixed annuities are the easy
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place to start. As the name might imply, fixed annuities have very few moving pieces. They're pretty simple. It's it's
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a straightforward trade-off between you sacrificing a lump sum of money upfront and an insurance company then taking
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that lump sum and providing you with a long-term income stream. The specifics of that trade-off are fixed. They won't
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be changing over time. It's it's predictable in that way. But with a variable annuity, those specifics, they
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actually can change over time. A variable annuity at its core mixes investing, you know, an investment
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account and mixes it with the idea of an annuity. So, a very common variable annuity might take your original
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lumpsum, invest that lumpsum in some way, and then create some sort of growth on your lumpsum and only then out in the
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future would you sensibly annuititize that larger investment grown lump sum into an income stream at a later date.
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And by the way, I just used the word annuitize. So to annuitize anything, including in this context, to
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annuititize something means to turn your lump sum into an income stream to to turn on the income spigot, so to speak.
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Again, you might think that this idea of a variable annuity sounds kind of good.
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You know, you get the guaranteed income still, okay, check, but your money actually has a chance to grow along the
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way. It's not bad. The problem is, how can an annuity protect you against the
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downsides? Remember, it it's guaranteed income. There's a downside protection
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there. How can it protect you against the downsides while also providing you with the upside from an investment like
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the stock market? The way they do this, the way they provide you both, it's really twofold. First, they cap your
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returns. For example, an indexed annuity, which is a a variable annuity tied to a specific stock market index.
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An index annuity might have a cap rate or a participation rate. A cap rate would say no matter how well the stock
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market does, your variable return is capped at X%. So, let's say X is 7%. The
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market's up 20%, well, your annuity got seven. The market's up 12%, you got
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seven. The market's up 4%, well, you only got four. The market's down 15%,
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well, okay, you're only down zero. There's no downside, but they cap your
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upside. The problem is, and and we'll get into this in a second, that's a bad
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trade-off. There's sometimes some uh variable annuities have something called
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a participation rate. It's kind of similar, but it's a ratio of the return
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that you receive. So, let's say your participation rate is 50%. The market's
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up 20, you only get 50% of that. You get 10. The market's up 12, you get six. The
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market's up four, you get two. If the market's down 15, okay, you're down
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zero. You don't lose. There's no downside, but there is a limited upside.
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Again, the problem is it's a bad trade-off. And before I get into some of the math of why that's a bad trade-off,
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let me tell you of the second of the two-fold ways that uh insurance companies protect themselves when it
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comes to variable annuities. The second way they protect themselves. The first way being they they somehow cap your
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returns. The second way is by charging you 2% or more per year in most of these products. So if you combine those capped
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returns with the 2% plus annual fee, that is how an insurance company can provide you guarantees prevention of
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loss and also provide you quote unquote growth at the same time. that the true growth is either cut down by 50% in my
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example or it's limited at 7% per year and then every single year, rain or shine, the full monty is cut down by a
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2% annual fee. So, in case you're wondering, well, how stifling is that kind of setup? I grabbed uh S&P 500
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returns from 1950 through 2025, 75 years of data. I threw, you know, $1,000 on the top of my spreadsheet, put $1,000
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into the S&P 500 back in 1950. And if it just grows on its own in the S&P 500,
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the $1,000 would grow to 4.26 million by the end of 2025. Trust me, it's not a
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typo. That's not a mistake. $1,000 over 75 years would grow to 4.26 million.
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That's what 75 years of compounding does. All right? Most of us only get 20,
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30, maybe 50 years of compounding if we start really young. 75 years of compounding at 11.6% 6% per year will
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turn $1,000 into 4.26 million. But now, what if we apply a typical index annuity
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rule to those same S&P 500 returns from 1950 to 2025? In this case, I I chose
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the 50% participation rate and I also applied a 2% annual fee. So, you know, if the market was up, I don't know, 22%
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in 1961, well, this annuity product was only up 11%. And then also got charged a
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2% fee that year. But, you know, it's also worth noting the value of the annuity never goes down. So, Black
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Monday, the crash of 1987, the 1970 stagflation, the.com bubble bursting, the great financial crisis, this annuity
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product did not go down during those times in in my little spreadsheet. Still the summary is if we get to the end of
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it, the annuity would have grown at 5.4% per year and the thousand would now be worth about 56,000. So 11.6% per year
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versus 5.4 $4.6 million versus $56,000. And that result, at least to me, it shouldn't be surprising. It shouldn't be
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surprising that the indexed annuity only generates a net 5.4% 4% return to the investor because when you look at
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long-term annuity payouts for typical lifespans, they typically end up in the 4 to 5% range. So, it would make sense
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that one of these products is set up by the insurance company, the and we'll get
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into this. It's it's the company, you know, they've got all the data about
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when people might die in the future. They've got all the data about what their expected payouts might be. And you
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better believe that they know that these products in their models are expected to
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pay out four to 5%. So, how do you give someone exposure to the stock market and
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then only pay out four or 5% at the end of the day and guarantee that it they never lose money? Well, you you cap
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their participation in stock market returns and then you charge them a high annual fee. And on that point, when it
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comes to defining annuities, I I do want you to think about these products from the point of view of where they are
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coming from. Annuities are sold by insurance companies. They are an insurance product. And how do insurance
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companies think? Well, insurance companies, they think about risks. They think about the average risks across
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very large groups of people. They price their products, meaning they price the costs and the benefits of their products
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to ensure that they yes address their customers concerns about risks, but also so that the insurance company makes
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money. If an insurance company doesn't make money, it's going to go out of
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business and the products themselves will fail. We do need insurance companies to make money in order to
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continue providing us insurance. But it is worth understanding that for you, the
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customer, to have your specific risk addressed, it is going to cost you. That's just business. You know, you want
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groceries, it'll cost you. You want to fix the leaky roof, it'll cost you. And
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if you want guaranteed income for life risk-free, that is going to cost you. And that's why I don't want you or me or
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anybody to be necessarily surprised that annuity payouts are what they are and certainly aren't as wonderful as maybe
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some people would tell us, especially those people happen to have a vested interest. Going back to the really high
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really high commissions. Anyway, if you're the insurance company and you're
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selling annuities to uh 60-year-old males, let's say like my example from a couple minutes ago, as the insurance
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company, you're thinking to yourself, well, some of these guys, they're going
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to die at 65 and 70. Most of them are going to die at 75, 80, 85. And yeah, some outliers are going to live to 90 or
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95, maybe even beyond. On average, if we average out all these 60-year-old males
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we're selling annuities to this year, on average, we might owe these people something like a 3 to 4% annual return
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over the next 20 to 25 years. I think the insurance company can pretty conservatively and reasonably invest
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their pool of assets and achieve that kind of outcome. Now, another quick pivot. Whenever an insurance product is
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is involved in one of our financial plans, especially a long-term insurance product, a good question to ask is,
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"What if the insurer themselves somehow fails to uphold their promise, right?
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What if they I don't go out of business? They somehow become illquid. Does my
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annuity just dissolve and and kind of do I get screwed over?" So, a few notes on
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that. An annuity is not backed by the federal government in the way that a Treasury or or that Social Security is.
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An annuity is a general obligation. It's kind of like a debt in a way of the
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issuing insurance company. So the risk is pretty simple in theory. If the insurance company becomes insolvent
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somehow, it may be able to unable to fully meet its annuity payment obligations to you. Unlike a mutual fund
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or an ETF, you don't own kind of these segregated assets inside of the insurance company like maybe the
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underlying stocks in a mutual fund. You are a creditor of the insurer. They owe a debt to you. This is credit risk. It's
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not market risk. But how real is the risk? And the short answer is yeah, it's
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it's real, but it's very historically rare. It's usually non-c catastrophic
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for annuity holders. Insurance company failures do happen. They have happened, but they're far less common than, for
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example, bank failures, and annuity holders are typically protected or largely made whole. There's never been a
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widespread collapse where annuitants broadly lost their income stream. historical failures have been, you know,
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kind of these regional, smaller insurance carriers. Usually the failures have been caught early on by regulators.
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There's a good point. Yes, insurance is regulated at the state level and those
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state regulators are always kind of sniffing around for signs of smoke and insurers fail less often because they're
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required to hold up statutory reserves and and match their longduration liabilities. Just like an annuity,
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they're required to match those liabilities with appropriate assets, stress test what's going on, submit
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themselves for actuarial review. It's a pretty rigorous risk profile that they
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have to go through. And you can think of that state regulation as the first line
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of defense for u an annuity customer. Uh there are also the maybe the second line
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of defense we can talk about now. There are state guarantee associations. Every state has a a life and health insurance
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guarantee association funded by the solvent in business insurance companies providing coverage in case an insurer
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fails. Now those coverage limits can vary by state, but typically on the low end it's something like $100,000. On the
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high end it's $250,000 and that's per owner per insurer. So again, you could have if something
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really cataclysmic happened and multiple insurance companies went out of business
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and you happen to have a product with those multiple insurance companies, your state coverage would apply to each
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company that goes out of business just in case it matters. The third line of defense and and really the third and
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fourth are are pretty um minor corner cases I would say. But the third one is if an insurance company happens to go
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out of business, their annuitants are considered senior creditors, meaning they get paid first, ranking above
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unsecured creditors, ranking above shareholders. So even without guarantee coverage or even if the guarantee
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coverage isn't enough, recoveries are are often pretty substantial. An annuity
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holder isn't totally screwed over. And then the fourth line of defense should
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it come to that. If you end up going down a route where you want to purchase an annuity or again any insurance
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product, if you spread your purchases, your products across multiple insurers, you are effectively, you know,
00:19:00
mitigating and diversifying your risk in that way. So that ends maybe my early foundation, my beginner's foundation to
00:19:06
understand what annuities are, how they work, the pros, the cons, the risks, the
00:19:10
rewards, all that stuff. Here's a quick ad and then we'll get back to the show.
00:19:14
I love getting your questions and some of you ask me questions about the wealth management firm I work for in Rochester,
00:19:19
New York. Others ask about the Best Interest blog and this podcast, Personal Finance for Long-Term Investors, which
00:19:24
operate without advertising, without pushy sales, and with no payw walls. How can the blog and podcast stay afloat
00:19:29
without me dumping my own money into it? Well, to answer both those questions, I
00:19:33
want to point you to episode 78 of Personal Finance for Long-Term Investors. I intentionally recorded
00:19:38
episode 78 to shine light on those topics and inform you how you are actually helping and can continue
00:19:43
helping these projects carry forward. So if you've ever been curious about the
00:19:47
business of my blog and podcast or if you're curious about my day job in wealth management, please check out
00:19:52
episode 78 and let me know what you think. Now, I want to dive into a specific annuity, maybe red diving into
00:19:58
it because I've already kind of mentioned how it works before, but this is might be the only annuity, one of the
00:20:04
only annuities that's in my opinion within sniffing distance of acceptable use. It's one of the only annuities, for
00:20:10
example, where if I don't know, if my uncle came to me and said, "Hey, Jesse,
00:20:14
just so you know, you know, I listen to your podcast and I decided to buy this thing." I'd say like, "Okay, I get it.
00:20:20
Might not do it myself, might not recommend it myself, but I do, but I get it. This annuity is called a single
00:20:25
premium immediate annuity or a SPIA SPIA. Single premium, a one-time lumpsum, a single premium. Immediate
00:20:32
annuity means the income stream starts immediately. There's nothing variable
00:20:36
here. Everything's fixed. There's nothing weird going on. From the insurance company point of view, it's
00:20:41
very, very simple math. Well, also from our point of view, it's very, very simple math. But the insurance company
00:20:46
is just saying, okay, when are you likely to die? Once we figure out when you are likely to die, we will take the
00:20:52
lump sum you give us and we'll figure out how do we make a income stream that
00:20:56
probabilistically means, yeah, you get some decent income, but we're probably
00:21:00
going to make a little bit of money on you. So, it it's simple no matter how
00:21:04
you look at it. At their core, SPIA, like all annuities, should be, SPAS are not investments. Again, they are
00:21:10
insurance products. And we should really think of SPIA as insurance against living too long or insurance against
00:21:17
some sequence of returns risk. We'll get into that later, but it's a product that
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guarantees a paycheck every month as long as you live, regardless of market returns, regardless of interest rate
00:21:26
environments or anything else going on. SPIA can do this because they exploit something called mortality pooling, and
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we we'll talk about that. But SPIA don't dabble in in market returns. And that's
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intentional, right? That's a feature, not a bug. Compared to other annuities,
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SPIA have built-in fees. It's, you know, an implicit fee, very low fees, minimal
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moving parts, no sort of illusion of liquidity, low complexity, low sales incentives, no writers, no caps, no
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participation rates, no annual resets, no ongoing account value to misunderstand. And I say this because
00:22:01
when you look at an annuity contract, I was just looking at one last week, it was about 90 pages long. There's like
00:22:06
four different ways that some of these variable annuities measure their account value. I don't know what's going on
00:22:11
there. But the point is that with a SPIA, what you see is what you get. Complexity in annuities almost always
00:22:17
benefits the insurer or the distributor, not the customer. Complexity does not benefit the customer. Anyway, ASPIA is
00:22:24
is the singular and immediate trade where you sacrifice your lumpsum forever in return for an income stream forever
00:22:31
until you die. Right now, as an example, a 55year-old male in New York State could receive a a 6.8% 8% income stream.
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Meaning if that male sacrifices $1 million at age 55 into the SPIA, he could get $68,000 in income every year
00:22:47
for life. And you might say that's not a bad trade. Doing that, off the top of my
00:22:51
head, I think it would take you somewhere between 14 and 15 years to turn the $68,000 income stream back into
00:22:59
the 1 million. So again, for the first 14 or 15 years, the return is technically negative. Now, criticisms of
00:23:05
SPO are definitely real. There's ill liquidity. there's no real upside. There's a a loss of principle at early
00:23:10
death. And we will come back to this idea because at least those are not hidden drawbacks. They might be
00:23:16
drawbacks, but they're clear and obvious. They can certainly be analyzed. They're explicit and knowable. And and
00:23:22
SPIA say that the point of a SPIA is just clear. You're buying income. You're
00:23:27
not buying optionality. It solves one problem about longevity and sequence risk. And it solves that problem in case
00:23:33
you suffer those uh those risks. But before I continue down the path of annuities, let me just pause and talk
00:23:39
about term life insurance for just a minute. Because if you if we think about term life insurance, which almost
00:23:44
everybody understands, it will help you understand annuities better. A term life
00:23:49
policy is to a large extent the exact opposite side of the coin from a SPIA. With a term life policy, you and a
00:23:57
million other people, you essentially are pulling your money together to protect against the risk of someone
00:24:03
dying early. With a SPIA, you and a million other people are pulling your money together to protect against the
00:24:09
risk of living a long time. With a term life insurance policy, if you live past the term, you have essentially lost your
00:24:16
money in the deal. But that money you lost goes at least in part to the people who did die early. So, you all shared
00:24:22
the risk together. Now, you didn't happen to realize that particular risk in your life and and you didn't get any
00:24:27
money back. With a SPIA, if you die early, you have lost money on the deal, but that money that you lost goes at
00:24:34
least in part to the people who do end up living for a long time. You all shared that longevity risk together, but
00:24:41
you didn't realize that particular risk and you didn't get all your money back.
00:24:46
Term life policies, they they raise the floor. A term life policy makes an early
00:24:50
death less painful, but it also lowers the ceiling because money that you could have otherwise used more productively to
00:24:56
grow over time. Instead, you had to use to pay uh insurance premiums. SPAS do the same thing. They raise the floor of
00:25:03
a retirement plan by ensuring this guaranteed income floor no matter how long you live. But SPAS also lower the
00:25:09
ceiling because money that you could have otherwise invested for the long run in typically more productive assets at a
00:25:16
higher rate of return. Instead, you use that money to pay the annuity premium. This type of sacrifice happens all the
00:25:22
time in life, right? We're given an option to to raise the floor. In other words, to take the worst case outcome,
00:25:28
the floor, and make it somehow better, to make our worst case less worst, but at the cost of lowering the ceiling or
00:25:35
making our best case scenario less good. And sometimes that sacrifice is worth it. Right? I own term life insurance,
00:25:41
but sometimes that sacrifice is not worth it. And as a financial planner, I don't usually think annuities are worth
00:25:47
it. Even speedas, I don't think speedas are usually worth it. But I will say
00:25:51
there are some very, very smart people who disagree with me on that. There are plenty of good financial planners out
00:25:55
there who believe that the trade-off, at least the trade-off for fixed annuities
00:25:59
like SPAS, certainly can be worth it to certain clients, and I I respect their opinions. But before continuing the
00:26:05
conversation about SPAS or getting any further uh into the the numbers, the math that way, I want to talk about a
00:26:10
quirky idea called erodicity. E R G O D I C I T Y. Eggicity asks whether what's
00:26:19
true on average is actually true for you over time. And that's a weird definition. What is true on average is
00:26:26
actually true for you over time. And often, especially in finance, that is not the case. So, let's just explain
00:26:34
through example. That's always a good way to go. Imagine that you all listening flip a coin. Each one of you,
00:26:39
I'm going to say uh about 5,000 of you are going to listen to this episode in
00:26:43
the first month. So, we have 5,000 coin flips. And we know to expect roughly 2500 heads and 2500 tails. We know it
00:26:50
might not land exactly on that, but that that's what the outcome is about is
00:26:54
going to be 2500 ads and 2500 tails. That is the average of many outcomes. And now imagine that just me, just one
00:27:01
person, that I flip a coin 5,000 times in a row sequentially. Now, in this case, I would also expect 2500 heads and
00:27:08
2500 tails. I would expect the same outcome. In this case, the outcome of many people doing one thing, that
00:27:15
average outcome is exactly the same as the outcome of one person doing that thing many times. So what's true on
00:27:22
average is also the same as what's true over time. And this example, this coin
00:27:28
flipping example is what we would call erotic. It is an erotic system. When the average of many outcomes is also what
00:27:35
plays out over time, that is an erotic system. But some systems very importantly are not erotic. In some
00:27:42
cases the average over a large group is much different than the average over time. And that's why this idea of
00:27:49
erodicity and erotic systems and non-erotic systems exists. It exists because people kept on making the same
00:27:56
mistake. We would use the average across many outcomes to make decisions about something that plays out over time. And
00:28:02
I know that's kind of a weird statement. I'll say it again. We would use the
00:28:05
averages across many outcomes to make a decision about something that plays out over time. And in some cases, we just
00:28:12
can't do that. There are scenarios in this world where doing that is a path to
00:28:15
failure. You can't apply the the large group average because the time series
00:28:20
average is different. I swear this this has to do with retirement. It has to do with annuities. Let's go back to the
00:28:26
coin flips for a second. Imagine we place a bet on the coin flips. And even imagine I gave you pretty good odds. If
00:28:32
you win, I'll triple your money. But if you lose, I get everything. Let's just
00:28:36
think about one coin flip to start. You bet $100. So if you win the coin flip, you walk away with 300. I triple your
00:28:43
money. If you lose the coin flip, you walk away with zero. The math's pretty
00:28:45
clear. Now, you should probably take that coin flip every single time. The expected outcome is that you start with
00:28:51
100 and that you walk away with 150 cuz you have a 50% chance of winning 300 bucks. 50% of 300, that's 150. Your
00:28:58
expected outcome is profitable. So if we think about the group of a hundred people who all have that bet and if
00:29:03
those 100 people all take the bet, we assume that about half of them win and half of them lose. So the winners all
00:29:09
turn $100 into 300. The losers turn $100 into zero. But on net, those players, again, it was 100 people 100 bucks each.
00:29:18
So they turned $10,000 into $15,000. 50 winners times 300 bucks. That's a net
00:29:24
win. Average outcome of this situation is a win. this group of 100 people. In fact, they probably could have teamed up
00:29:29
together beforehand and said, "Hey, every for every winner, pair up with a loser, split the proceeds, and it
00:29:35
guarantees that everyone walks away with a profit. They could agree to share the
00:29:38
winnings. But now, what if just one person had to take that same exact bet, but had to take that bet a 100 times in
00:29:46
a row? Does the time sequence of a 100 times in a row match up with the average outcome that we just described?" So,
00:29:52
let's think about it. You win your first flip. You turn a 100 bucks into 300
00:29:55
bucks. You win your second flip. You turn 300 into 900. Ah, but then you lose your third flip and you go to zero. And
00:30:03
once you're at zero, in this particular game I've invented, there's no coming
00:30:06
back. You can't triple zero. You've lost your chance to win any further. You
00:30:10
could win 10 flips in a row and you would actually turn a h 100 bucks into about $5 million, but then if you lose
00:30:16
the next flip, it all goes to zero. So the only way to avoid ruin in that particular time sequence game is to win
00:30:22
a 100 coin flips in a row. And we know that isn't feasible. So this game is no
00:30:27
longer erotic. It's not ergotic. The average outcome of the 100 flippers does
00:30:32
not align with the time series outcome of me flipping 100 times in a row. Now when you as long-term investors think of
00:30:39
a time series of investments, where does your mind jump to? I'll tell you mine
00:30:44
goes to sequence of returns risk. Now you can assume that the the average portfolio returns six or seven or eight
00:30:50
or 9% per year over the long run. I'll give you that. But why does the 4% rule
00:30:55
exist if portfolios are returning 8 9% per year? It's because retirement planning is a non- urgotic activity. Two
00:31:03
retirees can live through the exact same average investment returns but suffer vastly different outcomes if the time
00:31:10
series of those two returns are different. Here's a super simple math example for you to follow. Imagine our
00:31:16
first retiree, a $1 million portfolio. As they enter retirement, they follow the 4% rule to a te. So they withdraw
00:31:23
$40,000 in year 1 and then they adjust that withdrawal up each year by the rate of inflation. And we layer the the
00:31:29
following investment returns onto their retirement. We'll say they have uh negative 5% returns per year in each of
00:31:36
their first three years and then 0% per year returns in the next 3 years and then 8% per year forever after that.
00:31:43
It's not really a nice sequence. So the first six years are -5 -5 -5 0 0 0 but
00:31:50
then a nice consistent 8% per year forever after that. And then I take a a second retiree same exact circumstances
00:31:58
same exact average returns but all I do is I adjust the timing that's all I do.
00:32:02
I change the timing. I use that same -5 -5 -5 0000 sequence but instead of starting it in year 1 of retirement I
00:32:11
start it in year 10. every other year of their retirement is the same 8% per year. Our first retiree who suffered the
00:32:18
bad sequence up front. If they follow the 4% rule to a te, they would run out of money in year 28 of their retirement.
00:32:25
Of course, you know, the writing would be on the wall for them much much earlier and they might adjust their
00:32:30
withdrawals, assuming they had the the wherewithal to notice, but still the point is that if they follow the 4%
00:32:35
rule, keep adjusting up for inflation, they run out of money after 28 years. Now, what about our second retiree? the
00:32:41
one where all we did was uh we shifted their the bad sequence out to year 10. So they got 8% per year for the first
00:32:47
decade. Then they got -5 - 5 - 5 0000 and then back to 8% per year after that. Well, in year 28 when our first retiree
00:32:56
is running out of money, our second retiree would still have over $900,000 in their portfolio. Reminder, I mean,
00:33:03
they started with a million. They would end up running out of money after 43 years. maybe look at a third retiree and
00:33:09
we shift the the bad sequence out to year 20. That retiree by the time year 28 comes around where our first retiree
00:33:16
is failing. This third retiree would have $1.6 million in their portfolio. As a reminder, these three retirees,
00:33:23
they've all had the same exact withdrawals each and every year. All three of them withdrew $40,000 in year
00:33:28
one of retirement, then adjusted that number up each year by inflation. They also all had the same average investment
00:33:35
returns over their retirements. The only difference was the sequence of those returns as they came in. That is why
00:33:41
traditional investing for retirement, typical withdrawal strategies for retirement, the way that smart financial
00:33:47
planning, retirement planning typically works. It's a non-erotic system. Understanding the average is simply not
00:33:53
enough. The time series is too important. You know, retirement itself really is the ultimate non-erotic
00:34:00
activity because you only get one life path, right? You only get one time sequence. We know investment returns
00:34:05
compounded over time. That's non-erotic, right? The average return of an asset
00:34:09
across time is not what a single retiree experiences over time. As a result, sequence and volatility matter more than
00:34:16
expected return. We already discussed that withdrawal strategies are very much non-erotic too. You know, withdrawals
00:34:23
convert investment volatility and can convert that into permanent damage. You can't average your way out of an early
00:34:30
depletion of your portfolio because zero wealth just ends the game. And as you approach zero wealth, you actually
00:34:37
accelerate toward zero. That the rate of negative outcomes starts increasing. Things get worse and worse. The the
00:34:44
retirement implication is that tail risks dominate planning. Now, now what's
00:34:48
a tail risk? As an example, Ruben Miller wrote a great article a few uh weeks ago. I'll link it in the show notes
00:34:53
about the the tariff tantrum back in April 2025. And it was it's funny. He called it a one in a quadrillion event.
00:35:01
Or at least it would be a one in a quadrillion event. If investment returns followed a normal bell curve, but for
00:35:08
you stats nerds out there, investment returns don't follow a normal bell curve. The tails of an investment
00:35:14
distribution curve are very fat. And as Ruben wrote, stock market returns are not normally distributed. Daily outcomes
00:35:21
do not cluster around a daily average. Instead, we observe and expect super weird outsized fringe outliers. That's
00:35:29
his quote. And those weird outsized fringe outliers, those are called tails. Tail risks. These like, you know, kind
00:35:36
of rare but really impactful events. Tail risks affect our financial plans in really big ways and in non-erotic ways.
00:35:44
And if we get a bad sequence of tail events in the wrong order in our retirement, it's a it's a pretty big gut
00:35:49
punch. Longevity risk is very much non- urgotic, too. Just like Jeremy Kyle said
00:35:54
back on episode 127, he thinks longevity is the single most important number in retirement planning. Life expectancy is
00:36:01
a is an average across a population. You either die early or you live long. It's
00:36:08
pretty rare that you're going to be average. In fact, there's only a 4%ish
00:36:12
chance that you die at your expected age. In other words, you know, as I sit here today at age 36, my current life
00:36:18
expectancy is 77, but of course, I might die at 60 or 64 or 88 or 93. So, what are the odds I die at precisely 77?
00:36:28
Those odds are about 4%. And, you know, planning to age 84 works great unless you live to age 97. Living longer can be
00:36:36
usually is financially dangerous without some sort of protection. and planning to
00:36:41
averages might end up well it will end up underfunding the people who live the longest. That's why social security is
00:36:48
such a powerful tool and that's why good annuities at least and we'll get into
00:36:52
this in a second that's one of the corner cases in which good annuities like SPAS can be useful. Inflation can
00:36:59
be non-erotic too. It it compounds against you. You can't predict it. And if big inflation comes at the at the
00:37:05
wrong times early in a retirement, it can be hard to come back from or it can be permanently damaging. Again, it's not
00:37:10
about average inflation. It's about the inflation that you will suffer in your
00:37:14
specific time series of events. At the end of the day, if your wealth hits zero, the whole process stops. You know,
00:37:20
the the average across many people can ignore those who failed. Uh Monte Carlo analysis, for example, typically might
00:37:27
show average ending wealth. That's one of the outputs from Monte Carlo analysis. And that average is either
00:37:33
going to exclude paths that went broke or or much more likely, it's going to
00:37:38
swamp them out. So here's what I mean. Imagine I run a 100 Monte Carlo simulations in my retirement plan and
00:37:44
I'm sitting here today about to enter retirement. I've got $2.5 million and I
00:37:48
see something from the analysis that they call average terminal wealth and it's at $2 million. I said, "Wow, I
00:37:54
think I I have two$ 2.5 million today. I can spend money throughout my entire retirement and I'll still die with about
00:38:01
2 million bucks. That's great. I mean, let's go. Under the hood, though, you're
00:38:06
going to want to dig into those 100 independent results that comprise the the average of the Monte Carlo. And if
00:38:11
you did so, you might realize that some of those outcomes actually turn your $2.5 million into five or seven or 10
00:38:19
million or more, but that many other outcomes might actually hit zero. They might fail. In fact, what's the average,
00:38:26
for example, of of one outcome at 10 million plus four outcomes that all fail to zero? Well, the average is 2 million
00:38:32
per outcome. Again, that's one successful retirement out of five attempts or a 20% pass rate. But because
00:38:39
that one retirement simulation happened to have a a $10 million terminal value, the average terminal wealth is 2 million
00:38:45
bucks. Statistics can be misleading. And while I understand the desire to compound your wealth and to maximize, I
00:38:52
think that good planning also needs to focus on avoiding ruin. I really do. It's like the Charlie Munger quote. Tell
00:38:58
me where I'm going to die so I can make sure to never go there. Good financial
00:39:01
planning is tell me how my plan might catastrophically fail so I can make sure to avoid or mitigate that risk. Again,
00:39:08
we all have the desire to compound our wealth in in some way and and maximize what we have. But if you were to sit
00:39:13
here and say, "But Jesse, you know, there's a risk. I might not achieve a
00:39:17
$15 million nest egg. I would tell you that doesn't really sound like a risk to
00:39:22
me. Sure, maybe $15 million for you can be a goal, but the lack of $15 million isn't a risk. But if someone said,
00:39:29
"Jesse, there's a risk I've run out of money by 75 and I'm forced to vastly
00:39:33
underlive my final decade here on Earth." I just had someone the other day say that her biggest fear in retirement
00:39:39
is becoming what she called a bag lady. And if that's a risk that you feel and
00:39:43
that you fear, yeah, that sounds like a legitimate risk to me and and something worth considering. The risk of ruin is
00:39:49
non-orgotic. If you're one and only timeline has factors that increase your risk of ruin, then you don't care nor
00:39:56
should you care about the average that other people are living. You only care about the giant risk that happens to be
00:40:01
staring you in the face. Here's a quick ad and then we'll get back to the show.
00:40:06
Serious question. Why do podcasters constantly ask for ratings and reviews? Yes, they do help highlight our shows to
00:40:14
new listeners. They help strangers find us on Apple Podcast and Spotify. It's
00:40:18
totally true and a good reason to ask for ratings and reviews. But I have something more important, at least more
00:40:23
important to me. I want to know if you like this stuff. I want to know if you like my podcast episodes, my monologues,
00:40:30
my guests, the information I share with you and the stories I tell. I want to improve and make your listening more
00:40:36
enjoyable in the process. So yeah, I would love to read your reviews. And sure, if you throw a rating in there,
00:40:41
too, that's great. If you like what I'm doing, please share it with me. It's
00:40:45
such a great feeling to read your feedback. I'd love to read your review or see a rating on Apple Podcast or
00:40:52
Spotify. Thank you. What, if anything, can we do to turn the the non-erotic risks of retirement into something that
00:41:00
maybe is a little more erotic? Or in other words, how can we minimize our exposure to unique bad luck time series
00:41:07
and somehow maximize or increase our exposure to the long-term average or the average of many people, which we know
00:41:15
when you look at kind of some of the retirement numbers and you look at the average of many people, things start to
00:41:20
look better than when you're looking at the worst case time series. So, let's
00:41:23
think about that for a second and and maybe we can follow this example. Imagine you have 100 retirees and
00:41:28
they're all following the 5% rule in retirement. Yes, I said the 5% rule because depending on your preferred
00:41:34
asset allocation, the the 5% safe withdrawal rate works in about 75% of historical back tests. So, it means that
00:41:42
25% of the time our retirees suffer either a lousy stretch of investment returns and or they live so long that
00:41:49
they stress their portfolio and ultimately run out of money. And that's non-orgotic, right? We don't want that.
00:41:54
So, we approach this group of 100 retirees all following the 5% rule and we have a little idea. We say, "Hey,
00:42:01
let's see if we can kind of meet in the middle." We ask each of these retirees
00:42:04
to take a a small haircut from their original portfolio, maybe 10% from each retiree. And then we pull everybody's
00:42:11
10% haircut together into one big pot. We invest it pretty, you know, reasonably conservatively. And then we
00:42:18
actually start taking a small share of the investment growth from that pool and we give it back to all the retirees.
00:42:23
Now, not a ton of growth, but a little bit. And on average, our retirees are all going to have slightly less annual
00:42:30
growth from the pool because again, we're being a little conservative with our poolled investments. They're still
00:42:35
spending according to the 5% rule, though, but their overall net worth does look a little worse year-over-year
00:42:41
because they took the 10% haircut up front. But now, why are we doing this? Because here's the deal that we proposed
00:42:47
to our to the retirees about the 10% haircut and the big pool of money. We tell them, hey guys, if you die early or
00:42:54
basically no matter when you die, you are not going to get your 10% back. You put 10% in and you are starting to get
00:43:01
this this income from the pool and and maybe by the time you die, you're only
00:43:06
going to have pulled a couple percent of the of your original money back out. But
00:43:10
it doesn't matter. You're not going to get your money back. Now, before you cry
00:43:14
uncle though, we need to ask if you are one of these people who dies early and doesn't get their money back, did you
00:43:20
run out of money? Did you live a bad retirement? Did the haircut negatively affect you in your retirement years? I
00:43:27
would say no. While they certainly did suffer a net loss on their balance sheet, on their net worth statement, it
00:43:33
didn't actually harm their retirement in any way. You know, if we're just calling
00:43:37
successes and failures, period, their retirement was still a success. And if we do it right, maybe half, maybe even a
00:43:44
little over half of the 100 people might fit this bill. They will get less than their original 10% back or certainly
00:43:50
they would have been better off not taking the 10% haircut in the first place. But because they died relatively
00:43:57
earlier or earlier than average, that 10% haircut never actually comes back to harm them in terms of their retirement
00:44:03
success at all. The only measurable harm is that they have fewer assets at their
00:44:07
death. You know, their heirs get less of an inheritance. That's the only harm.
00:44:11
But now let's ask about the other people of the 100. Let's ask about the people
00:44:15
who die later than expected. Some of those people might die just a couple years later than average. And they'll
00:44:21
get most if not all of their original 10% haircut back in terms of the income distributions, but it's doubtful they'll
00:44:27
ever get enough back to say that they the pool concept was truly profitable or helpful for them. Nevertheless, they
00:44:34
don't really live that long past their average age of retirement and their retirements will still be successful. I
00:44:39
would say for them the pool was very much a a neutral a neutral uh addition to their retirement. And then that
00:44:45
leaves us with a small share of people who really live for a long time. They live many many years past their expected
00:44:51
age of of death. And for those people their 10% haircut, not only do they get the 10% back in terms of the even uh
00:44:59
income distributions, they end up getting a lot more. They end up getting much more than their quote unquote fair
00:45:05
share. And because those people did die late, they got more than their fair share back. A few of them will fit the
00:45:10
following criteria. Without the proceeds from the from the big pool, their retirement plan and their withdrawal
00:45:16
plan might have failed due to their longevity. But due to the proceeds of the big pool, their retirement plan
00:45:23
withdrawal plan was actually successful despite their longevity. So with all that explanation, let's examine what the
00:45:29
big pool of money actually did. For most of the 100 people, participating contributing their 10% haircut into this
00:45:36
pulled asset was negative to their net worth. But because they didn't live that
00:45:42
long, they certainly didn't live forever. Even though it was negative to their net worth, it really did nothing
00:45:47
to harm their retirement success. But for a small minority of the 100 people, not only was the pool possibly positive
00:45:54
for their net worth, at least it outpaced inflation. It might not have outpaced other assets, but it did
00:45:59
outpace inflation. But they also found that the existence of the guaranteed income pool actually increased their
00:46:06
odds of retirement success. So while the the average net worth of the group goes
00:46:11
down due to the participation in the pool, a few of the individuals a few of the individual people out of the 100
00:46:17
actually saw their odds of retirement success go up and none of them actually saw their odds of retirement success go
00:46:23
down. So we have decreased the impact of a specific time series of events. The time series is that well some people
00:46:31
happen to live a long time and we've lessened that impact and we've done that
00:46:34
by increasing a specific average outcome. We provided that guaranteed fixed income that all the retirees got
00:46:41
to benefit from. So really what we've done is we've taken some of the the
00:46:45
non-erotic outcomes of many people's retirement plans and we've just very
00:46:49
gently steered it toward a more erotic outcome. And if you haven't caught on
00:46:53
yet, this pool that I just described, that is an annuity. We're coming full circle now. What I just described to you
00:47:00
is exactly how an annuity works. And from an erodicity lens, why annuities make sense to at least to some
00:47:06
retirement planners. We've decreased the upside potential of everyone's retirement, at least if measured by net
00:47:13
worth over time or spending over time. We have decreased that, but in exchange, we've reduced the probability that a few
00:47:20
people will run out of money. The hard part for for any of you out there thinking as an individual is to really
00:47:25
consider, am I going to be one of that small minority who lives forever or suffers a particularly bad sequence of
00:47:32
returns? Am I going to be someone who suffers the the non-erotic downsides of retirement and wishes I could somehow
00:47:38
achieve less of a bad luck time series and achieve more of an average over the large group? It really is a, you know,
00:47:45
an amazingly interesting question because what it really comes down to is this. Would you knowingly take a bet
00:47:50
that is, you know, highly likely to reduce your net worth in exchange for avoiding the small probability that your
00:47:57
safe withdrawal rate or that your retirement plan or your lifespan ends up being an outlier? Would you accept a 95%
00:48:05
chance that you might lose money in exchange for a 5% chance that you'll avoid a retirement failure? You know,
00:48:12
remember how annuities are the opposite of term life insurance in many ways? I bought life insurance when we bought our
00:48:17
house a few years ago and and when we got pregnant with with our first child, I was 33. I bought a 30-year term
00:48:23
policy. And looking at Social Security actuarial tables for a 33y old male, there is an 83% chance I live to age 63.
00:48:32
In other words, there's an 83% chance that all my insurance premiums for the
00:48:36
next 30 years will not lead to any sort of payout in the future. I'm accepting
00:48:41
an 83% chance that I lose money in exchange for a 17% probability that I might die and leave my family
00:48:49
financially okay. I'm accepting a high probability of low-level failure in order to derisk myself from a low
00:48:56
probability of highle failure. And that is what term life insurance does, plain and simple. And it's interesting. I
00:49:02
don't think anyone in their right mind would say, well, you know that term life
00:49:05
is probably going to be a losing financial proposition. So, why would you ever buy it? I don't think anyone says
00:49:10
that. Back to our simple fixed annuity. To buy an annuity is a high probability of low-level failure in order to derisk
00:49:19
yourself from a low probability of a highle failure. So again, it's a high probability that you actually kind of
00:49:26
quote unquote lose money on the annuity to derisk yourself from the small chance
00:49:31
that you hit a retirement failure. In a perfect world, that is how annuities would work and that's how people would
00:49:36
use them to their utmost. And if you put an annuity or into a simple financial model or you run a simple Monte Carlo
00:49:42
simulation and you ask yourself what is this annuity actually doing under the hood, most of the time an annuity will
00:49:49
take an already successful retirement plan and will reduce the overall amount of money in that plan. Either you die
00:49:55
with less money or you got to spend less money along the way. in shorter lifespans or in lifespans with a a
00:50:01
neutral to good sequence of returns, that is certainly the case. But in a small minority of a Monte Carlo's
00:50:07
individual simulations, particularly when a a long lifespan combines with a bad sequence of returns, we see that the
00:50:15
annuity certainly increases the probability of retirement success. And you can see that result in the numbers
00:50:20
themselves. The last caveat though on that one, I will say the devil is in the details. If I run a Monte Carlo
00:50:26
simulation with ultraconservative investment rates of return and then I compare that to a known constant payout
00:50:32
from an annuity, that particular simulation is going to make the annuity look really good. And hopefully that
00:50:37
makes sense. You know, if I'm choosing to make my portfolio look ugly, the annuity is going to look pretty by
00:50:43
comparison. Similarly, if I knowingly use aggressive rates of return and then I compare it to a known constant annuity
00:50:49
payout, again, if I make my portfolio look gorgeous, well, then the annuity is going to look extra ugly in comparison.
00:50:56
Anyway, that is my breakdown of annuities. They are an interesting product. They are an insurance product.
00:51:02
Most annuities are variable, which I would avoid like the plague. Some annuities are fixed, though, and and
00:51:07
they do have these corner case uses. In most of those uses, you're knowingly
00:51:12
taking a bet that most likely will not work out in your favor. But you know that in a minority of cases, it actually
00:51:18
would work out in your favor. Why? Because the nature of retirement, which can be described using this idea from
00:51:24
the hard sciences, erodicity, retirement planning cares much more about your specific time series of events rather
00:51:31
than caring about what the average uh of all people go through. Annuities are a product that done correctly can diminish
00:51:37
your specific exposure to your one and only time series of events that you'll
00:51:42
go through in the future and increase your exposure to the average events of all people. This has a tendency to to
00:51:48
dull both ends of your potential outcomes. It dulls the end where your portfolio grows and grows and you have
00:51:53
lots of retirement money to spend or leave to heirs. But then it also dulls the end where you might run out of money
00:51:59
and suffer a painful retirement failure. Now, whether the potential payoff is worth the high probability cost, I've
00:52:05
explained, you know, much of the general math today. You have to understand your
00:52:10
specific math if you're interested. And then the rest of the decision, it's a
00:52:13
personal choice up to you. As always, thank you for listening to Personal Finance for Long-Term Investors. Thanks
00:52:19
for tuning in to this episode of Personal Finance for Long-Term Investors. If you have a question for
00:52:24
Jesse to answer on a future episode, send him an email over at his blog, The Best Interest. His email address is
00:52:31
jessevestinterest.blog. Again, that's jessevestinterest.blog. Did you enjoy the show? Subscribe, rate,
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00:52:46
we really appreciate it. We'll catch you on the next episode of Personal Finance
00:52:50
for Long-Term Investors. Personal Finance for Long-Term Investors is a personal podcast meant for education and
00:52:57
entertainment. It should not be taken as financial advice and it's not prescriptive of your financial
00:53:02
situation.