Lifetime SPIA can be Invaluable Part of MPT Planning in Tough Times

May 29, 2009

SOURCE: InsuranceNewsNet, Inc.

Since the Noble Prize-winning economist Harry Markowitz formulated the Modern Portfolio Theory (MPT) in the 1950s many financial advisors has been using it as the foundation of their clients’ retirement plans. The MPT proposes that diversification – combining various asset classes, stocks and bonds that are not perfectly correlated – is an effective way of minimizing investment risk and optimizing investment portfolios.  Over time, a well diversified portfolio will generally experience less volatility, according to the theory.

Investors, who have maxed out their retirement plans but still want to save more for the long term, are frequently told to put their money in a set of index funds that match their risk profile, and leave it there until they need it.

But the financial meltdown is proving that the MPT is not as reliable in the real world. Experts say that the past year have shown that while complex diversification strategies can raise returns over the long term their value is limited in times of crisis. Advisors and clients alike realized that various investment strategies based on MPT did not fare any better than having all eggs in one basket. The common strategy of mixing high yielding, high-risk stocks with low-risk, low-yielding bonds, for instance, provided little protection as both generated negative results.

As a result, investment experts have been trying out a new strategy: adding alternative assets in asset allocation portfolios. The alternative assets are non-correlated with traditional assets that use the S&P 500 as a benchmark. This mitigates risk and enhances returns through increased diversification.

A key asset is the lifetime single premium immediate annuity (SPIA). SPIA converts a single lump sum premium payment into a monthly, quarterly or annual income stream that begins at a time chosen by the investor. Payments begin within 30 days after or within one year after purchasing the contract.

These features make lifetime a suitable product for long-term planning. It is also compatible with MPT strategies. For example, a lifetime SPIA can be an alternative to secure fixed-income instruments such as bank CDs.

SPIA provides a guaranteed income for life option that’s typically higher than many other investments. SPIAs have a guaranteed minimum rate generally set at 3% or 4%. In comparison, current interest rates for six-month CDs hover in the range of 1 percent to 2 percent. During periods of falling or low interest rates the SPIA’s minimum guarantee prevent its interest rate from falling below that level.

With the regular guaranteed income provided by a lifetime SPIA, investors can then take on more market risk with their other savings and investments. The investor can count on the SPIA payouts regardless of the future performance of their portfolio. The investment horizon for other equity assets can therefore be set longer – which according to the MPT gives it time to recover any losses from down markets.

Experts say the S&P 500 needs to rally at an average annual rate of return of 18.3 percent for the next five years for a 60-year-old investor to recover the value of his or her investment in time for retirement. While the chance of this happening is not totally impossible, the historical (and more realistic) rate for stocks is only about 10 percent a year.

One strategy to counter the effect of market volatility on IRA accounts is to invest a portion of the assets in a lifetime SPIA. With the SPIA providing payouts during retirement the remaining IRA portfolio can be invested with a longer time horizon giving it more to recover.

Many financial planners already agree that the SPIA, as part of a diversified strategy, is the best vehicle for a personal defined-benefit retirement plan to dramatically decrease the probability that a client will outlive his or her assets. However given the depth of the financial crisis, when even venerated MPT-based strategies falter, the value of lifetime SPIAs as alternative assets is impossible to replicate using other products.

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