First person: Saved by the bell

I am a lucky person.

One of my most memorable streaks of good luck happened during my seven years in secondary school. Each term, we faced several written and oral tests. I breezed through the written ones with no problem. But the oral tests? They were nerve-wracking. One by one, the teacher summoned us to the front of the classroom and asked rapid-fire questions. One by one, students took their turn. This ritual of dread continued until the bell finally rang.

Why was I lucky? My name was in the middle of the class list. If the teacher began calling names from the top, there was never enough time to reach me. If they started at the bottom, ditto. As rare as it was, if I were called, then the bell usually saved me. This is the story of how, decades later, the magic bell saved me again.

In the late 1990s, I started my research on retirement planning. I had no grand aspirations; I just wanted a plan for a comfortable retirement. The basis for financial planning is Gaussian math, which is the random walk of market behaviour. Concepts like efficient frontier, asset allocation and Monte Carlo simulators rely on the Gaussian model. A closer look at the market history showed me that the model works about 94% of the time. It represents all the known unknowns of market behaviour. In this region, asset allocation and diversification work well.

In the remaining 6%, markets behave in a fractal fashion. This is where the unknown unknowns happen. In this region, a retirement portfolio’s longevity fluctuates significantly. A bad month early in retirement can easily knock off 10 years of portfolio life. To avoid this risk, one must go beyond asset allocation and diversification. One must consider guaranteed income for life, such as pensions or annuities.

Pooling risk

It is important to differentiate how retirement income is generated. When income is derived through investments, the sustainable withdrawal rate is about 3.3% (starting at 65, for essential expenses). When income is generated through life annuities, the payout rate is about 5%. For the annuity, the retiree hands over assets to an insurance company in exchange for a guaranteed income stream. The insurance company pools these assets (and the risk), and that’s why annuity payments are generally larger than the sustainable withdrawal rate from an individually-held investment portfolio.

My findings were consistent with what insurance companies were trying to sell. My graphs were more convincing, complicated and humourous than their marketing materials. Soon, many big names invited me to speak at their advisor conferences.

I had one big concern. Most insurers were pushing their variable annuities. These are hybrid products; the client keeps their investments as their own and still receives guaranteed income. Since assets are not pooled, the math would suggest that the guaranteed payout of a variable annuity should be closer to the sustainable withdrawal rate from an investment portfolio than the payout of a standard annuity.

Over time, the competition for retirement assets became fierce. At each of my speaking tours, I noticed richer benefits were being added to variable annuities. After each tour, I updated my spreadsheets to include them.  The benefits were becoming unsustainable. Insurers were, in effect, giving away free put options on lifelong income.

Marketing people were selling the idea of safety with such reckless abandon that they were actually making their company more vulnerable with each pitch.

I wrote a series of five articles about Canadian variable annuities (May to September 2007, Advisor’s Edge Report). A few weeks after the last one, my phone rang. The caller ID showed the name of a large insurance company. I imagined I was about to hear positive feedback, so I cheerfully picked up the phone.

The caller said he had read my articles. Then his stern monologue began: How can you write fiction like this? Where’s the proof? Why are you trying to scare people? and so on. After what felt like an eternity, he said he’d call me again and hung up. I was terrified.

My worries did not last long. Before his next call, my good luck shone on me again. Just like in my secondary school years, I was saved by the bell. This time, it was the opening bell of the New York Stock Exchange. The 2008 financial crisis was underway — the worst stock market crash since 1929 and a textbook fractal meltdown.

Insurers scrambled to pull their variable annuities from their shelves — some immediately, some shortly after. Some even offered to buy back their guarantees from unsuspecting retired clients. The share price of that insurance company, the one that called me about my articles, plunged like an anchor in the Bermuda triangle. I never heard back from that guy.

I was lucky, the bell saved me. Always remember, no matter how hard the marketing people push, math always wins. For an engineer like me, there is nothing more satisfying than to say, I told you so!