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Investing Blog Roundup: Why Does Annuitizing Reduce Risk?

This week Wade Pfau and Michael Kitces released a paper taking a close look at exactly why the probability of portfolio depletion goes down when you allocate a portion of your portfolio to a lifetime annuity. What they found was very interesting, both in terms of its implications for purchasing annuities as well as its potential implications for retirement asset allocation.

The classic understanding of annuitizing is that it reduces risk because of “mortality credits.” That is, when you annuitize, if you live past your life expectancy, you get to spend the money of annuitants who didn’t make it to their life expectancy.

What Pfau and Kitces found is that mortality credits are only part of the story, and a significant portion of the risk reduction effect of annuitizing is the result of an asset allocation-related phenomenon. Specifically, if you trade your bonds (or some of them) for annuities, you end up with a situation in which your effective asset allocation gradually shifts toward stocks throughout retirement. And they found that this shift is responsible for a significant portion of the risk reduction from annuitizing.

One relevant conclusion is that, by making the unorthodox asset allocation choice of increasing stock allocation over the course of your retirement (that is, decreasing stock allocation as you move toward retirement, then slowly increasing it again after retiring — so that your stock allocation is at its lowest point in the few years both immediately before and after retiring), you can obtain a portion of the risk reduction that normally comes from annuitizing without actually having to buy an annuity.

It’s thoroughly counterintuitive, and as Pfau mentions in the comments on his blog post discussing the article, further research is needed. But it’s certainly interesting.

Here’s the study itself:

And here are the authors’ respective articles summarizing/highlighting key points from the study:

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