Financial Planning Blog

Most people planning for their retirement years are concerned with maximizing their retirement income while minimizing the risk that they may outlive your savings. In Part 1, immediate annuities were introduced as a potential valuable tool in helping retirees meet these conflicting objectives. Some things to remember about immediate annuities are:

• They are a way for a person to turn their retirement savings, maybe an IRA or 401K, into a personal pension plan--basically a monthly check for the rest of your life, no matter how long you live.
• They are not really investments, but contracts with an insurance company. They are agreements where a person (the annuitant) pays a lump sum of money to an insurance company for the promise of a series of payments. These payments, usually monthly, start immediately and last for the life of the annuitant (and possibly the life of a surviving spouse). They are a way to transfer your risk of outliving your money to the insurance company. You essentially exchange that risk of outliving your money for the risk that you won't receive back all your money in the event you die earlier than expected. When you die payments cease, unless you purchase a joint and survivor annuity where some level of income would continue for your spouse. (There are also "period certain" annuities that guarantee payments for a fixed number of years. These guarantees obviously come with a cost.)
• They are a low risk way to increase your potential retirement income. Insurance companies are able to offer a higher level of income from a lump sum investment than a retiree can safely do on their own. This is because some in the insurance pool die early, effectively subsidizing those who live longer. This higher level of income is often referred to as the "mortality return" or "mortality credits".

Immediate annuities are not appropriate for everyone, but unless you have a surplus of assets to fund your retirement, they deserve your consideration. In the decision whether to utilize an immediate annuity, the key is to understand your personal priorities and how different retirement investment and withdrawal strategies help you achieve your goals. Consider these four potential priorities of the retiree:

1) Maximizing income in retirement: Presumably to fund a more comfortable lifestyle, but potentially for increased financial margin so monthly expenses don't need to be budgeted so closely, or for charitable giving.

2) Minimizing the possibility of running out of money: Essentially the peace of mind you will not be living in poverty later in life or financially dependent upon your children.

3) Maximizing the possibility and/or size of end-of-life bequests: This could mean leaving a significant inheritance to your children or grandchildren, or gifts to charitable organizations.

4) Flexibility in meeting future needs or desires: None of us knows exactly what our needs and desires will be over the next one to four decades, so it is important to have assets available to fund whatever comes our way.

The retiree has to choose how they will manage their retirement savings to meet these objectives. One option the retiree has is to manage their investment portfolio (with or without the help of an investment advisor) with the aim of providing adequate income, while not allowing their principal to be depleted before they die. This is can be a tricky proposition, especially if you aren't starting with an abundance of assets. Since a person's lifespan, spending needs, future inflation, and future market returns are all estimates with plenty of variability (i.e. risk), this task must be approached very conservatively*. With a combination of good planning, self-discipline, and reasonable luck, the retiree can be successful with this approach.

Another option for the retiree is to use immediate annuities to create a long term, secure, sustainable income. With this lifetime guaranteed income, the retiree is protected from running out of money in the event they live longer than expected. The retiree also can generally receive a higher initial level of income from this approach, due to the "mortality return". However, the retiree needs to factor in the impact of inflation into the lifetime income plan. If a nominal (i.e. non-inflation adjusted annuity) is used, the purchasing power of the monthly payout will continue to shrink over the years. If you assume 3% inflation, the purchasing power of the annuity payments will be halved in about 24 years. One option is to purchase immediate annuities with inflation adjustments, at the obvious cost of lowering the initial income payout.

If the retiree's top priorities are clearly #3 (maximizing end-of-life bequests) and #4 (flexibility), managing their investment portfolio for lifetime income is the obvious choice. If the retiree's top priorities are #1 (maximizing income) and #2 (the security of a guaranteed lifetime income), it points to annuitizing a significant portion of their retirement savings. For many of us a combination strategy that includes annuitizing a portion of our retirement savings, maybe enough to meet basic living needs when combined with Social Security, makes good sense. Since all of us require some level of flexibility to meet unexpected challenges or opportunities, it probably isn't prudent for anyone to annuitize their entire retirement nest egg. Also, if lifetime annuities without inflation adjustments are used, some assets need to be invested to supplement income in later years.

In Part 3, shopping for immediate annuities and other considerations will be briefly discussed.

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 *One commonly accepted withdrawal strategy is the "4% rule", where the retiree starts by withdrawing 4% (maybe 4.5%) of his portfolio the first year, and adjusting this dollar amount each year for inflation. Whereas this may give the retiree a high likelihood of success (i.e. not outliving his money over a thirty year period), it provides a much lower income than many seniors would like to obtain from their portfolios. (We'll explore retirement income strategies more in later articles.)