To follow up on last week’s question, let me now say that annuities DO in fact, have their place. To cut through all the complexity, the most important single reason to invest in an annuity is to protect you from outliving your assets.
“Outliving your assets” is not a meaningful concern for those who have earned, saved, and invested for growth throughout a working lifetime and now only need to draw 5% or less per year from their portfolio for the rest of their life. In such a circumstance, the only real uncertainty is how large the inheritance or charitable bequest is going to be at their death.
SO IF YOU ARE FAR AWAY FROM RETIREMENT, YOU SHOULD BE FOCUSED ON EARNING, SAVING, AND INVESTING FOR GROWTH.
But if you are already in retirement or considering it, you need to take stock of your assets and spending objectives and see if you can live on the earnings alone. And if, after determining your spending needs, predictable income, and liquid assets that you can invest so as to sustain a withdrawal rate of 5%, you find yourself short, then an annuity might close the gap.
So let’s talk a bit about annuities. In simpler times, an annuity referred to what is today called an immediate fixed annuity, a regular payment of the same amount every period until you expire. Fans of Jane Austen novels and adaptations are constantly treated to information about the annuities of eligible single men and women, which varied depending on whether they were invested in 4% or 5% annuities. In Pride and Prejudice, Mr. Collins magnanimously offered to marry Elizabeth even though she might only bring “one thousand pounds in the four per cents” to the marriage. Likely, these were 1,000 pounds worth of English government bonds with a perpetual 4% interest rate (and no due date for principal). It seems that even then it was pretty well established that the leisure class could only expect a secure 4-5% from their investments in spending money.
But what if you need more? Well, the annuities discussed in the Jane Austen novels really were perpetual, so that they continued after the death of the recipient and simply had a change in beneficiary (most often restricted to a male heir, which is a theme of so many of her novels). In theory, an annuity that stopped at death could be more generous per year, since it had an end date.
Enter the insurance product known as the fixed annuity. Based on your age and gender, you can get an insurance company to commit to payments for the rest of your life of,not just 4% or 5%, but 6%, 7%, 8%, or even more. The reason is that, in essence, some of your payments are not income, but principal, which the insurance company retains after your death. You could, in theory, do the same, spending your income plus a portion of your principal each year. All you need to do is make sure you die on the exact day you run out of assets. Now, how exactly can you manage that one?
So you can see why an insurance annuity might make sense: it removes the uncertainty caused by your longevity risk. The insurance company pays you based on your life expectancy, but has to continue paying you if you live longer (and, of course, gets a windfall if you die early). They take on the uncertainty, but if they sell enough annuities to enough different people, they can mitigate their own risk through the law of large numbers. So if you need or want a larger than 5% draw per year, this seems to fit the bill.
Okay, you know that isn’t the end of the story. All investments have fees, and some insurance company annuities are loaded with them. But others are reasonably priced, and the site Immediate Annuities can give you an idea of what the best of them have to offer.
But not so fast! What about inflation? Well, with a straightforward immediate fixed annuity, you’re out of luck. Fixed means fixed. Personally, I consider them too dangerous because of the lack of protection against changes in the cost of living, and won’t say more about them.
You can address the inflation problem in a couple of different ways. One is to purchase an inflation-adjusted annuity, which adjusts the payments each period based on changes in cost of living indexes. Social Security itself is a form of inflation-adjusted annuity, although it is linked to inflation in wages rather than consumer prices at the moment. Most companies don’t want to offer these, but those who do charge 40-50% more than they do for a fixed annuity. Once that extra cost is added, you might find that the initial benefit drops back below the amount you needed in the initial year.
My preference, when an annuity is appropriate, is for an immediate variable annuity. This interesting hybrid still protects you against longevity, since payments continue for life, but the size of the payment changes each period based on the performance of an underlying set of investments you can select and change. I also like the fact that these products typically start with a built in assumed rate of return, allowing your payments to begin at a higher level, which makes more sense since nearly all retirees spend more in the early years of retirement and less as they get older and lose interest in extensive travel, entertainment, and restaurant dining. You could closely duplicate an inflation-adjusted annuity with an immediate variable annuity by choosing Treasury Inflation-Protected Securities (TIPS) as the underlying investment. If the assumed rate of return in the annuity were 5%, the insurance company’s payment in the first period would be based on a fixed annuity yielding 5% (much higher than current interest rates), and subsequent payments would go up or down based on whether the investment rate of return was greater or less than 5% in that period.
But I wouldn’t recommend being so conservative. Accept the volatility of including equities as the underlying investments so as to increase the expected payments over time. Sure, equities also go down, but remember that you are ALREADY collecting on an inflation-adjusted annuity, Social Security, so you should be able to handle the volatility of your insurance annuity payment. Based on some of my earlier blog posts, in which I noted the historical basis for 80% in equities in retirement, and given that the Social Security benefits themselves might be large enough to represent the equivalent of 20%, I wouldn’t think you crazy if you kept your immediate variable annuity entirely in a globally-diversified equity portfolio. But you, of course, probably think I’m crazy, so I will only suggest that the immediate variable annuity gives you the ability to make modest moves in that direction. So instead of putting 100% in TIPS, you might put 10% each into a US stock index, an International stock index, and a REIT index, with the other 70% in Treasuries or similar choices, and achieve an increased expected return with only a modest increase in volatility. You can also change the allocation as you see fit. Immediate variable annuities make a lot of sense for those who are mainly interested in living out their lives with maximum cash flow and who have no important goals involving heirs or charities. Vanguard, that champion of low costs in the mutual fund world, works with an insurer to offer an excellent immediate variable annuity. Links change, but I’m hoping this will lead you to current information about their immediate variable annuity offering. TIAA-CREF also offers an excellent, low-cost Single Premium Immediate Annuity, which you can probably find by clicking here.
In my view, the immediate variable annuity is the insurance annuity product with the greatest overall potential for retirees whose goal is simply to maximize their lifetime cash flow. And once the questioner from last week has retired, this is the annuity product that I think deserves the closest look for his tax-sheltered assets. Those of you waiting for me to discuss deferred annuities will have to wait longer: I don’t see much use for them and would rather spend time discussing what you should do than what you shouldn’t. But if I get a good question about them, I’ll answer it.
Most of the retirees with whom I work did the “earn, save, grow” part for a long enough period of time that they didn’t have to give up on legacy goals. They want to provide as much as they can for their children and grandchildren and/or for beloved charitable causes as long as they don’t threaten the security of their own retirement years. For them, I think a carefully planned withdrawal strategy from their existing assets is the way to go. And I think that deserves a post of its own.