Retirees face two big challenges. The first is how to invest their retirement assets. The second is determining how much they can withdraw each year from their retirement portfolios.
What many retirees don’t realize is these challenges can be greatly reduced by paying for essential retirement expenses from guaranteed income sources. Guaranteed income sources include Social Security, pension plans, and annuities.
Surprisingly, only about 10% of retirees partially fund their retirement through annuities. Most just use a combination of Social Security and spending from their savings.
Sequence of Return Risk and Longevity Risk
The problem with trying to cover most retirement expenses from savings is the retiree has to plan for extreme outcomes. These extremes include below-average market returns, particularly in the early years of retirement. This is known as sequence of return risk. The other potential extreme that retirees have to plan for is living a very long time, well into their 90s or even past 100. This is known as longevity risk. Of course, living a long life is not necessarily a bad thing, but it does increase the risk of running out of money if the retiree is heavily dependent on savings to cover his or her retirement expenses. Due to the need to protect against longevity risk and sequence of return risk, retirees who depend on their savings to fund retirement expenses have to spend less each year to protect against these unknowns than they would if they relied on an income annuity.
Income annuities, also known as immediate annuities or longevity annuities, are offered by insurance companies. In exchange for a one-time premium, the insurance company pays the retiree a monthly payment for the rest of his or her life, and depending on how the annuity is structured, the life of the retiree’s spouse. Income annuities are a form of longevity insurance.
Income annuities allow retirees to spend more than they otherwise would because the annuity pays more than what retirees could safely spend from their own assets. That is because income annuities are priced based on average life expectancies. An insurance company offers the annuity to a pool of retirees, some of whom will die young while others will live a very long time. Collectively, the pool of retirees have an average life expectancy that the insurance company uses to price the annuity and determine payouts. A retiree who purchases an income annuity benefits from this risk pooling. The annuity allows the retiree to eliminate longevity risk because the guaranteed income source will last for the rest of his or her life.
More Flexibility with Income Annuities
Not only does an income annuity eliminate longevity risk, but it also reduces the potentially devastating impact of market losses. If retirees cover their basic living expenses through guaranteed income sources including an annuity, then their spending is less dependent on the whims of the stock market. Their remaining assets after purchasing an annuity can be used to fund discretionary spending and cover contingencies like long-term care.
Purchasing an income annuity allows retirees to invest their remaining assets more aggressively and opportunistically because they can more easily ride out market volatility without having to cut their spending.
Income Annuity Fears
Retirees are often hesitant to purchase an income annuity because they don’t like to see their account balance be reduced after paying the annuity premium, and they feel like they are giving up liquidity. These retirees don’t recognize that the income annuity is a valuable asset that gives them more flexibility and liquidity with their remaining portfolio investments. Without an income annuity, retirees have to conserve more of their assets for future spending needs so the portfolio is less liquid than the retirees realize.
Retirees often worry about the insurance company defaulting on an annuity, but defaults are extremely rare. By purchasing income annuities from highly-rated mutual insurance companies that are owned by policyholders, retirees can feel confident their payouts will be safe. In addition, each U.S. state has an insurance pool to cover annuitants in the case of default.
Please listen to this episode of the Money For the Rest of Us podcast to learn more about income annuities and reducing longevity risk.
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host David Stein. Today is episode 279, it’s titled, “Why All Retirees Should Consider Income Annuities.”
Questions on retirement
I get a lot of questions about retirement. Here’s an example. A member of Money for the Rest of Plus said, “Should after-retirement portfolios be structured differently from the savings-phase portfolio?” I got an email today from a listener. He has about $1.2 million in assets, he’s 54, about $400,000 in the stock market, half a million dollars certificates of deposits, and is considering taking some of that money in CDs and putting it in a laddered portfolio of individual bonds. So this would be a portfolio where you have bonds that mature in one year, two years, three, four, and onward. Individual bonds.
Finally, got an email from a member who asked about annuities. Given that they have no children, no debt, they don’t want to leave an inheritance to anyone, their primary goal is not to run out of money before they die. He asked, “Should we put all of our assets into annuities in order to maximize our ability to spend while reducing risk during retirement?”
Clearly, how we invest and what we do with our money when we’re retired is different during the accumulation phase, when we’re just seeking to save enough and earn a decent return so we have enough to retire. But what do we do with the nest egg once we’re retired?
Face to face with the problem
I came face to face with this during the Great Financial Crisis in 2008. We were managing portfolios for financial planners as one of our lines of business. And in the fall of 2008, I went out and met with the clients of one of these financial planners, this was in Baltimore. We managed a stock portfolio and a bond portfolio for this client and the advisor would allocate, mostly retirees, into these portfolios. Typically it was 50% stocks, on average. And so these retirees came filing into this meeting, it was held in the evening, and they looked shell-shocked. Their portfolios were down 25-30%. They were fearful. And as I spoke to them, I tried to calm them, let them know things were going to work out, but at the same time, I recognized that just investment tools aren’t going to work.
How is a retiree supposed to stomach a 50%–60% drop in the stock market? I spent 5 months researching retirement income strategies, different ways to go about it. And at the end of that time, I wrote a white paper. And here’s what I wrote, “We believe many retirees are underestimating the risk of depleting person savings during retirement. The probabilities of retirement ruin can change dramatically based on market-return patterns, what’s often called now “sequence of return risk,” and inflation over a 35-year retirement window. Entering retirement, knowing there is even a 10% probability of pre-maturely depleting personal savings when that is the primary source of retirement income is imprudent. There are too many unknowns that can potentially lead to catastrophic outcomes.”
Most retirees with homes wouldn’t think of going without fire insurance. Yet the probability of their house catching on fire over a 30-year period is only 1%. Much less than the probability of retirement ruin for many retirees. Just as retirees protect against fire, theft, and other risks by purchasing insurance, they should also protect against longevity and other retirement-income risks by making sure the majority of their retirement-income sources are guaranteed.
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