How To Get A Bigger Bang For Your Annuity Buck
Many people are reluctant to invest in an immediate annuity because they don’t want to tie up a big chunk of their savings. But new research shows that you may be able to benefit from an annuity’s ability to protect against a shortage of income late in retirement while devoting less of your nest egg to an annuity upfront. The key: be flexible about your spending in retirement.
Annuities certainly aren’t for everyone. But retirement income experts have long known that in many cases putting some of your savings into an immediate annuity can boost the amount of sustainable income your nest can generate over the course of a long retirement. What’s been less clear, however, is how much of their savings retirees who seek guaranteed income should invest in an annuity and when they should do it.
Previous attempts to shed light on this issue typically assumed that retirees would buy an immediate annuity at retirement and then draw income from their remaining assets by sticking to the 4% rule or similar system of systematic withdrawals. Based on these assumptions, researchers often concluded that retirees should allocate upwards of 50% or more of their nest egg to an immediate annuity—a figure many, if not most, retirees consider unacceptably high.
But a new study in the Journal of Retirement by Morningstar head of retirement research David Blanchett shows that if you instead assume that you will adjust your spending and savings withdrawals based on how the financial markets are performing—say, cutting back during a market downturn and spending more freely if the market surges—you may be able to reduce the amount you devote to an annuity by as much as half. The reason: By fine-tuning withdrawals to reflect market conditions you’re less likely to run through your savings prematurely, which means you don’t need as much guaranteed income from an annuity to avoid running short of spending cash late in life.
As for when to buy an annuity, if you’re more comfortable locking in a guaranteed stream of income as soon as you retire, that’s fine. But Blanchett notes that you don’t necessarily have to rush. While there can be a price to delaying—for example, if a bear market mauls your portfolio, you may not be able to afford as much guaranteed income as you would like later on—he found that the cost of waiting was usually small as long as you start converting savings to an annuity within 10 years of retiring.
Of course, reading about a strategy in a research paper is one thing, putting it to work in real life is another. I suspect most retirees would find it difficult translating the findings of this study into their retirement income strategy. Indeed, after perusing the paper’s brain-twisting equations for funding ratios, dynamic withdrawals, mortality assumptions and the like (Everyone okay with the Gompertz Mortality Model?), I wouldn’t be surprised if many financial advisers would also find it a challenge.
Still, there are lessons from this research you can apply when deciding whether to make an immediate annuity part of your retirement income plan. For example, an annuity generally makes the most sense if you feel you want more guaranteed lifetime income to cover essential living costs than Social Security and pensions alone can provide. But since that’s not always a cut-and-dried call. And since the cost of delaying the purchase of an annuity is relatively low, if you’re unsure, you may want to wait until you get a better handle on just what your essential retirement expenses will be before deciding whether to cover some or all of them with annuity income. (For help with estimating retirement living costs, you can check out this Retirement Budget Worksheet.)
If you do decide an annuity is right for you, you may also want to consider starting with a small investment and seeing how that goes. If you feel that you would like to lock up more guaranteed income later on, you can always purchase one or more additional annuities. This approach of buying gradually not only prevents you from committing more assets to an annuity than you may need; it also lowers the chance that you’ll invest your entire annuity stash when interest rates–and annuity payouts—are at a low point. (You can get current monthly income quotes based on your age, sex and the amount you have to invest by going to this Annuity Calculator.)
But the biggest takeaway from the study is that, annuity or no, you should stay flexible when it comes to drawing down your nest egg. A withdraw rate that seems sustainable when the market is cruising along smoothly can put you in jeopardy of depleting your retirement savings prematurely if returns sag or the market tanks. By going every year or so to a retirement income calculator that uses Monte Carlo simulations to make its projections, you can see how long your savings might last at your current withdrawal rate, and then adjust withdrawals (and spending) up or down accordingly.
Given all that can happen over the course of a long retirement, I doubt there’s any way to pinpoint exactly what percentage of one’s assets, if any, should go into an annuity. In many ways it’s as much an emotional decision as a financial one. But if you begin with a decent estimate of your retirement living expenses, how much of them you want to cover from guaranteed income and then resolve to adjust your spending from your remaining nest egg to avoid depleting it too soon, your retirement income plan will at least be off to a good start. (9/15/15)
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org. You can tweet Walter at @RealDealRetire.