A reader writes in, asking:
“My wife and I have no children, so we have no desire to leave anything behind when we die. At the same time, it is crucial for us NOT to run out of money before then because there is no backup plan, no kids to move in with if the ‘you know what’ hits the fan and we have another 2008 or worse. Am I correct that this means we should be investing differently, with a safer portfolio than most other boomers?”
For a person or couple with absolutely no bequest motive, yes, it does make sense to make different choices than most other retirees would typically make. Specifically, this sounds like a perfect case for a single premium immediately lifetime annuity.
For those not familiar, such annuities are basically pensions that you can buy from an insurance company in exchange for an upfront lump-sum premium. The single biggest drawback of such annuities is that, once you die, the money goes to the insurance company rather than going to your heirs. But, for somebody with no desire to leave behind an inheritance, this is clearly less of a concern.
That said, there are still some important decisions to be made.
How Much Should You Annuitize?
Even for people with no desire to leave any money behind, it doesn’t make sense to annuitize every last dime. Once you’ve purchased an annuity, you cannot easily sell it to raise cash. So it’s a good idea to keep some liquid savings for unplanned expenses.
In addition, it’s worth noting that stocks do typically have higher expected returns than what you’re likely to get from a lifetime annuity. So after meeting your basic expenses with safe sources of income, you might want to continue to hold higher-risk assets with the rest of the portfolio in order to provide the possibility of higher returns and the higher standard of living that would come with them.
Brief tangent: After determining what level of income you want to ensure, it’s typically most efficient to satisfy as much of that goal as possible by delaying Social Security prior to buying any actual annuities, because the dollar-for-dollar payout that you get from delaying Social Security is meaningfully higher than what you can get in the private marketplace, especially with today’s low interest rates.
Annuitize Immediately Upon Retiring?
The portion of an annuity’s payout that comes from “mortality credits” (i.e., the money from now-deceased annuitants being used to fund your annuity while you’re still alive) increases over time (because people are more likely to die at age 66 than at age 65, more likely to die at 67 than at 66, etc.).
For somebody purchasing a lifetime annuity in his/her early or mid 60s, the portion of the payout that comes from mortality credits would be rather modest in the first several years. Most of the payment would be from interest and the return of principal. See this chart from New York Life (originally found in this Fidelity article), for example:
In other words, for somebody early in retirement, delaying the purchase of an annuity (and holding other low-risk investments in the meantime) doesn’t cost much in the way of forgone mortality credits, and it exposes you to the possibility that interest rates will go up, allowing you to then lock the higher rates in by purchasing an annuity at that time. Of course, it also exposes you to the risk that rates go down even further. (I’ll leave it up to you to decide how likely that is.)
Fixed or Inflation-Adjusted?
Finally, you would have to decide whether you want to purchase fixed lifetime annuities or lifetime annuities with inflation adjustments.
Wade Pfau’s recent research showed that fixed annuities tended to perform better than those with inflation adjustments, but his simulations assumed a 3% inflation rate. While I think that’s a perfectly reasonable assumption, it’s important to note that 3% inflation is hardly a worst-case scenario.
Personally, I think the answer to the “fixed or inflation-adjusted” question should depend primarily on how exposed you are to inflation risk. For example, if you rent your home, you’re more exposed to inflation risk than a retiree who owns his/her home. And if a fixed (non-inflation-adjusted) pension makes up a large part of your retirement income, you’re more exposed to inflation risk than somebody for whom Social Security is the primary source of retirement income.