The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.
Many annuities (maybe even most) are a raw deal for investors. They carry needlessly high expenses and surrender charges, and their contracts are so complex that very few investors can properly assess whether the annuity is a good investment.
That said, one specific type of annuity can be an extremely useful tool for retirement planning: the single premium immediate annuity (SPIA).
What’s a SPIA?
A single premium immediate lifetime annuity is a contract with an insurance company whereby:
- You pay them a sum of money up front (known as a premium), and
- They promise to pay you a certain amount of money periodically (monthly, for instance) for the rest of your life.
The payout may be a fixed amount each period (making for a single premium immediate fixed annuity), or it may be linked to the performance of a mutual fund (making for a single premium immediate variable annuity).
Sometimes, the payout on a fixed SPIA will be set to adjust upward each year in keeping with inflation. However, an inflation-adjusted fixed annuity requires a higher initial premium than a fixed annuity without an inflation adjustment.
SPIAs (fixed ones, in particular) are helpful tools for two reasons:
- They make retirement planning easier, and
- They allow for a higher withdrawal rate than you can safely take from a portfolio of stocks, bonds, and mutual funds.
Retirement Planning with SPIAs
Fixed SPIAs make retirement planning easier in exactly the same way that traditional pensions do: They’re predictable. If you know that you need $X of income each year in retirement, you can go to an online annuity quote provider, put in $X as the payout, check “yes” for inflation adjustments, and you’ll get an answer: “For $Y, you can purchase an annuity that will pay you $X per year, adjusted for inflation, for the rest of your life — no matter how long you might live.”
Pretty easy, right? You now have a specific figure for the minimum amount of savings necessary to retire safely.
With a traditional stock and bond portfolio, retirement planning is more of a guessing game. There are whole books written on the subject of how to determine how large your stock/bond portfolio must be in order to retire safely.
SPIAs and Withdrawal Rates
Fixed SPIAs are also helpful because they allow you to retire on less money than you would need with a typical stock/bond portfolio. For example, as of this writing (Sept. 2010), according to Vanguard’s online SPIA quote provider , a 65-year-old male could purchase an inflation-indexed annuity paying 5.56% annually.
If that investor were to take a withdrawal rate of 5.56% from a typical stock/bond portfolio, then adjust the withdrawal upward each year for inflation, there’s a meaningful chance that he’d run out of money during his lifetime. That risk disappears with an annuity.
How is that possible? In short, it’s possible because the annuitant gives up the right to keep the money once he dies. If you buy a SPIA and die the next day, the money is gone. Your heirs don’t get to keep it — the insurance company does. And the insurance company uses (most of) that money to fund the payouts on SPIAs purchased by people who are still living.
In essence, SPIA purchasers who die before their life expectancy end up funding the retirement of SPIA purchasers who live past their life expectancy.
But I Want to Leave Something to My Heirs!
For many people, knowing that the money used to purchase an annuity will not go to their heirs is a deal breaker. And that’s OK. It’s perfectly natural to want to leave something to your kids or other loved ones.
The important takeaway here is that if your retirement may last thirty years or more, and if your savings are of a size such that you’d need to use a withdrawal rate much higher than 4%, you may not have much of a choice. If you choose not to annuitize — in the hope of leaving more to your kids — the decision could backfire. You could run out of money while you’re still alive, thereby becoming a financial burden on your kids.
What Portion of Your Portfolio to Annuitize
How much of your portfolio should you devote to an annuity? Let’s look at an example.
EXAMPLE: Greg is a 65-year-old male investor with a $600,000 portfolio. To fund his lifestyle, Greg plans to withdraw $30,000 in his first year of retirement and adjust that amount upward each year for inflation.
In other words, Greg wants to use a 5% withdrawal rate ($30,000 ÷ $600,000 = 5%). That’s more than most financial planners would recommend for a non-annuitized portfolio.
If we assume that Greg is comfortable with a 4% withdrawal rate for the non-annuitized portion of his portfolio, and we use the annuity quote from Vanguard mentioned above (5.56% payout for a 65-year-old male), we can calculate the amount Greg should annuitize (A) as follows:
- 0.0556 x A + 0.04 x (600,000 — A) = 30,000
The answer: If Greg wants to purchase the annuity at age 65, he should put $384,615 into it to achieve a 5% withdrawal rate for his overall portfolio.
But should Greg purchase the annuity at age 65, or should he wait?
When to Purchase an Annuity
Again, using Vanguard’s quote page, we can see that for a 65-year-old male with, for example, $100,000 to annuitize:
- If you annuitize now, you’ll get a monthly in-come of $463 (which adjusts upward for inflation) for the remainder of your life.
- If you wait to age 66, an annuity paying $463/month would only cost $95,673.
Therefore, you’re better off waiting if you believe that, between ages 65 and 66, you can invest that $100,000 on your own and, while spending $463 per month, have $95,673 or more left (after adjusting for inflation) when you turn 66. Doing so would require an after-inflation annual return of approximately 1.25%.
The Role of Interest Rates
The above analysis assumes that the payout for an immediate fixed annuity for a 66-year-old one year from now will be the same as the quote for somebody who is 66 today. Unfortunately, that’s not entirely true.
Annuity payouts and premiums change as a function of market interest rates. When market interest rates are higher, annuity payouts are higher as well, because the insurance company knows that it can invest your money at a higher rate of return and can, therefore, offer to pay you a higher rate.
So the decision to delay is a function not only of what inflation-adjusted rate of return you think you could earn over the period in question, but also of where you think interest rates are headed next. If you expect interest rates to rise, delaying annuitization is more attractive than if you expect interest rates to decline.
Annuity Income: Is It Safe?
Because the income from an annuity is backed by an insurance company, financial advisors and financial literature usually refer to it as “guaranteed.”
But that doesn’t mean it’s a 100% sure-thing. Just like any company, insurance companies can go belly-up. It’s not common, but it’s certainly not impossible, especially given that:
- The longer the period in question, the greater the likelihood of any given company going out of business, and
- The entire point of an annuity is to protect you against longevity risk (that is, the risk that you last longer than your money). So presumably, we’re talking about a fairly long period of time.
However, if you’re careful, the possibility of your annuity provider going out of business doesn’t have to keep you up at night.
Check Your Insurance Company’s Financial Strength
Before placing a meaningful portion of your retirement savings in the hands of an insurance company, it’s important to check that company’s financial strength. I’d suggest checking with multiple ratings agencies, for example:
- Standard and Poor’s,
- Moody’s, and
- A.M. Best
State Guarantee Associations
Even if the issuer of your annuity does go bankrupt, you aren’t necessarily in trouble. Each state has a guarantee association (funded by the insurance companies themselves) that will step in if your insurance company goes insolvent.
It’s important to note, however, that the state guarantee associations only provide coverage up to a certain limit. And that limit varies from state to state. Equally important: The rules regarding the coverage vary from state to state.
For example, Arkansas provides coverage of up to $300,000 per annuitant, per insurance company insolvency. But they only provide coverage to investors who are residents of Arkansas at the time the insurance company becomes insolvent. So if you have an annuity currently worth $300,000, and you move to Arizona (where the coverage is capped at $100,000), you’re putting your money at risk.
In contrast, New York offers $500,000 of coverage, and they cover you if you are a NY state resident either when the insurance company goes insolvent or when the annuity was issued. So moving to another state with a lower coverage limit isn’t a problem if you bought your annuity in New York.
Minimizing Your Risk
In short, annuities can be a very useful tool for minimizing the risk that you’ll run out of money in retirement. But to maximize the likelihood that you’ll receive the promised payout, it’s important to take the following steps:
- Check the financial strength of the insurance company before purchasing an annuity.
- Know the limit for guarantee association coverage in your state as well as the rules accompanying such coverage.
- Consider diversifying between insurance companies. For instance, if your state’s guarantee association only provides coverage up to $100,000 and you want to annuitize $300,000 of your portfolio, consider buying a $100,00 annuity from each of three different insurance companies.
- Before moving from one state to another, be sure to check the guarantee association coverage in your new state to make sure you’re not putting your standard of living at risk.
One last point about annuitizing: Even if your only goal is to maximize your spending power, you may not want to annuitize everything. The reason is that annuities cannot easily be sold. And, since it’s always possible that you’ll be faced with a sudden, large expense, it’s usually best to keep a portion of your portfolio in liquid assets: stocks, bonds, cash, and so on.
- Single premium immediate fixed annuities can be helpful because they allow for a higher withdrawal rate than would be sustainable from a typical portfolio of other investments.
- In exchange for this increased safe withdrawal rate, you give up control of the money as well as the possibility of leaving the money to your heirs.
- The decision of when to purchase an annuity is a function of the rate of return you would earn on a non-annuitized portfolio, the rate at which annuity payouts increase with age, and the direction in which you believe interest rates are headed.
- Before buying an annuity, check the financial strength of the insurance company and make sure you’re familiar with the rules and coverage limits for your state’s guarantee association.