In Friday’s roundup I briefly mentioned that annuitizing part of a retirement portfolio not only reduces the probability of running out of money, but also makes the oops-I-ran-out-of-money scenario not nearly as bad. Several readers asked how both of those things work.
Reducing Portfolio-Depletion Probability
The reason that inflation-adjusted lifetime annuities reduce the risk of portfolio depletion is that they provide a higher payout rate than you can safely take from a stock/bond portfolio. For example, even with today’s super-low interest rates, a 65-year-old female can purchase an inflation-adjusted lifetime annuity with a 4.4% payout.
To see the impact annuitizing would have, let’s look at an example.
Susie is 65 years old and recently retired with a $400,000 portfolio. She expects to need $30,000 of income per year in retirement, and her annual Social Security benefit will be $14,000. In other words, she hopes to spend $16,000 per year from her $400,000 portfolio.
If Susie does not annuitize any of her portfolio, she’d have to use a 4% withdrawal rate ($16,000 ÷ $400,000) to provide the desired level of income.
If Susie uses half of her portfolio ($200,000) to purchase a single premium immediate inflation-adjusted lifetime annuity, the annuity (given a 4.4% payout) would provide $8,800 of income per year. As a result, she would only need another $7,200 of income from the non-annuitized part of her portfolio. That works out to a 3.6% withdrawal rate.
Naturally, Susie is less likely to deplete her portfolio with a 3.6% withdrawal rate than with a 4% withdrawal rate.
Improving the Worst-Case Scenario
And possibly even more importantly, if Susie does end up depleting her portfolio, she’ll be left with an income of $22,800 per year ($14,000 Social Security + $8,800 from the annuity) rather than the $14,000 per year she’d be left with if she didn’t annuitize any of her portfolio.
Don’t Forget About Delaying Social Security
As we’ve discussed before, delaying Social Security benefits is economically equivalent to purchasing an inflation-adjusted lifetime annuity — one with lower credit risk and a higher payout than you can get from an insurance company.
For example, for somebody with a “full retirement age” of 66, if your Social Security benefit would be $18,000 per year at age 62, it would be approximately $31,680 per year if you waited until age 70. By giving up eight years of $18,000 in benefits, you’ve effectively spent $144,000 ($18,000 x 8) to purchase $13,680 ($31,680 — $18,000) of annual inflation-adjusted income. That’s much higher than the 4-5% payout you can get from an inflation-adjusted annuity.
In other words, delaying Social Security has the same two risk-reducing effects as annuitizing part of your portfolio (i.e., reducing the probability of depleting your portfolio and protecting you somewhat in the event that you do deplete your portfolio), and on a per-dollar-spent basis, it provides more of those risk reductions than an annuity from an insurance company would.