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Why Annuitizing Reduces Risk

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.

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Comments

  1. Mike, I’m sure we’ve gone over some of this ground before, but please excuse me if I’m not altogether clear on some points.

    First, how would your Susie example be affected if she waited to take SS at age 70? Does that mean she should annuitize a larger percentage of her portfolio earlier to compensate?

    Second, do you favor laddering annuity purchases in hopes of securing a larger payout in the future from possibly higher interest rates?

    And third, is there a good way to compute the optimum percentage of one’s portfolio to annuitize? Assuming no need to make a bequest to heirs, for example, and a state with a higher than average guarantee if the insurer goes under, would there be a limit on the amount you would annuitize, or is it always advisable to keep some of the portfolio in standard investments?

    Thanks.

  2. Larry,

    As to your first question, she could afford to annuitize less of her portfolio if she waited until 70 to collect Social Security. (Reason being that delaying Social Security has the same effect as annuitizing part of the portfolio.)

    As to laddering annuity purchases, that’s a very hard question in my opinion. I could certainly understand somebody wanting to hold off (to some extent) on annuitizing even after retiring in the hope that rates will rise.

    Of course, doing so involves taking on more risk. Because rates might not rise any time soon, and in the meantime the investor would likely be using something riskier. (Even cash is riskier, in my opinion, due to inflation risk.) And the investor would not be earning mortality credits in the meantime either.

    As far as how much to annuitize, that’s another difficult question where people disagree. My personal opinion is that:

    1. It’s never a good idea to annuitize everything, because you want to leave yourself with some liquidity for unplanned expenses. But
    2. People should annuitize (including by delaying Social Security) enough to make sure their basic needs are met by safe sources of income
  3. Mike,

    Great write-up, and a great lesson about how a complicated subject can be described very succinctly and clearly by a skilled writer.

    Wade

  4. Mike

    MANY Thanks for this!

    I would point out that, unlike annuities, delaying Social Security has no fees or
    sales commissions!

    We hear a lot these days about risk and Social Security payouts, but it is less common to hear the topic of insurance company insolvency mentioned in discussing annuities. In 2008 the world’s biggest insurance company became insolvent and US treasuries were nearly the only safe place for your money. Annuities are, of course, dependent on the ability of the issuing insurance company to continue to pay out in the distant future, with a backstop of state “guarantee”. The US government may not be as risk free today or in future as once assumed, but compared to the insurance industry and state guarantee bodies, I think the international markets have already voted!

    Jim

  5. That makes total sense – thanks for the great explanation of annuitization.

  6. I think I’d be inclined to annuitize only the minimum amount required for me to live happily in retirement. That way anything else is just icing on the cake

  7. I really think anyone thinking of taking any annuity should do their homework 100% before signing for one. Many are loaded with both hidden and disclosed fee’s and penalties.

    You can make your own simple versions of an annuity yourself with very little work and it will do exactly the same thing as a pre packaged one without any crazy fee’s. Annuities are simply another complex product to spring upon people that don’t really understand what they are getting into, but like the word “guaranteed”. Please do your own diligence please!

  8. Paul,

    It is actually not possible to build your own lifetime annuity. A significant part of the payment comes from mortality credits, and by definition that’s something that can’t be replicated by one individual person. (See this article for more on that.)

    Still, I agree that anyone should “do their homework” before buying an annuity.

  9. Mike,

    I was marveling more about how you summarized things so succinctly. Then I realized is that part of the reason is you are looking at an easier but less common case.

    That is, you assume that the annuity payout rate is higher than the retiree’s desired spending level. That makes partial annuitization somewhat of a no-brainer.

    The more common case is probably that people would like to spend more than provided by the annuity payout rate. Without changing your numbers much, just suppose the annuity payout rate is 3.6%. With half annuitization, this means using a 4.4% withdrawal rate with remaining assets, which in turn increases the probability of wealth depletion for those assets.

    Can you work your magic with explaining what to do in this scenario?

    Wade

  10. Wade,

    The short answer: Spend less.

    Almost by definition*, if a level of spending cannot be satisfied with a lifetime annuity, it can’t be safely satisfied with a nonannuitized portfolio either.

    You can give up the mortality credits in exchange for the hope of an equity risk premium (or other risk premium from another risky investment of your choice) that exceeds the mortality credits. But as is the nature with risk premiums, sometimes you don’t get them.

    *The reason I say “almost” is that if an investor is young enough, the mortality credits could be low enough that, at least for the time being, they’re exceeded by the expenses bundled into the annuity, thereby allowing for a higher safe withdrawal rate from a nonannuitized TIPS portfolio.

    In other words, if a person were to come to me and say he wants to spend an amount each year that is greater than what he could receive from a lifetime annuity, my recommendation would not be to forget about the annuity, go with a stock/bond portfolio, and spend as desired.

  11. Thanks Mike. This is a good explanation.

    Retirees need to essentially decide whether to lock in their spending with an annuity and give up on getting upside, or take their chances with a diversified portfolio that could allow them to spend more… or less.

  12. Mike,

    This is an excellent website you have. Wade Pfau told me about it when you mentioned my recent article. This is a good discussion about SPIAs. Here are a few additional tidbits–(1) Some concerns have been expressed about insurer default. It probably pays to be aware of state guarantee limits, but, historically, default losses have been minimal. (2) Insurers tend to charge a hefty extra premium for true inflation protection. It may be worth considering fixed step-ups and tilting other investments toward inflation protection. (3) Insurers pass along part of their investment margins in the pricing for for fixed (and fixed step-up) SPIAs and this may offset other charges–so mortality credits may shine through even at younger ages–like 55 or 60. Keep up the good work!

  13. Hi Joe.

    Thanks for stopping by to comment and share some additional information. I look forward to reading more articles from you.

  14. Hi Mike,

    Yes I agree with your comment that I could not replicate a “Lifetime” annuity. My mistake. I did however say you could mimic a “simple annuity” with very little cost and effort. That also may be all what most people need.

    I still believe that all “packaged” annuities are for a very tiny sliver of individuals out there. This type of product generally tends to make the issuers rich and the person taking out the annuity poorer over the long term when you do the math. There are a lot of advisors putting people into these products for the wrong reasons. Not always in the best interest of each individual.

    Just one example – there are very simple no load monthly income mutual funds out there that offer a higher payout every month consistantly year after year then then many annuities do. (at least in Canada) There are no penalties and if you pass away the remainder can be willed to someone else in your family and not into a pool of money supporting the annuity. (and probably some kind of trailing commission bonus to the advisor who sold the indvidual the product in the first place). This type of fund is like a gamble that whoever dies last gets the most (but still limited) benefit.

  15. Hi Paul.

    Thank you for the elaboration. I suspect we might be talking past each other because of the Canada/U.S. thing.

    I’m not 100% certain I understand what you mean by “packaged” annuities.

    In the above article, I’m speaking only about lifetime annuities with fixed or inflation-adjusted payouts (the kind that, as we’ve agreed, cannot be replicated by an individual investor). At least here in the U.S. these are not often recommended by advisors seeking commissions. (My understanding is that they pay relatively modest commissions.)

    More often, commission-paid advisors here in the U.S. recommend various types of variable annuities — which are something entirely different from what I’m talking about above as a useful tool for retirees. I do not think variable annuities are particularly useful for most investors. In most cases simple mutual funds are preferable. I think this might be the same as what you’re saying above.

  16. This is a great thread getting even better with additions from Wade and Joe and Mike – all people who are great writers, original thinkers, and folks I absolutely trust!

    Yes, Joe, I DO realize that “historically” insurance company losses to annuity customers have been uncommon, especially after actions by state guarantee bodies are considered, but I do have concerns – especially as our exceptionally low interest rate environment continues for longer than many people may have expected – that history may not be a useful guide, and may even make us too confident. Before 2008 I do not think many people would have expected several Wall Street banks that had been around 100 years could fail, either.
    Some insurance companies have been dropping fairly new and formerly hot products, like Long Term Care insurance and certain variable annuities [NOT the same thing discussed here], which would seem to indicate a certain amount of stress. My concern is not so much with single firms, but with a “Black Swan” type of event, and, perhaps, lessened possibilities of any future AIG-type large government bailouts, especially with state governments also currently experiencing economic duress.

    Does anyone know of any studies or histories, for example, from The Great Depression, or from modern Japan, on insurance company failures? The best one I found is here:
    http://fic.wharton.upenn.edu/fic/papers/03/0332.pdf
    “INSURANCE COMPANY FAILURES: WHY DO THEY COST SO MUCH?”
    which covers 1986-1999.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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