Retirement Investing: Annuities?

Any discussion with a retiring dentist about using annuities as a source of retirement income is almost guaranteed to tap into strong emotions, either positive or negative. This is unlikely to change soon. There is a love-hate relationship with annuity products among advisors as well, particularly as they relate to a retiree’s long-term financial plan.

I’d like to address some of the current attitudes among academics regarding the use of annuities as a retirement income source. In that regard, I want to look at single-premium immediate annuities (also known as “SPIAs” or, simply, “immediate annuities”). With an immediate annuity, a dentist exchanges cash for a guaranteed income stream from an insurance company. For example, let’s say a 65-year-old dentist exchanges $500,000 for an income stream of $30,000 per year (6%) for life. If the dentist dies before age 80, this might seem like a poor exchange; if he dies after age 90, perhaps it seems like a good exchange. In spite of the guaranteed income, it is this uncertainty about future life expectancy and the dentist’s loss of control over the money that creates strong emotions about these products.

Let’s assume another retiring dentist has $2 million in savings and must choose a portfolio allocation from among stocks, bonds, and annuities. This dentist is risk-averse and has heard of the 4% retirement withdrawal rule. She doesn’t like annuities and chooses a lower-risk portfolio of 40% stocks and 60% bonds. She hopes to withdraw 4% ($80,000) per year for the rest of her life. An immediate annuity at 6% per year at retirement could guarantee $120,000 of annual income for the rest of her life, a 50% increase in her retirement income. But how should one really think about this?

One of the major problems with annuities is the overwhelming number of choices: single-life, joint-life, period-certain, inflation-adjusted . . . and the list goes on. Most retirees give up under the weight of all these choices before even considering the annuity concept itself as part of a retirement portfolio. In an article titled “Why Bond Funds Don’t Belong in Retirement Portfolios,” Wade Pfau focuses primarily on annuities as part of a retirement portfolio, in general.1 He does this through the lens of four retirement goals that every retiree possesses (the four Ls: Lifestyle, Longevity, Liquidity, and Legacy). An annuity, as part of a comprehensive financial plan, could be a preferred source of income as it relates to lifestyle (in our example, it’s higher) and longevity (it’s guaranteed for life). It’s a poor choice for liquidity (the money belongs to an insurance company) and legacy (once you die, the money is gone). A stock-and-bond portfolio may be less attractive for lifestyle and longevity (the potential for market downturns), but great for liquidity and legacy (the money belongs to you and your kids). In an all-or-nothing decision model, it could be very difficult to choose between two versus two. And most investors, dentists included, would never want to give all of their savings to an insurance company.

Rather than choosing a portfolio allocated all to one investment or one allocated all to the other, Pfau argues in favor of a portfolio that combines the best planning aspects of both annuities and stocks and bonds. His proposed strategy may allow more certainty for covering all of a retiree’s goals. He constructs a portfolio of 40% stocks, 30% bonds, and 30% immediate annuities. With this mix, it’s still the case that dying early in retirement hurts an investor’s legacy. The amount given to the insurance company in exchange for a guaranteed retirement income is gone. However, the 70% of the portfolio in stocks and bonds is still available for legacy purposes. If the retiree lives until life expectancy or longer, the addition of an immediate annuity may increase progress toward goals associated with the other three Ls, while also increasing retirement income. It the retiree lives until age 90, the higher income provided by the annuity might mean that less income needs to be withdrawn from stocks and bonds. Guaranteed income from the annuity in our example is much higher than current returns on bonds. Therefore, the actual legacy left (as well as the degree to which goals pertaining to the other Ls are met) beyond age 85 might be higher than a stock-and-bond-only portfolio.

Unfortunately, all retirement planning is about choices. No one strategy solves every potential risk. Pfau boldly makes the case that bonds don’t belong in a retirement portfolio, but then backtracks, bowing to human nature. He appears to realize that, in the end, most investors will not exchange control of the larger part of their portfolios for even hundreds of Ls. But with the right understanding, you and your advisor can decide which annuity choices-if any-are right for you.

Reprinted with permission from Dental Economics

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