A retirement plan has two major objectives.
One is to provide assurance that you will not run out of money at an advanced age. Reflecting this objective, and because only an annuity pays you until you die, with few exceptions every retirement plan should contain an annuity.
The second objective is to avoid leaving more money in your estate than you would have chosen if you knew with certainty and well in advance the exact day of your death. The excess in your estate might have been the difference between a rich and rewarding retirement, and its absence.
Most Retirees Need an Annuity
If you have a defined benefit pension, you already have an annuity and may not need another. The only other substitute for an annuity is sufficient wealth relative to your plans and needs that you don’t need a retirement plan — you can spend what you like when you like with no risk of ever running out. This article and those that will follow aim at the much larger group of retirees, or soon-to-be retirees, who have limited wealth that requires careful management. They need an annuity to eliminate the risk of running out of funds, while avoiding excessive bequests to their estates.
Overcoming The Bias Against Annuities
Many retirement advisors avoid annuities because the rate of return on annuities is low relative to the return that the advisors are confident they can earn on the funds used to purchase an annuity. The average return on a diversified portfolio of common stock during 985 5-year periods during 1926-2012 was 8.6% whereas annuity yields are generally in the 3-5% range.
Annuity yields, however, are guaranteed so long as the retiree remains alive, and the yield rises with longevity. For example, an immediate annuity I priced recently for a female of 62 yielded 3.6% if she lived to her expected life of 86, and 5.50% if she lived to 104. In contrast, stock yields are subject to significant downside risk. In 10% of the 985 5-year periods referred to above, the return was 2.20% or lower, and in 2% of them it was negative. The downside is less pronounced when the period covered is longer.
The Annuity Hazard to Be Avoided
The market for annuities is extremely inefficient. The result is large differences in price quotes by different insurers on the same transaction. For example, I recently shopped monthly payouts on a 15-year deferred annuity costing $812,000 with 11 companies. The high and low quotes were $11,092 and $9,683, a difference of $1,409 – every month!
Bottom line, retirees should be sure that the provider of their retirement plan has the means to find the best price on their annuity. If your advisor has a deal with one or two insurance companies, run like a thief!
Year-to-Year Projections of Your Monthly Spendable Funds to Age 104
Spendable funds consist of draws from financial assets, annuity payments, and (in some cases) draws on a HECM reverse mortgage. While not many of us will live to 104, for the peace of mind you deserve, the retirement plan should assume that you will.
The chart projects monthly spendable funds for a female of 62 with a nest egg of $2 million. She uses part of the $2 million to purchase an annuity on which payments are deferred for a specified period, and while she waits for the annuity to kick in, she draws her spendable funds from the assets remaining. The 4 schedules assume annuity deferment periods of 5 years and 15 years, and rates of return on the financial assets during the deferment periods of 3% and 8%. An inflation adjustment of 2% a year is built into all 4 projections. The dotted part of the projection lines indicates that the funds received by the retiree are being drawn from her assets, while the solid portion indicates that the funds are annuity payments.
The chart reflects other desirable features of a retirement plan that will be discussed in future articles. One is integration of the plan components, with the asset draw period evolving seamlessly into the annuity period. If a HECM reverse mortgage is included in the plan, it should be integrated as well.
Another important feature of the spendable funds projections is that it provides the retirees with options and guidance. As one example of many, the case charted shows the retiree how the interest rate on her financial assets affects the decision on the best annuity deferment period.
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