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 $9683, a difference of $1409 – 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.
