Annuities in a Retirement Portfolio

Using annuities in retirement is an obvious choice whether the purpose is to create income, manage a portfolio or just grow money over time.  I’m becoming more direct with my commentary because several people who don’t like annuities have failed to come up with a reasonable alternative.  Sure you can get bonds, dividend stocks, REITs etc. but each of those has even more shortcomings and none provide the same level of security and stability.

Starting with the traditional design for retirement income is a good way to illustrate several advantages for annuities.  For comparison purposes let’s look at a fairly standard portfolio example.  Generally speaking this is going to consist of a pre-chosen blend of equity stocks and bonds.  Traditional advice suggests that a 4% withdrawal rate is sustainable so assuming no major volatility issues, a $1M portfolio should be able to produce $40,000 income annually with inflation adjustments.

Bonds provide steady income, stocks and mutual funds provide some dividends and the growth from the equity side is supposed to offset inflation.

We can use current interest and dividend rates to see how a mix of 40% bonds and 60% stocks will produce the income needed.

Right now we can assume bonds will pay 2% interest and the average dividend on stocks in the S&P 500 is around 2.5%.

40% of the portfolio in bonds will produce $8,000 interest annually.

60% of the portfolio in US-based equities will produce $15,000 in dividends annually.

This is a portfolio that is not particularly risk-averse and well positioned for growth on the equity side.  But the mix will leave someone $17,000 short of the initial income goal.  Making up the difference will require selling into principal and growth on the equity side will be needed to offset inflation and maintain a growing balance over time.

Selling into principal compounds risk and damages portfolio growth over time.

If you sell bonds, you have interest rate risk that could devalue the withdrawal, plus it will decrease future income payments with less principal.

Selling equities is fine except when the market is down in value.  Selling stocks when down in value only compounds losses and also decreases dividend yields with a lower balance.

“Interest rate risk and low rates on the bond side and market risk on the equity side make it complicated to manage income and achieve optimal growth.”

Over time the market will rise but if the timing is wrong on any withdrawals it will only be more difficult to keep pace with the income difference and any necessary inflation adjustments on spending.  This is the issue that causes long-term problems and has puzzled academics and industry analysts for years.

In basic form, income annuities improve the bond side by increasing cash flow.  Generally speaking you can get about a 5% payout on an income annuity, which would increase total income from the safe assets to $20,000 annually.  Including dividends on the equity side the portfolio is now only $5K short of reaching the income goal.  The difference of $12K in one year is not massive but over the long run it creates a dramatic reduction in risk.

I’m pretty sure many investment managers would counter with bond ladders and use a projection of rising rates to show how money can be repositioned over time to create more cash flow.  It’s wishful thinking that comes with drastic consequences if it doesn’t work out but many settle for this, fearing a lifetime commitment to an annuity.  But it’s not necessary to make a lifetime commitment if you simply know that annuities can be used for more than just income.

By replacing bonds with an indexed annuity you are not making a significant change to your overall portfolio.  Similar growth potential exists on the equity side and I’ll show you why the indexed annuity improves the safe allocation.  You don’t have to take income but can just grow the money over time and have access to it when you need.

Rather than use the bonds in a portfolio to produce income, use the indexed annuity as a place to draw income.  10% of the account can be drawn annually without penalty of interest rate risk.  And to beat a bond it only needs to grow at 2% or better, which is a joke because that’s easy to do.  There is no interest rate risk on withdrawals which makes the annuity superior in terms of liquidity.

Free withdrawals in a deferred annuity are discretionary in nature so you can always choose exactly how much you pull each year.  Payments can be taken monthly, quarterly or annually.  Funds in the annuity can be used for income and can be increased to take pressure off investments in down markets or can even be used to continually rebalance a portfolio over time.  Once the surrender period is over you have full liquidity.  If rates are higher you can go get an even better deal but you can keep the contract if it’s working.

The details of this example are intentionally general in nature.  Average yields for both bonds and dividends can be increased by taking on more risk with lower rated bonds or by accepting less growth on higher dividend stocks.  The interest and dividend figures are also void of management fees so I call it a wash.  Yes, rates are low and I can’t do anything about that except try to help you figure out a reasonable alternative.  Index annuities offer nothing more than the opportunity to leverage low rates for potentially higher yield.  The liquidity and growth potential make index annuities the superior retirement asset.

If you have a better idea I’d love to know what it is.  Comment below or respond to the email.

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Last Updated on February 1, 2023 by Bryan Anderson