Guaranteed Income Using Social Security and Annuities

This is a case that has been pretty difficult to figure out and I thought it might be useful for many of you to see the process that goes into my recommendations.  It has never been about just selling annuities.  It’s more important to make sure we can solve a problem and offer the absolute best solution.  This one started as a pretty standard case but became a little more complex and it may take me two episodes to work through it all.  It’s definitely similar to others in that an annuity will certainly make things a lot easier but we need to have some concrete reasons to justify the changes to this guy’s current plan.

He’s already retired at 62 and pulling $8000 per month from an adequate portfolio.  With a 50/50 split between stock and bonds across the board he’s seen steady performance.  Bonds got clobbered in the past couple of years but are paying a good coupon rate now so at first glance it’s hard to beat what he already has.  But the market may not always perform like it has in the last year and bond rates are variable as well.  The only risk to this plan is all of the normal market risk so it should be easy to touch it up and add some guarantees with an annuity.

The plan is to wait until 70 to collect social security which will then pay $4400 per month, further reducing requirements from the portfolio.  He just has to make it that far until the burden from retirement assets ease considerably.  Something I’ve seen dozens of times in the past, is that other advisors would suggest buying an annuity now that would cover the $8000 per month spending goal.  There are several ways to sell that with the most common being a simplistic look at income needs.  That is clearly inappropriate because he’d then have more income than necessary, bumping him into a higher tax bracket but also spending way too much in the beginning.

It’s a gap problem rather than a long-term income problem.  He only needs to bridge eight years of income to get to his real safe space where social security picks up the slack.  Since social security will pay him all but $43,000 of his spending goal, my approach has always been to recommend he buy enough annuity to cover that amount.  That’s the long-term income need and that’s what annuities are for.  It reduces the burden on the portfolio now and his full income would be covered when social security hits at 70.  Calculations show this would cost about $575K and I don’t recommend a purchase of that size unless I know it’s the best way to do things.  Also, you guys need to understand that it has nothing to do with the size of the annuity and has everything to do with the percentage of assets that it represents.  But for whatever reason things change when the numbers get bigger.

Someone with $500K of assets is always more willing to contribute $250K to an annuity than a person with $2M is to contribute $1M.

My gut told me it was important to test out various claiming strategies for social security but I didn’t do so until he hinted that it might be on the table.  Claim now or wait?  How would that affect the portfolio?  I did it a little differently this time and went with a net present value of all income payments to age 85.  Discounting the expected cash flow to find what it would cost to fund it today will show you which series of payments is the most valuable.  Hopefully I can explain this in a way that makes sense.  All we need to do is assign a reasonable discount rate, or rate at which we can confidently expect assets to grow over time.

Sticking with the current plan, let’s assume he draws $96K per year for the next eight years and when social security hits he will only need to draw $43K per year from the portfolio.  To the age of 85 that creates a cumulative income gap of $1,413,000.  Discounting at 5% brings the net present value to $979K.  That’s the amount of money he’d have to invest today at 5% interest to create the necessary income stream to age 85.

How about if he bought an annuity now to cover the long-term income gap?  $575K will buy him $43,000 annual income so when social security comes in all income needs are covered.  He would only need to cover $53K per year for the next eight years and then it’s all guaranteed.  Discounting that over eight years results in a net present value of $353K but you have to add the cost of the annuity for a total of $928K.  Clearly an annuity would offer him a substantial benefit in retirement with a net present value nearly half a million dollars less now.  Go ahead and change the rate of return.  Higher returns will result in a large difference and lower returns will inch closer and closer to nothing more than the cumulative income gap.

Now, there are a lot of different scenarios to test and that’s why this one is so difficult.  Different claiming strategies will produce different results with net present value determining which is the best deal.  We’ll do one to see if it makes a difference.  Suppose he claims now.  Social security will be roughly $31,000 per year, which is $22K short of what is expected at age 70.  Buy an annuity that produces $22K at age 70 after eight years of deferral.  That would cost him $160,000 today and he’d collect $248K of social security payments over eight years.  That’s a good deal because it’s just extra money.  That reduces the cumulative income gap to $1,165,000 and has a net present value of just $738K.  Wow!

There are lots of ways of looking at this and it only takes interest from him to go through all of them to see where he can find the best advantage.  This is really only a test to prove the annuity has value.  There are plenty of other benefits of using the annuity.  Most importantly, returns are not guaranteed in the market and his current portfolio carries plenty of risk.  An annuity would solve that problem to whatever extent he desires.  Second, the consistency and ease of regular payments is much more simple.  He can dial the annuity up or down depending on what he wants most.  Either way, using an annuity offers an unquestionable benefit in terms of overall cost which will lead to greater accumulation no matter how much annuity he buys.

If you followed me this far and like this type of deep analysis then get on my calendar.  This would go over the head of 99% of advisors so don’t feel bad if you want me to cover it again.


Podcast Episode: Guaranteed Income Using Social Security & Annuities

Last Updated on February 23, 2024 by Bryan Anderson