Why Not an Annuity?

This is a basic topic that popped up in a meeting last week.  I was running numbers to prepare ideas for a couple in Florida and the results reminded me of a simple lesson.  In many cases using an annuity makes no difference in terms of total output, so the addition of stability in the portfolio makes it an easy choice.  I’ve done this enough that often I can tell just by looking at the inputs whether an annuity will provide extra benefit.  This was a classic case and as easy as they come.

The podcast came out just a few days ago so if you’d like to see the charts click here to watch the YouTube video.

This couple first came to me about two and a half years ago.  Like many, however, they didn’t feel the time was right to use an annuity.  They put the decision off for a while and have been reading newsletters from me since then.  Obviously the market has done well so they were rewarded with healthy account values.

The majority of assets were in qualified plans, or Traditional IRAs and they don’t necessarily need the money.  The husband is old enough to already be taking required minimum distributions (RMD) but the wife is still four or five years away.  While this isn’t a traditional income planning case, the RMDs create the same issue.  Required minimum distributions are essentially a forced income plan so success requires an approach that goes beyond simple investment management.

I set up the spreadsheet with all assets in the market.  The income goal was set at the husband’s current RMD with additional subtractions in five years when the wife was required to do so as well.  It’s a really easy way to look at it.  Test the numbers over several market periods to see how much money is left after 20 years.  Currently all assets are in the stock market so there’s substantial risk in this portfolio but it still held up just fine in all scenarios.

In poor performing time periods, however, there were substantial shocks to the asset value.  The portfolio was shown to have recovered so it worked out ok but limiting those drawdowns creates a smoother ride and can provide a little peace of mind.  This is where I test different levels of annuity in the portfolio to see if we can make an improvement in safety in the worst time periods without sacrificing too much growth in the best time periods.

As is typical, in the worst case scenario, using an annuity made a dramatic improvement in final portfolio values.  But too much annuity in times of solid market performance can really drag down the yield.  What I’ve shown before is no different in this case.  There is a perfect amount of annuity that provides more stability and actually produces better returns in the portfolio over time.

For these guys the answer was to put about 25% of assets into an annuity.  It wouldn’t damage total growth in the portfolio if the market did well and it substantially improved things if we see a lot of volatility in the years ahead.  To me it’s clear as a bell.  A quarter of assets protected when you are at the age of taking RMDs is a prudent thing to do anyway so it’s not a difficult decision.  100% of assets in the stock market at that age is only appropriate for someone who doesn’t mind holding extreme risk.  Anyone who suggests otherwise is only looking to maximize fees, which is another point that is important in this case.  Currently they are working with an investment manager who doesn’t like the annuity idea, but using it would not only insulate the portfolio but also cut fees by 25%.  Not a bad additional benefit.

If you look at the sheet on the video I need to remind everyone that the annuity column was run at an extremely conservative 3%.  I don’t like to throw out super high yields on the annuity in my projections, preferring rather to set reasonable expectations that give us a better chance of exceeding those.

This is as simple as it comes.  Protection in poor market conditions without sacrificing growth in strong market periods.  Why not an annuity?

Enjoy your weekend!

Bryan

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Bryan Anderson

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