When an Annuity Is Critical

This is an easy case study that came up a few weeks ago and the basic parameters match many others but with all the personal variables involved, my recommendation can change.  Numbers are easy but there are only a few times in my career when people made a long-term decision based on the numbers alone.  I tell everyone that it’s easy for me to be objective but most of you make decisions based on subjective factors.  Emotions play a big part in this process and it’s something I understand because I know for your part how much work has gone into it.

The couple I’m going to talk about today are in their mid-60s and currently have 100% of their $700K in the stock market.  It is managed by a large national firm that everyone knows about but it’s not worth mentioning by name.  They are paying 1.25% annually in management fees and draw about $40K annually for retirement income.  It doesn’t take much to understand that it’s an extremely risky position and the likelihood of running out of money stands at least a 50% chance.  Between the income draw and fees they are pulling nearly 7% from the portfolio each year.  This is a distribution rate that’s probably ok if they were ten years old but they aren’t.

They don’t want to run out of money and on top of it would like to leave some money to their heirs.  A legacy is not imperative but something they want if possible.  Stock market risk is something that concerns them and they really don’t want to do it anymore.  It boggles my mind that an investment manager would be allowed to place a risk-averse investor with 100% risk assets.  If I did the same thing on the conservative side that manager would surely have something to say about it.  Nothing about that position is prudent, suitable or in the clients’ best interest.  But let’s see if an annuity can make things better.

I like to do something I call an all-or-nothing exercise with people.  It’s not anything that results in a solid recommendation but it is a good way to compare several options.  If you can see how the assets perform with every option in an all-or-nothing scenario then you can pick and choose how much of each you want in the final plan.  It’s an easier way to see how each component could perform.  Almost everyone else will show you a blended solution so that you have to think about all individual variables at the same time.  It’s a complex approach and most advisors wouldn’t be able to explain the results coherently.

First, of course, we had to look at what they could expect by leaving things as they are.  Withdrawals along with market volatility make for an unexpected outcome.  The numbers bear that out as well with the worst 20 year period in the market leaving them penniless after 16 years and a favorable market getting them through 20 years with only $100K left.  Either is unacceptable in my opinion and someone who wants less risk would likely agree.

Second, we looked at guaranteed lifetime income.  That would knock out the major concern so that they would never again have to worry about meeting a standard of living.  I knew they had enough to make it work but was afraid the cost might cause a little sticker shock.  Well I wasn’t too far off because it would take $600K to produce $40,000 annual income, leaving only $100K for future planning opportunities and potential legacy.  Some people might decide to do this but I’m never going to push hard on something like it.  If even one of them lives to the age of 90, they’d get a total of $1M in payments so it’s not bad but it does take a special set of parameters for this to be desirable. 

Lastly, we looked at using a fixed annuity (MYGA) with a guaranteed rate for ten years.  You can get up to 6% guaranteed on a deal like that so the interest alone would provide the income, without ever touching the principal.  In ten years they’d have more money than they have today and could expect much higher available payouts from an income contract if they decided to switch strategies.  For a risk-averse person it sounds like a pretty good deal.  Remember, previous withdrawals and management fees were nearly 7% and given the potential for market volatility, it would be hard for the market investments to match this.

Either annuity solution is far superior.  The income annuity provides a lifetime guarantee.  The remaining assets would grow to $200k-$300K over 20 years using the same market performance as above, plus they’d continue to get monthly paychecks from the insurance company.  The fixed annuity would give them the most flexibility and keep them in control of all the assets over time.  The only risk here is in wondering where rates will be in ten years when they have to reinvest the money.  With an increased principal balance it may be a risk worth taking.

There you have the all-or-nothing analysis.  I’m not here saying that it needs to go in only one direction.  To know that there are two ways to guarantee the result is a pretty nice thing to consider.  Some smartass is going to ask me how we plan for inflation and of course that all depends on how much money remains under their control.  A risky strategy has no guarantee of that.  The point of this is to say that these guys can take assurance of a positive result from two of the three strategies.  It stands to reason that you’d want to use an annuity when that’s the case.  Because of the desire to reduce risk then I’d say it’s critical.  Let me know what you think.


Watch The Episode: When An Annuity Is Critical

Last Updated on November 3, 2023 by Bryan Anderson