When an Annuity Makes Retirement Easier

Income planning is simple but product selection is tough.  Institutional investment managers have always been focused on accumulation of assets and most would prefer it stay that way.  There has been a demographic shift happening for several years as more people now are retiring than ever before.  Along with that needs to come a shift in strategy for managing assets.  That’s exactly what I’ve spent the past 21 years studying.  Annuities improve your chances of retirement success and sure make things a lot easier as well.

I started working on a case recently that gave me the chance to once again illustrate a couple of simple points that need to be covered.  This is a couple with good savings that will easily cover income needs in retirement.  It means that they could use any number of strategies and probably be just fine.  If they choose to use an annuity then it will be because the annuity gives them a significant advantage over other strategies.  Last week I talked about a couple who didn’t need an annuity at all and this couple is similar but there’s a more obvious reason why an annuity would help.

The major lesson: calculate annual income needed as a percentage of total assets.  In this case, 4.2% of their portfolio will cover both necessary and discretionary income.  This couple plans to fully retire in two to three years so buying an annuity now will give them guaranteed increases on cash growth or income for each year they wait.  The first thing I did was figure out how much guaranteed income they would get with a deferred income annuity.  In this situation, the deferred income annuity would payout about 8.4% of the initial investment as guaranteed income which would eliminate a significant burden from the portfolio.  

If just 15% of their money went to the income annuity, additional income needed would only amount to 3.4% of the remaining portfolio.  Just this amount is a significant reduction in risk and gives them steady income in retirement.  The more annuity that is added, the easier and less risky it gets.  But we also have to plan for residual value for planning changes and inflation adjustments so we don’t just want to use the income product for all their spending needs.  Some level of control should be kept to maximize performance for anything else they might want.

It turns out that a portion of the income they want is probably for discretionary spending.  Almost no one ever spends the same amount of money each year so sometimes they will need extra and sometimes they won’t.  With an income annuity, monthly payments are coming no matter what and it might not be necessary.  Taxes are the main consideration here and you don’t want to be forced into a higher tax bracket unless you have to.  Establishing baseline guaranteed income is a good first move but flexibility with the rest of it is a good idea.

For additional spending I would recommend a fixed annuity (MYGA).  Rates now are currently higher than the percentage required.  Remember, after the income annuity, spending needs were 3.4% of the remaining portfolio.  If a fixed annuity is paying 5%, interest can be taken each year without invading principal and it would further reduce requirements for the rest of the portfolio.  The best part of doing it this way is that withdrawals are completely discretionary up to 10% of the account value each year.  They can take money or not as they wish and even more than interest earnings if desired expenses are high enough.

Residual value of the annuities is important to some and there’s a big difference between these two.  The income annuity has a very aggressive payout and is preferable for maximizing cash flow for a portion of retirement assets.  But at average life expectancy there is no remaining value to pass on to heirs.  The fixed annuity, however, would have the full principal remaining which can be passed on to heirs or more importantly, used for planning changes if necessary in the future.  For those who don’t want to leave a legacy please remember that there are plenty of other reasons to plan to have money leftover and flexibility is major idea here.

It needs to be pointed out that annuities of either type are more preferable to bonds, although some would try to convince you that’s not the case.  The income annuity pays far more income than would be available with bonds and the fixed annuity has principal withdrawals that are not subject to fluctuating value via interest rate risk.  For these reasons annuities are far superior and it will translate to more performance on the total portfolio over time.

It’s also important to look at what the majority of other advisors might suggest in this situation.  Because adequate funding is available, most other agents would recommend a little more than half of the assets going into an annuity.  Investment managers, if they recommended an annuity at all, would stop at the baseline guaranteed income.  My recommendation was about 30% of assets which is far less than most insurance agents and a little more than what investment managers might recommend.  I created a nice spreadsheet that everyone loves to test each scenario to see which offers the best result.  That way we can be as objective as possible while trying to figure it out.

Before spending a large chunk of retirement assets it helps to do this analysis so my recommendation can be based on the best information we have.  Does an annuity really make things better?  Yes, in fact, it does.  Note that between the income annuity and fixed annuity roughly 30% of their portfolio would be allocated to it.  In the worst case scenario over 20 years, the annuity strategy showed more than two and half times as much portfolio value in comparison to just leaving it in a blended market portfolio.  In a favorable 20 year scenario the annuity strategy resulted in about a 50% increase in remaining portfolio value.  

This gives you a basic idea of the benefits of using the strategy I recommend.  A number of people will also ask how it turned out when looking at using more or less annuity, as others might suggest.  Well, I didn’t just imagine the 30% scenario with half income annuity and half MYGA.  I tested everything else and settled on the best projection.  Once again, I don’t have an agenda and sometimes the other strategies do make the most sense.  In this case it was just about a third that did it.

The one thing that is important to stress is that this doesn’t require any specific investments for the remaining portfolio.  It simply evaluates the benefit of using an annuity.  Figure out how to get the income first and then work on deciding how to invest the remaining funds.  A number of people will choose to put more in the annuity to get more income and more safety while others will use less annuity because market risk does not bother them.  This is a solution that can be customized to fit individual preferences, you just need to understand how the annuities work first.  Anyone who wants to run through the options again can check out last week’s case study in Episode 123:  Sleep-At-Night Annuities.

Hit the scheduling link on the top right corner of this page to get in touch and I’ll get more specific with your numbers.

Bryan

Episode 124: When An Annuity Makes Retirement Easier

Last Updated on February 8, 2024 by Bryan Anderson