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This was originally published in the May, 2006 edition of Retired Investor, a monthly international investment journal.

Using Annuities to Get the Most Out of Your Nest Egg

So, you are thinking about retiring...or maybe you have already retired. Your earned income will be lower than you are used to, maybe a lot lower. Yet, you intend to keep on spending - the money will have to come from somewhere!

You have accumulated significant assets - you expect to live on the income they generate, and maybe use some of the principal, too. You have two important decisions to make:

1) How to invest the assets; and
2) How much to draw from the assets.

When you think about drawing income from your assets after you retire, you have two critical worries:

a) Will there be enough income? And
b) Will I outlive my assets?

It turns out that the two critical worries relate in commonsensical ways, both to each other and to the two important decisions. If you draw a lot from your assets, you (by definition) have enough income now. Unfortunately, if you draw a lot from your assets, you are more likely to outlive them.

If you invest in inflation-indexed bonds, with low investment risk, there will be relatively little income, but so long as you don't consume your principal, you will not outlive your assets. If you invest in equities, with higher investment risk, you can expect more income, but the chances of a stream of poor returns early in retirement are higher, with the implied unpleasant dilemma of reduced income and spending now or premature exhaustion of your asset base later.

Introducing annuities as a tool for retirement income management expands your list of choices, and can reduce your the critical worries. In this article, we will discuss the various kinds of annuities, and how you can use them most effectively to manage your nest egg and your income.

Annuities Defined and Described

I have come to praise annuities, not to bury them. Annuities have a bad name among many investment advisors, and among many investors - largely because of the infamous variable annuity, that vastly over - sold (and under-needed) asset accumulation vehicle. Many brokers and "investment advisors" made (and continue to make) significant personal fortunes from commissions "earned" on sales of these expensive products to people who would have been better off in virtually any other investment. Variable annuity buyers pay dearly for the privilege of deferring taxes into the future - frequently the commissions and fees overwhelm the potential savings.

An annuity, however, is a distribution vehicle, a mechanism for doling out the fruits of your saving discipline. It is in this role, the role that it was designed for, that the annuity truly shows its mettle. The humble annuity can help you minimize the worry that you will outlive your assets.

How can it do that? Let's begin by developing a conceptual understanding of annuities.

An annuity is a reverse life insurance policy. In a standard life insurance policy, a person (the insured) contracts with a life insurance company to pay his family a large sum of money in case he dies prematurely.

This would be a large amount of risk for the insurance company to take for only one insured - in fact, just as much risk as the insured has before buying the life insurance policy. However, the insurance company assembles a group of people (a pool) who wish to buy life insurance, and now its risk is much different - in any one year, only a small fraction of the people in the pool will die, and the insurance company knows that fraction (or at least, its actuary[1] does). If the pool is large enough, and the actuary is good enough, the life insurance business is actually a very low risk proposition for the insurance company. It simply sets its premiums to cover the benefits it expects to have to pay out for the pool that year, plus a fair profit. Since its payments will be smaller than its total premium, the insurance company can invest the difference. The earnings on these investments help to keep premium payments low.

Now think about the retiree who wants to receive an income for the rest of her life from her accumulated assets. The retiree risks living too long (as opposed to the life insurance customer, who risks not living long enough). Suppose the retiree approaches an insurance company, and asks the company to bear the risk of "living too long" or longevity. The company would take charge of the investments, and guarantee the customer an income for the rest of her life.

Again, this is a very risky proposition for the insurance company with just one customer - they have just accepted that customer's risk. Just as with life insurance, however, the insurance company can turn this into a (nearly) no-risk situation by assembling a pool. If the pool is large enough, and the actuary is good enough, the company will know exactly how many customers will live to be 100, and how many will die next year. From this, it is easy to calculate how much the company will have to pay out each year until everyone in the pool has died.

Think back to the retiree's two worries:

a) Will there be enough income? And
b) Will I outlive my income?

The insurance company has solved the second problem with its risk pooling - it guarantees to pay a lifetime income to each of its annuity purchasers. A retiree who buys an annuity will not outlive the annuity income.

Table 1 compares life insurance and annuities. For each type of policy, there are winners, who receive large returns, and losers, who receive valuable "consolation prizes." In the case of life insurance, all members of the pool pay the insurance premium to the insurance company. The "winner" (financially) dies during the term, and his family receives the death benefit.[2] All of the "losers" survive - they console themselves with the knowledge that if they had died, their families would not have suffered from the loss of their incomes.

Insurance

Bet

Winner

Loser

Winnings

Consolation

Term Life Insurance

Premium

Dies during term

Lives through term

Death benefit

Family was safe

Annuity

Investment

Lives a long time

Dies before life expectancy

Extra-ordinary return on investment

Didn't outlive assets

In the case of the annuity, all members of the pool irrevocably transfer their capital to the insurance company for it to invest. The winners live longer than expected, but don't outlive their assets, receiving many income payments. The losers die before they expected to, and receive few payments. The premium they paid is gone, too, and not available for heirs.[3] However, the losers don't outlive their assets, either.

Life insurance is priced so that premiums paid by the losers are sufficient to pay the winners' benefits plus cover the insurance company's costs and profit. Annuities are priced similarly - purchase premiums must cover all of the payments to the winners plus cover the insurance company's costs and profit. If the actuary's assumptions are accurate, the insurance company neither wins nor loses in either case - it merely holds the money, paying the winners in accordance with the policy agreement.

Types of Annuities, and Choosing the Best Annuity

Historically, annuities have paid the same nominal income every year. Many pensions have this structure. This type of annuity has a major drawback - it does not keep up with inflation. A fixed income pensioner can't outlive her pension, but her purchasing power will decline if there is inflation.

Even in the staid world of insurance there is innovation, and annuities are no exception. We'll focus on three new kinds of annuities:

  • An inflation-adjusted annuity is just what it sounds like. Each year the payment increases to replace the purchasing power lost to inflation.

  • The annual payments for a graded annuity increase at a steady rate each year.

  • The annual payments for a variable payout annuity change according to a formula. The annuitant selects an Assumed Investment Return (AIR), and the payments grow or shrink depending upon whether the investments he selects exceed or fall short of the AIR.

Which annuity should you choose? The answer depends on the non-longevity risks you are concerned about. That is, buying an annuity helps deal with your worry about - "outliving your assets." Choosing among the annuity types addresses a different worry - "will I have enough income?"

Consider the risks to the value of the annuity income stream:

i) Inflation could erode its value
ii) Excellent investment returns on many asset classes could cause you to regret selecting fixed income rather than investing in stocks
iii) Your insurance carrier could renege on the promised payments.

The table below summarizes important differences in risk bearing among the alternatives available to you.

All types of annuities shift the longevity risk from you to the insurance company, at the cost of any potential inheritance for your heirs. Except for the variable payout annuity (and the self-managed, or no annuity option), the insurance company bears the investment risk. The variable payout annuity, like the self-managed nest egg, allows you to bear the inflation risk yourself, while the other annuities allow you to choose how much of the inflation risk you wish to bear.

Differences in Risk Bearing

Self- managed nest egg

Variable payout annuity

Fixed payout annuity

Graded payout annuity

Fixed payout annuity (inflation-adjusted)

Investment risk bearer

You

Insurance company

Inflation risk bearer

You (with market assistance)

You

Insurance company (below the grade) and You (above the grade)

Insurance company and sometimes you, if inflation exceeds a maximum rate.

Longevity risk bearer

You

Insurance company

Inheritance possibility?

Significant

None

Now, consider who is better equipped to bear the risks. The insurance company is inherently better at bearing longevity risk - it can diversify by including many people in the risk pool. You can't diversify your own longevity risk - your risk pool includes only you (or, at most, you and your spouse, partner or significant other).

The ability to bear investment and inflation risk is less clear - all the people in any one year's risk pool will face precisely the same risks over their lifetimes - poor market returns for one mean poor market returns for all, ditto for inflation experience. However, the insurance company holds risk pools for many cohorts,[4] and thus has the opportunity to diversify its investment risk and inflation risk over time, which you cannot do - you can retire in only one year, for example.

Also, the table says nothing about the risk of insurance company insolvency - the annuity types have little or no impact on that. Your best approach to this risk is to diversify your annuities across companies - although insurance companies themselves and state insurance regulation provide considerable protection already.

You have to compensate the insurance company to bear inflation, investment, and longevity risks, however, and the price might be more than you want to pay. The only way to be certain is to analyze the deal the insurance company offers. Here is an example, for a 65 year old man. Vanguard (www.vanguard.com) provided the quotes.

The man is considering purchasing a $100,000 annuity. He has several choices:

Annual Payouts by Annuity Type

Fixed

Inflation Protected

3% Graded

5% Graded

3.5% AIR

5% AIR

Payout

8,424

6,190

6,352

5,127

7,054

8,142

The quotes provide a sense of which contracts the insurance company finds to be most risky for itself. The highest payouts imply the lowest risk to the insurance company. The fixed annuity payout is highest (the annuitant assumes inflation risk). The AIR (Assumed Investment Return) annuities are next (the annuitant assumes investment risk). The Graded and Inflation Protected annuities offer the lowest payout (the insurance company assumes both investment and inflation risk). Another way to look at this is, the annuities where the annuitant bears the most risk have the highest payouts.

So, which annuity should the man in our example buy? At first blush, the fixed annuity looks good - it offers the highest payout! However, the payouts of all but the fixed annuity change in response to changes in economic circumstances, providing more security for the annuitant. The changes depend on the type of annuity and how markets evolve. The AIR payouts also vary with the annuitant's choice of investments, but we will ignore this uncertainty, and assume our annuitant will get the market return.

The value of each annuity to the retiree will depend upon what happens in the markets - the inflation rate and market returns that materialize as he lives in retirement. The fixed annuity payout is always the same, the graded annuity payouts grow by 3% and 5% per year respectively. The inflation - protected annuity payout grows at the rate of inflation (so long as inflation does not exceed 10%).

So, the best annuity depends upon what happens in the future! How can we choose when we don't know what will happen?

The first step is to determine what each annuity is worth in a variety of

Actuarial NPV ($000)

Fixed

Inflation Protected

3% Graded

5% Graded

3.5% AIR

5% AIR

Inflation Rate

$89

$110

$86

$83

$77

$80

Real
return

-2%

$89

$110

$86

$83

$77

$80

6%

-1%

$82

$99

$78

$75

$77

$79

0%

$76

$89

$71

$68

$76

$79

1%

$71

$81

$66

$62

$76

$78

2%

$66

$74

$61

$57

$75

$78

3%

$62

$68

$56

$52

$75

$77

4%

$58

$63

$52

$48

$74

$77

5%

$55

$58

$49

$45

$74

$77

6%

$66

$74

$61

$57

$75

$78

7%

$62

$68

$56

$52

$75

$77

8%

$58

$63

$52

$48

$74

$77

scenarios. For example, suppose inflation rates are 6% for the foreseeable future. The table shows the expected value[5] of each type of annuity for our 65-year-old retiree, depending upon how well the market performs. If market returns are low (less than 2%), the inflation protected annuity is best (green shading). If the market produces 2% or more, however, the 5% AIR annuity is preferred (ditto).

More generally, for high inflation and low investment returns, the inflation-protected annuity is best. For high investment returns, AIR annuities are best, regardless of inflation. When both inflation and investment returns are expected to be low, either the graded (for very low returns) or fixed (for moderate returns) annuity is preferable.

Inflation Rate

0%

2%

4%

6%

Real
return

-2%

Graded

Graded

Inflation Protected

-1%

0%

Fixed

1%

2%

Fixed

5% AIR

3%

4%

5% AIR

5%

6%

5% AIR

7%

8%

We will return to the question of selecting the best annuity shortly. Let's examine the role an annuity can play in distributing our 65-year-old's retirement assets. Suppose he has a $1,000,000 nest egg, and he'd like to draw $50,000 per year, adjusted for inflation.

Draw

$50,000

Assets ($M) in 35 Years

Chance of Reaching Target

Poor Markets

Average Markets

Good Markets

95%

50%

5%

Portfolio

$1M

will be better

25

0%

(0.6)

(0.4)

(0.2)

50

3%

(0.6)

(0.1)

1.1

60

12%

(0.6)

0.1

2.2

75

27%

(0.6)

0.4

4.4

90

45%

(0.6)

0.9

10.9

Using portfolio performance simulation software (similar to Monte Carlo simulation)[6], we see that our retiree has no chance of leaving $1M to his heirs if he invests in a 25% equity portfolio. In fact, even if markets perform extremely well, he is likely to either run out of money or leave his heirs a $200k debt if he doesn't curb his spending. Furthermore, if market returns are poor, he could end up $600,000 or more in debt by the time he reaches age 100.

Alternatively, if he is willing to draw only $35,000 per year, his odds are much better, both of leaving $1M to his heirs, and also of surviving a run of poor market returns with his portfolio, if not intact, at least not drawn below zero. But then, of course, he is drawing only $35,000 per year, not the $50,000 he wants to draw (and spend).

Draw

$35,000

Assets ($M) in 35 Years

Chance of Reaching Target

Poor Markets

Average Markets

Good Markets

95%

50%

5%

Portfolio

$1M

will be better

25

1%

0.1

0.4

1.0

50

35%

0.1

0.9

3.0

60

49%

0.1

1.2

4.7

75

61%

0.1

1.6

7.8

90

70%

0.1

2.4

16.3

Now, suppose we introduce annuities into the mix. Our retiree insists that he needs an income of $50,000. The more he annuitizes, the lower the draw rate on his remaining assets. Let's assume he will use the inflation-adjusted annuity (we'll see why this makes sense in a moment). If he is willing to annuitize $575,000 of his assets, the draw rate on the remaining $425,000 is about 3.5%. That would seem to be fairly safe, no matter what happens to market returns. And he would still achieve his target income.

In fact, as we see from the chart below, he even has a pretty good chance of growing the $425,000 to $1M by the time he reaches 100. Overall, he reaps a big improvement, simply by deciding to annuitize some of his assets.

Draw

$15k on $425k

Assets ($M) in 35 Years

Chance of Reaching Target

Poor Markets

Average Markets

Good Markets

95%

50%

5%

Portfolio

($1.0M)

will be better

25

1%

0.0

0.2

0.4

50

35%

0.1

0.4

1.3

60

49%

0.1

0.5

2.0

75

61%

0.1

0.7

3.3

90

70%

0.1

1.0

6.9

There are still some open questions. Which annuity should he buy? Why not annuitize all of his assets? And, if one decides to annuitize some amount of assets, should one annuitize all at once, or a little bit at a time?

Which annuity? Consider the chart below, which compares the outcomes for various levels of annuitization (and the associated portfolio withdrawal rates), assuming our simplified investment portfolio is allocated 75% to equities. The lower left oval highlights the outcomes when market returns are poor. In this scenario, the best outcomes occur when annuitization rates are highest, and portfolio withdrawal rates are lowest.

When market returns are high, any annuitization strategy works, and all allocations are "safe." High portfolio withdrawal rates exhaust assets when market returns are low - the same situation where annuitization provides its greatest protective effect. More annuitization allows a lower withdrawal rate on the remaining assets - and lower withdrawal rates are safer (at a 5% draw rate, expected remaining assets are negative; at 3.5%, positive). Low rates of investment return call for the graded or inflation-protected annuity, depending upon future rates of inflation.[7] Whether future inflation will be below or above current levels is a judgment call - we judge that inflation is unlikely to decline any time soon. Thus, Sensible Financial recommends the inflation-protected annuity.

Inflation Rate

0%

2%

4%

6%

Real
return

-2%

Graded

Graded

Inflation Protected

-1%

0%

Fixed

1%

2%

Fixed

5% AIR

3%

4%

5% AIR

5%

6%

5% AIR

7%

8%

Interestingly, annuitizing a large fraction of assets can, under some circumstances, actually increase the potential bequest available to heirs. If market returns are poor, or even average, the lower draw rate on the assets that the retiree doesn't annuitize means a larger bequest in cases where he annuitizes more assets to achieve a given income target. Only if market returns are excellent is the bequest larger in cases where a lower percentage of total assets is annuitized (dotted oval in the figure above). In this situation, however, the bequest is more than initial assets even for the largest annuitization amount (lowest draw rate).

How much should you annuitize? The more you annuitize, the smaller the draw rate on your remaining assets, under some circumstances, which provides both a larger margin of safety (you are less likely to exhaust them), and a greater potential bequest to your heirs. On the other hand, you will have fewer assets available to respond to unexpected contingencies - you cannot recover annuity premiums once you pay them, nor can you sell all or part of the annuity. While the answer is necessarily a personal one, it is fair to say that annuitizing 100% of your assets, while producing the highest possible safe draw amount, leaves you with too little financial flexibility. Suppose for example that you wish to buy into a retirement community. If you annuitize a high percentage of your assets, you'll have limited funds with which to do so - perhaps only the equity in your home.

If you do decide to annuitize some amount of assets, should you annuitize all at once or gradually? There are two good reasons to spread your annuitizing over your early retirement years:

1. You maximize your chances of learning about your lifespan.
2. You increase the likely size of your bequest.

Learning About Your Lifespan

As we have already described, annuities are a good deal only for retirees who live longer than average. You should annuitize only if you expect to have a long life after you retire. Suppose however, that a year or so into retirement, you learn something that causes you to revise down your expected remaining years of life - an unexpected illness, for example. If you've already annuitized the entire amount you planned to, you have no ability to adapt - and you've just learned that your annuitization decision was an expensive mistake. However, if you've annuitized only a fraction of what you planned, your loss is small, and you can simply decide to discontinue your annuitization program.

Increasing Your Bequest

The later you annuitize, the higher the payout rate for the annuitized amount, as the table below indicates. Of course, starting at an older age, you will be collecting the higher payout for fewer years. Still, the higher annuity payout allows you to draw less from your remaining assets, and that means that you are likely to have more to bequeath.

Beginning Age

Annual Payout per $100k

% Increase

66

6,190

67

6,396

3.3%

68

6,617

3.4%

69

6,853

3.6%

70

7,105

3.7%

71

7,373

3.8%

72

7,660

3.9%

73

7,967

4.0%

74

8,295

4.1%

75

8,647

4.2%

As the chart shows, for each annuitization plan and associated draw rate, the amount left for your heirs is greater for poor, average, and good markets if you annuitize gradually rather than all at once. The advantage is greater for larger annuitization amounts.

Deciding Whether (and how much) Annuitization is for You

While annuitization, like all financial decisions, is a personal one, analysis of your situation can help you decide. Here are some factors to consider:

  • Project your lifespan. If you are likely to live at least as long as the average retiree of your age, then annuitizing to reduce your risk of outliving your assets makes more sense for you. Here you can consider:

    • Your own health (including your smoking history)
    • Your family's longevity history - did your parents, grandparents, aunts and uncles have notably long (or short) lives?

  • Are your assets large enough to support your living standard easily?

    • Calculate the draw you need as a percentage of your assets. Is it less than 3.5%[8]? If not, annuitizing enough of your assets so that the draw on the remainder is 3.5% or less may make sense for you.
    • Do you already have significant annuity income? Examples include Social Security (although not a true annuity) and payouts from traditional defined benefit pensions. Carefully assess whether this income enjoys inflation protection - many defined benefit pensions do not.

  • What assets do you want to be sure not to annuitize? Examples include:

    • Preferred bequest amounts - annuitized assets cannot be bequeathed!
    • Lump sum reserves - amounts that you want available to deal with possible emergencies or contingencies. For example, you may wish to purchase a second home, or you or your spouse may need expensive health care.

  • How do you feel about risk now that you are retired? If you are comfortable reducing your living standard in the face of poor investment performance, and want to be able to enjoy fully the fruits of investment success when market returns are excellent, then annuitization will disappoint you. Alternatively, if you have a preference for living standard stability, more insulation from the performance of the market is desirable, and annuitization can fill the bill.

In Summary

Annuitization is not a panacea or silver bullet. It cannot guarantee a worry free and risk-free retirement. It can, however, reduce two otherwise significant risks - risks that we identified above as the two key worries:

  • That you will outlive your assets (reduced by allowing you to offload longevity risk);

  • That you will not have enough income (reduced by shifting some investment and inflation risk to the insurance carrier).

You buy insurance against much smaller risks than outliving your retirement assets. Now you can insure your retirement, too.

Contributor: Rick Miller is the founder of Sensible Financial Planning, Inc. (www.sensiblefinancial.com), a fee-only, index-oriented firm located in Cambridge, Massachusetts. Full disclosure: Rick is related to our publisher. However, before anybody complains about that, we should also mention that he has a PhD. in Economics from the University of Chicago. He has taught economics at Johns Hopkins University, and his business career comprises considerable experience consulting to and working for major financial services firms. His previous contributions on college savings accounts and tax planning for US investors were well received.  This article on annutities will be useful to all of our Retired Investor readers. But you are the judge: please feel free to email us to let us know what you think of this this article, and what other subjects you'd like Rick to cover in the future.


[1] An actuary is a professional who knows a great deal about the distributions of lifespans and health in populations of people.

[2] Life insurance is the only bet I know where you have to die to "win."

[3] It is possible to structure annuity payouts to allow some protection against premature death. These structures are costly, however. Instead, I believe it is more efficient to structure your annuity purchase pattern to provide this protection, as is described later in this article.

[4] A cohort is a group of people who are born, or retire, or do something else, all in the same year, or short period of years.

[5] The actuarial present value is a variant of net present value. It discounts cash flows not only by the discount rate (valuing future inflows less than today’s), but also by the probability that the annuitant will be alive to receive them (flows that would arrive at age 100 for any annuitant still living aren't paid to an annuitant who has died).

[6] Sensible Financial uses a mix of asset classes similar to those used in Retired Investor.

[7] In the poor market return situations, the inflation protected and graded annuities outperform the variables

[8] Experts generally agree that 3.5% is a reasonable figure for a 65-year-old man. If you are younger, the safe draw rate is lower; if older, the safe draw rate is higher. Women have longer expected lifespans, so their safe withdrawal rates are uniformly younger than men's are.