Fitting an Income Annuity into your Retirement Plan
In my last post I discussed my thinking about why I decided to purchase an annuity from an insurance company. This post will discuss how I arrived at the type of income annuity and how much to purchase.
Income annuities come in many forms. I do not want to get into a long discussion about the different annuities, but let me briefly explain why I chose the one we did. Annuities fall into three main categories:
- A variable annuity,
- An equity-index annuity,
- A fixed-rate annuity.
The first two annuity types allow the owner to participate in equity markets for potentially higher returns. Almost all of the “independent” research I read on these two types of annuities advised that most people stay away from them. And this advice makes sense. If you want equity-like returns, then invest directly in the equity markets. Do not go through an insurance company. The commission and fees the insurers charge significantly take away from the market returns you could get versus investing yourself. In fact, without adding an income guarantee rider to a variable annuity, it is possible to lose money just like investing in the markets directly.
An Equity-Index Annuity (EIA) does provide principle protection to the downside, but the insurer has to take much of the market upside gain to provide this protection (and pay all the management fees). Despite how they are marketed, EIA returns are designed to compete with bank CDs. The way EIAs work is they invest your premium paid in long-term bonds and use the interest generated from these bonds to buy “Call options” on your selected market index. Because they use the interest to buy these options (which often expire worthless), the minimum interest rate guarantee on EIAs is lower than a fixed-rate annuity. Thus, if we experience a long period of flat or negative market returns, it is possible an EIA could return less than a fixed-rate annuity of the same duration. Additionally, because variable annuities and EIAs are complicated products, their sales commission and fees are much higher than the simpler fixed-rate annuity products. For these reasons, we have settled on a fixed-rate annuity to help manage our longevity risk.
Most people should not be purchasing an annuity as an equity investment. They are OK to purchase as a fixed-income investment if you do not need liquidity. But mostly, annuities should be purchased because of the insurance guarantee. In other words, annuities are best used as financial “risk transfer” products just like a homeowner’s insurance policy. In our case we want to transfer some of our longevity risk to the insurance company. We want to make a one-time premium payment and have the insurance company provide us guaranteed income for as long as we live.
We decided on a fixed-rate income annuity, but there is another decision to make. There are two types of fixed-rate income annuities; an immediate annuity (this annuity pays income starting in the next 12 months) or a Deferred Income Annuity (DIA), sometimes called a longevity annuity. Our decision comes down to which type of fixed annuity to purchase and how much.
To assist with this decision, I created several more scenarios in my spreadsheet model incorporating fixed-rate annuities to see how their start date impacted the life of our portfolio. The model scenarios provided very clear results. To get our financial assets to last as long as possible it is better to purchase an immediate annuity rather than a DIA. However, there is one major and obvious tradeoff. To provide a certain level of income, the funds required to buy an immediate annuity is much greater than the funds required for a DIA. And the further into the future the income from a DIA starts, the lower the purchase price.
An example of the cost difference. A couple, both age 65, want to purchase an immediate annuity with a 2% annual inflation rider to provide $15,000 annual income starting today. Or the couple can purchase a DIA that pays the same inflation adjusted income of about $20,000 that starts in 15 years at age 80. The cost of each (assuming no return of premium):
- Premium of $15,000 immediate annuity: ~$350,000
- Premium of $20,000 DIA starting in 15 years: ~$150,000
The premium difference is about $200,000. If you do the math, the immediate annuity pays more than $200,000 income over the 15 years before the DIA starts paying income. This is consistent with my model results that says purchasing the immediate annuity allows our portfolio to last more years than with a DIA.
There has been a lot of research confirming that, for most people, annuitizing part of your portfolio will allow your remaining portfolio to last longer than if you do not purchase the annuity. Yet very few people purchase annuities. And I can understand why. Giving up a large chunk of your portfolio is psychologically difficult to do. Other than psychology, I think there are three main reasons people do not annuitize part of their portfolio for lifetime income:
- They think it is not a good investment, especially if they die earlier than expected,
- Many people feel they might need the funds to pay for a big healthcare issue like long-term care,
- They want to bequeath more funds to their heirs.
Item 1, as I mentioned above, is the wrong way to view any insurance product. It should not be viewed as an investment, but as a risk-transfer product.
Item 2 and 3 are legitimate reasons. If you feel you do not have enough other liquid assets to cover a major health care event or you prefer to leave a bigger inheritance to others, then perhaps purchasing an annuity is not the right choice for you.
In our case, neither item 2 or 3 apply. So the decision comes down to whether to purchase an immediate annuity or a DIA. Since I fall into the group that finds it difficult to give up a big chunk of assets for any reason, and since I am capable of managing our portfolio for income, we decided to go with a DIA or a longevity annuity. A longevity annuity will accomplish my main goal which is, after I am gone, my wife will have enough guaranteed income for as long as she lives. To provide the income we want our annuity premium will amount to about 10% to 11% of our total investment portfolio. This is certainly a big chunk of our portfolio, but not a huge chunk. Thus, this year we will purchase three annuities (why 3 explained below) that start providing annual income when I reach age 80 and my wife is 75.
There is another huge benefit to having these longevity annuities in place. Between social security benefits and the longevity annuities, we will not have to worry about income starting in 16 years when I turn 80. This means managing our portfolio becomes considerably easier. We now only have to manage our portfolio for income for 16 years rather than for as long as we both live, an unknown variable. In our situation, we can create a fixed-income ladder for the 16 years until I turn 80 when the annuity income starts up. Even after setting aside funds for emergencies and other capital costs, creating this 16-year income ladder obligates only about 65% of our total portfolio. The other 35% of our portfolio can be dedicated 100% to equities that we may never need to touch. And if we do, it will be 16 years from now when equities are likely to be much higher. A nationally known financial planner, Michael Kitces, wrote a good article about how a longevity annuity can make managing your portfolio much easier. You can read his comments on this subject here.
How did we decide how much funding to dedicate to our longevity annuities? This is an easy calculation. The most important step is to research your spending patterns and develop a detailed estimate of what your retirement living expenses are likely to be down the road. When I did this, I captured our current living expenses in two categories; one estimates our everyday living expenses to live a basic but comfortable life; the other captures our expenses for luxury items such as foreign travel. Our basic living expenses was the figure I used to calculate our annuity purchase. The purchase amount is determined using our current everyday living expenses inflated to represent this expense in 16 years. Then I deducted our projected social security benefits to arrive at our net income to be provided by the annuities. The three annuity premiums are the amount required to generate the net income required.
There are several good income annuity calculators for estimating annuity payouts on the web or, conversely, to estimate the premium required to generate a certain amount of income. The one I used for our calculations is from Fidelity. To try it out click here.
Why are we purchasing three longevity annuities? The IRS made a tax law change a few years ago allowing anyone with a traditional IRA to use 25% of this amount or $125,000, whichever is lower, to purchase a “Qualified Longevity Annuity Contract” (QLAC) to encourage people to consider annuitizing part of their retirement savings. This is a good tax law change because the funds used to purchase the QLAC are not included in your total traditional IRA funds used to calculate your Required Minimum Distribution (RMD) beginning at age 70. So the QLAC delays the taxes on a portion of your IRA funds until the QLAC begins paying income.
My wife and I each have traditional IRAs. A separate QLAC must be created for the funds taken from each of our IRAs. We will purchase a third longevity annuity because the total amount of our two QLACs do not create enough income to fund our basic living expenses later in life.
That is my thought process for choosing to buy a longevity annuity. However, everyone’s situation is different. I would advise anyone considering purchasing an annuity go to an independent financial advisor (that is, not the person selling you the annuity) and discuss whether an income annuity fits into your retirement plan.
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