The ultimate in retirement security is guaranteed, lifetime, inflation-adjusted income. Most of us will get some of that—though not enough— in the form of Social Security. A few will get the balance of what they need from pensions. But the rest of us will see a shortfall between our fixed living expenses and our guaranteed income.
You can try to fill that gap by making systematic withdrawals from your investment portfolio throughout your retirement. A balanced portfolio is likely to outperform many other retirement income options, if the markets do average or well. But it’s not guaranteed. Even for experienced investors, there are serious risks in managing a retirement portfolio.
The insurance industry offers what sounds like a safer idea: an annuity. Annuities can provide peace of mind by removing longevity risk—the chance you’ll outlive your assets. And, they let you generate more safe income than you could from the same amount in a portfolio of stocks and bonds. That’s because, with an annuity, you’re consuming both principal and earnings, plus you’re pooling your lifetime risk with other buyers.
Unfortunately, many kinds of annuities, especially complex variable and indexed annuities, are a quagmire of pushy salespeople, hidden expenses, and dizzying complexity. Consequently, many careful retirees rule out any kind of annuity as a retirement income solution. I was once in that camp. Why would I need an annuity, when I had proven success growing my own diversified portfolio in excess of our retirement income needs?
But then the market crashed in 2009. Our portfolio did better than most, and we had no need for income at the time, but the huge drop demonstrated the potential downside of retiring at the wrong time. I knew that retirees who had purchased annuities were happy with the steady paychecks they received during the crisis. I realized that annuities had a place in retirement planning, at least for those without the investing skills and fortitude to endure a severe recession.
Once I retired, the decades ahead without a regular paycheck suddenly became very real. It didn’t matter that I had many years of investing under my belt, and was confident in my ability to manage our portfolio. It didn’t matter that we lived frugally, and could cut our living expenses even further if needed. Because there was one thing I realized I couldn’t control: how long I would live. Insurers, however, could control that variable and protect me from running out of money, by combining my lifetime with thousands of others via an annuity.
Finally, when I reviewed my estate plan, I realized that, even though I had accumulated enough money to provide for my family, I would not necessarily be around to manage those assets for the duration. I could see that my loved ones might need to put a portion of our assets on “autopilot,” so they could count on a steady lifetime income without worries.
Then along came research demonstrating that combining single-premium immediate annuities (SPIAs) with stocks may be the best way to generate retirement income for a wide set of circumstances.
Given all those factors, I’ve come to believe that you should plan for a guaranteed income “floor” in retirement. This assures a reliable income stream that meets your essential living expenses until the end of your life, however long that may be.
Annuities will be a key part of that equation for many. We’re talking here about simple single-premium immediate annuities, not their complex and expensive cousins—variable and indexed annuities. With a SPIA, you hand the insurance company a lump sum and they immediately begin paying you a monthly amount. There’s no unexpected variability, no complex indexing formulas, and no extra fees.
When should you buy an annuity, and how much annuity should you buy? These are complex questions that require personal financial planning. For example, we are in our mid-50’s, our lifestyle is flexible, we can manage our own investments, and we don’t need extra income right now. So it’s too early for us to put our retirement finances on “autopilot.” We will probably wait until our mid-60’s, when we may put about half our current portfolio into annuities. While the need for an annuity is a given in many cases, the exact timing and amount are anything but…
Darrow Kirkpatrick is a software engineer and author who lived frugally, invested successfully, and retired in 2011 at age 50. He writes regularly about saving, investing and retiring on his blog CanIRetireYet.com.