A friend recently told me he’s planning to retire but is worried about his financial ability to do so. When he described his situation, I told him it seemed to me he didn’t have anything to worry about. But, still he’s worried. As luck would have it, I heard a finance professor lecture on retirement income planning the following day. He suggested a strategy that might just help put my friend’s mind at ease. I then also read an article in the Harvard Business Review by Nobel laureate economist Robert Merton touting the same idea. It’s not a cure-all, a panacea or magical solution. As a financial whiz-kid once reminded me, “No financial product has a ‘secret sauce’.” The concept: use annuities as a key element in your retirement income strategy.

My friend’s situation: A debt-free widower in his late 50s, Dave will be retiring from his firm at age 60. He’ll receive a five year buy-out of his stock at retirement, has a sizeable 401(k) and has built up a comfortable nest egg of savings. The problem — he’s so used to making a healthy income from working all these years that he’s uncomfortable with the idea of spending down his assets to pay for his retirement. Dave’s problem is not that he has a tangible lack of wealth, but that he has the intangible fear of outliving his assets.The reason the finance professor’s lecture hit home for me is he focused on the idea that people are far more comfortable with a retirement strategy of spending their income than spending their assets. To make his point, he referenced the problems with the “4 ½ Percent Rule” that some planners use as a retirement income approach. This rule of thumb suggests that a couple can annually withdraw 4.5% of their retirement capital, adjusting the withdrawal rate upward each year for inflation, with little fear of outliving their income. The professor pointed out that for some retirees this approach raises the fear, “What happens if I don’t make enough on my portfolio to justify this income; will I outlive my assets?”  For others, it engenders the opposite emotion: “What if my assets do better than this; will I have been too conservative, and robbed myself of a happy retirement while leaving more than I intended to my kids?”

An annuity strategy addresses both of these fears.The Strategy

Although these concerns are more rooted in emotions than numbers, the simple fact is a worried retiree is not a happy retiree. The professor’s suggested strategy is to convert assets into guaranteed income.  His point is that people are far more comfortable living within a known income stream than they are spending down assets for an unknown period of time. Thus, he suggests a prospective or current retiree take a portion of retirement assets and purchase a fixed annuity income stream. The annuity income can begin immediately or it can be deferred until a later age. It can pay an income for life, for a period of years or for the greater of life and a guaranteed period of years.This idea isn’t just an academic construct, but a realistic financial tactic. Commercial annuities offer a number of flexible features and options that come in handy in crafting a retirement income strategy with peace of mind. Consider my friend Dave’s situation and see where annuities might help him. 

  1. Ladder the purchase of annuities: Similar to a bond laddering strategy, the idea would be to invest in annuities that begin and end at different times. Start with laddering the purchase of annuities. Dave has a few years until he retires. When he retires at age 60, he will largely continue his current stream of income until he reaches 65 — the age at which the payments on his equity interest in the firm cease. Particularly since we are in a low interest rate environment, Dave might consider investing in a deferred annuity, where each year he deposits dollars to build up tax-deferred retirement capital; wealth he can then convert into an income at age 65. Although he can buy a new annuity each year, he doesn’t necessarily need to since a deferred annuity typically credits interest at current rates. And, deferred annuities have options as to how the money will eventually be distributed. Dave annually deposits money into his deferred annuity, and then at age 65 he could either take a fixed payout for life or withdraw a percentage of his annuity each year. This strategy gives him peace of mind that he’s replacing the income he loses when his buy-out is completed, yet gives him options as to how and when he receives income thereafter.     
  2. Ladder the payout of annuities: A different laddering strategy would be to target multiple payout periods. My friend is very active and wants to enjoy the “go-go” period of his retirement before it becomes a “slow-go”. He could take some of his capital and buy an annuity that pays out a significant income from 65 to 75, his hoped for “go-go” years. He could then buy a different annuity that doesn’t begin payouts until age 75, and is designed to pay out for the remainder of his life. This provides him with a higher income during his active years; and, then an income, albeit smaller, that he can’t outlive in his later years. 
  3. Annuities as a health care safety net: One of Dave’s concerns is the increasing cost of health care and the staggering cost of long-term care facilities. Annuities aren’t designed to replace Medigap and long-term care insurance, but they can provide an affluent retiree with a safety net. Even though Dave has a significant retirement fund built up, he is especially worried about having enough money for health costs in his later years when he might be committed to a long- term care facility. An annuity can provide an income supplement. One form of an annuity may be particularly helpful: a deferred income annuity. Consumers are generally familiar with deferred annuities, where they put money away now in order to take out an income in the future (the approach discussed above). These products typically credit current market rates, are flexible as to when they are annuitized and offer the ability to be surrendered. Not as many people are familiar with deferred income annuities. With this policy form, you put away money now and will receive a fixed income for a predetermined period of years at a designated future date. Because the owner can’t surrender or commute the annuity, the insurer is able to pay a higher income in the future. Dave might peel off $100,000 of his retirement capital today to receive a guaranteed lifetime income in the range of $30,000 when he attains age 80. This income would be there to provide a safety net in case he has unexpected health care costs, or should Social Security and Medicare fail to perform as planned. 
  4. Convert an asset into an annuity: The decision to purchase an annuity doesn’t exist in a vacuum. People near retirement typically have a number of financial assets at their disposal which can be turned into a stream of annuity payments. For example, Dave’s

    401(k) can be paid out in the form of an annuity for life. In fact, on July 1 the Treasury issued final regulations amending required minimum distribution rules to allow annuity investors to start collecting later. Even the IRS recognizes the retirement income value of this strategy. Dave also has a cash value life insurance policy. If he feels he no longer needs the death benefit of the policy, he can exchange the policy tax-free for an annuity. Likewise, he can convert his Roth IRA into a guaranteed stream of tax-free payments for life. 

The sole aim of a retirement income strategy cannot be simply to maximize retirement income. There are too many variables to even accurately make this calculation, and how will you ever know if you succeeded?  As my friend Dave’s situation makes clear, intangible concerns such as peace-of-mind must also factor into the planning. There is no one approach that solves this dilemma, but the use of annuities in retirement income planning is a strategy worth considering.