If you asked a hundred financial advisors about what they use to construct retirement strategies, you would surely get as many opinions as there are flavors of ice cream.
Many portfolio strategies today call for strategic mixes of equities and bonds. Lots of research is on the so-called 60/40 portfolio, made up of 60% equity assets and 40% bond assets.
The problem is that bonds are particularly vulnerable to interest rate risk, which is the danger of an asset losing value when interest rates rise. And with interest rates sitting at basically zero percent for the foreseeable future, the only direction they can go is up.
This isn’t to say that bonds don’t have a place in a retirement income strategy. But there is also the flip-side to consider.
Do you really have all options on the table if your advisor leaves annuities out of the conversation? Unlike bonds of any sort, annuities are unique in that life insurers include estimates of people’s expected mortality into their payouts.
The Big Income Advantage with Annuities
Every annuity payout is backed by an actuarial estimate of how long the insurer expects to pay an individual annuity policyholder — and how much. The insurer builds this calculation into every annuity payment it guarantees.
The life insurance company is better able to manage its risks this way. It spreads these risks out across a pool of thousands of policyholders. While some policyholders will outlive the expected mortality that the insurance company estimates, other policyholders may pass away sooner.
The excess monies from early annuity policyholder deaths help offset the insurance company’s overall risk of meeting its obligated payments to the payment recipients. Actuaries and insurance professionals formally call these situations “mortality credits.”
Bonds simply don’t have this same level of risk management. This is one of many reasons why annuities have a monopoly on guaranteed lifetime income over other asset types.
Bonds vs Annuities for Lifetime Income
Dr. Pfau is one of today’s leading researchers on retirement income. He is an author on the “safety-first” school of retirement thought.
In the Forbes column, Pfau looks at the retirement income prospects of a 65-year-old woman.
The analysis compares different income-producing assets for a fixed spending amount, not for inflation-adjusting income. That could be addressed by additional strategies with other assets working in a portfolio.
Pfau calculates a lifetime fixed payout from a $1 million annuity policy will give her a guaranteed income of $57,800 per year.
The alternative? A 50/50 portfolio with a split-even allocation to stocks and bonds. He assumes a 6% return and a 10% standard deviation.
If she and her advisor aimed for a 90% probability that her portfolio would last her to age 90, she would only be able to spend $47,746 of income per year.
To receive the same level of income as from the annuity, her 50/50 portfolio would otherwise need $1.21 million in assets. Or in other words, she would need 21% more money for the bonds than what she put into the annuity policy.
What About Until Age 100?
What if our retiree wanted to make sure that her portfolio lasted her to age 100? Let’s say that she and her advisor aimed for a 95% chance that it would go until she reached 100.
In that case, she could only spend $40,394 of income per year. And what would she otherwise need if she wanted the same level of income as the annuity paid for that period?
She would require $1.43 million in her portfolio — or 43% more money than what was in the annuity.
Pfau also recognizes that if our retiree weren’t as worried about longevity risk as before, the 50/50 portfolio strategy could come out on top.
If the retiree wanted only a 75% chance that her money in a 50/50 portfolio would last to age 90, then she could draw $60,421 of income per year.
That is above the $57,800 per year from the one-million-dollar annuity policy. But it also doesn’t carry the same level of confidence for success as the before situations did.
Don’t Insurance Companies Use Bonds to Support Annuity Policies?
Yes, life insurers do use Treasury securities, investment-grade bonds, and other fixed-interest holdings in the bulk of their holdings to uphold their promises to policyholders.
So, many people might ask, should annuities be considered if bonds are supporting them? Well, it goes back to that reality that bonds, and bond funds, don’t have mortality credits factored into their payments.
Every annuity payment has that risk priced into it. As a result, the life insurer can oftentimes offer you more income for less money than you might have to use for a bond-laddering or a bond fund-driven strategy.
Fixed index annuities also add another wrinkle into the equation. The superior growth potential in indexed annuities can further increase the annual lifetime payout from the annuity beyond what a fixed annuity could.
What About Variable Annuities?
Variable annuities aren’t quite as safe as fixed or indexed contracts because of their market risk. Why?
Because instead of paying a fixed interest rate or a variable rate like with indexed annuities, the money in variable annuities is invested in mutual fund subaccounts. The subaccounts rise and fall in tandem with the stock and bond markets.
That said, many variable annuities also have income riders that pay a guaranteed stream of payments for life. Virtually all annuities these days offer some form of guaranteed income payments.
Some income riders are better than others. But it’s not hard to find a competitive annuity product in today’s marketplace.
Can an Annuity Help with Your Retirement Income Goals?
Annuities have often gotten a bad rap because many of them come with various types of fees and expenses. This holds particularly for variable annuities.
You will also find that fees and expenses will vary from contract to contract. It’s why careful due diligence of different annuity products for what problem you are trying to solve is so important.
Not only that, the guaranteed streams of income that annuities can pay can’t be matched by an individual investor with any combination of stocks and bonds (at least not without taking a substantial amount of market risk.)
Consult your financial advisor today to see whether an annuity could be right for you.
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