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How Do You Know if You Need an Annuity?

Last Monday’s article briefly touched on some of the factors involved in whether or not it makes sense for somebody to purchase a single premium immediate annuity (“SPIA” — essentially a pension from an insurance company) with part of their portfolio. Several readers wrote in with related questions, such as this one:

“My question is related to SPIA and when to buy them. How do you know if you need a SPIA? Example: If you have a $1 million portfolio (60% bonds 40% equity) and you need to take 4% a year out are you a candidate for a SPIA?”

Generally speaking, a SPIA is useful when you want to increase the amount that you can safely spend from your portfolio per year. Said differently, it’s useful when your desired spending level might not be safe, given your portfolio size and given the other characteristics of your situation.

Based on the example the reader provided, there’s no way to know whether the person is a candidate for such an annuity. Much more information is needed. I would ask the person in the example the following questions.

How old are you? What kind of health are you in? Are you married? If so, how old is your spouse and what kind of health are they in? The key point with all of these questions is that the longer your life expectancy — or joint life expectancy — the riskier that 4% withdrawal rate is. If you’re 80 and single, a 4% withdrawal rate is super duper safe. If you’re 55, married to a 52-year-old, and you’re both in great health, that 4% withdrawal rate is quite a bit riskier.

Also, when you say that you “need” to spend 4% per year, what do you mean by “need”? For example, if the portfolio’s returns were poor within the first 5 or 10 years of retirement, how much of a disaster would it be to spend, say, 3% or 3.5% from the portfolio instead? The more flexibility you have, the safer the 4% initial withdrawal rate and the lower the need for an annuity.

And have you already claimed Social Security? If you haven’t, delaying Social Security (especially for the higher earner of the two of you, if you’re married) is a great way to increase your level of guaranteed income, and the payout is much better than the payout from annuities purchased from insurance companies. Conversely, if you’re already age 70 (or are already planning to delay until 70) and you are thinking (due to the factors discussed above) that your 4% necessary withdrawal rate is riskier than you’d like, a SPIA becomes more relevant.

And, speaking of Social Security, how much total safe income do you have? For example, if you’re planning to spend $40,000 from the portfolio per year but you also have $80,000 per year of Social Security/pension income, the impact of portfolio depletion would be much less dramatic than if you have $15,000 per year of Social Security/pension income. And, therefore, holding all else constant, a 4% withdrawal rate is much riskier if you have a lower level of guaranteed income from other sources than if you have a higher level of guaranteed income. (This was the major point of the article from David Blanchett that we discussed last week.)

And how strong is your “bequest motive”? That is, how much do you care about leaving money to heirs? One of the big drawbacks of purchasing a SPIA is that it reduces the size of your portfolio, so if you die soon after purchasing the annuity, your heirs will receive less than they would have received otherwise.

Overall point being: In some cases, a person with a $1,000,000 portfolio who plans to spend $40,000 per year (adjusted for inflation) from that portfolio has absolutely no need for a SPIA. Another person with different circumstances — but still with the same portfolio and still planning to spend the same amount from it — should think very seriously about purchasing a SPIA.

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