Archives for March 2013

As I’ve mentioned before, if I were retiring today, my strategy would be to lock in a sufficient level of safe, inflation-adjusted income to satisfy our basic spending needs. This would be done first by delaying Social Security until age 70 (with a few years of free spousal benefits in the meantime) and, if that doesn’t provide enough income, by buying inflation-adjusted lifetime annuities to cover the balance.

One key point to understand about that plan, however, is that it is largely influenced by the fact that my wife and I have no kids and care very little about how much money we leave behind when we die.

For those with a stronger bequest motive (i.e., desire to leave behind a pile of money) and a sufficiently large portfolio, it sometimes makes sense for annuitization to be “plan B” rather than “plan A.” That is:

• Begin retirement with a typical withdrawal strategy from a typical stock/bond retirement portfolio.
• Keep an eye on how your portfolio value compares to the amount needed to purchase an annuity that would pay the desired level of income for the rest of your life.
• Then, if things go poorly and your portfolio falls to the point where it can just barely fund the purchase of such an annuity, you can buy the annuity at that point in order to prevent things from getting any worse.

The upside of such a strategy is that it gives you the chance to experience a higher level of income (and/or leave behind a larger sum to your heirs) if your portfolio performs well. In addition, like laddering annuity purchases, it leaves more to your heirs if you die early.

How About an Example?

Claire is 65 years old. Her husband is deceased, and she has two adult children to whom she would like to leave something when she dies. She wants to be absolutely sure that her income does not fall below $35,000 per year.

Based on her earnings record, Claire expects Social Security to provide $18,000 of income. She has no pension. In other words, Claire wants her portfolio to satisfy at least $17,000 of spending per year.

As I write this, the highest quote for an inflation-adjusted lifetime annuity for a single 65-year-old female is 4.25%. In other words, it would take exactly $400,000 for Claire to be able to lock in $17,000 of annual inflation-adjusted income with an annuity (thereby giving her the $35,000 total she desires).

If Claire’s portfolio is, say, $600,000, she has no need to annuitize anything right this minute. (And in fact there’s a good chance she’ll never have to annuitize anything at all.) She can invest in a typical stock/bond retirement portfolio and use a typical withdrawal rate strategy. If Claire’s portfolio performs poorly and declines to the point at which she barely has enough to lock in her desired level of spending, she can annuitize at that time.

Important Caveats

This strategy requires that you keep a close eye on things. Not only do you have to watch your portfolio, you also have to regularly get new quotes for annuities. Otherwise, if interest rates decline and you fail to notice, you could find yourself in a situation in which your portfolio is no longer sufficient to safely provide the desired level of income.

In addition, if implementing such a plan, it’s important to go ahead and annuitize when there would still be some liquid investments left over to serve as a source of cash for satisfying unpredictable expenses (i.e., an “emergency fund”).

Finally, it’s worth noting that the psychological difficulty in implementing such a backup plan, should it become necessary, is likely to be immense. If you’re the type who finds annuitizing to be an undesirable idea even when you’d have a decent-sized portfolio left over, it’s going to feel even less desirable when:

1. The necessary annuity will consume most of your net worth, and
2. Buying such an annuity will require selling out of your portfolio immediately after a market decline.

A reader writes in, asking:

“I saw on the Bogleheads somebody mentioned the idea of laddering annuity purchases. Given the irrevocable nature of buying an annuity, buying annuities in chunks rather than all at once seems appealing. What would be the pros and cons of doing so?”

What Are You Doing With the Money in the Meantime?

The primary determinant in how this strategy plays out is how your money performs in the meantime (that is, while you wait before deploying it into an annuity at a later date). For example, is the money invested in I Bonds where it will precisely keep up with inflation? Or is the money invested in a typical retirement portfolio, of which unpredictable investments like stocks make up a significant portion?

Naturally, if your money earns very good returns while you wait to annuitize it, you’ll be better off waiting. And if your money earns very poor returns (e.g., due to a stock bear market), you probably would have been better off annuitizing right away rather than doing it over time.

For the time being, let’s assume that you keep the money in something that keeps up with, but does not outpace, inflation.

When Laddering Annuity Purchases is Helpful

When talking about inflation-adjusted lifetime annuities, the advantages to laddering the annuity purchases — rather than annuitizing a larger lump sum immediately — are twofold:

1. You benefit if interest rates increase over the period during which you’re building your ladder, and
2. Your heirs get more money if you die before the annuity ladder is completed.

For example, if you have $300,000 that you plan to annuitize over a 5-year period ($60,000 per year) starting at age 70, you will benefit from any interest rate increases that occur between ages 70 and 74, because you’ll be buying annuities at those higher rates.

Or, if you die at age 72, only $180,000 of the $300,000 amount will have been annuitized by that point, thereby leaving a significantly larger sum of money to your heirs.

What’s the Downside?

If you do not die prior to the point at which your annuity ladder is completed, you need rates to increase in order to win your bet.

If rates go down, laddering annuity purchases clearly works out poorly (relative to annuitizing all at once at the beginning of the period) because the payout on each of your successive annuity purchases will be based on a lower interest rate than the original annuity purchase.

In fact, even if rates stay the same you lose out by holding off on annuitizing. That’s because, the sooner you purchase the annuity, the more mortality credits you get to collect. (Mortality credits are the portion of the annuity payout that comes from the unused portion of annuity premiums from annuitants who died early, thereby relieving the insurance company of the obligation to make annuity payments to them.)

Granted, at young ages, these mortality credits are small, because few people are dying. (For example, out of a thousand people who have survived to age 60, the vast majority –more than 99% according to the Social Security Administration — will survive to age 61 as well.) But they’re still greater than zero.

In Short…

The decision to ladder the purchases of inflation-adjusted lifetime annuities will tend to be preferable to purchasing them all at once in scenarios in which:

• interest rates go up while you wait,
• you die prior to the ladder being completed, or
• your money outpaces inflation while you wait to annuitize it.