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Annuitizing as a Backup Plan

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.

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  1. “As I write this, the highest quote for an inflation-adjusted lifetime annuity for a single 65-year-old female is 4.25%. ”

    Mike – Where is the best place to find these quotes?

  2. For inflation-adjusted lifetime annuities, the only place I know to get such quotes is from Income Solutions:

  3. A third strategy after considering an annuity ladder or using annuities as back up “Plan B”
    would be to purchase longevity insurance in the form of a deferred single premium annuity, something that is not that common in the US, but growing in popularity.

    For example, a 65 year old man who buys a deferred $100,000 annuity which does not start payments until he is 85 can receive a far larger payment at that time – IF he is still alive.

    We are considering such a strategy for the future. We already have pension,s and Social Security [deferring collecting], and moderate sized supplemental retirement {IRA} accounts, and my wife is owed a lump sum payout for unused vacation/personal days which we do not need to spend now, so in a few more years when she is 65 or so we will look at the payouts, her health status, etc.

  4. Hi Jim.

    Good point.

    I really like the idea of such products.*

    Thus far though, I haven’t yet seen one that offers an option for inflation adjustments. And without inflation adjustments, there’s still a great deal of risk. To use your example, there’s a heck of a lot of uncertainty about what the (real) value (at 85) will be for the amount of income purchased at 65.

    *In fact I’ve been on a one-person campaign to try to get Vanguard to start offering such a product. I’ve suggested it at each of the last two Vanguard visits during the annual Bogleheads events. And I’ve brought it up online several times. (See this recent Bogleheads thread, for instance.)

  5. Joe Tomlinson says:

    Going from a stock/bond mix to a SPIA is akin to dumping stocks and going to fixed income. A concern I have is this strategy may result in dumping stocks at market lows (like early 2009). Re: longevity insurance, a risk is that you run out of money at, say, age 82 and the income doesn’t start until age 85. I think it’s also worth considering a low-cost VA/GLWB product like Vanguard offers–avoids that age 82/85 gap risk.

  6. *In fact I’ve been on a one-person campaign to try to get Vanguard to start offering such a product.

    Mike : Sign me up for that campaign!

    Our retirement accounts are split between Vanguard and TIAA-CREF, and so far neither has dipped a toe into this new market, but as I mentioned we have a few years until my wife turns 65, which is our loose target for purchasing one of these, especially considering the low current interest rates [otherwise earlier would be better!]. I hope they continue to get more widely available. They could be an annuity that is bought instead of sold!

    Joe Tomlinson makes a very good point: there is no free lunch, no completely risk-less retirement strategy; but the strategy I mentioned reduces longevity risk in a 2nd way, you only have to plan your “younger years” retirement to fund a KNOWN period [to age 85 typically]. This is a major benefit of these deferred annuities.

    You still have to deal with issues such as rising interest rates, or the market break [2008] falling before or just after your retirement date.

    I found this article on longevity insurance in retirement plans VERY interesting:

    It covers the possible role of longevity insurance annuities in 401(k) and IRA plans
    [new tax rules proposed by IRS in 2012], unisex based vs. gender-based mortality tables, the trade-offs between group annuities offered through employers [potentially priced cheaper] and single annuities in the private market, adverse selection, and also [for group plans] the actuarial effect of industries or occupations that predominantly employ men [or, I would add, predominantly women, like many TIAA-CREF customers].

  7. Mike, what is the difference between a period certain annuity and the annuity you are talking about besides the fact that a period certain annuity can go to your heirs if the annuitant dies!? Does a period certain annuity give lesser fixed income compared to the other annuity ?

  8. SJ,

    You might be asking about either of two types of annuities.

    The first is a simple period certain fixed annuity. In other words, it’s not a lifetime annuity at all. It just pays out for a certain period, and that’s it. In other words, it’s a lot like a bond (from an insurance company) except that the payments are (on average) received sooner because there is no lump-sum return of principal at the end.

    Then there are lifetime annuities that also include a certain guaranteed period of payments (e.g., a lifetime annuity with a 10 year guaranteed period, which if you died before the 10 years were up, would continue to pay for the remainder of those 10 years to your named beneficiary). And yes, you’re exactly right that these products will have a lower payout per dollar invested than lifetime annuities without such guarantees.

    For example, I just checked on right now, and for a 65-year-old male, a fixed (non-inflation-adjusted) lifetime annuity would pay 6.8%. If you add on a 10-year guarantee, it only pays 6.54%. Make the guarantee 20 years, and the payout goes down to 5.84%.

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