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Single Premium Immediate Annuity: Why They’re Useful and When to Buy Them

The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.

Most annuities are a raw deal for investors. They carry needlessly high expenses and surrender charges, and their contracts are so complex that very few investors can properly assess whether the annuity is a good investment.

That said, one specific type of annuity can be a particularly useful tool for retirement planning: the single premium immediate annuity (SPIA).

What’s a SPIA?

A single premium immediate annuity is a contract with an insurance company whereby:

  1. You pay them a sum of money up front (known as a premium), and
  2. They promise to pay you a certain amount of money periodically (monthly, for instance) for the rest of your life.

A single premium immediate annuity can be a fixed annuity or a variable annuity. With a single premium immediate fixed annuity, the payout is a fixed amount each period. With a single premium immediate variable annuity, the payout is linked to the performance of a mutual fund. For the most part, I’d suggest steering clear of variable annuities. They tend to be complex and expensive. And because they each offer different bells and whistles, it’s difficult to make comparisons between annuity providers to see which one offers the best deal.

In contrast, fixed SPIAs are helpful tools for two reasons:

  1. They make retirement planning easier, and
  2. They allow for a higher withdrawal rate than you can safely take from a portfolio of stocks, bonds, and mutual funds over the course of a potentially-lengthy retirement.

Retirement Planning with SPIAs

Fixed SPIAs make retirement planning easier in exactly the same way that traditional pensions do: they’re predictable. With such an annuity, you know that you will receive a given amount of income every year, for the rest of your life — no matter how long you might live. With a traditional stock and bond portfolio, retirement planning is more of a guessing game.

SPIAs and Withdrawal Rates

Fixed SPIAs are also helpful because they allow you to retire with less money than you would need with a typical stock/bond portfolio. For example, even with the low interest rates that prevail as of this writing, according to immediateannuities.com (a website that provides annuity quotes from various insurance companies), a 65-year-old male could purchase an annuity paying 5.88% annually.

If that investor were to take a withdrawal rate of 5.88% from a typical stock/bond portfolio (and continue spending the same dollar amount each year going forward), there’s a meaningful chance that he’d run out of money during his lifetime—especially given the current environment of low interest rates and high stock valuations. That risk disappears with an annuity.

How is that possible? In short, it’s possible because the annuitant gives up the right to keep the money once he dies. If you buy a SPIA and die the next day, the money is gone.* Your heirs don’t get to keep it — the insurance company does. And the insurance company uses (most of) that money to fund the payouts on SPIAs purchased by people who are still living.

In essence, SPIA purchasers who die before reaching their life expectancy end up funding the retirement of SPIA purchasers who live past their life expectancy.

But I Want to Leave Something to My Heirs!

For many people, it’s a deal-breaker to learn that none of the money used to purchase an annuity will go to their heirs.

The relevant counterpoint here is that, depending on how your desired level of spending compares to the size of your portfolio, choosing not to devote any portion of your portfolio to an annuity could backfire. That is, there’s a possibility that, rather than resulting in a larger inheritance for your kids, the decision results in you running out of money while you’re still alive, thereby causing you to become a financial burden on your kids.

Inflation Risk

Another important downside of single premium immediate annuities is that they are exposed to inflation risk. That is, the amount of income that the annuity pays each year is fixed, thereby leaving you with a purchasing power that will be eroded over time via inflation.

It is possible to purchase an annuity with a cost-of-living adjustment (COLA) each year. But that naturally requires paying a higher initial premium. Also, the COLA is a fixed percentage (e.g., the income increases by 2% annually), so you are still exposed to the risk of high inflation eating away at your purchasing power.

Not too long ago, it was possible to purchase a SPIA that had a COLA that was linked to the consumer price index (i.e., the actual rate of inflation), thereby eliminating inflation risk. But in 2019, the last insurance company offering such products decided to stop selling them. Will they be available again in the future? It’s possible, but I wouldn’t count on it.

It’s worth noting that for some people the lack of inflation protection may not be a problem at all. Some people explicitly desire to spend more per year in early retirement than in late retirement. A fixed nominal dollar amount may actually be a good fit for people with such a preference (because it has the effect of front-loading spending, when we measure spending in terms of actual purchasing power).

Annuity Income: Is It Safe?

Because the income from an annuity is backed by an insurance company, financial advisors and financial literature usually refer to it as “guaranteed.” But that doesn’t mean it’s a 100% sure-thing. Just like any company, insurance companies can go belly-up. It’s not common, but it’s certainly not impossible. However, if you’re careful, the possibility of your annuity provider going out of business doesn’t have to keep you up at night.

Check Your Insurance Company’s Financial Strength

Before placing a meaningful portion of your retirement savings in the hands of an insurance company, it’s important to check that company’s financial strength. I’d suggest checking with multiple ratings agencies, such as Standard and Poor’s, Moody’s, or A.M. Best. (Note that each of these companies uses a different ratings scale, so it’s important to look at what each of the ratings actually means.)

State Guaranty Associations

Even if the issuer of your annuity does go bankrupt, you aren’t necessarily in trouble. Each state has a guaranty association (funded by the insurance companies themselves) that will step in if your insurance company goes insolvent.

It’s important to note, however, that the state guaranty associations only provide coverage up to a certain limit. And that limit varies from state to state. Equally important: the rules regarding the coverage vary from state to state.

For example, the guaranty association in Connecticut provides coverage of up to $500,000 per contract owner, per insurance company insolvency. But they only provide coverage to investors who are residents of Connecticut at the time the insurance company becomes insolvent. So if you have an annuity currently worth $500,000, and you move to Arkansas (where the coverage is capped at $300,000), you’re putting your money at risk.

In contrast, the guaranty association in New York offers $500,000 of coverage, and they cover you if you are a NY state resident either when the insurance company goes insolvent or when the annuity was issued. So moving to another state with a lower coverage limit isn’t a problem if you bought your annuity in New York.

Minimizing Your Risk

In short, annuities can be a useful tool for maximizing the amount you can safely spend per year. But to maximize the likelihood that you’ll receive the promised payout, it’s important to take the following steps:

  1. Check the financial strength of the insurance company before purchasing an annuity.
  2. Know the limit for guaranty association coverage in your state as well as the rules accompanying such coverage.
  3. Consider diversifying between insurance companies. For instance, if your state’s guaranty association only provides coverage up to $250,000 and you want to annuitize $400,000 of your portfolio, consider buying a $200,000 annuity from each of two different insurance companies.
  4. Before moving from one state to another, be sure to check the guaranty association coverage in your new state to make sure you’re not putting your standard of living at risk.

*There are some exceptions. For example, you can buy a SPIA that promises to pay income for the longer of your lifetime or a given number of years. But purchasing such an add-on reduces the payout, thereby reducing the ability of the SPIA to do what it does so well—provide a relatively high payout with very little risk.

Simple Summary

  • If you desire a larger “floor” of safe income than you will receive from Social Security (and pension, if applicable), a single premium immediate fixed annuity may be a good idea.
  • Such annuities allow for a higher level of spending than would be safely sustainable from a typical portfolio of other investments.
  • In exchange for this safety, you give up control of the money as well as the possibility of leaving the money to your heirs.
  • Another drawback of single premium immediate annuities is that they leave you exposed to the risk that inflation will significantly erode your purchasing power over time.
  • Before buying an annuity, check the financial strength of the insurance company and make sure you’re familiar with the rules and coverage limits for your state’s guaranty association.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

401k Rollover: Where, Why, and How

The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.

After leaving your job, you’ll have to decide whether or not you want to roll your 401(k) into an IRA.

Comparing Investment Options

Reducing your investment costs is one of the most reliable ways to improve your investment returns. Some employer-sponsored plans offer a satisfactory lineup of low-cost choices. For example, federal employees with access to the Thrift Savings Plan can build an extremely low-cost diversified portfolio without needing to take their money anywhere else.

Many 401(k) plans, however, do not provide their participants with low-cost options. If that’s the case with your employer’s plan, that’s a strong point in favor of rolling the money into an IRA, where you’ll have access to a wide array of low-cost investment options in every asset class.

Lower Fees in an IRA

In addition to potentially limiting you to high-cost funds, some 401(k) plans include administrative fees, whereas it’s easy to find brokerage firms that will charge no annual IRA fees at all.

Between less expensive investment options and lower administrative costs, you may be able to reduce your total investment costs by 0.5% per year (or even more, in some cases) simply by moving your money from a 401(k) to an IRA. That might not sound like much, but when compounded over your whole retirement, improving your investment return by 0.5% can have a significant impact on how long your money lasts.

Roth 401(k) Rollover to Avoid RMDs

If you have a Roth 401(k) account, there is an additional point in favor of rolling it over (into a Roth IRA). Specifically, after you reach age 72 (age 70½ for anybody born before July 1, 1949) you will have to start taking required minimum distributions each year from your Roth 401(k). In contrast, Roth IRAs do not have required distributions while the owner is still alive. So by rolling your Roth 401(k) to a Roth IRA, you can avoid having to deal with RMDs during your lifetime.

Reasons Not to Roll Over a 401(k)

There are, however, a few specific situations in which it doesn’t make sense to roll over a 401(k)—or other employer-sponsored retirement plan—after leaving your job.

Retiring Early?
If you are “separated from service” (i.e., you leave your job, were laid off, etc.) in a calendar year in which you turn age 55 or older, distributions from your 401(k) with that employer will not be subject to the 10% additional tax that normally comes with retirement account distributions before age 59½.

As a result, if you are 55 or older when you leave your job (or you will turn 55 later that year) and you plan to retire prior to age 59½, it may make sense to put off rolling your 401(k) into an IRA until you are 59½. This way, if you need to spend some of the money prior to age 59½, you can do so without having to worry about the 10% additional tax.

Planning a Roth Conversion?
Alternatively, if you currently have a traditional IRA to which you made nondeductible contributions and you are planning a Roth conversion, you may want to hold off on rolling over your 401(k) until the year after you’ve executed the Roth conversion, so as to minimize the portion of the conversion that’s taxable.

Does Your 401(k) Include Employer Stock?
Lastly, if your 401(k) includes employer stock that has significantly appreciated in value from the time you purchased it, you’d do well to speak with an accountant before rolling over your 401(k) or taking distributions from the account. Why? Because under the “net unrealized appreciation” rules, you may be able to take a lump-sum distribution of your 401(k) account, moving the employer stock into a taxable account and rolling the rest of the account into an IRA.

Why would such a maneuver be beneficial? Because, if you roll the stock into a taxable account, only your basis in the stock (i.e., the amount you paid for it) will be taxed as a distribution. The amount by which the shares have appreciated in value (the “net unrealized appreciation”) isn’t taxed until you sell the stock. And even then, it will be taxed at long-term capital gain tax rates (currently, a max of 20%) instead of being taxed as ordinary income.

In contrast, if you roll the stock into an IRA, when you withdraw the money from the IRA, the entire amount will count as ordinary income and will be taxed according to your ordinary income tax rate at the time of withdrawal.

EXAMPLE: Martha recently retired from her job with a utility company. She owns employer stock in her 401(k). The stock is currently worth $100,000. Her total cost basis for the shares is $42,000.

If she rolls her entire 401(k) into an IRA, when she withdraws that $100,000, the entire amount will be taxable as ordinary income.

If, however, she rolls the employer stock into a taxable account, she’ll only be taxed upon her basis in the shares ($42,000). And when she eventually sells the shares, the gain will be taxed as a long-term capital gain (at a maximum rate of 20%) rather than as ordinary income.

Remember, though, that holding a significant amount of your net worth in one company’s stock is risky—especially when that company is your employer. Be careful not to take on too much risk in your 401(k) solely in the hope of getting a tax benefit in the future.

And to reiterate, if you think you might benefit from the net unrealized appreciation rules, it’s definitely a good idea to speak with a tax professional to ensure that you execute the procedure properly.

How to Roll Over a 401(k)

In most cases, rolling over a 401(k) is just four easy steps:

  1. Open a traditional IRA if you don’t already have one,
  2. Request rollover paperwork from your plan administrator,
  3. Fill out the paperwork and send it back in, and
  4. Once the money has arrived in your IRA, go ahead and invest it as you see fit.

When you’re filling out the paperwork, you’ll want to initiate a “direct rollover.” That is, do not have the check made out to you. Have it made out to—and sent to—the new brokerage firm.

If for some reason the check arrives in your own mailbox, don’t panic. But be sure to forward the check to the new brokerage firm ASAP. If you don’t get it rolled over into your new IRA within 60 days, you will (in most cases) lose the ability to roll it over, and the entire amount will count as a taxable distribution this year.

Where to Roll Over Your 401(k)

In terms of where to roll over your 401(k), you have three major options. You can roll your 401(k) account into an IRA at:

  1. A mutual fund company,
  2. A discount brokerage firm, or
  3. A full service brokerage firm.

Rolling a 401(k) into an IRA with a mutual fund company can be a good choice. As long as you make sure to choose a fund company that has low-cost funds, low (or no) administrative fees for IRAs, and a broad enough selection of funds to build a diversified portfolio, you should do just fine. For example, Vanguard and Fidelity have excellent index funds and would be great places to roll over a 401(k).

Your second option is to roll your 401(k) account into an IRA at a discount brokerage firm, such as E*TRADE. Due to the proliferation of exchange-traded funds (ETFs), you can now quickly and easily create a low-cost, diversified portfolio at any discount brokerage firm.

Option #3—using a full service brokerage firm (e.g., Edward Jones)—is one I’d generally recommend against. At these companies, financial advisors will usually try to sell you a portfolio of funds with front-end commissions (a needless cost) or an advisory account with unnecessarily high ongoing fees.

Simple Summary

  • Rolling your 401(k) into an IRA after leaving your job may give you access to better investment options and/or reduce your administrative costs.
  • If you left your job at age 55 or older (or in the year in which you turn age 55), and you plan to retire prior to age 59½, you may want to postpone rolling over your 401(k) until you reach age 59½.
  • If you’re planning a Roth conversion of nondeductible IRA contributions, you may want to hold off on a 401(k) rollover until the year after your Roth conversion.
  • If you have employer stock in your 401(k), before rolling your 401(k) into an IRA, it’s probably a good idea to speak with an accountant to see if you can take advantage of the net unrealized appreciation rules.
  • In most cases, the best place to roll over a 401(k) is a mutual fund company with low-cost funds or a discount brokerage firm that offers low-cost (or no-cost) trades on ETFs.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Monte Carlo Analysis: Understanding What You’re Dealing With

A reader writes in, asking:

“What are the pros and cons of using the Monte Carlo tool for retirement planning?”

I wouldn’t focus so much on the pros and cons of Monte Carlo simulations, because there’s so much variation among how the Monte Carlo simulation concept is applied. Instead, I would focus on knowing what is going into (and coming out of) a specific Monte Carlo tool — or a study based on such.

For instance, what assumptions are being made about returns? Is the analysis using historical mean return as the mean return for each asset class? Or is it making a downward adjustment to account for today’s relatively low interest rates and high valuations? And what type of distribution is being assumed about returns? (For instance, many Monte Carlo tools assume a normal distribution for stock returns, which significantly understates their risk.) And what assumption is being made about reversion to the mean? That is, are the simulations assuming that several bad years in a row increases the likelihood that the next year is a good year? A set of simulations that does include such an assumption will have fewer very bad scenarios than a set of simulations that does not include such an assumption.

And what assumptions are being made about mortality? Are you (and your spouse, if married) assumed to live precisely to your life expectancy but no longer? Or is age at death one of the variables that the simulation is allowing to fluctuate? Or is mortality completely ignored, and the analysis is simply looking at a fixed length of time, such as 30 years?

And what assumptions are being made about spending? Most analyses don’t account for the possibility of spending shocks (i.e., an unanticipated and unavoidable large amount of spending in a given year). That’s fine, but it is important to recognize then that the analysis is leaving out one significant type of risk that exists in real life.

Overall point being, if you don’t know what assumptions are being made by the tool (or if you’re reading a study/article based on a set of simulations the writer performed and you don’t know what assumptions were made), it’s hard to get a lot of value out of the conclusions.

And what metrics are coming out of the simulations? For instance, if the simulations are regarding retirement strategies (i.e., a combination of spending decisions and asset allocation decisions — and possibly Social Security/tax decisions), does the tool give us something other than simply “likelihood of running out of money”? For instance, a few other metrics that are useful to know are:

  • In scenarios in which the portfolio is depleted, when is it depleted (e.g., does the average/median depletion occur 15 years into retirement or 25 years into retirement)?
  • In scenarios in which the portfolio is not depleted, what is the average/median bequest?
  • If the strategy allows spending to fluctuate based on market performance, how much does it end up fluctuating?

(See this excellent paper paper from Wade Pfau, Joe Tomlinson, and Steve Vernon for a more thorough discussion of useful metrics for evaluating retirement plans.)

In short, one Monte Carlo analysis can vary significantly from another. So I wouldn’t worry so much about the pros and cons of Monte Carlo analysis in general, but rather make sure you understand what you’re dealing with when you use a given Monte Carlo tool or read about a Monte Carlo-based study. What types of risk are being excluded from the analysis? And what information is being left out of the output?

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Getting out of the Market in Retirement?

A reader writes in, asking:

“An acquaintance emailed recently to ask input on her portfolio. She said her ultimate goal is to get out of the stock market. This woman and her husband are both retired and in their early 70s I think, with no extreme wealth. I assume they are comfortable enough but live simply and likely need to watch expenses.

When I asked what her concerns were about the market, she replied ‘political objections, volatility, ignorance..lack of control..risk aversion..Would consider investing in something I could believe in..’

Can you point me to any resources (articles, books, charts) that clearly explain why getting out of the market probably isn’t a good idea?

Any thoughts about how to respond to something like this?”

The idea of getting in and out of the stock market necessitates a belief that the market is predictable in the short-term. And it is not.

People are always looking for ways to predict short-term market movements — a reliable such method is basically the holy grail of investing. Of course, nobody ever finds it. For example, here is a well known study that looked at over 5,000 different trading rules and found that they “do not add value beyond what may be expected by chance.”

The best stock market predictor I am aware of is the concept of valuations (which can be measured in an assortment of related ways). It’s useful (though not at all perfect) for longer-term predictions, but essentially useless for short-term predictions. Here’s a recent article from Larry Swedroe on that topic.

But a separate question is whether a retiree might want to permanently get out of the stock market (i.e., not attempting to move back and forth between stocks and bonds at advantageous times, but rather simply electing to have a permanent 0% allocation to stocks).

And that isn’t necessarily such a bad idea, depending on circumstances. Many experts think it’s entirely reasonable (wise even) to prioritize building a sufficient pool of safe assets to fund retirement before allocating any part of a retirement-stage portfolio to stocks.

For example, the following two quotes come from Bill Bernstein’s book The Ages of the Investor.

“As one approaches the end of one’s human capital and hopefully has accumulated enough investment capital to safely offset the expense of retirement living, it makes little sense to put at risk the funds earmarked for retirement living expenses. In other words, once the game has been won by accumulating enough safe assets to retire on, it makes little sense to keep playing it, at least with the ‘number’: the pile of safe assets sufficient to directly provide or indirectly purchase an adequate lifetime income stream.”

“If, at any point, a bull market pushes your portfolio over the LMP [liability matching portfolio] ‘magic number’ of 20 to 25 times your annual cash-flow needs beyond Social Security and pensions, you’ve won the investing game. Why keep playing? Start bailing. After you’ve put enough TIPS, plain vanilla Treasuries, and CDs into your mental LMP, you’re free to start adding again to your RP [risk portfolio].”

Or as many people have quoted him since: “if you’ve won the game, why keep playing?”

When comparing various stock/bond allocations, this 2015 paper/article from Wade Pfau may be of interest. In that paper, we can see that once we look at horizons greater than 20 years, it becomes clear that having some stocks is helpful relative to an all-bond portfolio, in the sense that those stocks will reduce the likelihood of running out of money.

But there are important caveats:

  • Probability of portfolio depletion is not the only relevant metric here. In the failure scenarios, we don’t just care that a failure occurred (i.e., portfolio was depleted), we want to know when it occurred. That is, in the scenarios in which the portfolio is depleted prior to death, it makes a big difference to the retiree whether the depletion occurred 15 years into retirement or 25 years into retirement. And a risky allocation can result in depleting the portfolio sooner than would be the case with a super safe allocation.
  • If the goal is just to maximize spending over their lifetimes in as safe a way as possible, a boring (likely inflation-adjusted) joint lifetime annuity is probably the best tool for the job rather than stocks.

With regard to that first caveat, this paper from Joe Tomlinson may be of interest.

Key questions that could help determine how much of their portfolio should be annuitized (and how to allocate the non-annuitized portfolio) would be:

  1. What type of health are they in (i.e., what type of planning horizon is necessary)?
  2. How much (what percentage of the portfolio) is the couple hoping to spend per year?
  3. How flexible is the answer to #2?
  4. How strong is their “bequest motive” (i.e., desire to leave behind money to heirs)?

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

A Rough, General-Purpose Retirement Plan

For a few years now I’ve been talking about a basic “cookie cutter” sort of Social Security plan (i.e., an approach that works reasonably well in most cases) and about factors that would suggest that a person or couple should make adjustments to such a plan.

I’ve been thinking recently that it might be fun/useful to extend that same type of thinking to a broader range of retirement planning areas. So here’s my attempt to do just that.

And just to be super clear about something that is hopefully obvious given the brevity of this article: there are many, many cases in which the suggestions below would not be the best approach for an actual person, due to their personal circumstances. I have mentioned some of the circumstances that would suggest alternative approaches, but in each of the topics below there are plenty of potential factors that I have not mentioned.

Social Security

If you’re single, delay claiming benefits until somewhere in the 68-70 range. If you’re married, the spouse with the higher earnings record files at 70, and the spouse with the lower earnings record files as early as possible (62 and 1 month in most cases).

Some of the circumstances that would suggest an adjustment to such a strategy include:

  • You are single and are in very poor health (in which case you should file earlier),
  • You are married and both spouses are in good health (lower earner should file somewhat later) or very bad health (higher earner should file somewhat earlier),
  • The lower earning spouse is working beyond age 62 (in which case they should usually wait to file until they quit work or have reached full retirement age),
  • You have minor children or adult disabled children (may be a reason for the higher earner to file earlier), or
  • You or your spouse will be receiving a government pension (could affect the decision in either direction).

Tax Planning (Retirement Account Distributions)

Try to “smooth out” your taxable income over the course of your retirement.

For example, if you retire at age 60 but don’t plan to take Social Security until 70, you have a 10-year window during which your income will be markedly lower than it has been in the past (because you’re retired) and lower than it will be in the future (because neither Social Security nor RMDs have started yet). So it’s likely wise to spend from tax-deferred accounts and likely do some Roth conversions during that 10-year window — with the goal being to shift income from future years (which would otherwise be higher-income years) into the current lower-income years (i.e., smoothing out your taxable income over time).

To be clear, that’s somewhat of a simplification. In reality you want to try to smooth your marginal tax rate — rather than taxable income — over time. That is, if your marginal tax rate now is lower than it will be later, try to shift income from future years into this year. (And it’s key to remember that your marginal tax rate is often quite different from your tax bracket, especially during retirement.)

Spending Rate

Firstly, set aside (in something safe, such as a short-term bond fund) enough money to fund any Social Security delay that will be happening. For example, if you are forgoing $150,000 of Social Security benefits by waiting from 62 until 70, set aside $150,000 in something safe in order to fund the extra spending necessary until age 70. Then, from the remainder of the portfolio, use the IRS RMD table (i.e., “Uniform Lifetime table“) to calculate a spending amount each year. And for years prior to 70, use the same overall age-based approach — with a lower rate of spending the younger you are.

We discussed this overall strategy last year, and you can find a paper here from Steve Vernon that discusses it in more depth. Broadly speaking though, basing spending on RMD percentages has two main advantages:

  • It adjusts spending over time based on portfolio performance, rather than spending a fixed inflation-adjusted amount each year of retirement, and
  • It adjusts spending based on your remaining life expectancy (i.e., it accounts for the fact that you can afford to spend a larger percentage of your portfolio per year when you are age 90 than when you’re age 60).

Circumstances that could suggest an adjustment to such a strategy:

  • You have an unusually long or short life expectancy,
  • Real interest rates are very high or very low,
  • Market valuations are very high or very low, or
  • Your portfolio makes up a relatively small part of your overall financial picture. (For instance if you have a government pension that covers all of your major needs, you can spend from your portfolio at a faster rate, if you so desire — because, unlike many retirees, you would not be in an especially bad situation if you depleted, or nearly depleted, your portfolio.)

Asset Allocation

There’s a huge range of asset allocations that could be reasonable for a retirement portfolio (i.e., the portfolio that does not include the fixed sum that is set aside for the purpose of delaying Social Security).

  • Want a 70% stock, 30% bond portfolio? Go for it.
  • Prefer a 30% stock, 70% bond portfolio? That’s cool too.
  • Want to exclude international stocks completely? Sure.
  • Prefer to have a heftier 30-50% international stock allocation? Knock yourself out.
  • Want to use only Treasury bonds for your fixed-income holdings? That’s reasonable.
  • Prefer to use a “total bond” fund instead? Super.

One key point — something that surprises many people — is that a higher stock allocation (or any allocation decision that shifts things toward more risk and more expected return) tends to result in only a relatively modest increase in the amount you can safely spend per year early in retirement. The higher expected returns are, to a significant extent, offset by the increased unpredictability. (For related reading, here’s Wade Pfau’s 2018 update to the Trinity Study — though of course that has to be considered with all the usual caveats about using historical returns to try to plan for the future.)

The more dramatic impacts of higher-risk, higher-expected return allocations are that they tend to mean more volatility (duh) and a greater chance of either a) leaving a large sum to your heirs or b) increasing spending later in retirement.

Insurance

If you are retired, you probably don’t need life insurance, as it’s likely that you have no dependents anymore. One noteworthy case in which you likely would want life insurance as a retiree would be if you still have minor children or if you have an adult disabled child. Another case in which a retiree might want life insurance is if they’re married and a major portion of their total income comes from a pension with a small survivor benefit amount.

If you are retired you almost certainly don’t need disability insurance. Disability insurance exists to replace income that you’d be unable to earn if you’re unable to work. But if you aren’t working anyway (i.e., you’re retired), you don’t need it.

Health insurance is a must-have. If retiring prior to Medicare eligibility, make sure you have a very specific, well-researched plan for health insurance. The Affordable Care Act makes it possible to get insurance, but make sure you have a good idea of the cost, and make sure you have researched plans to know what they cover — though of course it’s subject to change every year.

Long-term care insurance is a genuine predicament, regardless of what decision you make. If you don’t buy it, you could potentially be on the hook for huge costs. If you do buy it, you might be faced with premiums that rise rapidly and unpredictably. (Other related products to consider are “hybrid” long-term care annuities or long-term care life insurance, but those both have their problems as well.)

Having proper liability insurance (including an umbrella policy, in many cases) continues to be important. In fact, it’s likely more important than at any prior point, given that during retirement you are more dependent on maintaining your assets than you are at earlier stages.

As far as longevity risk (i.e., the risk of outliving your money, because you live well beyond your life expectancy), lifetime annuities (whether immediate or deferred) can provide protection. The downside is that they reduce your liquidity/flexibility, reduce the amount you’re likely to leave to your heirs, and usually come with significant inflation risk. Delaying Social Security provides the same type of protection at a much better cost — and with an inflation adjustment. So purchasing such an annuity generally only makes sense if you are already age 70 and still want additional longevity protection (or if you are already planning to delay Social Security to 70 and still want additional longevity protection).

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Lifetime Annuity: Avoid the Period Certain

A reader writes in, asking:

“Can you please write an article about SPIAs with guarantees of a minimum payout period?”

For those who are unfamiliar, a single premium immediate lifetime annuity (sometimes referred to as a SPIA) is an insurance product where you give the insurance company a lump sum of money (which you cannot get back) and in exchange the insurance company promises to pay you a certain amount of money every month for the rest of your life. In short, it’s a pension that you purchase from an insurance company.

Such annuities are useful because they protect against longevity risk (i.e., the financial risk that comes from living very long and therefore having to pay for a very long retirement).

One thing that stops many people from buying such annuities, however, is the fear that they’ll die soon after purchasing the annuity. For example, if you spend $100,000 on a SPIA that pays you $6,000 per year for the rest of your life, but the rest of your life only turns out to be a couple of years, you will have had a net loss of $88,000.

And that’s why insurance companies offer the option to purchase a “period certain,” whereby the insurance company promises to pay out for at least a given period of time. For example, for a lifetime annuity with a 10-year period certain, the insurance company promises to pay out for the rest of your life but no less than 10 years. (So if you died after two years, the insurance company would continue to make payments for another 8 years to your named beneficiary.)

Of course, because of this guarantee, a lifetime annuity with a period certain will cost more (i.e., will require a higher premium) for a given level of income than you would have to pay for a lifetime annuity without a period certain.

Why a Period Certain Is a Bad Deal

The whole point of insurance is risk pooling. For example, consider 1,000 people who purchase homeowners insurance from a given insurance company. Most of those people will not have their homes destroyed by a fire or a tornado. And that fact — the fact that the insurance company is going to collect money from all of those people without ultimately having to make a huge payout to them — is how the insurance company can afford to make a huge payout to the person whose home is destroyed by a fire.

A key point, however, is that for every dollar that an insurance company receives in premiums, they keep some part of it to cover their administrative costs and to provide profit to shareholders. So only some of the money spent on premiums ultimately goes to pay for claims to people purchasing the insurance product in question. So in general it is unwise to purchase an insurance product unless:

  1. There is risk pooling going on (i.e., many people are going to ultimately get a bad deal so that some people can get a very good deal), and
  2. You need such risk pooling (i.e., you cannot reasonably afford to cover this risk out of pocket on your own).

With a lifetime annuity, risk pooling occurs because some annuitants will die prior to reaching their life expectancy (i.e., the insurance company will pay less than the “expected” amount to those people — which is how it can afford to pay more than the “expected” amount to the people who live beyond their life expectancy).

But if the insurance company is providing a period certain, it knows it must pay out for that entire period. In other words, the annuity then offers no risk pooling for that period. Instead, what’s occurring for that period is just the insurance company gradually paying your money back to you — after taking a piece off the top for profit and expenses — without any actual net insurance effect.

In most cases you would be better off investing the money yourself for the period certain, then buying the annuity at the end of that period. (Of note: if you would be considering a 10-year period certain, don’t buy 10-year bonds. Instead buy longer-term bonds to offset the interest rate risk that you face with the annuity purchase. See this prior article and this Bogleheads discussion for a more thorough explanation.)

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
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