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How Should Annuitizing Affect Asset Allocation?

A reader writes in, asking:

“If I buy a lifetime annuity after retiring, should that money come out of my bond allocation, stock allocation, or equally from all of my holdings?”

Any of those approaches can make perfect sense, depending on the situation. In short, after annuitizing, you should ask exactly the same questions you would have asked before annuitizing in order to set your asset allocation:

  • How much risk can I afford to take?
  • How much risk do I want to take?

In other words, just like always, you want to figure out what risk level is appropriate for you, then choose an asset allocation that meets that risk level. Once you know the allocation that you want to have after you’ve purchased the annuity, it will be easy to figure out which holdings to sell in order to meet that allocation.

If you were comfortable with your risk level before annuitizing, it’s likely that it makes sense for the annuity to come from the bond allocation. But that won’t always be the case. After all, for many people, the whole point of annuitizing is that they want to reduce the level of risk in their portfolio.

Example #1: Shortly after she retires, Glenda buys an inflation-adjusted lifetime annuity. Between the annuity and her Social Security benefits, she has about $30,000 of safe annual income — enough to satisfy her basic needs, given that she owns her home and has paid off her mortgage. She would like to be able to spend more than $30,000 per year, but she knows she can get by on that amount, if she has to.

Because Glenda can afford to take on a good deal of risk with the rest of her portfolio, because she has always been fairly comfortable with volatility, and because she wants to shoot for high returns, Glenda decides to use a high stock allocation with the remainder of her portfolio. (That is, she uses bond holdings to fund the annuity purchase.)

Example #2: Glenda’s twin sister Gail is in the exact same position as Glenda, but she has always been less comfortable with seeing the value of her holdings bounce around. So, despite having a high economic tolerance for risk, Gail decides to use the same conservative allocation for her portfolio after annuitizing that she used prior to annuitizing — that is, she uses both stock and bond holdings to fund the annuity purchase — thereby resulting in an overall reduction of risk, given that she has transferred a significant portion of her wealth from stocks to fixed income (i.e., the annuity).

Example #3: Tom found himself unintentionally retired at age 62. He held off on claiming Social Security all the way until age 70, but because of a modest earnings history, he still only receives about $15,000 of Social Security per year. He also purchased a fixed lifetime annuity that pays another $8,000 per year. While Tom would have liked to be able to lock in a higher amount of safe income, he felt that he couldn’t afford to allocate any more money to an annuity because doing so would have left him with very little in the way of liquid assets.

Because Tom has a level of safe income that doesn’t quite meet his needs, and because he doesn’t have a very large remaining portfolio, Tom has a low economic risk tolerance. That is, regardless of his emotional comfort level with volatility, Tom cannot afford to take on a great deal of risk with the non-annuitized portion of his portfolio — meaning the annuity should probably come out of his stock holdings or a combination of his stock and bond holdings.

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