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Retirement Planning with No Children

A reader writes in, asking:

“My wife and I have no children, so we have no desire to leave anything behind when we die. At the same time, it is crucial for us NOT to run out of money before then because there is no backup plan, no kids to move in with if the ‘you know what’ hits the fan and we have another 2008 or worse. Am I correct that this means we should be investing differently, with a safer portfolio than most other boomers?”

For a person or couple with absolutely no bequest motive, yes, it does make sense to make different choices than most other retirees would typically make. Specifically, this sounds like a perfect case for a single premium immediately lifetime annuity.

For those not familiar, such annuities are basically pensions that you can buy from an insurance company in exchange for an upfront lump-sum premium. The single biggest drawback of such annuities is that, once you die, the money goes to the insurance company rather than going to your heirs. But, for somebody with no desire to leave behind an inheritance, this is clearly less of a concern.

That said, there are still some important decisions to be made.

How Much Should You Annuitize?

Even for people with no desire to leave any money behind, it doesn’t make sense to annuitize every last dime. Once you’ve purchased an annuity, you cannot easily sell it to raise cash. So it’s a good idea to keep some liquid savings for unplanned expenses.

In addition, it’s worth noting that stocks do typically have higher expected returns than what you’re likely to get from a lifetime annuity. So after meeting your basic expenses with safe sources of income, you might want to continue to hold higher-risk assets with the rest of the portfolio in order to provide the possibility of higher returns and the higher standard of living that would come with them.

Brief tangent: After determining what level of income you want to ensure, it’s typically most efficient to satisfy as much of that goal as possible by delaying Social Security prior to buying any actual annuities, because the dollar-for-dollar payout that you get from delaying Social Security is meaningfully higher than what you can get in the private marketplace, especially with today’s low interest rates.

Annuitize Immediately Upon Retiring?

The portion of an annuity’s payout that comes from “mortality credits” (i.e., the money from now-deceased annuitants being used to fund your annuity while you’re still alive) increases over time (because people are more likely to die at age 66 than at age 65, more likely to die at 67 than at 66, etc.).

For somebody purchasing a lifetime annuity in his/her early or mid 60s, the portion of the payout that comes from mortality credits would be rather modest in the first several years. Most of the payment would be from interest and the return of principal. See this chart from New York Life (originally found in this Fidelity article), for example:

In other words, for somebody early in retirement, delaying the purchase of an annuity (and holding other low-risk investments in the meantime) doesn’t cost much in the way of forgone mortality credits, and it exposes you to the possibility that interest rates will go up, allowing you to then lock the higher rates in by purchasing an annuity at that time. Of course, it also exposes you to the risk that rates go down even further. (I’ll leave it up to you to decide how likely that is.)

Fixed or Inflation-Adjusted?

Finally, you would have to decide whether you want to purchase fixed lifetime annuities or lifetime annuities with inflation adjustments.

Wade Pfau’s recent research showed that fixed annuities tended to perform better than those with inflation adjustments, but his simulations assumed a 3% inflation rate. While I think that’s a perfectly reasonable assumption, it’s important to note that 3% inflation is hardly a worst-case scenario.

Personally, I think the answer to the “fixed or inflation-adjusted” question should depend primarily on how exposed you are to inflation risk. For example, if you rent your home, you’re more exposed to inflation risk than a retiree who owns his/her home. And if a fixed (non-inflation-adjusted) pension makes up a large part of your retirement income, you’re more exposed to inflation risk than somebody for whom Social Security is the primary source of retirement income.

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  1. I would like to see how many lifetime annuity owners “win” versus how often the insurance company “wins.” Do you think it’s about 60/40 or like 90/10? Obviously the insurance company has to come out ahead but by how much? I’m interested to know your thoughts. Let me know if I need to expand on my definition of “winning.”

  2. Funancials,

    I have no data on what percentage of people come out ahead. But you’re right of course that it must be actuarially advantageous for the insurance company, otherwise they wouldn’t do it. Wade Pfau (in Appendix 2 to this article) estimates that about 15% of the premium goes to insurance company costs and profit margin.

  3. Interesting. I haven’t given this much thought — especially the risks associated with the lack of familial support late in life. So yeah, given the (greatly) reduced need to think of things like the size of the inheritance that you leave behind and the increased risk associated with the lack of a familial safety net it makes sense to be somewhat more conservative in your approach. Of course, if you’re too conservative, you could wind up outliving your assets.

  4. “After determining what level of income you want to ensure, it’s typically most efficient to satisfy as much of that goal as possible by delaying Social Security prior to buying any actual annuities.”

    I’m confused here. Are you saying that one should not purchase an annuity until after one starts taking Social Security? Let’s say one retires at 65 and does not start taking benefits until 70. That would mean 5 years of living solely on an un-annuitized portfolio. Please clarify if I’m missing something.

  5. Larry,

    I’m not talking about timing so much as talking about amounts. That is, I’m suggesting that a person estimate how much safe income they’ll have once Social Security starts (assuming they delay it).

    If that’s enough, then there’s no need to annuitize further — and yes, they would be living on an un-annuitized portfolio for the period until Social Security kicks in.

    If it’s not enough, then annuitizing further would make sense, and it would likely make sense to do that right away (unless, as described above, the retiree wants to make a bet that interest rates will rise sometime soon).

  6. Ah. It was the word “prior” that threw me. But if I can pursue this annuity issue a little further: let’s say from the previous example that the retiree has about 5 years of expenses in relatively safe vehicles like short-term US Treasuries and TIPS, and that amounts to about 50% of his/her total portfolio. In addition, SS will satisfy about 2/3 of their needs if taken starting at 70. Do you still see any advantage to buying an annuity in such a case?

  7. Well, yes, I see an advantage. But I also see disadvantages.

    Buying an annuity to satisfy the remaining 1/3 of needs is certainly safer. But in exchange you give up:
    1) The possibility of leaving an inheritance with that money, and
    2) The possibility of much-better-than-annuity returns that stocks sometimes achieve.

    In this case, we’re assuming that disadvantage #1 isn’t very relevant/important. As a result, it mostly comes down to risk tolerance. The less risk tolerant the retiree is (not in the sense of tolerance for volatility, but in the sense of tolerance for having to cut spending if things go poorly), the more sense it makes to annuitize to cover the remaining 1/3 of expenses.

    Of course, it doesn’t have to be all-or-nothing. The retiree could annuitize, say, enough to satisfy 1/6 of expenses, leaving 1/6 to be satisfied from stocks/bonds/etc.

  8. I heard somewhere that it makes sense to have an annuity only if you think you might run out of money – such as lower or middle net worth amount holders. Is there a case for persons with higher amounts to buy an immediate annuity with part of their assets?

  9. Marie,

    I would agree that lifetime annuities are most useful to those with lower savings-to-expenses ratios. But I think they can be useful to anybody who:
    1) is looking to increase the amount of money that can be safely spent each year per dollar of savings, and
    2) is willing to reduce the amount they leave behind to their heirs in order to achieve #1.

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