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  1. Default How Much of Your Portfolio Should Be in Annuities?

    Should more of your retirement income come from annuities?

    For many of you, part of your retirement income already is delivered as an annuity payment. Social Security is an annuity, providing guaranteed income for life. It also has the bonus of being indexed for inflation.

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    Most economists recommend people purchase immediate annuities with part of their nest eggs. Recent surveys indicate that a high percentage of retirees these days would like a stream of income that is guaranteed for life. Yet, the insurance industry reports that only a small percentage of retirees own annuities.

    There are a lot of reasons why people don’t buy immediate annuities for retirement income.

    Some people don’t want to give up control of their money… and with it the opportunity to earn higher returns. Some don’t want to lose the opportunity to leave something for their heirs. Others don’t like dealing with insurance agents, have heard bad things about annuities, or don’t fully understand annuities.

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    I think most people don’t buy annuities for retirement income because they don’t receive good advice on portfolio allocation. The question many people need to answer is: How much of my nest egg should be in annuities? Another way to frame the question is: How much of my retirement income should come from annuity payments?

    Let’s be clear that I’m talking only about immediate annuities and their cousins, longevity annuities. Each type of annuity is purchased with a lump sum payment to an insurer, and the insurer promises to pay a fixed annual income for life, no matter how long you live.

    The difference is that immediate annuities begin paying income in the year of purchase, while longevity annuities begin paying income in a future year selected by the buyer. These annuities are simple, straightforward, and have low costs.

    Various studies have shown that using part of your nest egg to buy immediate annuities makes your nest egg last longer. That makes sense, since you can’t run out of money when you have some guaranteed lifetime income. Having an annuity also makes it possible for you to take more risks with the rest of your nest egg, perhaps generating higher returns.

    You also might be able to withdraw more from your nest egg each year than you otherwise would, because you know the annuity backstop is there to ensure a minimum of lifetime income.

    The studies generally test having 25% to 50% of a nest egg in annuities. While those studies show the advantages of annuities, they don’t help determine the amount you should put in annuities.

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    A very wealthy person isnít likely to run out of income or assets that can be converted to cash, except under the most dire circumstances. That person doesnít need annuity income. The cutoff for that category depends on your net worth, the composition of your assets (can they be converted to cash easily?) and your standard of living.

    A person with a high level of fixed expenses, especially one whose net worth primarily is in a small business or real estate, has a lot of risk and not much liquidity in his or her assets. That person should consider investing part of the nest egg in annuities.

    Yet, a person with the same net worth who has lower fixed expenses and assets that are easily converted to cash might not need to worry about running out of income. The latter person might not need any annuity income. There are a lot of factors for the wealthy person to consider before deciding whether or not to own annuities.

    At the other end of the spectrum is someone who has barely saved enough to fund expected retirement expenses.

    A person in that situation canít afford to sustain investment losses or a period of low investment returns. That person should consider putting all or most of the nest egg into annuities. (If most of your expected expenses will be covered by Social Security and any other pension income, you probably donít need additional annuities.)

    Some advisors say the person whoís barely saved enough or not enough should invest for growth to try to increase the nest egg. I think that person is better off not taking the risk that investment losses will reduce the retirement fund. He or she needs a reliable income thatís guaranteed to last for life.

 

 

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