Are people better off using annuities to fund their retirement spending? You will find few questions more hotly debated in the retirement planning industry. People on both sides of the argument have strong opinions that are unlikely to reconcile anytime soon. Advocates for annuities argue that immediate annuities should be used for a retiree’s fixed expenses because they are “safe” and don’t fluctuate like the stock market.
They also argue that annuities are a good longevity hedge if a person is worried about living too long. On the other side, people argue that immediate annuities are over-priced and any arguments in their favor are likely based on unrealistic assumptions. They also point out that inflation can erode the purchasing power of a fixed stream of payments to the point no longer supports the lifestyle it was intended to provide.
When I meet with conservative clients and prospective clients, the question of whether or not to use annuities to lock in some or all of their retirement spending needs comes up frequently. They usually ask about immediate, joint life fixed annuities in particular as they simply want all portfolio fluctuation off the table and to “lock in” their most important fixed expenses now.
A guaranteed stream of fixed payments for as long as one of them is still around to receive them sounds appealing; it makes people feel safe. But with all things in finance, this safety comes at a cost – likely in the form of lower spending, less flexibility, and the inability to leave a legacy to your heirs. Are these disadvantages too great of a price to pay for the safety of a guarantee?
I decided to research the subject myself by creating several scenarios in our financial planning software. My aim was to compare buying an annuity to simply investing in a conservative portfolio (90% bonds, 10% stocks) and withdrawing from that. In all scenarios, I used a married couple, both age 65 with $1,000,000 of investable assets.
The couple has $50,000 in yearly fixed expenses they need to cover. When it comes to “being conservative’” and achieving a spending goal like this with a high degree of certainty there are really three different options:
- Buy an annuity – in this case, a Joint Life Single Premium Immediate Annuity
- Plan to fund a conservative portfolio and an overly conservative probability of success
- Plan to fund a conservative portfolio with a reasonable probability of success
For the second and third options, we assumed a person would need the services of a financial planner/advisor and included a typical 1% advisor fee accordingly. We also accounted for mutual fund expense ratios of .30% in our calculations as well. We did not adjust the portfolio withdrawals for inflation in order to make an apples to apples comparison between withdrawing from a portfolio and a fixed annuity.
Which option makes the couple better off? The answer, as with all financial planning questions is, it depends. In this case, it depends a great deal on their life expectancy. How long are they going to be around to receive their guaranteed annuity payments? Let’s look at a couple examples.
Example 1: Life Expectancy 89
According to the Social Security Administration’s Actuarial Life Tables, a 65-year-old male has a life expectancy of 83; a 65-year-old female has a life expectancy of 85. However, their joint life expectancy is higher than that, and since the annuity pays as long as one spouse still remains, joint life expectancy is what matters as far as deciding whether or not to annuitize.
A male has a 21% chance of making it to age 89; a female has a 33% chance of making it to that age. That means there is around a 54% probability that at least one of them makes it to this age. So although neither individual would expect to live that long themselves, there is a greater than 50% chance one of the two is still around (and receiving annuity payments) at that age. By age 90, the probability that at least one person remains is only 47% – meaning more often than not, neither person is still around at age 90. That is how I arrived at age 89 for the lower life expectancy to use in my analysis – it is the highest age a couple could rationally expect to still be receiving payments according to the Social Security Administration’s actuarial tables. The results are summarized in the table below:
Joint Life Single Premium Immediate Annuity
In this scenario, the couple took $1,000,000 and bought a joint life single premium immediate annuity. As an example of what $1,000,000 could purchase as far as a stream of annuity payments, I referred to Charles Schwab’s income annuity estimator, which estimated this couple would receive around $53,784* per year as their payout for this type of annuity. They will not have to deal with the ups and downs of the stock market.
They are guaranteed to cover the $50,000 in fixed expenses they want to cover for the rest of their lives. However, they will leave nothing to their heirs. Some different types of immediate annuities provide a refund provision that provides the possibility of leaving a legacy if you die early. However, there is a cost to having that option, usually in the form of a lower payout.
Conservative Portfolio and Conservative Planning:
Suppose they didn’t buy an annuity but instead invested their assets in a conservative 10% stock / 90% bond portfolio. I used such a conservative portfolio because the clients want to make sure they have $50,000 to spend every year without much fluctuation in their portfolio or spending. We ran Monte Carlo simulation and targeted a very (unreasonably) high probability of success of 95% to see how much they could spend from their portfolio with an extremely high level of confidence.
It is important to note, in the simulations we run in our planning software roughly 25% of the simulated portfolio returns included are worse than we have ever experienced in history. A plan that funds the vast majority of these pessimistic simulated outcomes that were actually worse than we have ever experienced before is probably overly conservative. For that reason, we would never recommend someone target such a high probability of success. But just for the sake of argument and run to an illogically conservative extreme, we’ll show the results.
If they chose to do this, they could spend $53,800 every year and leave a median legacy of $339,000. They would not have to worry about the possibility of needing to decrease their spending, even in a bad bear market. They would also have the ability to make adjustments to their spending down the road in case life circumstances change.
Even though their spending would most likely never need to change their probability of success is so high, a person still has to see their investment portfolio fluctuate slightly. They may also be sacrificing spending or other retirement goals by being so pessimistic in their planning.
Conservative Portfolio and Reasonable Planning:
I have to again emphasize – it is somewhat irrational to target such a high probability of success like 95% when building financial plans – it is overly pessimistic and will likely result in the clients needlessly sacrificing during their retirement. It is much more sensible to target somewhere in the 75%-90% range for a probability of success to balance the risk of falling short of your goals with the risk of needlessly sacrificing lifestyle.
For this reason, I ran another scenario and targeted a probability of success of 80% to see how much the couple could reasonably expect to spend from their portfolio. Keep in mind, in the simulations we run roughly 25% of the simulated outcomes includes investment returns that are worse than we have ever experienced in history – we are still funding a lot of those pessimistic simulated outcomes. Moral of the story, this is still somewhat conservative spending.
The result was $57,500 of spending, almost $4,000 per year higher than the annuity. Not only that, they would also be expected to have a median legacy of $175,000 to leave to their heirs.
In this case, the couple can spend more than an annuity with even as little as 10% of their money in the great companies of the world and reasonably conservative financial planning. They have a high chance of being able to spend even more in the future due to the conservative nature of our planning process (remember they have an 80% probability of exceeding their goals).
Even though this portfolio is conservative with only 10% of the client’s money invested in stocks and the rest in bonds, it will come with some fluctuation. This means the clients will need to be open to making slight adjustments if a bad bear market rears its ugly head. When I looked at how the plan would be impacted by a severe bear market, the clients would theoretically need to be willing to temporarily cut their yearly spending by around $3,000 in order to get the plan back into the comfort zone (75-90% probability of success). It is important to note they would still be able to cover their fixed expenses of $50,000 even if this were to occur.
Conclusions: Life expectancy 89
As you can see the difference in lifestyle between buying an annuity and withdrawing from a conservatively invested portfolio shows up in differences in spending and the ability to leave a legacy to your heirs. Even with unreasonably conservative financial planning, the couple can spend more than the $50,000 they want from their portfolio but with the flexibility to make adjustments down the road and the added benefit of a large legacy left over for their heirs. It is also worth noting a life expectancy below 89 would likely result in higher spending or a larger legacy and provide the approaches that withdraw from a conservative portfolio with even more of an advantage relative to an annuity.
Example 2: Life Expectancy 100
A male has around a 0.9% chance of making it to age 100, a female has a roughly 2.7% chance of making it to that age. That means there is a little over 3.6% chance that one of them makes it to this age. Call them the very, very lucky ones. It is irrational to expect a couple to live this long, but considering extreme longevity is one of the main concerns for people who consider buying an annuity, I decided to take a look. The results are below:
Joint Life Single Premium Immediate Annuity
As in the above scenario, they are guaranteed to receive $53,784 per year for their fixed expenses. The sample client will not have to deal with the ups and downs of the stock market. They are guaranteed to have the $50,000 they want to spend the rest of their lives. They leave nothing to their heirs and are not able to adjust their spending to respond to life’s changes.
Conservative Portfolio and Conservative Planning:
If they chose to take this route, they could only plan to spend $44,000 every year, far short of their requirement of $50,000. Though their spending will likely go up over time due to conservative nature of our planning process, because of the low initial spending amount this does not seem like a viable option. Keep in mind, this is also in part because they decided to be so conservative in their financial planning, the fact that they leave so much to their heirs is evidence of this. This is money they could have spent themselves.
Conservative Portfolio and Reasonable Planning:
Since it is pretty unreasonable to shoot for 95% certainty, people would probably be better off targeting something more reasonable like the 80% we used in the last example. In this case, they are still only able to spend $47,500 to begin with. Due to the conservative nature of our planning process, this number would likely go up over time, and they would also have the ability to make adjustments to their spending down the road. But considering the spending starts out below their $50,000 threshold, this option is probably not going to work. They would also have to be comfortable with temporarily reducing their spending by around $3,000 in the event of a bear market, something I doubt they would be able to accept in this case.
Conclusions: Life expectancy 100
When it comes to the extremely unlikely situation that at least one of the two members of a couple lives to age 100, the strain of many years of expected withdrawals on a conservatively invested portfolio makes it difficult for this option to compete with the guaranteed payments of an annuity as far as yearly spending. Does that mean annuities are a good or bad bet considering you have to live to such an old age for them to be advantageous? It is tough to say.
Final thoughts
I was having a conversation with my brother about after he reviewed my first draft of this blog and he kept asking me about longer and longer life expectancies because that’s one of the things people who annuitize are the most concerned about. At a certain point I responded with “well if the person lives to be a million years old the annuity will look pretty good.” Extreme example, but you get the point – when something guarantees payments until you can no longer receive them, the longer you stick around to receive those payments, the better the deal you received.
You are probably going to have a better estimate of your life expectancy than anyone else based on your health and family history. This number can allow you to work with a financial planner to see objectively how using an annuity applies to your particular situation. The decision to annuitize is one of those “it depends” financial decisions. There is no one size fits all, only what works for you. Beyond the objective, numerical aspects of the decision, your decision will also depend on emotional factors like your need for certainty in income, the desire to leave a legacy, and the preference for flexibility in your financial plans.
That is why when it comes to the decision to annuitize, as with all important financial decisions, the only strong recommendation I can give is to make sure you talk to a financial advisor and find out what is right for you!
Disclaimers:
Examples are for illustrative purposes only and do not represent a specific recommendation. Before making any financial decisions you should conduct your own due diligence and consult your own financial advisor or another financial professional.
All life expectancy data is based on the Social Security Administration’s actuarial life table available here: Social Security Administration Actuarial Life Table
*Annuity payout estimate is taken from Charles Schwab’s income annuity estimator available here: Charles Schwab Income Annuity Estimator
1: $53,800 is the amount of spending that provides a 95% probability of funding the spending goal when all funds are invested in a 90% bond, 10% stock portfolio (expected return: 5.6%; standard deviation: 3.95%) with an expense ratio of .30% and an advisory fee of 1% for 24 years. The median legacy value of this spending strategy is $339,000.
2: $59,000 is the amount of spending that provides an 80% probability of funding the spending goal when all funds are invested in a 90% bond, 10% stock portfolio (expected return: 5.6%; standard deviation: 3.95%) with an expense ratio of .30% and an advisory fee of 1% for 24 years. The median legacy value of this spending strategy is $175,000.
3: $44,000 is the amount of spending that provides a 95% probability of funding the spending goal when all funds are invested in a 90% bond, 10% stock portfolio (expected return: 5.6%; standard deviation: 3.95%) with an expense ratio of .30% and an advisory fee of 1% for 35 years. The median legacy value of this spending strategy is $616,000.
4: $47,500 is the amount of spending that provides an 80% probability of funding the spending goal when all funds are invested in a 90% bond, 10% stock portfolio (expected return: 5.6%; standard deviation: 3.95%) with an expense ratio of .30% and an advisory fee of 1% for 35 years. The median legacy value of this spending strategy is $301,000.