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GAO Likes Annuities, Investors Don't: Here's Why

The US Government Accountability Office (GAO) recently came out with its Retirement Income Report as a part of its work with the Senate Committee on Aging. In the report, the GAO discusses the need for more retirement income solutions as many Americans enter their retirement years without a good sense of what they're going to live on. While the drafters of the report like the concept of immediate annuities for retired investors, the report itself illustrates why investors don't like or use them much.

The reason many investors shy away from annuities is because they don't produce that much retirement income. Moreover, to create the modest income payments, the investor has to give up ownership of and access to their retirement savings. While the concept of guaranteed income sounds nice, the results for investors are not that impressive and come at a high cost.

Annuity Example. For instance, the GAO report analyzes the inflation adjusted income that could be produced from an immediate annuity for a 66 year old retired couple. The income stream is about 4.4% of the amount invested, meaning if this couple invested $100,000, they would receive about $4,440 a year of income adjusted for inflation for as long as they both live. But, the couple has to give up ownership of the assets (they go to an insurance company), which means they can't take any distributions above the $4,440. Plus, when they die, there's nothing available to pass along to their kids. The insurance company keeps all the money.

Draw-Down Strategies. Compare the annuity payment to another approach the GAO analyzes called a "draw-down" or distribution strategy. With a draw-down strategy, you try to figure out how much you can take out of your retirement portfolio every year and not run a huge risk of depleting your account before you die. What the GAO found was that historically investors had about a 97% chance of not running out of money over a 25 year retirement by using a 4% inflation adjusted draw-down strategy from a diversified investment portfolio. That means if you had $100,000, you would take out $4,000 your first year and increase that amount every year to keep up with inflation.

Now, 97% is not 100%, and you can't simply rely on historical market returns, but it does show you that the historical odds of running out of money using a 4% inflation adjusted distribution are pretty low. And if you keep the money yourself, you get the upside, meaning that if market returns are good, your portfolio could support inflation adjusted distributions above 4%.

  • The reason you start at 4% is to protect you from a bad cycle, particularly at the beginning of your retirement. Over a 25 year retirement, however, it's likely you'll have some good investment cycles, which means that it's likely that some years of your retirement could support distributions of more than the 4%.
  • According to the GAO study, and this is consistent with other research in the field, more than 85% of the historical cycles would have supported a 5% distribution and 65% would have supported a 6% distribution.
Compare those historical odds to the annuity where the initial payout is slightly higher at 4.4%, but can't be more than that because your payment is fixed from the insurance company. So if we get another bull market in stocks, the insurance company keeps those gains, not you. That's the trade-off. For a slightly higher initial payout of 0.4%, you have to give up ownership of your assets and flexibility with your distributions.

That's why many investors don't like or use annuities. The reality is that they may provide a baseline income guarantee, but there's no upside and the investor loses ownership of his retirement account. Plus, one cannot assume there's no risk of default with an annuity because an annuity is backed by an insurance company. While it's not possible to predict the likelihood an insurer would go out of business in a 25 year cycle, many of them almost went out of business a few years ago, but for the grace of the Federal government. And they may not be so lucky next time. Investors have to consider that risk, and it's certainly greater than zero.

The reality is that creating retirement income is a big challenge. You'll have to get seriously educated about the options that are available to you, and what risks you want to bear. I prefer using an investment strategy as opposed to a product approach (like an annuity) because markets are dynamic and change all the time. Strategies allow you to change and adapt to market conditions. Products can lock you into one approach that may not work well for all of the 25 or more years you might be retired.

Bottom line. Immediate income annuities can provide income guarantees, but investors may not like the costs or lack of flexibility.

Above material does not constitute investment advice and is not a complete discussion or analysis of the issues. Consult your individual financial advisor prior to making any financial decisions. Past performance is no guarantee of future returns.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.

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