With an immediate annuity, you've protected yourself against two risks:
- The longevity risk, which is the risk of living too long, and
- The investment risk, or the risk of getting wiped out by stock market declines
Dividing your retirement savings between these two methods of generating retirement income can cover all the bases. But how much of your retirement savings should you use to purchase an annuity, and how much should you invest for managed payouts or living on interest and dividends? That depends on these considerations:
- How much of your basic living expenses are covered by predictable sources of lifetime income, such as Social Security benefits, pensions, and the annuity? For example, if you'll be receiving a substantial pension from your employer, or if your living expenses are low and can be covered mostly by Social Security benefits, you may have less need for an immediate annuity.
- What's the appropriate balance for you between the protection of an annuity vs. the flexibility you'd get with managed payouts or interest and dividends?
Another strategy to consider is a phased purchase of immediate annuities, where you start at the low end of the above range and end up at the high end of the range. It could work like this: If you retire at age 65, use 25 percent of your savings to buy an immediate annuity, and invest the balance. When you reach age 70, use one-third of your remaining investments to buy another immediate annuity from a different insurance company. And when you reach age 75, use one-half of your remaining investments to buy another immediate annuity, again from a different insurance company.
With this strategy, you give up flexibility gradually as you age. When you get older, you might be less able or willing to manage your investments, it might become more important to have predictable lifetime income, and you also have a shorter period of exposure to inflation. This strategy has another advantage: It diversifies your annuity purchases among three different insurance companies. This spreads your risk of an insurance company going bankrupt and defaulting on your annuity.
If you want to see detailed analyses of strategies that combine immediate annuities and managed payouts, here are two excellent papers you can read:
- Revisiting Retirement Withdrawal Plans and Their Historical Rates of Return, by Chris O'Flinn and Felix Schirripa
- Comparing Strategies for Retirement Wealth Management: Mutual Funds and Annuities, by Gaobo Pang and Mark Warshawsky
There's still more to cover on the subject of using IRAs, 401ks, and retirement savings to generate retirement income. Stay tuned!
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