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IRA and 401k Retirement Income: How You Can Get Both Predictability and Flexibility

I've previously written about using immediate annuities and managed payouts to generate retirement income from your IRAs, 401ks, and retirement savings, and each of these methods has their pros and cons. Does it make sense to use part of your retirement savings to buy an immediate annuity, and invest the remainder of your retirement savings for managed payouts? Yes, because this strategy can give you the best of both worlds. Let me show you how.

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
With managed payouts, you've kept the flexibility to tap into your savings for emergencies, and hopefully your investment strategies will help you outpace inflation. And you don't have to use managed payouts for this portion of your retirement savings -- you could also live on just interest and dividends, if that produces enough retirement income together with your annuity income.

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?
That said, there is a range that will work for most people: no less than 25 percent and no more than 75 percent of their retirement savings devoted to an immediate annuity, with the balance invested for managed payouts or living on interest and dividends. A 50/50 split might be a simple answer that works for many people.

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:

In addition, MetLife recently introduced its Retirement Income Selector, a simple tool that can help you decide the proportion of your savings to devote to managed payouts and to an immediate annuity. You answer nine simple questions, and the tool suggests the appropriate balance between these two approaches. I think it's a good way to help you think through the relevant issues. (MetLife does sell annuities so you might think they're biased towards them, but I've found their Retirement Income Selector to be objective and useful.)

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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