Retirement Income Annuities Part 2

Last Updated Jul 20, 2011 9:59 AM EDT

Last week I had a post about retirement income annuities and my thoughts on why many investors don't like them. Whenever I post things about annuities, I tend to get lots of emails from people who like them and then take issue with my position.

Well, I thought I would address some of the comments I received from readers on the income annuity issue.

Payouts. A few people thought that my source for the income annuity payment was ridiculously low and wondered where I got it. I got it straight out of the GAO report, which provides an immediate, inflation adjusted income annuity quote for a 66 year old couple. And the payout is about 4.4% on the amount invested.

If you spend any time researching this issue, you'll find that the figure is correct for current market conditions. The reason it is lower than other annuity quotes is because it is inflation adjusted, which is a big deal. Very few insurers will even offer an inflation adjusted annuity because of the risks involved. And inflation is the main risk for retirees who receive fixed annuity income streams. If you can't get inflation protection, you're taking a huge risk that the value of that income stream will be decimated by a period of higher inflation.

Moreover, in today's low interest rate environment, it's a double whammy. Your income annuity payment is depressed by the low interest rates, and because of these low rates, you face a higher likelihood of inflation down the road.

Distribution Rates. If you study historical distribution rates, you'll again find the 4% inflation adjusted figure is a pretty good base distribution assumption. Now, that doesn't mean it will always produce good results. The historical numbers are an educational tool, and of course past performance is no guarantee of future returns. So if you want to take distributions from your retirement account, you have to bear some risk, but in exchange for bearing it, you have the opportunity for upside.

The reality with any 25 or 30 year retirement cycle is that you most likely won't have one distribution rate for your entire retirement. Over any long-term market cycle, you're most likely going to have years with both bad returns and amazingly good returns. So you have to figure out when to lower your distribution to get through a bad cycle and when a good cycle can support a higher distribution.

Moreover, if you only look at the "success vs. failure" rate for portfolios when you run a static distribution rate, you don't get the full story. You have to look at the range of ending account values.

For instance, based on historical market data, if you start at a 4% inflation adjusted distribution from a balanced portfolio, in more than half of the historical cycles the investor would have ended up with double the money he or she started with, all while taking increasing distributions each year. And in many cases investors ended up with three, four and even five times more than their original retirement account balance. That means if you simply used a static distribution rate, many retirees would have left huge amounts of money on the table that could have been used to enhance their lifestyle.

  • I think it's worth bearing some risks of market declines for the chance of improving your retirement lifestyle. But you may not feel the same way.
Finally, some readers cited research that suggests a safe sustainable inflation adjusted distribution rate might be as low as 2.5%. Now, I disagree. But let's allow them their point, and think through this.

Let's assume that a retiree places his entire retirement account in a 30-year US Treasury bond. Those bonds are currently yielding about 4.2%. Let's further assume the investor took an initial distribution of 2.5% of the value of the account and increased that distribution each year by 3% for inflation. When you run those numbers, you see after 30 years the investor has more money than he started with, even though he was taking distributions each year.

While this is a hypothetical illustration and we don't know what inflation will be, a 2.5% distribution rate seems far more conservative than required. Now, of course, the more you crank down your distribution rate, the higher the odds are you won't run out of money. So if you drop it to 0%, you'll be fine.

The whole purpose of retirement income management is to try to maximize your distributions for the market cycle you're in and not significantly increase the odds of depleting your account.

That's why I generally prefer an investment strategy approach as opposed to a fixed product approach. I want the flexibility to respond to what will likely be changing markets and investment opportunities over a typical 25 to 30 year retirement.

Bottom line. Immediate income annuities generate strong feelings from investors on both sides of the fence. You'll have to educate yourself and decide what fits.

Above material is for education and information purposes only and does not constitute investment advice or a complete discussion of the issues identified. Consult your individual advisor prior to making any financial decisions. Past performance is no guarantee of future returns, and all investing involves the risk of the permanent loss of principal.
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 amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.