Retirement: A 25% better life

If you’re like most retirees, your money is held in two types of investments: stocks and fixed income. But what if you’re worried about making your money last for a long life? Then maybe it’s time to think about a third type of investment known as life annuities. These products guarantee you regular payments until the day you die. In effect, they give you the security of a do-it-yourself pension plan.

Used properly, annuities have a remarkable ability to help you safely increase your retirement cash flow. They allow you to boost the withdrawals from your nest egg by 25% or more without exposing you to any added risk, according to respected researchers such as David Babbel, professor of finance at the Wharton School, and Moshe Milevsky, professor of finance at York University’s Schulich School of Business, and author of Are You a Stock or a Bond?

Annuities are based on the simple notion that by pooling resources we can reduce the financial risks of old age. One major risk is longevity risk—the surprisingly strong chance that you or your spouse will live an exceptionally long life and thereby run out of money. If you’re both 65 now, chances are more than one in five that at least one of you will still be drawing breath at 95. With traditional investments, you need to throttle down your withdrawals from savings in case you’re one of the lucky few to live exceptionally long. But with annuities, insurance companies average or “pool” individual risks together. This allows the insurers to provide more generous payouts. The long-lasting payouts to a few Methuselahs are offset by the briefer payouts to the many who die younger.

Annuities can make a big difference to your retirement standard of living. Consider a 65-year-old retiree. If he invests only in stocks and fixed income, he can safely withdraw only 4% to 5% from his portfolio each year (with annual inflation adjustments) if he wants to be reasonably sure that he will not run out of money. Life annuities let him increase those payouts substantially because they provide him with the assurance that at least one part of his portfolio will never run dry.

Milevsky says you get the greatest benefit from gradually adding annuities to your investment mix from your late 60s to your late 70s, until you have about one-third of your portfolio in annuities. In the early years, this strategy allows you to boost your safe withdrawal rate from under 5% to somewhere between 5% and 7% (again, with annual inflation adjustments). If you have a moderate-sized $400,000 nest egg, that can add at least $4,000 a year to your standard of living. By the time you reach your mid-70s, you can expect to add an additional 1.5 to 2.5 percentage points to the safe withdrawal rate, Milevsky says. Using a different research approach, Babbel says the potential increased payoff from annuities is 25% to 40% over what you could achieve with a traditional stock and bond portfolio of equivalent risk.

Annuities are most likely to benefit you if you’re a typical middle-class retiree. “[An annuity] is really something that doesn’t make a lot of sense in the extremes, but in the middle it’s very important,” says Milevsky. “Warren Buffett or Bill Gates doesn’t need an annuity. On the other hand, [an annuity] is not going to help the individual that just hasn’t saved enough.” Annuities also don’t make as much sense if you already have an ample company pension plan (since you’re already well covered); if you’re unlikely to live a long life (the payoff comes from living to a ripe old age); or if your priority is leaving money to your heirs (annuity payouts are curtailed by death).

If annuities make sense for you, Milevsky advocates diversifying your portfolio among annuities, traditional mutual funds and insurance products. Each category of investment has different strengths. By your late 70s you should aim to have about one-third of your portfolio invested in each category, he says.

Another approach suggested by the Canadian insurance broker Jim Otar (retirementoptimizer.com) is to use annuities to cover your basic living needs. With essentials covered you can invest the rest however you choose.

Whatever annuity you choose, make sure its payouts are guaranteed for life rather than just a limited term. You buy annuities from an insurance company through an adviser who is licensed to sell insurance products. If it looks like annuities might fit your needs and your adviser isn’t qualified to advise you about them, think about getting an adviser who is. The following are three types of annuities to consider, with current payout rates provided in the accompanying table.

Fixed annuities: These work like a traditional company pension. They pay you a fixed monthly amount for life. By doing so, they provide excellent protection against longevity risk and the risk of a stock market crash. Their only weakness is that their payouts are not adjusted for inflation, so the purchasing power of your payments will dwindle with time.

Many insurers sell fixed annuities and you typically get the best payout rates by buying at an older age. Couples should consider getting “second to die” joint life annuities to ensure good coverage for the longer-living spouse. Consider having the first five or 10 years of payouts guaranteed even if you die—that ensures a minimum return if you die early. But be warned that once you’ve purchased a fixed annuity, your money is committed. You have no account balance to tap into in an emergency.

Indexed annuities: These products are like fixed annuities, but have an added advantage—their payouts are adjusted annually (“indexed” in other words) to cover inflation. The catch is that to compensate for the cost of inflation protection, the initial payout rate on indexed annuities is much lower than for fixed annuities.

In theory, indexed annuities are ideal, because they provide all-in-one protection against the three big risks of retirement: longevity risk, the risk of a market crash, and inflation risk. But despite their theoretical advantages, indexed annuities haven’t caught on in the marketplace. Some experts say you’re better off protecting your portfolio from inflation in indirect ways—for instance, by also holding investments such as stocks, which tend to rise in value with inflation. Other experts say the inflation protection provided by indexed annuities is well worth the cost. “You cut the cheque to the insurance company and then for the rest of your life you don’t have to worry about anything,” says Otar. “You get lifelong income indexed to inflation—no market risk, no longevity risk, no inflation risk.”

Variable annuities: Variable annuities offering a guaranteed minimum withdrawal benefit (GMWB) for life are marketed under such names as Manulife’s IncomePlus and Sun Life’s Elite Plus. They feature a guaranteed payout and the possibility of sharing in stock market gains.

These complex products demand a bit of study. Typically, they guarantee that you canwithdraw 5% per year with no inflation adjustment. This is usually lower than fixed annuity payouts. But they sweeten the deal by also providing “upside” potential for sharing in stock market gains. They accomplish this by embedding a mutual fund within the product and promising to “reset” to a higher guaranteed withdrawal rate if the embedded mutual fund increases in value over a specific three-year period (after deducting withdrawals and fees, of course). You can choose to defer withdrawals—every year you do so increases subsequent annual payouts by 5%. You can even get some or all of your remaining funds out in an emergency, although you must pay redemption fees to do so.

Consumers appear to like the flexible features and GMWB products are very popular. But critics point to the relatively high total fees—about 3.5% a year—that these products charge. They also don’t like the low guaranteed payout rate of these products compared to fixed annuities. Finally, skeptics such as Otar caution that your chances of getting a reset are low. For you to enjoy a reset, the embedded fund would have to rise at least 25% in a specific three-year period to compensate for the drag from withdrawals and fees.

One more thing. When you buy an annuity from an insurance company, you are relying on that insurer to be able to make payments to you for several decades. How do you know if the insurance company will still be around in 30 years? Malcolm Hamilton, an actuary and worldwide partner with Mercer Human Resources Consulting, says the risk of an insurer being unable to pay is limited—but the means of protecting yourself from that risk is also limited. Buying your annuities from a large, well-established, well-capitalized insurance company with a good credit rating helps to increase your safety, he says. So does keeping your annuity purchases within levels guaranteed by the industry-sponsored guarantor, Assuris. It guarantees non-GMWB annuity payments for up to $2,000 a month or 85%, whichever is larger. In the case of fixed-term GMWB products, Assuris protects the guaranteed balance amount up to $60,000 or 85%, whichever is larger. Assuris is also considering what protection it might offer on the GMWB periodic payouts.