Bonds vs. an Annuity in Retirement
To me, the most interesting observation Frederick Vettese makes in his book The Essential Retirement Guide is what to do with the bond allocation of your portfolio at retirement. “It makes sense to liquidate these fixed income investments and buy an annuity.” This seems so logical, but it had never occurred to me before.
The main advantage of an annuity is that it eliminates longevity risk. When the insurance company sets your annuity payments, it can do so based on average lifespans. However, if you invest your money yourself, you have to account for the possibility that you’ll live to be very old. The main disadvantage of an annuity is that its returns are based on long-term bond returns; you can’t get the higher expected returns and inflation protection that stocks provide.
Vettese isn’t the first person to suggest putting part of your nest egg into an annuity. However, what is new to me is the direct comparison to a bond portfolio. To maximize your spending from the fixed income part of your portfolio, it seems like a no-brainer that you should go for the higher payouts of an annuity.
I’ve been thinking about how using an annuity would compare to what I call cushioned retirement investing. The idea of cushioning is to have 5 years’ worth of spending in fixed income and the rest in stocks. Each year you spend from your fixed income investments and replenish them by selling some stocks.
Cushioning protects you if your stocks perform poorly. If this happens, you can cut your yearly spending by a little. This cut creates a fixed income surplus equal to 5 times the cut. At the end of the year, you won’t need to sell as many stocks to replenish your fixed income at a time when stocks are down.
An alternative to cushioning is to just take the amount you planned to put in fixed income at the start of retirement, buy an annuity, and leave the rest in stocks. The stocks will be volatile, but that income volatility will be on top of a solid base of guaranteed income.
I don’t have any good ideas yet for how to quantify the benefits of the annuity plus stocks approach compared to cushioned retirement investing. However, my guess is that the partial elimination of longevity risk might be enough to give the annuity an edge.
The main advantage of an annuity is that it eliminates longevity risk. When the insurance company sets your annuity payments, it can do so based on average lifespans. However, if you invest your money yourself, you have to account for the possibility that you’ll live to be very old. The main disadvantage of an annuity is that its returns are based on long-term bond returns; you can’t get the higher expected returns and inflation protection that stocks provide.
Vettese isn’t the first person to suggest putting part of your nest egg into an annuity. However, what is new to me is the direct comparison to a bond portfolio. To maximize your spending from the fixed income part of your portfolio, it seems like a no-brainer that you should go for the higher payouts of an annuity.
I’ve been thinking about how using an annuity would compare to what I call cushioned retirement investing. The idea of cushioning is to have 5 years’ worth of spending in fixed income and the rest in stocks. Each year you spend from your fixed income investments and replenish them by selling some stocks.
Cushioning protects you if your stocks perform poorly. If this happens, you can cut your yearly spending by a little. This cut creates a fixed income surplus equal to 5 times the cut. At the end of the year, you won’t need to sell as many stocks to replenish your fixed income at a time when stocks are down.
An alternative to cushioning is to just take the amount you planned to put in fixed income at the start of retirement, buy an annuity, and leave the rest in stocks. The stocks will be volatile, but that income volatility will be on top of a solid base of guaranteed income.
I don’t have any good ideas yet for how to quantify the benefits of the annuity plus stocks approach compared to cushioned retirement investing. However, my guess is that the partial elimination of longevity risk might be enough to give the annuity an edge.
I think annuities can play a role but I haven't worked this out either. Here's a thought experiment. Imagine you are single, 90 years old, and have a life expectancy of 4 years. Also assume you have no interest in leaving an inheritance. You really don't know if you will live for another year or 10 years, so it would be prudent to plan for say 10 years (pick a number). Alternatively an annuity can pool longevity risk with other 90 year olds and so can offer you a larger payout.
ReplyDeleteMy point is the benefits of pooling longevity risk with others through an annuity increases as your life expectancy decreases.
My question is you (maybe you could work on this problem), is how can you best optimize for this by shifting to annuities. It seems to me that a 90 year old would be better off having most of their assets in an annuity.
@Blitzer68: Your comments line up with common advice to wait until you're about 75 to buy an annuity. On the other hand, Vettese's argument makes a strong case for choosing an annuity over a bond allocation right from the start of retirement. Maybe the best strategy is to get a modest annuity at the start of retirement, put the rest in stocks, and buy a second annuity with some fraction of the stocks at age 75.
DeleteTo get back to your original post, I like the idea of retiring with a solid base of guaranteed income. I think this base comes from some combination of annuities, fixed income, defined benefit pensions, and government payouts (CPP & OAS),
DeleteI think the best "annuity" out there is CPP. I think there is real value in deferring payments until 70 to increase this payout. I'm not a big fan of using traditional annuity products early on in retirement due to their high costs. Maybe wait until after age 75 to start buying these.
I agree with blitzer68 - his idea of a mix of income sources will work for us. We are fortunate in that my husband's small DB pension and our combined CPP and OAS will cover our necessities - we are saving up for the extras that make life more enjoyable. But if we had to clamp down on spending for a year or more if markets are down for an extended period, we could. I won't go the annuity route - I'd rather the kids got what was left over.
Delete@Theresa: I'd never put all my money in an annuity. But I am considering putting some of it in a simple annuity.
DeleteI also agree that CPP & OAS are the best annuities that we have available. If the powers in Ottawa wanted to really offer some useful pension reform, why not make it possible for anyone to purchase "additional" CPP? Should be a simple to implement, and could be made cost neutral. Of course they would have to stand up to the finance & insurance industry lobby, so I won't hold my breath on this...
Delete@Garth: I suspect that voluntary CPP doesn't solve the problem governments focus on. They worry about those who won't look out for their own futures.
DeleteOK, then make it revenue positive, and use the excess to beef up the GIS etc. It would probably still be a good deal for all... It just seems a shame to see all those "mortality credits" go to waste.
Delete@Garth: Making it revenue positive is an interesting idea. As long as the promised payment levels remain iron-clad so that future governments don't just keep helping themselves to ever large amounts, this might work well.
DeleteAlthough the concept as you note seems to be good, how does the average Joe pick the right annuity. There are too many out there that are too high in fees, and if you do want to leave something to survivors and die out early that could really be unfortunate because all that money is fully gone. Insurance companies who sell these products love them. What does that tell you?
ReplyDeleteAn alternative, again something I don't like but maybe others would is "T-funds". Again a bit high in fees, and make sure you don't get one that pays out more than 6%. It works like an annuity in a way and you deffer the taxes hopefully until you pass away then its not your problem :)
But if you die early you could will it the way you want after taxes of course...
@Paul: Wanting to leave an inheritance definitely changes things. I'm considering the case where you're not planning to leave anything (at least not on purpose). As for the type of annuity, I ignore variable annuities and all other types except for simple life (or joint) annuities with no guarantee period, preferably with some indexing such as a rise of 2% each year. Indexing to inflation would be better, but that appears hard to find.
DeleteAre you referring to T-class funds or target-date funds?
@MJ: Just wondering if you know of any Canadian providers that offer a true indexed to CPI annuity (with no provisos/restrictions about indexation up to some threshold number, like 3%). I've done a little research on annuities but the absence of inflation protection always gives me pause.
Delete@Juan: I don't know of any true indexed to CPI annuities in Canada. The whole area is quite frustrating because insurance companies supply very little information about annuities on their web sites. I think the idea is that you're supposed to talk to an insurance broker or agent who will upsell you to the most profitable possible product.
DeleteT-series or T-class.
ReplyDeleteI found this definition on line.
I originally heard about these from an advisor who got tipped off by a real estate agent that my dad had died and my mom had some money from her downsizing her home. He showed up out of the blue on her doorstep and tried to talk her into one of these. (one of the many reasons I have great distrust in the "advisor" industry, some are like vultures circling) Huge MER's and and trailer fees if you got out early.
http://www.fundlibrary.com/features/QuestionAndAnswer/page.asp?id=14863
@Paul: These funds look like the usual mutual fund garbage to me. The carrot is the steady income stream that partially comes by giving you your own money back. This creates the illusion that you're not spending principal when you actually are.
DeleteAgreed. I'm just pointing out if you want to throw your money away, there are different ways to do it. IMO an annuity is the same garbage, with a different container, that carries a different kind of risk.
ReplyDeleteIf you live to 90 depending on how its structured, maybe you win. If you retire at 65 die at 69 you certainly can lose, and so can your survivors. The one issue I see as we age is we may not make the best future decisions. Setting the table far in advance and whatever your strategy is that your comfortable with and protects your families wealth, will be very important.
@Paul: My main point in this article is that a simple annuity is less risky than owning bonds due to eliminating longevity risk, assuming you're not concerned with the inheritance you leave behind.
DeleteGail Bebee left a comment on one of my mom's posts about annuities:
ReplyDelete"This article I wrote about annuities last year provides more information about annuities.
Of note, true inflation protection is not available. Rather, you can choose an annuity that increases by a fixed amount annually, up to 4% for registered annuities. And this option is expensive."
http://cawidgets.morningstar.ca/ArticleTemplate/ArticleGL.aspx?culture=en-CA&id=690354
@Robb: I remember that Standard Life used to mention a CPI-indexed annuity, but they've been gobbled up by some other insurance company and I don't know of any other such annuities.
DeleteThe following isn't directed at you, Robb, but
I get irritated by the number of people talking about indexed annuities saying something like what Gail Bebee says: "this option is expensive." Of course your starting payments will be lower if they are to rise by 2% or so each year. Are these people claiming that the reduction is more than can be justified with a proper actuarial calculation? I don't think so. I think they are literally just looking at the two starting payments and choosing the larger one. This will work fine until inflation decimates the value of the fixed annuity payment.
Hi Michael, I agree that people will likely fixate on the starting amount and ignore that the indexing component will likely surpass the fixed amount (eventually). I find that people are also overly pessimistic about their life expectancy (or believe they will get hit by a bus the day after buying an annuity).
DeleteI will have to read this book. I have been thinking about annuities as a replacement for part of my fixed income bonds since reading the book Pensionize Your Nest Egg around the time I retired just under 2 years ago. My needs and situation seem suitable.
ReplyDeleteI have bonds now, no need to leave an inheritance, my spouse has a DB pension, and I would like to create some steady cash flow, ideally with inflation factor, and limit longevity risk. In time I could also consider adding to annuities.
It would be nice if there was more information readily available. I think you're right Michael the companies want a sales person to call instead.
@RBull: If you sort out whether it makes sense for you to get an annuity, you'll have to come back and let me know. I suspect an important part of the answer will come from the numbers of the annuity payouts.
DeleteIf I do I'll be certain to let you know. Yes, the payout is really the major consideration. I'm pretty much sold on taking something like 15-20% of holdings for an annuity at this time if the numbers make sense. We are planning to apply for earliest CPP in ~3 yrs so will have some additional cash flow there.
ReplyDelete@ RBull The best paying annuity you can buy is delaying CPP and OAS to the max. Nothing else comes close. Doing so will allow you to "safely" spend down your nest egg in the interim...
DeleteHere is a link to an article by retirement expert and researcher Wade Pfau about delaying Social Security...the same arguments apply this side of the border.
Deletehttp://www.forbes.com/sites/wadepfau/2015/11/17/social-security-the-best-annuity-money-can-buy/#7f8e44264d68