From the April 2008 issue of Boomer Market Advisor • Subscribe!

Annuities and the illiquidity myth

Financial advisors tell me that pre-retirees are more aggressive spenders than retirees. They've not accumulated the necessary amount to fund the lifestyles they want in retirement, but are less willing than previous generations to accept a diminished lifestyle after they stop working. Advisors are then pressured to develop new approaches that can generate more income for those who reach retirement. One approach that's not often used is to ladder life annuities in a retired client's portfolio.

Financial advisors rely on three ways to make money for their retired clients: capital gains, interest and dividends. Life annuities offer a fourth way by pooling mortality risk. Advisors recommend portfolios comprised of 60 percent equities and 40 percent fixed instruments for their retired clients. This obviously leads to a substantial investment in bonds and similar instruments. However, this presents a problem. For example, consider a couple who retires at age 65 in good health and are getting $1,000 a month from a bond investment. In order to get that $1,000 a month for lifestyle needs, the bond must pay 5 percent on an investment of $240,000. Yet this same couple can get a life annuity that pays $1,000 a month guaranteed for as long as at least one of them is alive for $171,400. That frees up $68,600 to be invested in equities without any reduction in the income from the fixed portfolio. If that investment pays 8 percent a year, which is below the average performance for stocks, the investment will be worth $253,800 by the time the couple is age 82. Both men and women in good health at age 65 have a life expectancy that exceeds age 82. By age 90, when there is better than a 50 percent chance that one person in the couple will be alive, that investment will be worth $469,800 if the 8 percent average holds.

Let's compare the two strategies. The first is to keep $240,000 in bonds and make money from the interest. If the bond continues to pay 5%, the investor at age 90 will have $240,000 in bonds and will have received $1,000 a month for 25 years. The couple who bought a life annuity for $171,400 and invested the rest in stocks will have an equity investment worth $469,800 and will have received $1,000 a month for 25 years. This couple will also have ownership of a life annuity that will continue to pay $1,000 a month for as long as at least one is alive.

I think the better strategy is clear. There is, of course, a short term decrease in liquidity and estate value. But how injurious are those decreases? Take a client with assets of $750,000. Even after a $171,400 investment in a life annuity, $578,600 remains. Isn't that sufficient liquidity? If both people die before the $68,600 grows back their estate will indeed be lower. But how much of a problem is that? Those who have a short retirement have less of a chance to run out of money, so they will probably leave some estate anyway. They do take a risk of a smaller estate, but the odds are they will leave a bigger estate. The people who do not annuitize are at greater risk of leaving a smaller estate by constraining their investments in equities. This means they'll keep a larger portion in an investment that does not have the upside potential of equities.

I suggest you re-consider your position on life annuities. For clients who are in good health and want to spend both aggressively and prudently, life annuities can be an important part of the portfolio.

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