How To Add Payout Annuities To The Retirement Mix

With nearly 14 million baby boomers retiring over the next 10 years and having over $4 trillion in assets, there is a strong need for innovative solutions to the financial challenges these boomers will face.

Complex issues such as longer life expectancies, volatile markets, rising health costs and low interest rates require new approaches. These approaches need to integrate investment and insurance products, and provide a comprehensive planning approach to managing retirement income.

What is clear is that lifetime fixed payout annuities will need to be added to the retirement asset mix. What is not clear is the issue of timingwhen to liquidate all or a portion of the investment portfolio and purchase the payout annuity.

Purchase timing is a critical consideration for retirees, for several reasons:

1. The annuity purchaser gives up access to the funds (not withstanding so-called “liquidity” features).

2. The annuity purchaser is locking in a “mortality bet” even though health may change in the future.

3. Interest rates underlying the pricing of fixed payout annuities depend on current long-term interest rates, and “timing the interest rate market” is generally an ill-advised strategy for retirees.

4. Income payments under a payout annuity are taxed at ordinary income rates, albeit with an exclusion ratio when purchased with nonqualified assets.

5. To “buy” the annuity the investor has to “sell” some assets, which has its own market timing and tax considerations.

To see the impact, consider the following: A large study concerning timing for purchasing fixed payout annuities (both level and cost of living adjustment) included review of 2 commonly discussed annuity purchase strategies, plus a variation on a “dollar cost averaging” approach used during the investors accumulation phase.

The 3 strategies reviewed were:

1. Terminal Funding. Invest 100% in mutual funds and delay purchase of the annuity as late as possible. In the study, the mutual funds were 70% equities and 30% fixed income.

2. Partial Initial Funding. Allocate one-third of the investors portfolio to the annuity immediately, and put the balance in mutual funds.

3. Dollar Cost Averaging. Gradually shift from mutual funds into the annuity by purchasing annuity “tranches” over time. In the study, purchases were made over 15 years.

To compare these 3 strategies, the study assumed that equivalent income amounts were paid out during an initial period and that any balance remaining in the mutual fund portfolio was used to purchase the annuity at end of that period (which, in this case, was at the investors life expectancy). The study then compared the amount of lifetime income that the investor could count on for the rest of his or her life.

The results indicate that dollar cost averaging into the annuity is likely to outperform both of the commonly recommended strategies described above, for the following reasons:

The downside risk of running out of money is virtually eliminated by the gradual conversion into the lifetime annuity.

Potential for higher income is retained through significant exposure to the investment market in early retirement years.

Fluctuations in interest rates are “averaged out” as annuity tranches are added.

Significant allocation of an investors portfolio to the annuity is avoided in todays low interest environment.

The cumulative results of annuity purchases create an asset that produces significantly greater cash flow than the comparable bond/money market fund component of the investment portfolio.

The chart compares the 3 strategies by forecasting potential monthly life income in force at the joint life expectancy (in 27 years) of a couple where the male is age 65 and the female is 62 with $1 million in a rollover IRA. The income result is defined as the amount of future lifetime purchasing power the couple is able to guarantee by their joint life expectancy. In each case, the couple receives income that starts at $3,750 per month (approximately 4.5% per year) based on the $1 million rollover. COLA-adjusted annuities are purchased for all 3 strategies.

The distributions of income results are presented as a “bell curve,” with each curve representing the results of a different annuity funding strategy. Results are based on 500 Monte Carlo simulations.

The width of the bell curve represents the range of potential monthly incomes associated with the particular annuity funding strategy. The height of the bell curve represents the relative frequency of the outcomes. Values with a high frequency of occurrence (the highest points in the curve) are more likely than those with a low frequency.

This chart shows that dollar cost averaging dramatically improves the risk-return for the investor. With the majority of results clustered between $3,500 and $6,500 per month of purchasing power (compared to the original $3,750 per month) and a significantly smaller downside risk than the alternatives, the approach provides lifetime income security with lower risk and greater upside potential.

As part of the larger study, a review of the 15-year period ending in November 2003a period characterized by initial high interest rates and generally rising marketwas performed using the same methodology. The results indicate that at the end of the period, the dollar cost averaging strategy produced 36% more lifetime income than the terminal funding approach, and 23% more than the partial initial funding approach.

This study demonstrates that the payout annuity, when used in a coordinated long-term strategy with market investments, provides a unique vehicle for creating income security for the average investor.

Additional research shows that creating income security may, in fact, free up other assets to be invested more aggressively in the market, and with greater tax efficiency. In this way, the payout annuity may prove to be the greatest boon not only to the investor but also to the investment industry.

Jerome S. Golden is president and chief executive officer of Golden Retirement Resources Inc., New York, N.Y. He can be reached at jsg@goldenretirement.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 3, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.