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.
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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.