The Annuity Imperative

Retirees and near-retirees often wonder whether they should purchase an annuity to provide sustainable lifetime income — in effect, a guaranteed retirement paycheck — that they cannot outlive. Most do not. That’s often a big mistake. No other financial tool converts lifelong savings into lifelong income as efficiently or as safely.

Since at least the publication of the “Trinity study” (published by three Trinity University professors in The AAII Journal in Feb. 1998), the financial planning community has focused considerable effort trying to create a “safe withdrawal rate” — the amount which may be withdrawn per year for a given period of time, including adjustments for inflation, without leading to portfolio failure.  A “4 percent rule” is the advice most often given for managing this period of portfolio distribution. The analysis commonly assumes something like a 60/40 equities/bonds portfolio with annual returns in the 7-8 percent range, 10 percent volatility and 3 percent inflation.

Such assumptions are highly optimistic, obviously, in that an annual Dalbar study, based upon mutual fund flows, shows that the average investor’s return on stocks is dramatically less than the return of the S&P 500 index. Professionals have similar difficulties in both the equity and credit markets. Nearly everyone tends to buy high and sell low.

Of related concern is that the rule and its variants are explicitly designed to finance a consistent spending plan using a volatile investment strategy.

Consequently, retirees will accumulate unspent surpluses when markets outperform and face spending shortfalls when markets underperform. Moreover, the success of this approach is highly dependent upon portfolio performance early during the distribution period.

Perhaps most importantly, if obviously, a “safe” withdrawal rate is dependent upon what one’s definition of safe is. Most results assume safety as something like a 90 percent success rate over a set period of time, commonly 25 to 30 years. Unfortunately, with the consequences of failure being so high — being destitute at a time in life when vulnerability is at a peak — a 10 percent failure rate hardly qualifies as anything like safe.

Limiting the analysis to a set period of time is similarly deceptive on account of longevity trends. Indeed, according to the Society of Actuaries, there is a 39 percent chance that at least one member of a 65-year-old couple today will live to age 90 and a 15 percent chance that one will live to age 95.

Those statistics suggest that a 25-year plan isn’t remotely good enough for anything like real safety. The reality is that there will be a significant number of catastrophic outcomes using the 4 percent rule. This alleged safe withdrawal rate is anything but.

On the other hand, income annuities are incredibly powerful tools for providing sustainable lifetime income and are almost surely the most underutilized financial asset in the market today. As a Wharton Financial Institutions Center (WFIC) study has shown, annuities can assure retirees of an income stream for life at a cost as much as 40 percent less than a traditional stock, bond and cash mix. As a different WFIC study points out:

“Lifetime income annuities may not be the perfect financial instrument for retirement, but when compared under the rigorous analytical apparatus of economic science to other available choices for retirement income, where risks and returns are carefully balanced, they dominate anything else for most situations. When supplemented with fixed income investments and equities, it is the best way we have now to provide for retirement. There is no other way to do this without spending much more money, or incurring a whole lot more risk coupled with some very good luck.”