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Retirement Planning > Retirement Investing > Annuity Investing

Does Your Client Need an Annuity? Here’s a Formula to Help Decide

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What You Need to Know

  • Annuities provide income payments that are not only higher than investors could generate on their own but also guaranteed for life.
  • Advisors can use a formula to help the client determine if an annuity would fit their needs.

As demand for guaranteed income is on the rise these days, advisors might need to be prepared when clients ask about annuities. These products allow clients to invest a lump sum to guarantee a future income stream, insuring against running out of money in retirement.

Perhaps the first question from a client is, why bother?

As Amy Arnott, a portfolio strategist for Morningstar, writes in a recent column on these insurance products, “because the insurance company spreads risk across a broader pool, it’s able to manage longevity risk and provide income payments that are not only higher than investors could generate on their own but also guaranteed for life (assuming the insurance company is financially sound).”

In addition to this, a client needs to understand they would be moving funds into an annuity from their portfolio or savings, and the decision to do this, once the contract is signed, is “irrevocable” in most cases, Arnott says.

Another question: What kind of annuity should they get, and how much will it cost?

There are Internal Revenue Service limits with certain annuities. For example, Arnott notes, for a qualified longevity annuity contract, which is a deferred annuity funded with retirement assets, a client can convert up to $135,000, or 25% of the account, whichever is less.

Also, the kind of annuity a client should get depends on several factors, and there is a wide variety to choose from. Features, benefits and costs differ.

Other than making sure the insurance company a client uses is solid, there is a formula to determine how much a client will need for an annuity to ensure a certain level of guaranteed income.

Arnott runs down six steps to determine how much a client would need to invest in an annuity. The math is based on purchasing an immediate fixed annuity:

1. Determine monthly spending needs.

Conservatively, determine essentials such as housing, utilities, food, medical costs and insurance. Let’s say spending needs will be $6,166 per month, or $73,992 a year.

2. Subtract monthly income, which includes payments from pensions or Social Security.

Multiply the result by 12 to get an annual number for net spending needs. If the client’s Social Security payment is $2,500 a month, subtract $2,500 from $6,166 to get $3,666. Multiply that by 12 to get $43,992 for net annual spending needs.

3. Divide that result by the client portfolio’s total value.

So if a client has $1 million in a portfolio, the result is 4.4%, which is the withdrawal rate.

4. Determine the safe withdrawal rate.

Although the 4% rule is a standard, often a lower number is “more prudent,” Arnott states. In this case we’ll put a safe withdrawal rate at 3.5%.

5. Next, determine the effective income rate a client can earn on an annuity.

Based on Arnott’s example, if the client wants to receive monthly annuity income payments of about $1,000 in exchange for purchasing a $200,000 annuity, that would become an effective income rate of 6% per year.

6. By using the above math, an advisor can determine what percentage of a portfolio to allocate to an annuity.

In this case it would be the withdrawal rate, which here is 4.4%, minus the safe withdrawal rate of 3.5%, divided by the effective income annuity rate (6%) minus the safe withdrawal rate of 3.5%. This multiplied by 100 provides the percentage of how much of a portfolio should be apportioned to an annuity. In this case, 36%. This would mean moving $360,000 out of a portfolio to purchase an annuity.

The larger the allocation percentage, the bigger the gap that could be filled with an annuity.

In our example, it looks like an annuity would help with spending needs, but the question is whether the client can purchase an annuity that large or perhaps reduce spending expectations.

Although the choice is the client’s, an advisor can use this formula to guide them to the point of determining if they need an annuity.

From there, selecting the type and insurance firm is a more complicated step that will take further research.

Arnott notes, however, that annuities “can play a valuable role in filling retirement-income gaps for retirees who worry about running out of money, value certainty over flexibility, or still find themselves short on retirement assets even after cutting down planned spending.”


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