A new report published by retirement researchers Michael Finke and Jason Fichtner examines the so-called three-legged stool of retirement planning — employer pensions, personal savings and Social Security.
Conventional wisdom suggests that the typical American won’t be able to rely on one of these sources alone to fund a comfortable lifestyle in retirement. But when combined, each leg helps to support the whole.
That framing, Finke and Fichtner warn, no longer holds. Most retirees lack the employer pension leg, and many also have concerns about the future of Social Security and the possibility of benefit cuts. These worries, in turn, create greater pressure when a retiree expects to fund a desired lifestyle from portfolios made up of stocks and bonds.
That said, Finke and Fichtner suggest, today’s retirees and late-career workers have compelling options to prop up the wobbly retirement stool — namely delayed Social Security claiming and the purchase of guaranteed income annuities.
They propose a framework whereby the typical investor would eschew the traditional 60/40 portfolio of stocks and bonds in favor of a 50/30/20 portfolio of stocks, bonds and protected income.
“Retirees can increase the strength of the income leg by adding a lifetime income guarantee that reduces the risk of an unknown length of retirement and provides protection against the risk of low returns early in retirement,” Finke and Fichtner propose.
This approach also takes advantage of the ability to defer tax on gains, they note, while the Social Security leg can be strengthened by bridging spending between retirement and age 70. By increasing both of the income legs of the retirement plan, retirees can gain greater lifestyle security.
Annuities vs. CDs
Finke’s and Fichtner’s analysis includes a number of case studies to argue for greater annuity adoption among the retired population.
First, they consider a healthy 60-year-old woman who has saved $250,000 in certificates of deposit to fund basic expenses after she retires. Her remaining investments will fund more flexible spending goals and her bequest.
“At today’s CD rates and at a 32% combined state and federal marginal tax rate, she can grow her $250,000 to $308,724 by age 67 when she retires,” the authors note. “Then, at retirement, she would like to invest in low-risk investments such as Treasury bonds to create an income to an age at which she has only a 10% chance of outliving her savings, which is about age 100.”
In this situation, the retiree’s “safe” monthly income amount equates to $1,464. Would she be able to spend more with an annuity? In this situation, the answer seems to be a clear yes.
To demonstrate why, the authors consider the minimum income a retiree could create from an annuity purchased for $250,000 at age 60 with income withdrawals beginning at age 67.
“She can spend $2,268 each month with a deferred income annuity and $1,464 if she invests in CDs earning 4.5% until age 67 and then purchases $308,724 of Treasury bonds that mature to provide a stable income until age 100,” Finke and Fichtner find. “In other words, each month she can spend an extra $804, or about 55% more, by investing $250,000 in an annuity years before retirement rather than investing in safe assets such as CDs and Treasury bonds.”
Much of this extra spending power derives from annuities allowing a retiree to spend more each year without the fear of running out of money because an annuity transfers the risk of an unknown lifespan to an insurance company.
“If a retiree is not willing to risk the possibility of running out of savings in old age, they will need to spend cautiously,” they observe. “Pooling this risk through an annuity lets the retiree enjoy their lifestyle without the fear of running out.”
Additionally, the government encourages retirement saving with annuities by offering tax deferral on the growth of assets held within the annuity. Since she purchased the annuity at age 60 and began income at age 67, she received seven years of tax-deferred growth within the annuity. This provided about 10 percentage points of the 55% increase in income.
Freedom to Spend
As Finke and Fichtner detail, prior research shows that the ability to receive a lifetime income guarantee allows retirees to spend twice as much as a retiree with retirement investments of an equal value.
Despite such evidence, many financial professionals still view purchasing additional protected income from a retirement portfolio as a trade-off for potential growth in assets. They also broadly overlook the use of annuity income as a bridge to delayed Social Security claiming.
“While retirees may be excited about the prospect of claiming Social Security when they retire, claiming too early means that a retiree will need to take more money out of investments to fund spending goals for decades,” Finke and Fichtner observe. “Financial professionals can help retirees focus on the benefit of delayed claiming by showing them how much of their future budget will be covered by higher Social Security retirement payments and protected lifetime income from an annuity.”
Showing the percentage of a budget that will be covered by lifetime income sources is an easy way to help clients recognize the value of a strengthened-income approach compared to an early claiming, investments-only approach.
“By increasing the share of wealth allocated to guaranteed income, retirees can address both longevity risk and achieve a more comfortable and enjoyable retirement by feeling the freedom to spend more,” the authors conclude. “Because retirees spend more from the portion of their savings allocated to an annuity — as shown in the example above — they can meet a greater percentage of their income goal from a smaller percentage of their investment portfolio.”
And if growth limitations are a concern, clients could also take greater investment risk from the remaining portfolio since they now have a stream of income that covers less-flexible expenses, allowing them to invest more aggressively to cover more flexible expenses and legacy goals.
Pictured: Michael Finke
© Arc, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to TMSalesOperations@arc-network.com. For more information visit Asset & Logo Licensing.