Finding Retirement Income for “Life”

Many studies show a strong reluctance on the part of retirees to buy immediate annuities, which are simply a series of payments (often monthly) for a certain period of time (such as a retiree’s lifetime, however long or short that may be). On the plus side, immediate annuities typically offer a higher “yield” (interest rate) than you can find on say a 20- or 30-year bond. For instance, a 65-year old Indiana woman who invests $100,000 today (December 2011) in an immediate annuity could receive monthly payments of about $550 for her lifetime.

Alternatively, our hypothetical Indiana resident could buy $100,000 of 30-year Treasury bonds today yielding about 3%, which works out to about $300 per month. Why 30-year bonds? To make a nearly apples-to-apples comparison to the lifetime annuity example, we need to have an investment like the 30-year Treasury bonds to ensure she will have a lifetime of income. Now clearly the small chance exists that she may live past 95, but even then she could simply buy another round of say 10-year Treasury bonds at that point (to cover her to the potential age of 105). But at age 65, a 30-year life expectancy and source of income is probably more than enough.

So let’s compare the two choices side-by-side. Both offer essentially lifetime income (slight nod to the annuity though, since it offers lifetime income). Both are very safe (slight nod to the Treasury bonds, since they are the safest investment out there). Both are very exposed to inflation risk; while the monthly income amounts won’t change during her lifetime, who knows how much the cost of her goods and services will increase over the next 10 to 20 to 30 years? The annuity offers a much higher income level of about $250 more per month, an 83% increase over the Treasury bonds. The Treasury bonds, however, give her much more flexibility in handling an emergency and/or leaving an inheritance for her heirs.

Once she purchases a lifetime annuity, her monthly payments will stop when she passes away, with nothing left for her heirs. Many studies note that consumers view this lack of flexibility with immediate annuities as a “gamble.” If she passes away say two years after buying the annuity, she “loses.” Her payments stop, and she would at that point only have recovered about $13,200 of her original $100,000 investment; nothing would go to her heirs. On the other hand, let’s say she lives 20 years. In that case she “wins,” because she will have received about $132,000 from her original $100,000 investment. Regardless of how long she lives, once she buys her immediate annuity, she cannot cash it in if she needs a chunk of it for an emergency (such as medical bills). She might be able to access a small portion of it, such as 5 or 10%, depending on the terms of the annuity contract; but the bulk of her investment is locked up.

Contrast that lack of flexibility with the Treasury bonds option. She can sell any amount of her Treasury bonds at any point, should an emergency arise. The downside here is that there is no guarantee she will get back her full $100,000. Bond prices rise and fall as interest rates change, and if her emergency occurs when bond prices are down, she may only get back say $85,000 or $95,000 of her original $100,000. Still, that’s a lot more flexibility than the immediate annuity option.

So when it comes to retiree income, it seems the major tradeoffs between immediate annuities and Treasury bonds are these: annuities provide a much higher monthly payment but little flexibility for emergencies or inheritances. Treasury bonds offer nearly instant access to your principal but with lower payments than immediate annuities. So the question comes down to whether you as a retiree want more income (annuities) or more flexibility (Treasury bonds).

Of course, there’s no rule that says you can’t have both. In fact, some mix between the two might be a pretty good alternative. With a 50/50 mix, for example, our hypothetical retiree invests $50,000 in an immediate annuity and $50,000 in Treasury bonds. She would receive monthly payments of about $425 (more than the Treasuries alone, but less than the full immediate annuity) and instant access to $50,000 of her principal should she need it. And she’d potentially have $50,000 to pass on to her heirs.

You can vary the mix, obviously, to meet your income needs as a retiree. Immediate annuities and Treasury bonds each have their individual pros and cons, so there’s no reason to rule either of them out entirely. But likewise there’s probably little reason to put all your eggs in just one basket. Once again in the world of retirement income planning, diversification is usually a wise approach to maximizing your retirement readiness.

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About Mike Wilson

Michael L. Wilson, MBA, CFP®, CRC®, is the owner of Integrity Financial Planning. Prior to founding Integrity in 1998, he worked for two years as a faculty member at the College for Financial Planning in Denver, training other financial advisors. Mike has 10 years of experience in the mutual fund industry, having worked with Fidelity Investments and Invesco Mutual Funds. He holds an MBA in Finance from Baylor University. Learn more about his work at www.integrityplanner.com.
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