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~Buying an Annuity for Retirement~

 

It's probably fair to say that retirees tend to underestimate the significance of having enough diversification in their portfolio so that they don't run out of money as their needs change.

 

For example, annuities are a relatively popular investment vehicle for retirees.  Fixed annuities can offer a retiree a guaranteed stream of monthly income for life.  This is attractive for obvious reasons.  Suppose that one is about to retire and has saved $500,000 for retirement.  Currently, a 62-year-old can purchase a fixed annuity from Fidelity for $500,000 that will pay the retiree about $2700 a month for life (see results here:  https://digital.fidelity.com/prgw/digital/gie/ ).  If this $2700 a month is more than enough to supplement the retiree’s pension and/or Social Security income, then this might be an entirely appropriate choice.  But, one should also consider the implications of this investment decision.  The upside of course is that the income stream from this annuity is guaranteed and will never change.  One of the downsides though, is that at the end of the retiree’s life (assuming they have lived at least 15 years after retirement) they will have nothing left of the original $500,000 to pass on to their heirs or to give to their favorite charity.

 

A well-diversified, conservative portfolio can help address that significant shortcoming.

 

Suppose that instead of buying an annuity, one decided to diversify their income streams in retirement since they already have a “fixed” income source from Social Security and/or a pension.  So, they put their $500,000 into a well-diversified, very conservative portfolio (with almost half of the retiree’s money in very short-term government bonds).  Then they drew “income” from this portfolio each month for the rest of their life.

 

What does history tell us about how this retiree made out?

 

Well, if the retiree lived for another 20 years and was unlucky enough to have invested during the WORST 10th-percentile of all 20-year investing environments since 1972 (during which a lot of bad things happened in the economy) AND had the misfortune of starting retirement during the worst investing year in the 20-year period (ouch), this historical investor would still have been able to withdraw $2700 a month from the $500,000 portfolio without running out of money!  Just like with the annuity!

 

 

But here’s the big difference.

 

This retiree actually had around $300,000 left in the portfolio when they died!  This is despite withdrawing $2700 a month for 20 years!  (see results here:  https://tinyurl.com/yckumxka ).

 

How was this possible?  This is because this very conservative portfolio grew, on average, by more than $2700 a month.

 

And what if the retiree had experienced just AVERAGE investing results since 1972 during their 20-year retirement?  This retiree would have had over $700,000 left in their portfolio when they died – again, this is after withdrawing $2700 a month!  And how about the retiree who purchased the annuity?  How much did they have remaining when they died after 20 years?  Right - zero.

 

The implications of this are remarkable.  This means that the retiree who invested their $500k in the conservative portfolio, and was “unlucky” enough to invest during the WORST 10th-percentile of investing environments since 1972, would have been able to spend an additional $300,000 in retirement!  Or they could have passed that $300,000 on to their children, grandchildren, or to their favorite charity when they died.  What a difference this money could have made in those lives!

 

So one might ask, for the retiree who purchased the annuity, where did the additional $300,000 go?  It went to the company that sold them the annuity.

 

When a retiree purchases an annuity for $500,000, the company invests this money.  The company simply uses the returns (and fees) on the $500k to generate the $2700 a month to pay the average retiree.  So, that’s essentially how an annuity works and that is how the annuity company stays in business (and generates income for its shareholders).

 

It’s not that an annuity is a bad investment for a retiree.  Annuities certainly have benefits.  One is that you are able to pay the annuity company a significant sum to accept all of the market risks of your $500,000 investment.  That certainly might be worth it.  But one must also consider the costs, which can be substantial, especially if you’re worried about outliving your savings in retirement.  So there are two, important and related questions:  who is going to assume the relatively modest market risks of the relatively conservative portfolio and who’s going to make all of the money on your $500,000 investment – you or the annuity company?

 

Of course, past results don’t guarantee future results.  We don’t know if the next 20 years will be as good as the average, or even as good as the worst 10th-percentile, of all 20-year periods since 1972.  But based on the past, retirees who invested in a relatively conservative, well-diversified portfolio would have done much better than if they had invested in an annuity (or if they had at least diversified their investment and not put all of it into the annuity "basket").

 

Happy retiring!