Annuities are forever, or at least they can be, and that’s both their strength and their weakness. It’s a strength because, at a time when almost everyone is concerned about market volatility and the prospect of outliving retirement savings, annuities can provide predictable payments that will last as long as you do. It’s a weakness because, in the case of fixed annuities, the amount of your perpetual payout is determined when you buy an annuity, and if you sign up when interest rates are low, you’ll receive less than if you purchase an annuity when rates are higher. Also, fixed annuities don’t protect you against inflation unless you pay extra for an inflation-adjustment feature.
 But what if you spread out annuity purchases, much as you would build a bond ladder or use dollar cost averaging to add to a stock portfolio over time? In a recent study, “Variable Payout Annuities and Dynamic Portfolio Choice in Retirement,” in the Journal of Pension Economics and Finance, Olivia Mitchell, professor of insurance and risk management at the University of Pennsylvania’s Wharton School, and three German academics found that laddering annuities can reduce the risks of saving for retirement and increase the likelihood of reaching long-term financial goals.
Particularly in today’s unsettled investment markets, annuities have an undeniable appeal. You pay a sum of money to an insurance company or other financial firm, and the company promises to make specified monthly payments for a fixed term or life. There are many variations on the annuity theme, but for simplicity, consider a fixed, immediate annuity for a 60-year-old male living in New York. Annuity payouts are based on interest rates and life expectancy, and according to an estimator on ImmediateAnnuities.com, if he had invested $50,000 in late June 2009, he could have received lifetime monthly payments of $311.
Viewed on the surface, that’s a very good deal. It amounts to $3,732 a year, or an annual return of about 7.5% on that $50,000 investment. Compare that with a typical withdrawal strategy that calls for taking 4% annually from an investment portfolio during retirement—which would provide only $167 a month during the first year—and the annuity seems clearly preferable, at least for a time. But with the lifetime annuity there’s a risk you’ll die prematurely, thus ending the payments and greatly reducing the investment’s value, as well as the risk of locking in returns based on lower-than-usual interest rates.
Laddering annuities could minimize both those risks. Purchasing an annuity each year for a decade, for example, means that each investment will be based on a different interest rate and averages out the impact of annual variations. It also reduces mortality risk—if you die early, the purchases end—and can often provide slightly higher payouts with each new annuity, because the buyer is one year older and his life expectancy one year less. To return to the earlier example, the $311 monthly payment would have been $328 for a 63-year-old male, or $342 if he were age 65.  The results of the Pension Economics and Finance study echo those of a 2007 report from MassMutual Financial Group that looked at how three investment strategies would have fared during 181 different 27-year periods beginning monthly from 1965 through 1980 and ending in 1991 through 2006. Comparing a half-stocks, half-bonds portfolio to alternatives that replaced some bonds with either a single annuity bought at the outset or with several purchased in a laddering strategy, the illustrations showed both annuity methods outperforming the traditional stock-and-bond portfolio, and the laddered approach doing better than the single annuity through all of the back-tested periods and many economic ups and downs.
One approach to laddering would be to keep adding annuities until you’ve met most of your basic retirement income needs. If that 60-year-old knows he’ll need at least $10,000 a month and plans to retire in seven years, the first year he might buy a $200,000 annuity that pays about $1,250 a month, then purchase another annuity the next year that adds another $1,250 in monthly income, and so on until, after seven years, he has almost $9,000 in guaranteed monthly income. He may use social security or a pension to fill the rest of his retirement income needs, while keeping any remaining assets in stocks to provide discretionary retirement income and build an inheritance for his children.
Annuities themselves and laddering approaches are complex, with many variables to consider including credit risk of the issuing institutions. We can work with you to see whether an annuity ladder might reduce your retirement risk and help you achieve your long-term goals. |
