With pension plans quickly fading into history, it’s up to most of us to function as our own “pension plans.”
Not only are we responsible for saving enough money for a comfortable retirement, but once we retire we’re responsible for creating a dependable, long-term income stream to replace our employment income.
As you probably know, the biggest financial risk in retirement is outliving your assets and losing your financial independence. To avoid this scenario, we need not only savings, but in most cases, very good investment returns.
But betting your future on investment returns isn’t something everyone is comfortable with. For many people, annuities are more attractive. Let’s walk through an exercise to help illustrate why.
It’s universally accepted that retirement portfolios should have a lot less risk than the portfolios of younger people who are building their nest eggs. One way to determine the right balance of risky and less-risky assets is to use the “Rule of 100.”
The rule is simple—just subtract your age from 100; if you’re 65, then 35% of your assets should be in riskier growth assets. The rest should be in lower-risk assets that simply deliver solid income without much potential for capital appreciation.
But there’s a problem with this approach. Today, the assets that retirees used to rely on for safe income are not getting the job done. Bonds currently have very low yields—and they themselves are risky. When interest rates rise, the value of the bonds declines. Certificates of deposit and money-market funds barely pay any interest at all.
That brings us to income annuities. In many cases, annuities are not the best vehicle for accumulating assets and building a nest egg. On the other hand, they can be excellent vehicles for creating safe, reliable income in retirement. The catch is that you need to be patient. If you were to deposit $300,000 now into an annuity that matures in 10 years, that annuity can provide you with a guaranteed lifetime annual stream of income of $33,113—starting, of course, 10 years from now.
Here is where it gets interesting. It’s important to limit your annual withdrawals from your retirement savings to about 3%. The more you withdraw above that amount, the less likely it becomes that your savings will last throughout your lifetime.
So let’s say that you decide not to invest in an annuity, but rather to invest your $300,000 right away in the market. To match the income of the annuity while pulling out 3% per year, you would have to earn more than 14% per year. And that is a tall order indeed.
Now, obviously you will need enough income—from savings or continuing employment income—to last that 10 years until your annuity matures. But in an era marked by low yields and uncertain market returns, this patient approach can result in valuable peace of mind. Please don’t hesitate to contact us if you’d like to learn more about annuities for retirement income specifically, or retirement income planning in general.