Should clients annuitize their retirement assets?

With the decline in the stock market over the last year, there is renewed interest in lifetime income guarantees for retirees. So, does it make sense to annuitize retirement money or roll the dice with market based returns?

When you run the numbers, there doesn’t seem to be much of an advantage to annuitizing. In fact, clients may forfeit significant opportunities for greater income by doing so.

To run the analysis, you have to compare the income distribution you would receive from an immediate annuity against the likelihood of not running out of money using that same distribution rate from a balanced investment portfolio.

Let’s take a look at some numbers. I ran quotes from one of the highest-rated insurance companies asking for the income payment I could receive on a $1 million joint and survivor, life-only immediate annuity for a 65-year-old couple. The payment was $61,700 a year, or 6.17% of the $1 million purchase price. In other words, this is the equivalent of a 6.17% distribution rate.

Now, that looks pretty good, but in exchange for the 6.17% income payment, the client must give up complete ownership of the $1 million. This means the client has a fixed payment for life, but no access to the principal for the client or the client’s heirs. That’s the deal with immediate annuities. Otherwise, if you want some guaranteed payout period or return of principal, the payments start to decline, which reduces the leverage available from an immediate annuity.

Let’s compare the guaranteed 6.17% income distribution from the annuity to the historical success rate using a 6.17% distribution rate from a balanced portfolio. Basically, that means we take a $1 million balanced investment portfolio, distribute $61,700 a year, and see how the distribution holds up on a historical basis over an assumed 30-year retirement.

If we run every 30-year hypothetical period starting in 1926 using the 6.17% non-inflation adjusted distribution rate, we find a success rate of about 94%. This means that 94% of the time a $1 million portfolio was able to support a 6.17% distribution rate for the entire 30 years. There are different ways to run these historical scenarios, but it’s fair to say that you would find success rates at percentages ranging in the mid- to low-90s in most cases.

Moreover, during many of these historical cycles using the 6.17% non-inflation adjusted distribution, the portfolio would have doubled and tripled over those 30 years, while still pumping out 6.17% a year. This means that by keeping the funds invested in the markets, the client had a pretty good chance of not only living on 6.17%, but living on more.

From an estate planning perspective, they also could have elected to pass some of those assets on to their kids and grandkids. With the immediate life-only annuity, they lose that right.

I don’t want to make these probabilities sound as if they’re set in stone. They are rough assessments based on a limited number of historical cycles, and past performance is no guarantee of future returns. But they are the best we have, and they are informative from a risk management perspective.

Let’s summarize these numbers:

With the immediate annuity, the payment is guaranteed at 6.17% per year, no more and no less. Of course, you must also factor in some probability of default by the insurer, especially after the experience of last year. I don’t know what risk factor is reasonable, but it certainly isn’t 0%. Given that many of the world’s largest financial firms were on the verge of collapse over the last year, I’d have to put the risk in the 1% to 2% range over a 30-year retirement. That puts our estimated success rate for the annuity in the 98% to 99% range.

With the investment portfolio, the historical success rate using the same 6.17% distribution was about 94%. Plus, the client has the opportunity for significant upside and gets to retain the $1 million.

Each client will of course need to weigh the risks and rewards of the different strategies, and some may elect to do a little of both. But the immediate annuity does not appear to offer a great deal more income certainty than a prudently managed investment portfolio. And the annuity has no upside, but a potential downside if the insurer defaults.

While guaranteed income for life sounds great from a marketing standpoint, it may come at a high cost.