What the heck is an annuity and why would I want one? (Part 2)

Why would I want one?

The greatest benefits to using an annuity during retirement are the dependability of getting monthly income, and the security of not outliving your funds.

Most of your expenses, even in retirement, come monthly. It becomes much easier to manage those expenses if you also generate monthly income. While it’s not terribly difficult to create a monthly stream of payments from a large lump sum, it does give the illusion of wealth in the early years. If you have $400,000 in your account, withdrawing $500 per month seems like a trivial amount. But it could easily exhaust the funds, especially so if there was a market correction or very low interest rates in the early years. And this danger would not be evident until much later unless you were doing estimates every year.

The major downsides to an annuity are you lose access to your lump sum, and the monthly income usually doesn’t keep up with inflation.

If you turn all or a portion of your pot of money into an annuity, you’re no longer able to get at that chunk should you need it. If the roof needed to be replaced, you had a large car repair, or wanted to take an around-the earth tour, you would have to fund those expenditures from your monthly income or another portion of your cash.

While $500 per month might seem adequate to cover, say, your property taxes right now, inflation can take a serious bite out of the spending power of that $500. If inflation were to increase to 4% (which seems unlikely now, but was the norm as recently as 2007), those property taxes would rise to almost $1100 in just 20 years. There are annuities out there that have an option to increase with inflation, but they come at a price – less monthly income than if you forego the inflation “rider.” In essence, it would take a larger lump sum to generate the same monthly payments.

We’ll use a 67-year-old male (Joe) as our example. To generate $500 per month in income, he’d need a lump sum of approximately $96,000 (at current rates). The same lump sum would only generate $321 per month with inflation protection equal to the consumer price index. To get the same $500 with inflation protection, Joe would need to invest $149,000 as compared to the $96,000 with no inflation protection.

Another strategy to combat the erosive effects of inflation is to “annuitize” in stages. The older you are, the more an annuity pays out (because there are fewer years it will have to do so). If you needed $500 in monthly income, you’d need the same $96,000 above. But instead of purchasing inflation protection, you could wait ten years, then purchase another annuity. At that point, inflation would have eroded about $172 in monthly income. To generate that amount, you’d need a lump sum of only $27,000, since you’d be ten years older and annuities get cheaper as you get older.

Now, we’ll look at how to incorporate an annuity into your retirement plan. One of the strategies I especially like is to use an annuity as guaranteed income to fill in against non-discretionary spending. Let me explain how this might be constructed.

Let’s use Joe as our case study. He’s a 67-year old male just getting ready to put his paperwork in to retire. He’ll get social security, but doesn’t have a pension. He does, however, have a 401(k) with his employer that he’s been adding to, and now amounts to $425,000.

First, Joe needs to look what his expenses will be in retirement. Once he’s done that, he’ll divide them into two kinds: discretionary and non-discretionary expenses. Joe’s expenses total $3200 per month, with $2500 being non-discretionary (groceries, utilities, insurance, property taxes, his car payment, gas, money put away for car and home repairs, and healthcare); the other $700 is discretionary (money he’s saving for vacation, his clothes budget, donations, entertainment and putting away for a new car).

Joe’s social security will be $1700 per month, which he’ll use to fund those monthly, non-discretionary costs. But that leaves him $800 short of the total. That’s where an annuity comes in – for $153,000, Joe can purchase an annuity that will provide $800 per month of income. He’ll take that $153,000 and roll it from his 401(k) to an immediate annuity (technically an IRA holding the annuity), which will provide the monthly income. He’ll be taxed on that income (the same as any withdrawal from his pre-tax retirement account) but not on the entire rollover.

Now Joe has guaranteed income to cover his non-discretionary expenses. If (when) the market drops, he won’t have to withdraw funds from his retirement accounts to pay ongoing bills – he’ll use social security and his annuity payments for that.

After removing the $153,000 for the annuity, his account would be left with $272,000. A safe withdrawal rate is considered 4% per year, which would generate just less than $11,000 per year, or $900 a month, easily covering the $700 in monthly discretionary expenses. What’s more, these optional expenditures can be delayed during a market decline. If the market drops 20%, Joe can simply put off a vacation, make his clothes last a little longer, decrease his donations and stay home instead of going out to eat. That gives Joe the flexibility to wait for his portfolio to recover before resuming his 4% withdrawal.

The other challenge Joe will face is inflation. As we all know, costs increase every year. At some point, the $2500 in non-discretionary expenses will eventually be greater. What Joe can do is “ladder his annuities.” For a short time, he can use some of the excess income from the portfolio (remember the portfolio can generate $900 per month and he’s only using $700 of that) to cover any increased costs. At some point, however, what he’ll need to do is purchase another annuity to cover the excess.

After five years of retirement, at 3% inflation, Joe’s non-discretionary expenses would have risen by approximately $400 to $2900 per month. His social security also increases with inflation (by $270 or so), but not his annuity. To cover the extra $130, he would purchase a second annuity – in this case it would cost less, approximately $25,000, since Joe is five years older and now 72. He’d remove the $25,000 from his retirement portfolio. Depending on how his investments performed, his account may actually contain more than when he started. Remember, he hasn’t been spending the whole $900, and if there was a market downturn, he could turn off (or at least drastically lower) his discretionary spending.

And Joe could continue annuitizing another chunk of money each five to seven years to cover the increase in his expenses.

That’s how an annuity could benefit Joe’s retirement spending plan. In the last article in this series, we’ll look at how to pick out an annuity, and some calculators that will help you with your retirement plan.