This is a guest post from Mike Piper, a long-time GRS reader and the author of Oblivious Investor, where he explains how exciting things like 401k rollovers and tax brackets work. Previously at GRS, Piper wrote about earning extra income with a small blog.
Would retirement planning be easier if you had a pension?
It's a silly question, I know. For most people, the answer is, “Yes, of course.”
Here's a less-silly question: Did you know that you can buy a pension?
Most people I talk to don't know that. But it's true. If you want to, you can buy a pension from an insurance company. You can pay an insurance company a lump-sum of money, and the insurance company will promise to pay you a certain amount of money, which will adjust upward with inflation, every month for the rest of your life. (Or, if you prefer, they'll promise to pay a smaller amount of money every month for the longer of your life or your spouse's life.)
The technical name for such a product is a bit of a mouthful: single premium immediate inflation-adjusted lifetime annuity.
Yep, the dreaded A-word: annuity. It's true that many types of annuities are a poor deal for investors. But I hope you'll suspend your suspicion for a moment to see if this one particular type of annuity may be helpful for you.
They Let You Spend More Money
In addition to making retirement planning simpler (because of the predictable level of income they provide) this type of annuity has another major benefit: It can allow you to spend more per year than you can safely spend from a typical portfolio of stocks, bonds, and mutual funds.
If you've read much about retirement planning, you've probably come across the “4% rule.” That is, most retirement planning experts recommend withdrawing no more than 4% per year from your portfolio in the early stages of retirement.
Even in today's low interest rate environment, a 65-year-old male can get a lifetime annuity paying 5.1%. And that payout will increase with inflation every year for the rest of his life. For a female of the same age, the available inflation-adjusted payout would be 4.5%. (The annual payout is lower for women because the insurance company knows that, on average, they'll have to make payments for a longer period of time for female annuitants.)
What's the Catch?
So far, I've made these annuities sound like an investor's dream come true. But that's not exactly the case. Like anything else, they have their drawbacks.
First and most importantly: The money disappears when you die. If you retire, put your entire portfolio into a lifetime annuity, and promptly get hit by a bus, the money is gone. Your heirs do not get a dime of it. Rather, the money goes to fund the payouts on annuities for still-living annuitants. This is the reason that you cannot build your own lifetime annuity using bonds and other fixed-income investments. Lifetime annuities provide a higher payout per year than you can safely take from a typical investment portfolio because part of that income is coming from other annuitants–ones who have passed away.
The second drawback to such annuities is that they involve credit risk. Granted, insurance companies are subject to regulatory funding requirements that make it very uncommon for them to go belly-up, but that doesn't mean it's impossible.
Finally, lifetime annuities aren't “liquid” in the way that stocks, bonds, and mutual funds are. If you find yourself crunched for cash, you cannot sell a piece of your annuity in the way that you could with other investments.
The Bottom Line
Because they allow for a high withdrawal rate, and because they provide predictable income, lifetime annuities can be a helpful tool for people who have under-saved and are now looking to safely draw the maximum amount of income from a portfolio. But this isn't a retirement tip suitable for everyone.
For investors who have saved enough to be able to deal with the unpredictable returns that come with a stock/bond portfolio, lifetime annuities may not be a good fit. In addition, even if a lifetime annuity would be a good fit for you, it's not a good idea to annuitize your entire portfolio.