Some people are interested in leaving a financial legacy for their families and some people want to spend every penny they have accumulated. The hard part of spending every penny—of making sure that the last check you write bounces—is that you do not know how long you will live. One way to make sure your last check bounces is to create an income stream that continues to pay you for your entire life. Most Americans have one of those—it is called Social Security. Many Americans that are currently retired have a second stream of lifetime income called a pension.
With the decline of pensions, many people, including the U.S. Treasury Department, are concerned about our ability to fund retirement. The U.S. Treasury Department is encouraging retirement plan sponsors to make it easy to annuitize distributions from retirement plans. They believe Americans have not saved enough for retirement and risk running out of money. Annuities, fixed immediate annuities, could replicate that stream of pension income.
Annuities seem to be in the news a lot lately. In some discussions, it is not clear just what kind of annuity is being discussed. To reduce that confusion, this piece is about immediate fixed annuities. With this type of annuity, you would exchange a lump sum of money for a stream of income. I will also make one reference to an inflation-adjusted fixed annuity.
If you have limited resources as you are accumulating assets for retirement, in some respects, you want to save as little as possible. Those resources that are needed for retirement are saved; those that are not needed for retirement can be allocated to another goal or spent. If money is scarce and you save $1 more than needed for retirement, you have deprived yourself of some other pleasure from the use of that money.
If an insurance company is providing lifetime income to several thousand people, they have the law of large numbers on their side. They will only have to pay for the average life expectancy of the group and with large numbers that will be about the life expectancy of the population. Current life expectancy for a single person at age 65 according to IRS tables is 86.
If an individual is providing lifetime income to himself or herself (self-insuring their risk of a long life) they do not have the benefit of the law of large numbers. To be assured that the money is available, an individual has to have enough resources to pay to the maximum life expectancy. According to Isaac Asimov, the maximum life expectancy is age 115; however, most financial planners will plan for a 30 year life expectancy or plan to a specific age between 90 and 100.
If an insurance company has to plan for payments until you reach 86 and self-insuring your retirement requires you to plan for payments until you reach 90 (or 100), you would have to allocate more to retirement if you self insure than if you use an insurance company. In other words, it costs more because those assets cannot be allocated to another purpose. This difference in cost is reduced (but not eliminated) because insurance companies assume lower investment earnings than investment professionals generally use for their clients (insurance companies have more conservative investments).
Of course, the other benefit of insuring your retirement through an annuity is that you may live longer than you planned. If you plan to live to 90 but live to 100 you have not accumulated the funds for the last ten years. If you have an annuity, the insurance company is responsible for payments during the extra ten years. In fact, using a fixed annuity allows you to eliminate two specific risks (transfer the risks to the insurance company): living longer than planned and earning less from your investments than planned. You can buy an inflation-adjusted annuity to reduce the inflation risk but it does not eliminate the risk. An investment pool, on the other hand, has kept up with inflation historically—so it mostly eliminates inflation risk. An investment pool also eliminates the risk of dying too young.
Dying too young is a risk that keeps many from buying an annuity. Although a teenager is invincible and will live forever, our senior citizens expect to die tomorrow afternoon. If I buy an annuity that will pay me until I am 95 but die at 66, I will not get value from the annuity.
There are a few ways to moderate this risk. You could only annuitize part of your income stream or you could delay the annuity until you had already reached an advanced age. If you need $60,000 to live each year and receive $15,000 from Social Security, you could annuitize just $15,000 or $20,000 and fund the rest with investment income. Living to an extended old age might mean a reduced income level in your 90s but it would provide a base level of support.
You could also purchase an annuity at age 65 that will pay you a benefit from 85 until your death. That benefit could fully fund your retirement lifestyle after age 85 or it might be a lesser amount. You still have to fund your retirement from age 65 until 85 with investment money but the dollars to purchase the annuity would be minimized. Your life expectancy at age 85 is only 7 ½ years, plus the money would be invested for 20 years before you received the first payment.
When making decisions about retirement distributions, you should consider multiple risks and try not to spend too much energy eliminating one risk while ignoring your exposure to another risk. Some retirees want to reduce investment volatility but take on more inflation risk than necessary to reduce that volatility. Some retirees are so concerned about dying young that they take on too much risk of living a long life.
If you want to leave a legacy for your children, fund that legacy separately from your retirement money and consider reducing your longevity risks through annuities. With your legacy funded you can make sure you spend all your retirement money on yourself. With your retirement fund set up this way, you can sleep well assured you have a well-funded retirement and that your last check bounces.
John Comer, CFP®
Comer Consulting, LLC