07 Dec Seeking a Stable Retirement
Anecdotally, retirement finances formerly were based on a ‘three-legged stool.’ After people stopped working and no longer had earned income, their cash flow would come from Social Security, personal savings, and a pension from a former employer. This pension would have been a traditional defined benefit plan, paid out for the retiree’s lifetime and perhaps for that of a surviving spouse.
It may or may not be the case that former decades were the ‘good old days’ for retirees. It is true, though, that most private companies do not offer periodic pensions to retirees today. Thus, one ‘leg’ of the fabled stool does not exist for many people who have left the workforce.
In addition, an increasing number of retirees are living until their late 80s, 90s, and into triple figures these days. Running short of money may become a concern, without a true pension to supplement Social Security.
The annuity answer
Financial professionals use the term ‘longevity risk’ to describe this issue. People may live longer while their assets dwindle. One way to address this risk is to purchase an annuity.
Many products are sold as annuities these days, including life immediate annuities, which focus on managing longevity risk. Some insurers use other titles, such as income annuities or payout annuities, for these contracts.
Example 1: Greg Sawyer, age 65, pays $100,000 to ABC Insurance Co. (ABC) for a single life immediate annuity. In return, ABC promises to send Greg a check for $500 each month for as long as he lives. That might be for 40 years, or it might be for 40 days, if Greg is hit by the proverbial truck soon after buying this annuity.
Some academic research supports the premise that an immediate annuity can provide financial benefits to retirees, when combined with other investments and Social Security. In the real world, though, relatively few people are willing to enter into such an uncertain transaction.
Less risk, lower yield
Responding to consumer concerns, insurance companies typically offer many options to a basic straight-life annuity. Married couples, for example, may prefer an annuity that will pay as long as either spouse is alive. Annuity issuers also may promise a ‘cash refund’ in case of an untimely death.
Example 2: Insurer ABC offers Greg a cash refund policy that pays $475 a month and he invests $100,000. Again, Greg will get a (somewhat smaller) check every month for as long as he lives. In this scenario, Greg lives for 10 years, collecting 120 checks at $475 apiece, for a total of $57,000. If Greg dies then, ABC will send a check for $43,000 (the $100,000 invested by Greg minus the $57,000 paid out) to a named beneficiary.
Other choices might include ‘period certain’ annuities that will pay, say, at least 10 years of checks to either Greg or to a surviving beneficiary. Yet another possibility is an annuity that starts with a smaller payout but increases to keep up with inflation. Generally, the more safeguards that are added to a straight life annuity, the lower the amount the insurer will pay.
In recent years, the seemingly oxymoronic ‘deferred immediate’ annuity has gained ground as a way to offer higher yields on lifetime annuities. Insurers may call these products deferred income annuities or longevity annuities.
Example 3: Dissatisfied with the rates offered on standard immediate annuities, Greg pays $100,000 to ABC but defers the start of cash flow for 10 years, until he is age 75. At that point, he will receive $1,200 a month for the rest of his life, a huge increase from the start-at-65 payout. On the downside, Greg’s death will halt the payments, even if that occurs before he reaches 75.
The cash flow from an immediate annuity will be taxed in one of two ways, depending on where the annuity is held.
Example 4: Greg Sawyer might hold his annuity inside a tax deferred retirement account—specifically, in an IRA. If so, all withdrawals will be taxed as ordinary income. If Greg is in a 25 percent tax bracket and receives $6,000 each year from the annuity, he will owe $1,500 in tax (25 percent of $6,000) and net $4,500 a year.
Example 5: Instead, Greg might buy the annuity with after-tax dollars, in a taxable account. In that case, some annuity payments will be treated as an untaxed return of capital.
Assuming a 20-year life expectancy, Greg can expect to receive $120,000 from this annuity, at $6,000 per year. The ‘exclusion ratio’ is $100,000 over $120,000 (investment/assumed return), or 5/6. (The insurance company will calculate the exclusion ratio, to facilitate tax return preparation.) Thus, only 1/6 of Greg’s cash flow, or $1,000 a year in this hypothetical example, will be taxable. Greg would owe 25 percent of $1,000 in tax each year, so he would net $5,750 a year after tax.
Note that this tax treatment expires once 20 years have passed and Greg has excluded $100,000—his original outlay—from income tax. Any further cash flow from the annuity would be fully taxed.
Alternatives to annuities
Annuity payouts will vary from one issuer to another, and among various product features, so it may pay to shop among multiple issuers. The credit quality of the insurance company should be considered as well. Our office can help you evaluate immediate annuities, if you feel one would help your retirement income security.
Moreover, there are other approaches to reducing longevity risk. One way is to delay starting Social Security, perhaps as late as age 70. Foregoing Social Security benefits while in your 60s will lead to much larger payments later in retirement.
In addition, you can construct what amounts to a synthetic annuity via gradual portfolio withdrawals. The so-called four percent rule, which calls for distributing four percent of your portfolio in year one of retirement, followed by inflation adjustments as you grow older, is advocated by some advisers, perhaps with modifications for current circumstances.
The lack of a lifetime pension does not mean financial stress over a long retirement, if you act prudently to put plans for long-term cash flow on a firm footing.