Managing Money in Retirement II: Income for a Lifetime

This is the second of a series of posts on retirement withdrawal strategies.  If you haven’t read Managing  Money in Retirement I, please read it first! 

Most of us would feel more comfortable having a reliable source of income in retirement — at least enough to cover our essential needs – rather than being completely at the mercy of uncertain investments in stocks, bonds, real estate or more exotic things.   As a practical matter, though, how can we go about building the floor of a floor-and-upside strategy?   

First, let’s define what we’d like in the ideal world.  The best source of income would be an inflation-indexed payment, lasting for your lifetime (and that of your spouse, if you’re part of a couple), paid by some entity that you’re confident will be around and solvent for the next 30 or 40 years.  

Hmm… are there really any income sources that meet these criteria?  Perhaps not perfectly.  But Social Security comes close – it’s guaranteed for a lifetime, is indexed for inflation, transfers to a spouse upon death, and is backed by the full faith and credit of the US government.  Of course, long-term financing issues remain unresolved, which creates some uncertainty – primarily affecting younger workers. 

Pensions are also excellent sources of retirement income, meeting most of the same criteria.  Unfortunately, defined-benefit pensions are disappearing quickly, with government workers the primary class of workers still covered. 

What if Social Security (and, if you’re lucky, a pension) aren’t sufficient to cover your essential needs?  Some financial planners suggest creating a ladder of bondsthatwill mature each year of retirement.  Buying TIPS (Treasury Inflation-Protected Securities) would protect your bond ladder against inflation (otherwise a significant risk to purchasing power over 30 years or so).   I really like TIPS, which address several of the major drawbacks of investing in bonds – inflation risk and default risk (since they’re guaranteed by the US government).  However, a 30-year TIPS ladder would be cumbersome to manage and potentially very expensive.  Also, it doesn’t really provide longevity protection (certain income for a lifetime), since in practice one needs to buy bonds for a certain number of years (say, 30), after which your income ceases! 

Annuities – the Answer, or Financial Snake Oil?

An annuity, specifically a Single Premium Immediate Annuity (SPIA), is another approach favored by many financial planners that, in theory, meets most of the criteria for ‘certain’ lifetime income.  Just hold on there, pardner, you say.  You’ve heard the horror stories about annuities and, besides, there are ads all over the Internet warning against them. They’re the spawn of Satan, aren’t they, just waiting to ensnare unwary old-timers?

It is true that annuities have been subject to abuse in the past.  One example: a family member was sold an annuity with a 15-year surrender period when in his mid-80s.   He couldn’t have withdrawn his money without a stiff penalty until he was over a hundred!

Still, annuities are not inherently evil.  In theory, they could serve as the vehicle we’re looking for to provide safe, secure, lifetime income.  Basically, you pay an insurance company an amount up front and they promise to provide you a certain payment for your lifetime.  In essence, you’re buying your own pension. 

Many financial planners see annuities as an essential tool for managing retirement income.  By spreading the risk across many people, insurance companies should be able to pay out more than you could safely withdraw on your own.  You can purchase an annuity that covers both halves of a couple and/or is indexed to inflation (both of these reduce the payout). 

By spreading the risk across many people, insurance companies should be able to pay out more than you could safely withdraw on your own.

Annuity Downsides

One risk with annuities is that you’re depending on the ability of the insurance company to be around to pay you when the time comes.  The risk may be small, but it is not zero.  (Remember the AIG bailout in 2008?)  You can mitigate, but not eliminate, this risk by purchasing annuities from several different companies, and by making sure those companies are financially sound.  (They’re rated by outfits such as Standard and Poor’s and AM Best.)   They are typically regulated by state insurance commissioners, so there is some oversight to ensure (in theory, at least) that they are managed responsibly.

A big downside to annuities is that you lose liquidity.  Indeed, with an immediate annuity the money is no longer yours at all – you’re paying it to the insurance company in return for the promise to pay you back over time.  This might be a problem if down the road you have a large, unexpected expense, such as a medical bill or disaster not covered by insurance (e.g., fire, flood, or lawsuit).  For this reason, financial advisers caution retirees never to lock up more than 50% of their savings in an annuity. 

What does an annuity cost?  Prepare for sticker shock!  As of the date of this post, I looked up (on immediateannuities.com) the cost of an immediate lifetime annuity, indexed to inflation, for a 65-year-old couple.  For a $100,000 investment, I received an offer of $320 a month, or $3,840 per year – a payout rate of 3.84%.  Ouch!   Since I’m confident I could withdraw 4% a year with little risk of running out and without losing control of my money, I find this offer easy to pass up.  (Thanks, Bill Bengen.)

What does an annuity cost?  Prepare for sticker shock!

Look Before You Leap

I suspect most retirees who look into annuities come to the same conclusion I do.  But some – especially those who lack a pension and receive little or no social security – may value the promise of a steady, lifetime income enough to be interested.  My advice: even if you’re a do-it-yourselfer on most financial matters, putting a substantial chunk of your retirement savings into an annuity is a big, irreversible decision.  Consult a financial adviser (one who doesn’t stand to make any money from your decision!) or a trusted, financially savvy friend before making this leap.

At this point, you may be feeling discouraged.   Don’t be!  In the next post, I outline a way that most people can increase their lifetime income at a very reasonable cost.

References

Piper, Mike.  (2018).  Can I Retire?  Simple Subjects, LLC.

Quinn, Jane Bryant.  (2016). How to Make Your Money Last.  New York: Simon and Schuster.

Vernon, Steve.  (2012). Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.  Oxnard, CA: Rest-of-Life Communications.