Morningstar - Q4 2021 - 41

Spotlight: Guaranteed Income
Guidelines on Making the
Annuity Decision
A simple formula can help investors
determine their need.
Amy C. Arnott
GUIDELINES
Like most insurance products, annuities are
a form of risk transfer. Because the insurance
company spreads risk across a broader
pool, it's able to manage longevity risk and provide
income payments that are not only higher
than investors could generate on their own but
also guaranteed for life (assuming the insurance
company is financially sound).
As you've read in this issue, annuities can be
confusing because they come in so many different
varieties-from immediate to deferred and
fixed to variable. Even within the same broad type,
there's a long list of potential features, benefits,
and costs that can be tough to make sense of.
In this article, I'll focus specifically on the
type of guaranteed-income product my colleague
Jasmin Sethi favors in the prior article,
single-premium immediate annuities, which
provide a predetermined income stream that starts
paying out right away (technically within 12
months of signing the contract). I'll also explain
how to decide if these annuities make sense
for most investors and how much they might want
to allocate their portfolio to one.
Background
Investors often think of annuities as overly
complex, high-cost products peddled by aggressive
salespeople. In some cases, that reputation
is well deserved. (Variable annuities, I'm
lookin' at you.) But fixed annuities are relatively
plain-vanilla products that can add significant
value by filling gaps in retirement income.
Thanks to the long-term decline in interest
rates (which affects how much insurance
companies can earn on their portfolios), payout
rates aren't as high as they used to be.
Based on data from Schwab's Income Annuity
Estimator, a 65-year-old man could currently
expect to receive monthly payments of
$481 in exchange for purchasing a $100,000
annuity. That's down from average payouts
of more than $700 in 2001, based on data from
the Center for Retirement Research at
Boston College.
Even so, that translates into an effective
income rate (which includes both interest
payments and return of principal) of about 5.8%,
which is higher than the cash flows
generated by most investments. And in contrast
to an investment portfolio, which runs the
risk of depletion from unexpected longevity,
market downturns, or a bad sequence
of returns, an annuity won't run out during the
investor's lifetime (or payout period). That
makes annuities especially valuable for retirees
who fear running out of money.
Running Through the Numbers
Here are a few steps to take to figure out
the specifics.
gDetermine monthly spending needs. The
most conservative approach would be to base this
spending analysis only on essential items,
such as housing, utilities, food, medical costs,
and insurance.
gSubtract any monthly income, such as payments
from a pension or Social Security, and then
multiply the result by 12 to get an annual number
for net spending needs.
gTake the result and divide it by the portfolio's
total value. This is the required withdrawal rate,
or WR in the formulas below.
gDecide on a figure for the sustainable
withdrawal rate, or SWR, which is the percentage
of the portfolio's value that can be safely
withdrawn each year. (Retirees typically use this
percentage to calculate the starting withdrawal
amount and then increase subsequent
withdrawals for inflation each year.) Many
investors rely on the 4% figure originally tested
by Bill Bengen in 1994, but a lower number
(such as 3.5%) may be more prudent in an era of
lower bond yields and potentially lower
stock returns. On the other hand, investors willing
to allocate a larger portion of their assets to
stocks can use that as a lever to allow for higher
withdrawal rates.
gFind out the effective income rate that can
be earned on an annuity-the annuity rate, or AR.
For example, a 70-year-old man can currently
expect to receive monthly income payments of
$559 in exchange for purchasing a $100,000
annuity, which translates into an effective income
rate of 6.7% per year.
gPlug the numbers into the following formula:1
% of portfolio to allocate to annuity =
100 " (WR , SWR) / (AR , SWR)
Here are three examples of how this might
work in practice. I'll use the same assumptions for
the annuity rate and sustainable withdrawal
1 Source: Adapted from Otar, J. 2006. " Lifelong Retirement Income: How to Quantify and Eliminate Luck. " In Evensky, H. & Katz, D., Retirement Income Redesigned: Master Plans for Distribution.
P. 94. (New York: Bloomberg Press.)
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