Four Basic Retirement Planning Questions

Should you annuitize your savings?

Along with failing health, outliving your savings is one of the greatest sources of anxiety for retired investors.
Technically, this is called "longevity risk." There are four ways to manage it.

The easiest is buying longevity risk insurance. Products which offer longevity insurance are known as "annuities." Annuities promise to make payments to you over some period of time. These payments can be either fixed (i.e., not increase with inflation to keep their real value constant) or variable (i.e., payments rise with inflation). By investing in a real annuity, you avoid the risk of having inflation erode the purchasing power of your income over time. Hence, in this article, we focus only on real return (inflation indexed) annuities.

The simplest inflation-indexed annuity promises to pay you a fixed real income for as long as you live. More complicated products will also make payments for a period of time after you die (e.g. until a spouse dies). However, annuities come with two potential costs: first, they require a large up front premium payment, which is not available for use as a bequest if you die earlier than you expect. While annuities that guarantee a payout for a minimum number of years to some extent limit this potential cost, the financial consequences of dying too soon have caused many people to decide against purchasing an annuity and instead look for other ways to manage longevity risk.

Another concern is that, as the 2008 crisis made clear, since annuities are issued by insurance companies, they also carry some amount of credit risk. If the issuing insurance company goes bust, there may be little or no payout under the annuity (though there has yet to be a major insurance company bankruptcy where we have seen how this scenario would actually play out).

The second way to hedge longevity risk is to use a long expected life in your calculations. However, this has two potentially adverse consequences: it leads to a higher accumulation goal (which implies reduced consumption before you retire), and, if you die sooner than expected, it results in a higher than desired bequest.

The third way to manage longevity risk is to use your bequest goal as a buffer, drawing it down if you live longer than expected. Of course, this means that, depending on the returns you earn on your investments after retirement, you may not achieve your bequest goal if you live longer than you expect.

The fourth way to manage longevity risk is to assume a relatively low real rate of return on your investments after you retire. The lower the assumed rate of return, the easier it is to achieve, and the less likely you will outlive your savings if your portfolio withdrawal strategy assumes low future real returns.

Let's look more closely at annuities.

Probably no other subject causes as much confusion as annuities. So let's start with the basics. Essentially, an annuity is the mirror image of a life insurance policy. The latter protects your family against the risk of you dying sooner than expected. In contrast, annuities protect you against the risk of you dying later than expected (and thereby outliving your savings).

Both of them work the same way: a group of people who want protection against the risk in question pay premiums into an insurance fund. In the case of life insurance, payouts are only made when an insured person dies. Some people pay premiums, but never receive a payout before they let the policy lapse. In the case of a life annuity, payouts are made at regular intervals to provide income to policyholders, and stop only when the policyholder dies. When this happens soon after the annuity is purchased, the "annuitant" receives less than the premium he or she originally paid. However, when the person dies many years after the annuity is purchased, he or she often receives payments well in excess of the premium paid.

Annuities come in many different forms (our most recent in-depth comparison "To Annuitize or Not to Annuitize? That is the Question" may be found in our May 2006 issue or signup). Two of the most important differences between them have to do with the length of time over which the payments are made, and whether they are fixed or variable.

With respect to the length of time, among the most important annuity types are "lifetime" annuities, which make payments only until the annuitant dies; "joint and last survivor" annuities, which make payments until the second of two people dies; "guaranteed term" annuities, which make payments for a guaranteed period, even if the original annuitant has died (with the remaining payments going to a designated beneficiary).

With respect to fixed and variable payments, some of the most important distinctions are between fixed payment annuities (where the amount remains fixed over time), variable annuities (where the size of the payment is tied to the performance of underlying investment accounts), and inflation indexed annuities (where the payment is increased with the consumer price index, to keep real purchasing power constant over time).

While annuities reduce the risk that you will outlive your savings (and suffer a drop in your standard of living), they do so at a cost.

First, they reduce the amount of money you have available for precautionary savings and bequests.

Second, they are not liquid -- once you have purchased one, it can be expensive or impossible to change your mind later. For this reason, studies have shown that using a portion of one's savings to purchase an annuity tends to be most attractive when (a) a person or couple expect to live for many more years; (b) they have relatively low income from other annuities (e.g., from national and private employer defined benefit pension plans); and (c) they are relatively more risk averse (see, for example, the paper "Private Pensions, Mortality Risk, and the Decision to Annuitize" by Jeffrey Brown).

Third, in today's low interest rate environment, life annuities have become much more expensive for any given target level of income.

In sum, annuitization remains perhaps the most difficult decision that retirees face. We strongly recommend discussing it with a financial advisor who has a fiduciary relationship with their clients (e.g., Registered Investment Advisers in the United States).

The portion of your target income not provided by annuity payments, as well as your precautionary and bequest goals must be generated from your accumulated savings. Asset allocation is the key to achieving these goals

Next: How to Determine Your Target Portfolio Return