How Annuities Can Extend a Portfolio

Annuities received a bad name over the last few decades, with some help from this newsletter. But there are different types of annuities, and they are not all bad investments. For example, the greatest fear of most retirees is outliving their portfolios. The right kind of annuity can reduce the probability of running out of money by making a portfolio last longer.

Retirees should consider shifting part of their portfolios to immediate annuities, if not immediately than at some point in retirement.

An immediate annuity is one that shortly after purchase begins making fixed payments for the life of the owner (or the joint lives of the owner and spouse). The retiree (and spouse) will not outlive that portion of the portfolio, as long as the insurance company is solvent.

Despite this, sales of immediate annuities are low. Most retirees do not like the idea that if they die early, the annuity payments will stop, and there will be nothing for the estate. In addition, the annuity payments and fixed and will lose purchasing power over the years because of inflation.

Yet, shifting a portion of the retirement portfolio to immediate annuities can increase financial security. Studies done both by Retirement Watch and by others demonstrate this. The immediate annuity replaces the old-style defined benefit plans that are available to fewer and fewer retirees. It provides an income floor to cover a portion of retirement expenses.

A study in the December 2001 Journal of Financial Planning found that putting 25% or 50% of a retirement fund into an annuity increased the odds that the portfolio will last through at least 30 years of retirement. The study looked at four different portfolios, ranging from a conservative portfolio that was 20% in stocks and an aggressive portfolio that was 85% in stocks. Using Monte Carlo simulations, the study found that the initial conservative portfolio had a 32.6% probability of success with no annuity, but the odds improved to 53.3% when an annuity was purchased with 25% of the portfolio and to 81.3% when an annuity was 50% of the portfolio. The improvement was less dramatic for the aggressive portfolio, which already had a 90% probability of lasting at least 30 years, but still increased security after adding an annuity.

Beyond the decision of whether or not to use immediate annuities, the next issue is when to buy the annuities. A study in the April 2005 issue of Financial Planning found that retirement security is enhanced when annuities are purchased a period of years using dollar-cost averaging instead of in one purchase late in retirement.

The study compared two strategies. In one strategy, a couple purchases annuities gradually until age 80. The other strategy involved a gradual shift of the portfolio from stocks to bonds until late in retirement, then annuities were purchased. The couple purchased variable payout annuities in each case, so the annuity payout rose with inflation. The study found that dollar-cost averaging into the annuities increased the amount of wealth the couple owned at age 92.

One assumption that contributed to this result was that owning the annuities allowed the couple to invest more aggressively with the rest of their portfolio. The couple kept a constant percentage of its non-annuity investments in equities. Another assumption was that the annuities were purchased through tax-favored accounts. This allowed the couple to sell equities to purchase the annuities without incurring taxes, and also allowed taxable accounts to be used for investments that will qualify for the 15% maximum tax rate. Purchasing the annuities through a tax-deferred account also allowed the income from the annuities to compound tax-free until needed for spending.

A third strategy that also produced good results was to shift a third of the portfolio into annuities at the beginning of retirement. But dollar-cost averaging did better.

An immediate annuity provides several advantages to the retiree. Unlike the rest of the portfolio, the value of the annuity and its distributions will not fluctuate with changes in the stock market and interest rates. Also, the payout will not decline if there is a long-term decline in interest rates, as happens with bonds and CDs.

Retirees often are not advised to purchase immediate annuities. These annuities pay agents lower commissions than other annuities. Also, most financial services firms that provide investment advice, such as mutual fund firms, receive no benefit from advising investors to include annuities in their portfolios. But retirees who seek out independent advice and research will learn that immediate annuities in a portion of their portfolios can increase their retirement security.

When purchased in a taxable account, the full annuity payment is not taxed. Part of each payout is a tax-free return of the original investment or principal. The rest of the payout is fully taxed ordinary income. To determine the taxable and nontaxable portion of each payment, the taxpayer uses IRS life expectancy tables to estimate life expectancy and the expected return from the annuity. This is used to determine the percentage of each payout that is excluded from income. Details are in IRS Publication 575, Pension and Annuity Income.

National Annuity Sources

Web Sites

annuityscout.com
immediateannuity.com
brkdirect.com
tiaa-cref.org
fidelity.com
troweprice.com
topannuities.com
masterquote.com
quotesmith.com
quickquote.com
annuityshopper.com
vanguard.com

National Brokers

Annuity & Life Insurance Shopper 800-872-6684
Quotesmith 800-556-9393

NOTE: Each broker does not offer the products of every insurer. Consumers should compare quotes from three or more brokers to view the full range of offerings on the market.