A Simple Way to Save for Retirement

By Jonathan Clements Posted Apr. 9, 2006

This article appears at the following website: southcoasttoday.com

Americans tend to be an optimistic bunch except when it comes to their own longevity. They don't realize how long they might live, how ill-prepared they are for a lengthy retirement and how easy it would be to outlive their savings.

What to do? My contention

Many baby boomers could salvage their retirement dreams by buying immediate-fixed annuities, which would convert their modest savings into a healthy stream of lifetime income. As an added bonus, the recent rise in interest rates has boosted annuity payouts.

Yet income annuities are shunned by retirees, with sales stuck at a modest $5.3 billion in both 2004 and 2005. Indeed, if the emails I receive are any guide, many people think they could generate just as much income on their own. But that's a lot trickier than it seems.

To understand what's at stake, imagine a 65-year-old woman with $100,000 to invest, trying to decide between high-quality bonds and an annuity that provides lifetime income. (These income annuities shouldn't be confused with tax-deferred variable annuities, the controversial product that allows folks to save for retirement by investing in a menu of mutual funds.)

If she purchases the annuity, she might get an annual income of $7,336, according to a quote for Vanguard Group's Lifetime Income Program. This quote is for income that's paid as a single annual sum, with the first payment made soon after the annuity's purchase.

The annuity may offer a heap of income, but it's also a nerve-racking investment. If our 65-year-old dies soon after buying, her $100,000 would be gone and she would have received scant income in return. Fearful that might happen, she instead sinks her $100,000 into the Vanguard Long-Term Investment-Grade fund, which was recently yielding 5.7 percent.

This fund would get hammered if interest rates rose sharply. Still, it is Vanguard's highest-yielding high-quality bond fund. There's also no charge to sell the fund, which is important. The reason our 65-year-old will endeavor to replicate the annuity's income by slowly selling off her fund shares.

That might seem like a safe strategy. For instance, in the first year, she would pull out $7,336 for spending money, leaving a fund balance of $92,664. That $92,664 would then grow 5.7 percent over the next 12 months, so she finishes the first year with $97,946. That's not much below her initial $100,000. In fact, even after 10 years, when she is age 75, her bond fund would still be worth over $73,000. From there, however, things start spiraling down.

The problem

She keeps pulling out $7,336 each year, but the amount of interest she earns keeps shrinking as her fund balance gets smaller and smaller. age 88, she would be down to some $7,000 and unable to afford the next year's full withdrawal.

Today, a 65-year-old woman can expect to live until age 85. In other words, picking the bond fund over the annuity would be a problem if our 65-year-old woman lives more than three years beyond her life expectancy.

The numbers for a 65-year-old man tell a similar story. The annuity would pay $7,927 each year. If he tried to replicate that income by drawing down the Vanguard bond fund, he would run out of money at age 85. That's three years beyond the median life expectancy for a 65-year-old man.

Living long

What percentage of 65-year-old men and women will live three years beyond their life expectancy? New York insurer MetLife puts the number at 39 percent. Make no mistake, for today's 65-year-olds, living until their late 80s is a distinct possibility and thus an immediate-fixed annuity could be a smart purchase.

These annuities, of course, hold the most appeal if you are in good health and family history suggests you will live a long time. Indeed, in pricing annuities, insurers assume buyers will live longer than average.

But even if you aren't sure you will live to a ripe old age, an annuity could still be a comforting purchase. If you stash maybe 25 percent of your portfolio in a lifetime-income annuity, that will give you some downside protection, allowing you to invest and spend down your other assets more aggressively. Intrigued? Here are five tips for immediate-fixed annuity buyers.

1. Get a fistful of quotes from your insurance agent or from a Web site like www.immediateannuities.com. There's often a wide spread in the income offered by insurers, so it pays to shop around.

2. Many annuity buyers opt for a guarantee, such as promised payments for 10 or 15 years. But I wouldn't bother, unless taking the guarantee involves only a tiny cut in the annuity's income. Instead, to eliminate the risk that you will invest a huge chunk in an annuity and die soon after, consider making smaller annuity purchases each year through the first 10 years of your retirement.

3. If you buy income annuities over time, that will also give you the chance to reduce risk by buying from different insurers. Even then, stick with top-rated insurers.

4.To protect against inflation, purchase an annuity where payments are linked to inflation or where your annuity check is stepped up each year by, say, 3 percent.

5. If you're married, consider a joint-life annuity, where the income is paid until both of you have died. Because you are insuring two lives, your annuity investment won't be wasted money if one of you dies prematurely. Buying a lifetime income stream could also be a smart move if you're worried about your spouse's ability to manage the household's finances after your death.