If you’re planning for retirement, you may be trying to determine the best source of safe, yet reliable income. Some of the more popular income-producing tools may even have been presented to you. Annuities versus bonds versus CDs – the list goes on and on, as does the debate between financial advisors, as to which of these financial vehicles is really the best answer.
But, with the unpredictability of the stock market over the past decade or so, coupled with minuscule interest rates on “safe” investments, it can be difficult for those who are approaching retirement to generate a solution for providing a truly livable amount of income and to keep principal protected from potential losses in the future.
That is unless you actually have an income plan
Unfortunately, going with the more “traditional” retirement income generation approaches doesn’t really work anymore in today’s world. One reason for this is because the market – as well as financial products – have changed.
For instance, for many years, financial advisors relied upon “The 4% Rule” to help retirees create a balanced portfolio from which they could “drawdown” 4% each year for income and leave the rest to continue growing.
The idea was that a balanced portfolio (which often consisted of roughly 50% stocks and 50% bonds) would be able to sustain itself – even after withdrawing 4% of the total – and by the following year, the growth in the portfolio would have filled-in some, or even all, of the gap left by the withdrawal. So, in a perfect world, this process could go on for many years, generating a livable income for the retiree.
Sadly, though, the failure rate of this rule of thumb has become far too great for most current and future retirees to rely on. And those who do rely on portfolio drawdown plans will oftentimes fall into one of two camps.
One is withdrawing (and in turn, spending) too much money as it relates to the re-growth in the portfolio. In other words, if you withdraw 4% (or even just 3%) each year, but the assets in the portfolio are only generating a return of 2% or less, slowly but surely, the well will run dry.
This can be akin to driving down a dirt country road, with no gas station in sight, while you watch the fuel gauge make its way towards Empty. In this case, even if you don’t know exactly when that will happen, you know that it eventually will.
On the other side of the coin are those who withdraw “too little” from their portfolio. The money is there and available to them, but they live under the constant worry of “what if.” What if the stock market crashes? What if our home needs a new roof? What if we purchase that vacation home we’ve always wanted, and then the real estate market takes a dive?
These are the people that famed retirement income expert Tom Hegna says are living a “just in case” lifestyle. While it is certainly necessary not to make willy nilly decisions with your life savings, many of the folks in this camp end up passing away with a large account balance still in-tact.
And guess what happens then?
Their kids (or grandkids) inherit the money and they don`t worry about all of the what if’s…and they buy the beach house, the boat, and the brand new car!
Combine the market uncertainty with the fact that Social Security is on shaky ground, and that most employers have done away with defined benefit pension plans, and you have quite a dilemma regarding where retirement income will come from and how long it can be relied upon.
So, what can you do to create a reliable income stream that lasts as long as you need it – even in the midst of market and economic uncertainty?
One solution is to use an annuity
Annuities are actually designed to pay out a set amount of income for a predetermined amount of time (such as ten or twenty years), or even for an indefinite period of time like the remainder of the annuitant’s (i.e., the income recipient’s) lifetime, no matter how long that may be.
Because of that, annuities can bring a great deal of certainty to your overall retirement income plan. That’s because you know when you’ll be receiving your next income payment, as well as how much it will be.
These financial vehicles can be used to create a floor, or a base, amount of incoming cash flow, similar to how your regular paycheck did during your working years. Having this guaranteed income from an annuity, you can more easily budget your expenses, as well as plan for purchases in the future.
Another nice feature that a reliable stream of income from an annuity can bring is the ability to leave some of your other assets in the market with the opportunity for added growth, yet without worrying about completely changing your lifestyle if the market and your investments go south.
Which Retirement Income Plan Would You Use?
Consider the example of John and Janet who both turn age 66 soon, and plan to retire within the next few months. They’ve each spent the last 40 years setting aside money for the future – and they’ve both done quite well, having accumulated $1 million in each of their portfolios.
With the volatile stock market, both John and Janet have protection of principal at the top of their lists when designing their income plan, especially because a loss could mean a decrease in the amount of incoming cash flow they can generate.
This is particularly the case with John, as his investments took quite a hit during the 2008 recession. He knows how hard he had to work – even taking on a side job for several years – so he could add more to his portfolio and get back to even.
Because of his fear of future stock market-related losses, John decides to play it safe and purchase government bonds with the bulk of his savings. He locks $1 million into 30-year Treasuries, which generate approximately 2%, or $24,000 per year in income.
That, coupled with another $2,000 per month from Social Security, provides John with $4,000 to spend every month – giving him just enough to pay his everyday expenses, including housing, utilities, gas, food, and other necessities.
So, even though John knows that he’ll need to downgrade his lifestyle in retirement, he finds comfort in the fact that he won’t have to worry about losing money in a future market “correction.”
He will, however, have to be mindful of the value of his bonds over time. For instance, typically, when interest rates go up, the value of bonds goes down. This, in turn, can cause a loss in the value of the principal.
If John lives for another 20+ years – which is becoming much more common due to longer life spans – his living expenses will undoubtedly go up. And, since he is already cutting it close with his $4,000 per month income, there’s a chance that he will need to sell some of his bonds at a loss in the future in order to meet those higher expenses.
This, in turn, can start a dangerous cycle of dipping into his principal over time, which could cause John to eventually run out of savings. Given that the U.S. has been stuck in a low interest rate environment for more than a decade, the chances of interest rates rising in the future is much more likely than rates being reduced even further. With that in mind, John stuck with his decision, knowing that he’d have to make a “tradeoff” to get the safety he was looking for.
Janet also wants to keep her money safe, while at the same time generating an ongoing income she can rely on for the rest of her life. Longevity runs in Janet’s family, so one of her biggest fears is running out of income in retirement, regardless of how long she may need it.
She talks to a retirement income specialist who, after listening to Janet’s concerns, shows her a single premium immediate annuity, or SPIA. Based on her age and her contribution of $1 million, Janet learns that she has several income options available to her, depending on other guarantees that she may or may not want.
Janet’s Income Options
Female age 66. Income start date 01/01/2020. Accessed Dec. 4, 2019
For instance, she could choose to go with a lifetime income that will continue for either 10 or 20 years to a beneficiary, even if Janet passes away sooner than anticipated. Alternatively, Janet could receive a higher dollar amount, with no death benefit or continued income after she passes away.
Ultimately, Janet chose to go with the single life only income annuity option, and she will be able to count on money coming in each and every month – even if she lives well into her 90’s (or beyond).
Janet is also very happy that she compared the different options that were available for her, rather than just simply going with a “traditional” market-based retirement income plan like John did.
With the $4,924 that Janet will receive from the annuity, plus the $2,000 she’ll get from Social Security, Janet will start her retirement with nearly $7,000 per month, as versus John’s $4,000 – and she was able to do so with the same amount of principal, as well as far less risk and uncertainty.
Unlike John, Janet won’t have to worry about what happens with interest rates, or with the stock market – and her income will continue to flow in. Knowing that she has an income “floor” that she can count on for the rest of her life, it is much easier for Janet to budget for her needs and her wants in retirement.
Beyond the Income – Added Benefits of Owning an Annuity
In addition to the steady stream of income they provide, annuities can also offer a long list of other perks. For instance, deferred annuities do not begin paying income until a time in the future.
During a deferred annuity’s “accumulation” period (i.e., the time before the annuity is converted over to an income stream), the funds that are in the account are allowed to grow on a tax-deferred basis.
This tax-deferral can allow the money in the account to grow and compound over time, because not only are the funds earning interest on the principal, but also on the interest, and on the money that would otherwise have been paid in taxes.
Bonds, CDs, and most other “safe” investments can’t say the same. So, in addition to earning pitifully low returns, these other investments can end up putting even less money in your pocket after taxes.
Annuities can also provide other “bells and whistles” that most traditional income and safe alternatives don’t. For instance, there are many annuities today that include a terminal illness and/or a nursing home waiver.
What this means is that if the annuitant is diagnosed with a terminal illness (usually with a life expectancy of one year or less) and/or they must reside in a nursing home facility (typically for at least 90 days), funds may be accessed from the annuity penalty-free…even during the surrender period.
Annuities versus CDs and Bonds
Some types of annuities may even be able to offer the “best of all worlds” in that they provide the opportunity for market-linked growth, while at the same time keeping principal safe in down markets, and offering the ability to secure a lifetime income for as long as it is needed.
Fixed indexed annuities base their return in large part on the performance of an underlying market index, such as the S&P 500. If the index is up in a given time period, the annuity is credited with a positive return – typically up to a certain set maximum, or “cap.”
However, if the underlying index performs poorly in a given contract year, and it has a negative return, the annuity will not suffer a loss. Instead, it is simply credited with a 0% return for that time period.
This means that even in down years for the index, there are no losses for the annuity to make up for – and in turn, future growth can continue to build upon prior gains. Added to that is the tax-deferred nature of the growth. So, the funds could pick up some significant momentum over time.
Many fixed indexed annuities also offer optional add ons, or riders, that can enhance the benefits and guarantees even more. For instance, a Guaranteed Minimum Withdrawal Benefit (GMWB) rider or a Guaranteed Minimum Income Benefit (GMIB) rider can ensure that you won`t run out of money or income – even if the annuity’s account value is depleted.
There are many “moving parts” on annuities, though. So, even if the benefits seem to far outweigh the potential downfalls, it is important that you have a good understanding of what you are purchasing – particularly because annuities could comprise a large portion of your savings.
Individual Financial Products are Not Complete Income Plans
For most people, just one single financial product (such as an annuity, bond, or CD) does not equate to an actual retirement income plan. Rather, various products are used in conjunction as “tools” to help solve for specific short- and long-term financial goals.
So, before committing to any financial option – regardless of how safe it could be – it is essential to determine how it works, and how it may (or may not) work with other investments you own or plan to purchase. With that in mind, even if an annuity seems right for you, it should often be used as just one component of your overall financial and retirement income plan.
Want to Create a Real Plan for Income in Retirement?
Rather than relying on a hodge-podge array of “traditional” investments that may or may not provide you with an ongoing income stream, an annuity offers long-term certainty. Not all annuities are exactly the same, though, so in order to make sure you get the particular benefits you’re looking for, you first need to match your specific needs to the right one.
There are lots of annuities to choose from today. But don’t worry. We’ve already done the heavy lifting for you. Our annuity “geeks” thrive on educating consumers about how different types of annuities work, as well as what to look out for when considering the purchase of one.
At Annuity Gator, they focus on researching and reviewing all flavors of annuities – including fixed, fixed indexed and variable annuities – so they can help you to narrow down which one – if any – could be the right fit for you.
Wouldn’t you rather spend your time in retirement relaxing and planning your next adventure, instead of wondering when (or IF) your next income check will arrive?
That’s what we thought!