When you break it down, saving for retirement is fairly straightforward: Set aside a portion of your earnings each year, invest for a long-term time horizon, be patient, and grow your wealth. While this is obviously an over simplification, saving for retirement – at least from an investment standpoint – is pretty simple.
It’s when you actually reach retirement and start drawing income from your savings that things start getting much more complex and uncertain. As such, retirees generally consider guaranteed income and safety of principal more important than average returns.
And it’s not just a preference of retirees – the research backs them up, too.
When it comes to generating what is often considered to be a “safe” income source in retirement, there are really three major ways:
- Get safe income from the government through bonds or Social Security
- Use a bank with a money market account or CD
- Use an insurance company through life insurance or annuities
Despite a somewhat negative perception, annuities have been shown time and time again by researchers to add significant value to a retiree’s financial security. Additionally, annuities often outperform the other two sources of safe income options in retirement.
Let’s look at a few ways research has shown annuities to be valuable.
1. Reduce Portfolio Failure
Research conducted by John Ameriks, Robert Veres and Mark Warshawsky tested the sustainability of investment portfolios. Amazingly, their research found that when adding an immediate annuity into a retirement income portfolio, “for all time periods and for all portfolios, the addition of the annuity leads to a decline in the portfolio failure rates.”
I do not think the value of this can be understated. Adding an annuity into a retirement income portfolio can help reduce your likelihood of running out of money in retirement. The benefits of the annuity are enhanced with longevity, but this research showed value across the spectrum.
It is important to note that their research found that while annuities reduced the downside, they also helped reduce the potential upside of investment gains on the positive side. In other words, they simultaneously decrease your chances of running out of money and accumulating money.
2. Replace Bonds, SPIAs, and Variable Annuities with Fixed SPIAs
Dr. Wade Pfau, one of the leading professionals in retirement income planning research, published a research study called “A Broader Framework for Determining an Efficient Frontier for Retirement Income,” which looked at the efficient frontier of a portfolio to balance two financial objectives for retirement: satisfying spending goals and preserving financial assets. Interestingly, Dr. Pfau found that the most efficient investment mix consisted of a combination of stocks and fixed single premium immediate annuities, and not a more traditional portfolio of stocks and bonds or stocks.
This general position has been supported by other research like Roger Ibbotson’s whitepaper, “Fixed Indexed Annuities: Consider the Alternative,” which notes that fixed indexed annuities (FIAs) can outperform bonds in today’s low interest rate environment.
3. Increase Legacy
Many people worry that adding annuities to your retirement income portfolio will reduce your legacy. However, research has found that it can actually increase your estate and legacy in some cases.
Additional research from Dr. Pfau shows that by adding an annuity to help support lifetime spending in retirement, you may have a greater chance of meeting lifetime spending needs with a smaller portion of assets, creating potential to allow for a larger legacy amount in the event of a longer life. Additionally, the research found that “true liquidity” is increased when an annuity is added into a retirement income portfolio.
Without an annuity, the other assets are typically invested for future income and gains, so they are not really available for annual spending and liquidity needs. By adding an annuity into the mix, liquidity and spending capabilities can actually be increased. So, you can increase spending, true liquidity, and in some cases, legacy, by adding an income annuity into a retirement income portfolio.
The existing research presents us with a few major takeaways.
- Annuities are likely more beneficial to a retirement income plan than you first thought.
- Income annuities can provide cheaper and more efficient ways to generate income than traditional safe investments like CDs and bonds.
- Income annuities really help with one risk that almost no other investment can handle: longevity and portfolio failure.
If you are worried about living a long life and running out of money, consider a simple income annuity as part of your retirement income plan to help increase the sustainability of your retirement income and portfolio.
