Immediate Annuities Can Help Retirees Offset Market Losses
Sunday, July 19, 2009
Retirees who watched in horror as their account balances plunged along with the stock market face a new challenge: how to generate enough income to pay their bills.
A widely accepted rule of thumb suggests that if you hold initial withdrawals to 4 percent of your nest egg during the first year of retirement and increase that dollar amount by 3 percent in each of the following years to keep up with inflation, you won't run out of money over a 30-year retirement. Now even that strategy may not be cautious enough, and you may have to rethink your plans for retirement income.
Depending on the extent of your losses, you may want to freeze your withdrawals at current levels, skipping the annual inflation adjustment until the market rebounds. Or, if you suffered losses of 30 percent or more, you may want to restart your 4 percent withdrawal schedule based on the new, lower balance. But that can take a big bite out of your income. Say you started with a $1 million retirement stash and had been withdrawing more than $40,000 a year. If your savings shriveled to $700,000, you'd now have to get by on just $28,000 a year.
There is, however, another way to stretch your income and increase your annual withdrawals to 8 percent or more of your savings. And you can still be assured you won't outlive your money. A study by the University of Pennsylvania's Wharton Financial Institutions Center found that by purchasing an immediate annuity, you could create a stream of secure lifetime income for 25 percent to 40 percent less than it would take to generate the same income from a traditional portfolio of stocks, bonds and cash using the 4 percent withdrawal rule. (That's because with an annuity, you're tapping both your principal and your earnings as well as pooling your risk with other annuity owners.)
Say you're 65 years old with a $1 million nest egg that has shrunk to $700,000. If you use half of your money to buy an immediate annuity, you would receive nearly $29,000 a year in payouts.
With the remaining $350,000, you could continue to invest in a diversified portfolio of stocks, bonds and cash and withdraw 4 percent a year. That would produce an additional $14,000 annually. Together with the annuity payouts, your retirement income would total about $43,000 a year -- $3,000 more than under the original 4 percent withdrawal scenario, even though your portfolio is now worth 30 percent less.
Naturally, there is a downside: With an immediate annuity, you give up control of the money. And although you get the maximum monthly income with a single-life annuity, it stops paying out when you die. If you die prematurely, you forfeit a chunk of your initial investment (which is then returned to the investment pool to pay the benefits of other annuity holders).