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INVESTING A RETIREMENT NEST
EGG
If you’ve been prescient enough to save for your retirement,
what investment strategies will help ensure that your money
lasts as long as you do? There are two basic alternatives.
First, one can annuitize all or part of one’s retirement nest
egg. Second, the retiree can continue to hold his investment
portfolio and set up a withdrawal rate that provides for a
comfortable retirement while minimizing the risk of outliving
the money. How should one decide between the two
alternatives?
Annuities
Sturgeon’s Law, coined by the science fiction writer
Theodore Sturgeon, states, “95 per cent of everything you
hear or read is crap.” That is certainly true in the investment
world, but I sincerely believe that what you read here falls
into the category of the other 5 percent. With respect to the
advice regarding annuities, I suspect that the percentage of
misinformation is closer to 99 per cent. Your friendly annuity
salesman will tell you that annuities are the only reasonable
solution to the retirement investment problem. But many
financial advisers are likely to say, “Don’t buy an annuity:
You’ll lose all your money.” What’s an investor to make of
such diametrically opposite advice?
Let’s first get straight what annuities are and describe their
two basic types. An annuity is often called “long-life
insurance.” Annuities are contracts made with an insurance
company where the investor pays a sum of money to
guarantee a series of periodic payments that will last as long
as the annuitant lives. For example, during late 2010 a
$1,000,000 premium for a fixed lifetime annuity would
purchase an average annual income stream of about $75,000
for a sixty-five-year-old individual. If a sixty-five-year-old
couple retired and desired a joint and survivor option (that
provided payments as long as either member of the couple
was alive), the million dollars would provide fixed annual
payments of about $62,500.
Of course, with any inflation, the purchasing power of
those payments would tend to decrease over time. For that
reason, many people prefer to purchase “variable annuities.”
Variable annuities provide the possibility of rising payments
over time, depending upon the type of investment assets
(typically mutual funds) chosen by the annuitants. If the
annuitant chooses common stocks, the payments will rise
over time if the stock market does well, but they will fall if
the stock market falters. Annuities can also be purchased
with a guaranteed payment period. A twenty-year guaranteed
period means that even if you die immediately after
purchasing the annuity, your heirs will receive twenty years
of payments. Of course, the annuitant will pay for that
guarantee by accepting a substantial reduction in the dollar
amount of the annual payments. The reduction for a seventy-
year-old male is likely to be over 20 percent. Thus, if you are
really bothered by the possibility of dying early and leaving
nothing behind, it’s probably better to scale back the
proportion of your retirement nest egg used for an annuity
purchase.
Variable annuities provide one approach to addressing
inflation risk. Another possibility is an annuity with an
explicit inflation-adjustment factor. For example, the
Vanguard Group offers an annuity with an explicit inflation
(consumer price index) adjustment up to 10 percent per year.
Such a guarantee will naturally lower the initial payment
substantially. A sixty-five-year-old couple desiring a joint
and survivor option would find that $1,000,000 would
provide an initial annual payment of only about $57,400 per
year.
Annuities have one substantial advantage over a strategy
of investing your retirement nest egg yourself. The annuity
guarantees that you will not outlive your money. If you are
blessed with the good health to live well into your nineties, it
is the insurance company that takes the risk that it has paid
out to you far more than your original principal plus its
investment earnings. Risk-averse investors should certainly
consider putting some or even all of their accumulated savings
into an annuity contract upon retirement.
What, then, are the disadvantages of annuities? There are
four possible disadvantages. Annuitization is inconsistent
with a bequest motive, it gives the annuitant an inflexible path
of consumption, it can involve high transactions costs, and it
can be tax inefficient.
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