Guaranteeing a regular income after retirement

Annuitising your savings reduces chances of running out of money

Ilana Polyak

There comes a point in every saver’s life when it’s time to stop saving and start spending. There are lots of calculators to help you figure out how much regular income you’ll need once you stop working. But where will this money come from?

The traditional sources of retirement income, often referred to as the three-legged stool, belong to a bygone era of Nehru jackets and Rubik’s Cubes. These three income sources — company pensions, social security and individual savings — worked together to create retirement security. There was little risk of running out of money — if these three sources contributed their fair shares. While longevity is certainly a wonderful thing, when it comes to retirement planning, it’s a wild card.

Defined-benefit pensions are a guaranteed source of income, an assurance that no matter how long you live you will continue to collect a check. The same is true of social security, which provides inflation-adjusted payments for life. Current retirees receive some 69% of their incomes from these two sources, according to the Employee Benefit Retirement Institute. But today’s workers can expect these two sources to account for just a third of their income needs.

That leaves individual savings to assume a bigger role. The only problem is, “You can outlive your personal savings,” says Bill Reichenstein, professor of finance at Baylor University in Waco, Texas. Milevsky, Reichenstein and others say that future retirees should strongly consider annuitisation, a process of converting some savings into predictable income. There are several ways to achieve this, but the goal is to secure a steady check month after month.

According to Constantijn W A Panis, manager with Deloitte Financial Advisory Services in Los Angeles, having an income stream that funds at least 25% of your retirement spending boosts retirement satisfaction to almost 70%.

People who derived much of their retirement resources from an annuity exhibited fewer depression symptoms, a study says. At any given level of income, just having a portion of retirement resources in the form of annuities was perceived as having more money.

Reducing risk
Retirement today is filled with risks that personal savings alone can’t address. The biggie is longevity. The longer you live, the more money you’ll need and the greater your chances of running out. While average life expectancy is 77 years, according to the Centers for Disease Control and Prevention, those who reach age 65 can expect to live another 18 years to age 83. In fact, the over-85 set is the fastest-growing segment of the population.

Another biggie is inflation risk, or not being able to keep up with ever-rising prices. Finally, there is investment risk, the possibility that a market downturn will hit your portfolio just when you need the money most.

Annuitisation can take the sting out of all three risks. First, there’s no fear of running out of money, since by its very nature annuitisation provides lifetime income. Second, you can invest your other assets in higher-risk fare that has a better chance of beating inflation. And third, if a bear market strikes, you can ride out the storm.

“If you don’t have to touch the stocks in your portfolio, there’s your investment hedge,” says Rande Spiegelman of Schwab Centre for Investment Research in San Francisco.

Milevsky and Chen earned a patent in 2006 showing that the right combination of annuitised and non-annuitised assets in retirement can significantly reduce a person’s chances of running out of money. For example, with a portfolio composed of 60% stocks and 40% bonds where an investor takes systematic withdrawals to meet his or her income needs, the pair found that the chances of depleting assets starts to rise before age 80 and runs to about 49% at 100. But annuitising about half of such a portfolio greatly enhances the chances of not running out of money.

How to annuitise assets
Workers who are lucky enough to have a pension are usually better off opting for a lifetime annuity payout rather than a lump sum if presented with the choice. It might be tempting to get one big pot of money all at once, but most of us are pretty lousy at managing that kind of money and making it last.

The most straightforward of these products provide a fixed monthly amount. However, you can also purchase a variable annuity and tie the amount of the benefit to the performance of fairly conservative investments such as intermediate bonds that could help you keep up with inflation.

Shop around for the lowest fees and make sure you go with a well-established insurance company with solid financial backing before making a purchase.

Figuring the annuity amount
Once you’ve decided to go with some type of annuity, you need to figure out how much of your income it should represent. That depends largely on your resources. Those who receive a generous pension, combined with their social security income, won’t need to do more. Ditto for the superrich.

For those in the middle, experts recommend that you convert about a quarter to a third of your assets into an annuity if you don’t have a pension. Together with social security, about half of your income needs can be annuitised.

Of course there are downsides to annuitising. The biggest is giving up control of your assets. There’s always the possibility that you’ll make the wrong bet. In other words, you won’t live long enough to get the full benefit and in the meantime you’ve given up a chunk of your assets.

Think of annuities as insurance. For example, good drivers usually feel like they’re getting ripped off with car insurance. Bad drivers, on the other hand, come out ahead because their accidents get covered. If longevity runs in your family, chances are pretty good that you’ll be like one of those bad drivers getting the most from the insurance company.

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