How to plan for a long retirement
Thanks to increased longevity and the lack of traditional pensions, one of the many questions people face when shaping their retirement portfolios is whether or when to move money to an annuity.
Annuities, complicated products with no shortage of detractors, are often described as life insurance in reverse.
When you purchase one, you give an insurance company a chunk of your savings and it agrees to send you a monthly cheque — either for a certain period of time or for the rest of your life, depending on the option you choose.
The amount you get depends primarily on your age and the current level of interest rates. For a slight cost, you can also add inflation protection to the mix, thus creating your own version of the indexed defined-benefit pension plans many public sector workers enjoy.
The catch, of course, is that you’ll never be able to touch that money again, apart from receiving the monthly income.
Despite this, conventional wisdom among economists has been that most people should ultimately go this route, because doing so will allow them to spend reasonably without outliving their money.
But a new research paper suggests this conventional wisdom may not hold true.
When is the best time to switch to an annuity? Much later than most imagine, it seems. And, in some cases, the paper suggests, annuitizing may not make much sense at all.
The researchers calculated that the break-even age between opting for an annuity versus spinning off income from two model portfolios — one with a 50 per cent equities allocation; the second, 20 per cent — and the likelihood of outliving the break-even income levels for various potential annuitization ages ranging from 65 to 85.
For the most part, managing a portfolio of stocks and bonds produces greater overall wealth than using annuities, they maintain.
Implicit in this comparison are two assumptions: that retirees value consumption equally in all years of retirement; and they don't feel the same way about bequests. In other words, people want no worries when it comes to running out of money, and can accept their heirs winding up with less.
According to the paper, although annuities do pay out more than managed portfolios initially, managed solutions deliver greater returns over time — even factoring in different asset allocations, fees and the impact of inflation.
In particular, those interested in leaving a legacy to friends and family will come out ahead by keeping their assets in their own hands and bequeathing the eventual remainder — even if they outlive 70 per cent of their peers.
Despite this, there are times when buying an annuity might make sense.
In my experience, most retirees want stability as they age. While you can certainly arrange for steady monthly income payments from your retirement portfolio, you need to create and manage a process to do so. An annuity is a more predictable choice.
While prospective buyers may be cool to the whole idea because interest rates are so low right now, it’s important to understand how mortality credits — the “other people dying” factor — can work to your benefit here.
Knowing that some of those who buy annuities will die prematurely allows insurers to essentially pass along money that would have otherwise gone to them to those who are still alive. The longer you live, the more of these mortality credits you get.
This feature appeals to certain people — those who don’t smoke, aren’t overweight, and whose parents lived in to their 90s — since it increases the effective yield on their investment while they’re living.
Of course, the idea that strangers might somehow split the remainder of their hard-won savings if they die young strikes most people as somehow unfair.
Despite this, an annuity does provide protection for those who anticipate having a longer than average life expectancy and expect to endure a long bear market, the researchers note.
If you’re one of them, you might consider buying an annuity — although not until well into retirement. In general, they suggest that most people shouldn't consider such a move until at least age 75.
If your primary concern is to protect against extreme longevity, though, the reality is that annuities and the mortality credits they accumulate still produce returns far beyond most alternatives for those who really do live a long time.
Got a question about investing, saving or retirement? Send Gordon an email and we might answer your question in a future column.
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