By Dennis Ho
No matter how you define it, retirement marks a transition into a new chapter of your life. One that comes with more freedom to spend time doing things that make you happy. But making your vision of retirement a reality involves more than saving enough money. It comes down to confidence.
For most people, the biggest concerns heading into retirement are declining health (50%) and running out of money (40%). As people live longer, often with chronic health issues, worries about outliving their savings become more realistic. And fewer retirees have pensions to rely on. Today, only 7 percent have the traditional three retirement income sources – pension, savings (including defined contribution plans), and Social Security.
When researchers studied what makes people happiest in retirement, they found an interesting correlation. Retirees with regular guaranteed income, such as pensions or deferred annuities, are happier. The peace of mind that comes with having a steady, predictable income stream helps reduce uncertainty and makes retirees more confident.
So, how do you achieve a happy, confident retirement, especially in an uncertain economy? For many, deferred income annuities – also known as longevity annuities – add a practical element to their retirement plan by creating a guaranteed future income stream.
The Benefits of Deferred Income Annuities
Deferred income annuities transform a lump-sum investment with an insurance company into guaranteed payments that begin at a future date of your choosing. For example, you can buy a deferred income annuity in your 50s, but delay the payouts to start in your 70s or 80s.
The main appeal is certainty. When you purchase a deferred annuity and choose the date you want to start receiving income, you know exactly what the monthly payout amount will be. The payments are guaranteed, no matter what happens in the stock market or how long you live.
Along with guaranteed income, tax efficiencies are another benefit of including deferred income annuities in your retirement plan. Any investment earnings accumulated are tax-deferred until the payments begin. In addition, part of the payout is the principal you contributed, making that portion tax-free.
Another appealing option is a Qualified Longevity Annuity Contract (QLAC). This type of deferred income annuity provides additional tax savings by enabling you to avoid taking required monthly distributions from an IRA or 401(k) until later in retirement by purchasing a QLAC with pre-tax or qualified account money.
Three Deferred Income Annuity Strategies to Consider
To determine if a deferred income annuity makes sense as part of your retirement plan, start by assessing your risks and evaluating the strategic role for deferred annuities.
De-risk the transition into retirement
As you get closer to retirement, it’s important to reduce the impact of market volatility on your accumulated savings. If you’re heavily invested in stocks and the markets tank a few years before retirement, you could be left with a hole in your retirement accounts that’s impossible to recover from. By converting part of your savings into a deferred income annuity, you can de-risk your portfolio and create a future income stream at the same time.
For example, if a man purchased a small deferred annuity each year starting at age 55, with the income payments set to begin at age 65, he would be able to gradually de-risk his savings while also gaining the value of dollar-cost-averaging over the ten-year timeframe.
Based on today’s rates, a $100,000 investment contributed evenly over ten years would generate $6,744 in annual income starting at age 65. In contrast, if he waited to invest the entire $100,000 at age 65, the annual income would be lower at around $5,861 per year. Note, if the 55-year-old waited to invest the $100,000, he would be able to earn a return on the money in the meantime, so the difference could be smaller by the time he reached age 65 as he may have more to invest, but he might also be taking more risk versus the deferred income annuities which guarantees income once the purchase is made.
Protect against extreme longevity
One of the main reasons the research finds people are happier when they have guaranteed retirement income, like a pension, is because it gives them the confidence to spend money earlier in their retirement without worrying about how they’ll cover expenses in their 80s or 90s.
If you don’t have a pension, a deferred income annuity can help you achieve the same comfort. For example, a 65-year-old couple could buy a deferred income annuity to cover the income they’ll need starting at age 85. Depending on their needs, they can choose to invest an amount that will provide enough income to cover all of their expenses at age 85 or a smaller amount designed to supplement their other retirement income down the road.
At today’s interest rates, a 65-year-old man and woman who invest $200,000 into a deferred income annuity can receive $42,358 per year starting at age 85, with income continuing as long as either is alive. By guaranteeing themselves a paycheck in later years, they’re able to focus on enjoying their retirement today.
De-risk and protect
A third strategy is a combination of the first two. Essentially, you still use a deferred income annuity to slowly de-risk a portion of your portfolio, but you do it at a later age. Instead of initiating the annual annuity purchases in your 50s, you can wait to see if the option makes financial sense as you near your 70s. This enables you to factor in your health and retirement spending to date as you determine the guaranteed income you’ll need as well as when it makes sense to start the payouts.
What You Need to Know Before Purchasing a Deferred Annuity
Like any retirement vehicle, deferred income annuities aren’t perfect and shouldn’t be the sole component of your financial strategy. As you evaluate the uses and benefits for your situation, keep the following in mind.
Don’t invest too much. If you’re 70 or younger, limit your allocation to income annuities to 10 to 20 percent of your portfolio. Keep in mind that you forgo returns you could earn with other investments during the deferral period, so it’s important to ensure that you’re optimizing your overall portfolio and addressing your long-term retirement needs. You can always opt to allocate more money to deferred income annuities as you get older, once you have a good handle on your liquidity needs.
Shop around – among A-rated insurers or better. Annuity pricing across insurers can differ by 10 percent or sometimes more, so it pays to shop around. Along with price, be selective about which insurers you consider. The financial strength rating should be the first thing you look at, then the price. By choosing an A-rated or better company, you reduce what’s called “counter-party risk” or the risk that the company won’t be around to meet the terms of the annuity contract. If you’re looking to spend more than $200,000, consider splitting your purchases across multiple insurers to further diversify your counter-party risk. To get income annuities quotes from top insurers, you can visit here to access the free online quote tool offered by Saturday Insurance.
Purchase over time. Interest rates drive annuity prices. Rather than attempting to time the market, the best approach is to purchase deferred income annuities over time, such as annually, so you have the opportunity to dollar-cost-average the prices, while still aligning to your retirement timeline.
About the author - Dennis Ho
Dennis Ho, CFA, FSA, is co-founder and chief executive of Saturday Insurance, an online independent insurance agency that focuses on income annuities, long-term care insurance and other products. With over 20 years of industry experience, Dennis has a passion for insurance and the role that it can play in building financial security. Dennis is a Fellow of the Society of Actuaries and a CFA Charterholder. Originally from Winnipeg, Canada, Dennis now resides in New Jersey with his wife and three young children. Dennis can be reached at firstname.lastname@example.org or on LinkedIn.