How Can You Make Your Retirement Money Last?

Making your retirement nest-egg last through retirement isn’t easy. Company pension plans have all but disappeared, which means it’s now up to you to be your own actuary. Unfortunately, it’s not something many are equipped to do.

How can you make retirement money last? Let’s begin with one that gets a lot of heavy industry promotion. Some firms promote them as being the answer to all your prayers while other disparage them as evil, hateful, and to be avoided at all costs.

Both are wrong – big surprise. Absolutes seldom prove credible.

Let’s start with fixed annuities. Fixed annuities with yields tied to a stock index – indexed annuities – have become hot in recent years, much of it due to an aging population increasingly wary of volatile stocks. The rise of annuity sales is great. Fear of stock market volatility has affected variable annuity sales, as well.

One of the reasons index annuity sales are up is partly due to more consumer friendly product designs that have made the product more acceptable to the industry (and their compliance departments) and, as noted, partly due to demographic trends, i.e., baby boomers’ changing priorities. Making retirement money last has become a priority and annuities do speak to a need.

Remember, though, the financial industry is famous for responding to trends (and fears) with saleable solutions designed to generate revenue for the distribution channel.  If you’re considering purchasing an annuity, here are a few guidelines you may want to consider.

Index-linked annuities are NOT a substitute for equities.  

If you want to compare them to something, they should be compared to other investments designed to protect your money, i.e., CDs, treasuries, etc.  The reason for this is simple:   Annuities are not stock market investments; they are fixed-return investments that pay an unpredictable rate of return each year – the rate applied is dependent upon the return of an outside index.  While you can’t lose, the upside is generally capped.    A little math tells you that if the market is up 2 out of every 3 years, the best you’ll make is the cap rate for two of the three years and one will be 0.  So even if you have a cap rate of, say 10% and you earn 10%, 10% then 0%, your compounded rate of return for the three years is 6.56%.  While the return is tax-deferred, you still have a tax issue:  If your combined federal and state tax bracket is 30%, it means, in reality, you’re making 4.59% – the rest is Uncle Sam’s money that’s growing…. and Uncle Sam can (probably will) change his mind about how much of it is his when the time comes you decide to withdraw your money.  He could decide he wants more.

So, return is unpredictable, though tax-deferred, and it’s capped.   In exchange for giving up a guaranteed return, you might get 1%–2% more per year over the long run, depending on what future interest rates and the stock market does. If interest rates move up and the market is flat, results could be problematic. My own take is that one should expect a return similar to short-to-intermediate bonds.  

If you are considering an index annuity with a living benefit, realize that the income guarantees on the date of issue are the most you will likely ever receive.

Do Annuities make sense for Lifetime income?

It’s a strategy for making your retirement money last. The premiums you pay go into the insurance company’s general account, which is then invested heavily in bonds. Outlays are then matched to the length of time they are needed.

The growth potential for stocks is greater, of course, and individual bonds can support an income for a fixed period, but they do not offer longevity protection.  You can create a bond ladder, but, the longevity protection won’t exceed the last bond in the ladder, so it may not be the best way to make sure your retirement money lasts.

And, contrary to what many may believe, bond funds can be quite volatile.  Funds with long bonds can be as volatile as the stock market, exposing retirees to both potential losses and sequence risk while still not providing the long-term inflation hedge required to support maybe 30 years of spending during retirement.  

One thing an annuity provider can offer: risk pooling.  This allows an income annuity to support a higher level of lifetime spending compared to bonds.  Stocks have proven to provide that long-term inflation hedge; but short-term risk. A downturn in the market during the early years of retirement, while a retiree is withdrawing money, can create a hole that’s very difficult to dig out of.  So, we have sequence-of-returns risk on the short end of the time frame and longevity risk – outliving your money – on the long end.

Think about annuities as income bonds of a different type:  The length of payments are for life with no maturity date.  The flip side is the principal value is not repaid upon death.  You’re trading principal (which you hope you don’t have to spend anyway) for security, which was the whole point of investing in the first place. And, even though they may appear to make retirement money last, their value as an inflation hedge is problematic.

When you think about it, Social Security is a form of annuity – you’ve been paying premiums all your working career that goes into pooled money sharing the risk – providing an income you can’t outlive with no return of principal.  Ask some seniors if they like their Social Security – I’ll bet the answer will be unanimous. And, Social Security DOES provide inflation adjustments – key to making retirement money last.

So, we do know an income annuity can be a great tool for managing longevity risk. The payout rates for an income annuity assume bond-like returns and longevity is further supported through risk pooling and mortality credits, rather than by seeking outsized stock market returns.

Risk pooling is the ‘secret sauce’.  While you may think it counterintuitive to subsidize payments to others, this act can allow all owners in the risk pool to enjoy a higher standard of living than bonds could support. All annuity owners know that the mortality credits will be waiting for them if they do end up living beyond life expectancy.

An income annuity not only provides longevity risk protection, it also avoids sequence risk.  The annuity provider invests the pooled money mostly into individual bonds which create income that matches the company’s obligations for covering its promised annuity payments.

So, someone near or in retirement has some choices; but, it’s not an all-or-nothing proposition.  There are stocks, bonds, annuities, or they can self-annuitize. Do you want to make retirement money last – or do you wan to make your income last? Or, can you do both?

Bonds: One could spread the money over a bond ladder of 20 years or so; but, history tells us spend rates over that period wouldn’t be sustainable, especially with taxes and inflation.  In short, you could still expect to be taking longevity risk and a danger of no late-life income.

Income annuities: With risk pooling, longevity risk is eliminated, no matter how long the annuitant survives.

“Self-annuitizing”: Now suppose the retiree “self-annuitizes” instead by managing this longevity risk without insurance.  Suppose we assume a retirement of thirty years.  Note that there is a direct relationship between a longer life and a lower rate of spending. Retirees who plan to self-annuitize are forced to spend less to the extent they worry about outliving their money.  For those with substantial portfolios and responsible spending habits, this is an option – as it is for most of my clients.

Stocks: I saved stocks for last.  Stocks create risk. No news there. The greater the stock exposure, the greater the exposure to volatility.  And, as we’ve noted, spending from investments further heightens sequence risk. A few poor returns early on could easily derail retirement outcomes for years, even permanently.

It seems life is full of trade-offs. Annuitized assets do not provide upside stock market potential or a legacy for heirs, but spending (longevity) risk is also eliminated.

One problem with “Self-annuitizing” is that it requires lower spending, and stocks could support higher spending with upside growth – and both options have their risks, as we’ve seen.

Bonds? The question is why would anyone want to hold bonds to meet spending obligations, given what we’ve noted above?   After all, an income annuity invests in bonds and provides payments precisely matched to the length of retirement, while bonds alone hold no advantage.

So, the income annuity provider’s risk pooling allows us to spend more in the early years when sequence of return risk is greatest and addresses longevity risk as well. Again, remember, their value as a long-term inflation hedge – money is worth only what it can purchase – might be problematic.

Sequence risk has another wrinkle. Many people are faced with spending less in the early years in the hopes that values will increase so that they can spend more later.  But, in fact, most people spend more in retirement’s early ‘go-go’ years, compounding sequence risk, and may be forced to reduce their standard of living later. This can be disastrous because inflation compounds, too!

Now, after reading all this, you might think I’m a huge promoter of annuities. Well, yes and no. The fact is while I am licensed for annuities, I have not placed one with a client for over ten years. Now, this could change, of course – they’ll need to come up with a low-cost long-term inflation solution – but, while I think they can be a fine tool for many people, I just haven’t found them the right ‘fit’ for anyone I work with. After all, penicillin is a miracle drug, but some people are allergic to it. Doctors don’t go around selling penicillin and advisors shouldn’t be just be prescribing annuities either. Annuities can be very complex and contain a lot of hidden levers under the hood. I’ve always believed that anything a client invests in should be simple, clear, and easy to understand. The more complex something is, the less I like it. There are a lot of good, clean, simple annuities out there (without the bells and whistles that can make them both highly marketable and dangerous); I just haven’t found the right fit yet – but, I’m sure at some point I will. There’s more at stake than simply making retirement money last.

Back to our retirement income issue, how does a retiree prepare? Like building a house, it begins with a blueprint. However, understanding: how to address retirement income and portfolio construction begins with understanding there’s usually a combination of tactics required to create a strategy.  And, it helps to have some guardrails built in.

If you’d like some help getting your planning started, I hope you’ll reach out.



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Jim Lorenzen, CFP®, AIF®

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-based registered investment advisor. He is also licensed for insurance as an independent agent under California license 0C00742.  IFG helps specializes in crafting wealth design strategies around life goals by using a proven planning process coupled with a cost-conscious objective and non-conflicted risk management philosophy.

Opinions expressed are those of the author.  The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

Jim's picture
Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-based registered investment advisor. He is also licensed for insurance as an independent agent under California license 0C00742.

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