Transfer The Risk Of Outliving Your Money
How much of your retirement nest egg can you afford to spend each year without running the risk of outliving your savings? Despite considerable ongoing research to identify a maximum safe withdrawal rate, there's no consensus, and most estimates are discouragingly low, often less than 5%. That means if you've saved $1 million, for example, you'll have to live on $50,000 a year or less (not including Social Security).
But there is a way to do considerably better, though it comes with its own trade-offs. An insurance product known as an immediate annuity lets you exchange cash for a promised monthly payment that keeps coming as long as your heart keeps beating. A recent quote for a 60-year-old New York male from ImmediateAnnuities.com, an online broker, would convert a $1 million investment into a guaranteed lifetime monthly payment of $6,115. That's considerably more than the monthly draw of $4,167 you'd get at a 5% annual withdrawal rate.
An immediate annuity, in effect, lets you transfer your risk of outliving your money to an insurance company. It's the kind of deal you get from Social Security (and may still get from a corporate pension plan, though there are fewer and fewer of those). In all of these cases, you're promised a relatively generous lifetime payout because the payer—an insurance company, the government, or your employer—knows it won't have to make good on all its promises. Many people will die relatively soon, ending the payer's obligation. That leaves more money for those who live longer.
The most obvious problem with this equation is that you could die early. Suppose that 60-year-old New Yorker hands over his million and dies a year later. He has received a grand total of $73,380—and his heirs get nothing. To reduce that risk, insurers typically offer a variety of guarantees. For example, the New Yorker could purchase an annuity paying $5,652 a month that also promises at least 20 years of payments, with payouts going to his designated beneficiaries if he dies before that time. Or he could buy a joint policy with his 60-year-old spouse that gives them $5,256 a month for as long as either is alive; to get a 20-year guarantee, they could accept a lower monthly payout of $5,027.
Immediate annuities have other risks beyond the owner's early death. Your money is irrevocably tied up, unavailable even in an emergency. Moreover, the insurance company could go out of business, or interest rates could rise steeply after you've locked in a low rate. One way to spread such risks is to "ladder" your annuities, buying from a few different companies over several years. That way, if an insurer defaults or interest rates change, only part of your savings will be affected—and in any case, you'll likely want only a portion of your nest egg in annuities. In addition, immediate annuities usually don't have inflation protection, and the buying power of your monthly payments can be eroded sharply by inflation. A handful of carriers do offer inflation protection, however.
The potential benefits of immediate annuities are alluring. They turn savings into paycheck-like income, and you could buy an annuity large enough to cover most or all of your fixed expenses. With those costs covered, you might feel comfortable taking slightly more risk with the rest of your portfolio, potentially increasing long-term gains.