Steady Flow Of Income

Kiplinger's Personal Finance Magazine, Oct, 2001 by Mary Beth Franklin, Christine Pulfrey

RETIREMENT | The security of an OLD-FASHIONED ANNUITY can make for smooth sailing

AN OLD idea is gaining ground in the new, new economy: guaranteeing a steady stream of income in retirement that you can't outlive. That was the concept behind traditional pension plans. But 21st-century retirees will soon be looking for ways to turn years of accumulated savings in 401(k) plans and IRAs into reliable streams of income without suffering stockmarket nausea.

"Ten years ago, most of my clients had a pension," says Robert Kreitler, a financial planner in New Haven, Conn. "Today most of them don't." Kreitler is one of a small but growing number of financial experts taking a second look at single-premium immediate annuities as a way of creating predictable income for retirees. "It's a do-it-yourself pension for a do-it-yourself world," he says. When you buy an immediate annuity from an insurance company, you exchange a lump sum of cash for the assurance that you will receive monthly checks for the rest of your life. The size of your checks is based on your age and sometimes gender (women get less because they tend to live longer) and how much you invest. How much you get each month also depends on whether you buy an annuity with payouts that cover your lifetime only, your life but with a guaranteed minimum term (so all is not lost if you die prematurely), or your life and that of your spouse (see the table on page 102).

From heresy to gospel

LIKE MOST financial planners, Eleanor Blayney of Sullivan, Bruette, Speros & Blayney, in McLean, Va., always thought that turning over a chunk of a client's nest egg to an insurance company in exchange for paltry guaranteed payments was sheer heresy--particularly when stocks were routinely producing double-digit returns.

By managing stock investments for growth and laddering bonds for income, Blayney believed she could easily generate higher earnings than the approximately 6% return a fixed-rate annuity could provide. By maintaining control over the portfolio, retirees could tap it for extra expenses--whether an emergency or an around-the-world cruise--and, counting on historic rates of return, increase their annual take to keep up with inflation. Any money left over at death would go to their heirs.

With a fixed annuity, the payout amount is set in stone and, in exchange for the promise that the checks won't stop until they die, retirees agree that any leftover money goes to the insurance company. Blayney concedes that some planners' anti-annuity bias may be partially based on self-interest: Money that is used to purchase an annuity is no longer an asset that can be counted toward an adviser's management fee.

But recent findings from the TIAA-CREF Institute, the research arm of the world's largest retirement system for teachers, has prompted Blayney and some other advisers to reconsider their position. The institute found that a retirement portfolio divided between an annuity and a managed portfolio could supercharge retirement security, providing both more certain and larger payouts than from a fully managed portfolio.

This isn't an all-or-nothing deal. It may make sense to hedge your bets by using part of your cash for an annuity to establish a guaranteed stream of income while leaving the rest of your money invested for growth.

For example, assume you retire with $1 million. Most financial experts recommend that retirees limit initial annual withdrawals to 5% of assets, and increase subsequent withdrawals only enough to keep pace with inflation. If you withdraw more than that, you increase the risk of outliving your money, particularly if you experience poor market returns early in your retirement. In this example, then, you could withdraw $50,000 the first year, and if inflation ran 3% a year, you could increase your annual withdrawal to $51,500 the next year.

Now assume you use half of your money ($500,000) to purchase an annuity for you and your spouse that pays $3,200 a month, or $38,400 a year, as long as one of you is alive. You still have another $500,000 to invest as you please. If you withdraw 5% a year from your remaining assets, you would have $25,000 on top of the $38,400 annuity payout for a total annual income of $63,400. That's 26% more money than if you relied on a straight withdrawal from your investments, and more than half of your annual income is guaranteed for life--no matter what the stock market does.

"In most cases, a 5% withdrawal rate solves the problem of not outliving your money, but it keeps a client's income lower than it needs to be," says Kreitler. With the annuity strategy, retirees maximize income from that portion of their assets because they use them all up. The annuity checks represent not only earnings on the money you have invested, but also part of the principal itself.

While Kreitler concedes that an immediate fixed annuity offers no inflation protection, he notes that retirees can always buy an additional annuity later in life to increase monthly income and get a bigger bang for their buck because the payouts increase with your purchase age. Meanwhile, the assets invested for growth can help protect against inflation. You're still counting on that growth, but diverting part of your cash to an annuity reduces the stakes if the market slumps.