As a financial advisor, I’ve seen many retirees fearing “longevity risk” – the real possibility of outliving savings in later years. With people living longer and markets delivering unpredictable returns, this risk is top of mind for clients.
To be very clear,
Longevity risk is the chance of outliving your savings, and it’s emerging as one of the most pressing financial threats faced by retirees today. With average life spans stretching longer thanks to healthcare advances, and serious market downturns capable of depleting portfolio balances precipitously, there’s ample reason for concern about running out of money before running out of breath.
Mitigating this risk has become a central focus in my clients’ conversations about retirement. And one strategy I commonly prescribe is incorporating annuities into an overall retirement income plan.
Annuity In Simple Words…
Annuities are essentially insurance contracts designed to provide guaranteed income for life. First, You pay an amount to the insurance company. Next, they offer you a monthly income guarantee in return which can either be for a limited time period, or even lifetime. You also have the option to choose if you need the payments to start immediately or at some point in the future.
While not appropriate for everyone, they can serve an invaluable role in securing essential retirement expenses despite unknown remaining lifespan or market conditions.
In this article, I’ll explain what longevity risk means, why it’s often underestimated, and how to effectively use annuities to hedge yourself against the chance of outliving your assets. Even if you consider yourself financially savvy, I think you’ll find some useful perspectives here as you look ahead to your own retirement security.
The Retirement Landscape Today
Before diving into annuities specifically, it’s helpful to understand today’s retirement terrain. We’re witnessing two shifts that are colliding to amplify longevity risk. First, life expectancies have increased markedly in recent decades. When Social Security was introduced in the 1930s, average life expectancy was barely over 60 years old. Today, it’s closer to 80. And those averages obscure the fact that roughly a quarter of today’s 65-year-olds will live past age 90. So even for healthy retirees, planning for a retirement spanning 30 years or more is prudent.
Yet while lives are lengthening, sources of reliable retirement income are declining. Defined benefit pension plans that send monthly checks for life are increasingly rare outside the public sector. Social Security faces long-term financing questions, especially for younger workers. Home prices and interest rates – common sources of equity harvesting in retirement – appear overvalued. And markets increasingly demonstrate extreme volatility, as retirees enduring the dot com crash and 2008 financial crisis learned all too painfully.
So the margin for error in retirement planning is shrinking from both sides – longer retirements needing support just as safety nets erode. Together those trends underscore the necessity of the reliable, stable income in retirement that annuities can provide.
The Problem With Typical Retirement Withdrawal Plans
Most retirees plan to fund spending needs from investing portfolios built over their careers. The popular approach is withdrawing 4-5% of initial savings each year, adjusted upwards for inflation. Financial models show this strategy has historically held up well over normal lifespans.
But we’re now facing longer retirements spanning 30 years or more. And market performance can fluctuate sharply from year to year. Both these factors pose challenges for withdrawal systems.
If investments drop early in retirement, it becomes hard to regain lost ground over time. And even small variations below historical returns over decades multiply impact. Extreme events like once-a-century market crashes increase failure risks further.
So while backtested models say 4-5% withdrawal rates are “safe”, that assumes average lifespans and market behaviors. Reality may not be so accommodating.
Bond portfolios struggle here too. Interest rates sit near historic lows limiting future returns. And bonds carry inflation risks if consumer prices rise faster than normal.
In essence, typical withdrawal plans require multiple assumptions – on lifespan, markets, inflation, etc – to break in your favor year after year. But retirement requires planning for the full range of probable scenarios – both normal and more extreme. Simple withdrawal frameworks struggle to provide reliable income safety against those risks. Hence, a more robust solution needs consideration.
How Annuities Mitigate Longevity Risk
This is where annuities can play a vital role in crafting durable retirement income plans. Annuities are insurance contracts designed to alleviate concerns over an unknown lifespan and market conditions thwarting retirement success. In exchange for an upfront premium payment, the annuity issuer provides guaranteed lifetime income to the annuity owner beginning immediately or in the future.
Think of annuities as akin to Social Security but offered by private insurance companies rather than the government. In fact, at their core, annuities represent insurance against longevity – the risk of exhausting assets should you live beyond normal life expectancy. The annuity pool collects premiums from all purchasers and directs the common funds out as scheduled income payments to those still living.
Those still living collect what are known as mortality credits. These credits represent the share left unclaimed from payments intended for annuitants who died with shorter lifespans. So longevity insurance through annuitization provides larger income payouts than would be feasible for individuals self-managing investments in retirement years. Annuities allow spending confidently based on average remaining years rather than ultra-conservative assumptions forced by extreme scenarios.
Deciding if Annuities Are Right for You
When planning for your retirement future, one key question is whether to allocate some money towards buying annuities. Let’s walk step-by-step on how you can decide if incorporating appropriate annuities into your overall income mix might help you better achieve retirement goals and confidence.
Start by Looking at Your Total Income Picture
Get organized on sources providing reliable lifetime income. This includes Social Security benefits, especially if you or your spouse plan to delay starting payments until age 70 when the monthly amount reaches its maximum. Add any pension benefits or retirement funds from past jobs guaranteeing paychecks for life too.
Next factor in income that you won’t have flexibility in controlling, such as Required Minimum Distributions that mandate withdrawing some funds every year from retirement accounts once you turn 72. While not guaranteed, RMDs do provide some income cushion.
Assess Your Expected Costs Versus Risk Comfort
Now examine how much discretionary income you’ll depend on investments to generate by looking closely at your retirement lifestyle hopes and spending habits. Build in some buffer too for unexpected costs. If meeting all these expenses solely from withdrawals seems risky or unrealistic, adding sources of guaranteed income may ease worry.
Are You Optimistic on Longevity Based on Health and Family History?
While genetics offer no definitive answers, considering your health, fitness level, and family longevity provides clues on how long assets may need to last and if late-in-life protection merits emphasis.
Weigh Your Priorities Around Estate Planning
Annuities provide excellent longevity protection for you by converting assets into income for life. But they then leave less wealth behind for heirs compared to traditional investment accounts. Assess how this aligns with your legacy wishes.
Evaluate The Types of Annuities
If the above analysis shows exposure or risk in relying strictly on Social Security, pensions, RMDs and withdrawal plans, incorporating appropriate annuities can significantly enhance retirement certainty.
Deferred income annuities address tail-end longevity concerns, providing peace-of-mind through guaranteed income if you live well past normal expectations.
Meanwhile, immediate annuities give flexibility to boost spending from the start of retirement knowing market performance can’t derail those paychecks. Either can be purchased on an ongoing, laddered basis.
Layering annuities together with Social Security also creates diversification.
Adding joint or survivorship terms in the annuities can maintain coverage for both you and your spouse as well.
So, The wide array of annuity contracts allows tailoring solutions to your situation. While tradeoffs exist, longevity protection is invaluable for confidently enjoying retirement. If gaps appear in your income strategy or the risks seem too high, discuss it with your financial advisor if certain annuities could help you achieve financial security.
Annuities Aren’t for Everyone – Know the Drawbacks
While I often recommend annuities to clients, some people still have reservations. It’s important to consider possible downsides too before making decisions. Let me explain in simple terms:
They Can Be Complicated – Annuities have more complex features than basic investments like stocks. This makes it harder to compare and assess the fees. The financial industry needs to simplify how these products work. But rather than reject annuities due to confusion, seek advice navigating the choices.
Loss of Flexibility – Yes, once you buy an annuity you commit that money to produce income. It no longer remains available to withdraw or reinvest. If you think you’ll need ongoing access to all your capital, annuities may not be the best fit, or buying gradually over time may be better.
Company Stability Matters – Because insurers promise to pay annuity income for many years, you want to pick a financially sturdy company. State guarantees provide backup protection too if defaults were to ever occur.
Missed Investment Gains – Annuities convert assets into guaranteed income, not chasing stock market returns. Compare the secure monthly payments to what withdrawing 4-5% yearly from investments might generate based on history. If your priority is minimum lifetime spending, not maximum wealth, annuities may still accomplish the key goal.
Conclusion: Choosing Annuities For Your Future!
I firmly believe retirement planning today should actively address longevity risk through reliable income sources guaranteed to last a lifetime. With Americans living longer amid increasing scarcity of pensions and Social Security concerns, it seems overly optimistic to bet markets reliably achieve historical returns for 30+ year retirements.
Fortunately, annuities exist expressly to manage longevity risk and financial risks that could undermine retirement spending. Where appropriate to your health, risk tolerance, and family assets, adding annuity income atop Social Security and pension funds can provide great peace of mind through predictable income for life. That allows full enjoyment of your retirement without worrying whether retirement savings might outlast your lifespan.
Discuss with your financial advisor about incorporating annuities aligned to your specific situation. Annuities need not dominate all retirement assets to manage risk. Their purpose is not accumulating maximum wealth, but securing the minimum income essential to your retirement plan.