Are You Missing a Variable in this Critical Calculation?
The following content is adapted from Tax-Free Income for Life, by David McKnight.
There’s a massive X factor when it comes to retirement planning: you simply don’t know how long you’re going to live.
You’re trying to solve the most important math equation of your life, and you’re missing the most important variable! That’s why longevity risk, as I’ve mentioned before, is every retiree’s most vexing concern. If you don’t make provisions for how long you’re actually going to live, then you could run out of money before you run out of life.
Over the past twenty years, economists and retirement experts have become increasingly convinced that the most efficient way to neutralize longevity risk is to off-load it to the institutions who are in the very business of managing risk: insurance companies.
Ugh! Not insurance companies, you must surely be thinking. They’re the last ones I want poking around in my retirement! As it turns out, insurance companies are exceptionally adept at managing and mitigating longevity risk. It’s what they do. It’s their sweet spot. By bringing insurance companies into the picture, you can completely vanquish longevity risk from your retirement plan.
Insurance companies mitigate longevity risk through a technique known as risk pooling. Here’s how it works: You give a portion of your investments to the insurance company, who pools it with the assets of thousands of other investors. This enables insurance companies to subsidize the guaranteed income streams of those who live longer lives with the capital of those who live shorter lives. But here’s the point: so long as you’re alive, that guaranteed income never stops flowing. When it’s coupled with other guaranteed streams of income such as Social Security, you can rest assured that your minimum lifestyle requirements are always going to be met.
When you give an insurance company a lump sum of money in exchange for an immediate, guaranteed lifetime stream of income, it’s called a single premium immediate annuity, or SPIA.
WHAT IS A SINGLE PREMIUM IMMEDIATE ANNUITY (SPIA)?
Purchased with a single lump sum, a single premium immediate annuity is a contract between you (the investor) and the insurance company that is designed to create a lifetime stream of supplemental retirement income. Unlike a deferred annuity, an immediate annuity forgoes the accumulation phase and begins paying out guaranteed lifetime income either immediately or within a year of having purchased it. SPIAs are also referred to as income annuities, immediate payment annuities, and immediate annuities.
Wait, hold the phone, you may be thinking. Did he just use the most verboten term in all of retirement planning: annuity? I sure did. And I know what you’re thinking: Isn’t Ken Fisher always railing against annuities? Haven’t I always been told to be supremely skeptical of them?
There’s a lot of misinformation around annuities, but this much I can tell you: if you don’t like them, then you almost certainly aren’t going to like Social Security or that company pension you may be planning on receiving. Why? Because they’re both governed by the exact same risk- pooling principles that govern annuities: those who live shorter lives subsidize the income streams of those who live longer lives.
Once you can get past whatever misgivings you may have about annuities, you’ll discover a vast array of positive benefits that stem from receiving a guaranteed stream of lifetime income.
The first benefit of guaranteed income for life is the most important and obvious of all. When you guarantee your income for life, you vanquish the biggest bogeyman in retirement planning: longevity risk. You will never run out of money, no matter how long you live. Even if the stock market goes straight down for the entire span of your thirty-year retirement, you will always have food on the table and a roof over your head. Even if you live to age 105, you’ll keep getting that check and you’ll keep having to find a way to spend it.
ANXIETY- FREE RETIREMENT
When your lifestyle needs are no longer tied to the rise and fall of the stock market, you give yourself permission to enjoy retirement. In fact, according to a study by the Wall Street Journal, retirees who have a guaranteed lifetime stream of income are much happier than those who rely on positive returns in the stock market to achieve their retirement goals.
A LONGER LIFE
If leading a stress-free retirement isn’t enough to push you over the hump, consider this: studies have shown that those who have guaranteed lifetime annuities live longer. I know what you’re thinking: the type of people who have annuities are the type who have money, and those who have money live longer anyway. While that may be the case, studies further show that all other factors being equal, guaranteed lifetime annuities still extend life expectancy. As Freakonomics’ Stephen Dubner explains, “It’s that little extra incentive of the annuity payout that keeps people going.”
Jane Austen drove this same point home in Sense and Sensibility when she said, “people always live forever when there is an annuity to be paid to them.”
In short, if that retirement paycheck is guaranteed to arrive so long as you’re on this side of the grass, you have a powerful incentive to stay alive! And here’s the best part: the longer you live, the greater the return on your investment!
RETIREMENT ON THE CHEAP
Remember one of the biggest shortcomings of the Three Percent Rule, which I wrote about previously? It takes massive quantities of cash to achieve that high probability of never outliving your money. If you need $100,000 per year to meet your basic lifestyle needs, you will need to have accumulated $3,333,333.33 by day one of retirement, and that doesn’t include a discretionary account for shock or aspirational expenses! A guaranteed lifetime annuity, on the other hand, can accomplish the exact same thing, but at a much lower cost.
Consider the following example:
You’re 65 years old, ready to retire, and you want $100,000 of annual income. You also want an ironclad guarantee that $100,000 income will last as long as you do. So how much money would you have to give to an insurance company in exchange for an immediate, guaranteed lifetime annual income of $100,000?
In order to calculate this, you have to determine the going SPIA withdrawal rates for a 65-year-old. This number fluctuates based on the insurance company, sex, and the prevailing interest rate environment, but for this example’s sake, we’ll use 6 percent.
Once you have your guaranteed withdrawal rate, you can apply the same formula we use with the Three Percent Rule, this time substituting in 6 percent. The math goes as follows:
$100,0000 / .06
When you divide $100,000 by 6 percent, you get $1,666,666.67. In other words, in order to receive a guaranteed $100,000 income for life, you’d have to give the annuity company $1,666,666.67 on day one of retirement. That’s it. End of story. That’s half the amount you’d need to accumulate by day one of retirement were you to abide by the Three Percent Rule!
Here’s the bottom line: a SPIA can give you the same amount of income, with an ironclad guarantee and without all the shortcomings of the Three Percent Rule, for half the initial outlay. You can see why more and more financial experts are lauding guaranteed lifetime income annuities as the way to permanently remove longevity risk from your retirement portfolio.
HIGH-OCTANE STOCK MARKET INVESTING
Because SPIAs can mitigate longevity risk at half the cost of the Three Percent Rule, you’ll have leftover capital to invest in the stock market. And because you’re no longer reliant on these liquid investments to meet your basic lifestyle expenses, you can take more risk in your portfolio.
But do I really want to take a lot of risk in my investments when I’m retired? you might be asking yourself. Remember, just because you’re retired doesn’t mean it’s time to batten down the hatches.
Here’s why: much of the money you’re planning on spending in retirement hasn’t even been earned yet! You’ll need to harness the power of the stock market to stretch your liquid investments over the full arc of your retirement. This is no time to become a shrinking violet!
Because of the SPIA’s ironclad guarantees, you now have the luxury of taking more risk with your liquid investments than you might otherwise take. This in turn increases the likelihood that your stock market assets will last the full length of your retirement. It’s the SPIA’s permission slip to take more risk in the market that can make the difference between a thrive retirement and a barely-enough-to-survive retirement.
THE DEATH OF SEQUENCE-OF-RETURN RISK AND WITHDRAWAL RATE RISK
When you utilize a SPIA for guaranteed lifetime income, you effectively vanquish two of the most deadly retirement risks:
Sequence-of-return risk: When you pay for your lifestyle expenses with a SPIA, you are no longer forced to distribute money from your stock market portfolio during down markets. Should the market go down in a given year, you can patiently wait for it to recover before taking additional distributions.
Withdrawal rate risk: When you aren’t forced to rely on your stock market portfolio to meet your basic lifestyle needs, you’re less likely to prematurely deplete your liquid assets through unduly high distributions. You’ll still take distributions, but in much smaller amounts and only for the occasional discretionary expense.
GUARANTEED LIFETIME INCOME: IN SUMMARY
The fact is that guaranteed lifetime income from a single premium immediate annuity can eliminate longevity risk for far less capital than its stock market counterpart. What’s more, guaranteed lifetime income gives you permission to feel happier, incentive to live longer, and a larger, more productive investment base from which to pay discretionary expenses that are all but certain to arise during your retirement years. You don’t have to love annuities; you just have to love what they can do for you!
Would you like to guarantee your income for life? If you haven’t implemented a strategic plan with Hanson Wealth Management, please reach out for a consultation to see how this wisdom could look in your world. My approach to a secure retirement includes lowering your tax burden and optimizing your income streams with the objective of achieving a tax-free retirement so you can truly live your best life.