Could Annuities Be Better Than Bonds for Lifetime Income?
Updated: Sep 30, 2020
If you asked a hundred financial advisors about what they use to construct retirement strategies, you would surely get as many opinions as there are flavors of ice cream.
Many portfolio strategies today call for strategic mixes of equities and bonds. Lots of research is on the so-called 60/40 portfolio, made up of 60% equity assets and 40% bond assets.
The problem is that bonds are particularly vulnerable to interest rate risk, which is the danger of an asset losing value when interest rates rise. And with interest rates sitting at basically zero percent for the foreseeable future, the only direction they can go is up.
This isn't to say that bonds don't have a place in a retirement income strategy. But there is also the flip-side to consider.
Do you really have all options on the table if your advisor leaves annuities out of the conversation? Unlike bonds of any sort, annuities are unique in that life insurers include estimates of people's expected mortality into their payouts.
The Big Income Advantage with Annuities
Every annuity payout is backed by an actuarial estimate of how long the insurer expects to pay an individual annuity policyholder -- and how much. The insurer builds this calculation into every annuity payment it guarantees.
The life insurance company is better able to manage its risks this way. It spreads these risks out across a pool of thousands of policyholders. Actuaries and insurance professionals formally call these calculations "mortality credits."
Bonds simply don't have this same level of risk management. This is one of many reasons why annuities have a monopoly on guaranteed lifetime income over other asset types.
Times like now show that the 4 percent rule might not apply well all the time. In fact, a retirement plan can fall short if the risks of this withdrawal rule aren't carefully accounted for.
In one Forbes.com column, Dr. Wade Pfau shows how, in certain situations, annuities may be better-positioned to generate guaranteed lifetime income than a bond-ladder strategy might.
Bonds vs Annuities for Lifetime Income
Dr. Pfau is one of today's leading researchers on retirement income. He is an author on the "safety-first" school of retirement thought.
In the Forbes column, Pfau looks at the retirement income prospects of a 65-year-old woman.
The analysis compares different income-producing assets for a fixed spending amount, not for inflation-adjusting income. That could be addressed by additional strategies with other assets working in a portfolio.
Pfau calculates a lifetime fixed payout from a $1 million annuity policy will give her a guaranteed income of $57,800 per year.
The alternative? A 50/50 portfolio with a split-even allocation to stocks and bonds. He assumes a 6% return and a 10% standard deviation.
If she and her advisor aimed for a 90% probability that her portfolio would last her to age 90, she would only be able to spend $47,746 of income per year.
To receive the same level of income as from the annuity, her 50/50 portfolio would otherwise need $1.21 million in assets. Or in other words, she would need 21% more money for the bonds than what she put into the annuity policy.
What About Until Age 100?
What if our retiree wanted to make sure that her portfolio lasted her to age 100? Let's say that she and her advisor aimed for a 95% chance that it would go until she reached 100.
In that case, she could only spend $40,394 of income per year. And what would she otherwise need if she wanted the same level of income as the annuity paid for that period?
She would require $1.43 million in her portfolio -- or 43% more money than what was in the annuity.
Pfau also recognizes that if our retiree weren't as worried about longevity risk as before, the 50/50 portfolio strategy could come out on top.
If the retiree wanted only a 75% chance that her money in a 50/50 portfolio would last to age 90, then she could draw $60,421 of income per year.
That is above the $57,800 per year from the one-million-dollar annuity policy. But it also doesn't carry the same level of confidence for success as the before situations did.
Don't Insurance Companies Use Bonds to Support Annuity Policies?
Yes, life insurers do use Treasury securities, investment-grade bonds, and other fixed-interest holdings in the bulk of their holdings to uphold their promises to policyholders.