Posted by Shelly Eweka.
When I tell 403(b) participants they need to replace at least 80% of their pre-retirement earnings, they do the math in their heads and, more often than not, look thrown off. That’s a lot of money. 1
With employees taking on more responsibility for their retirement planning, and the Social Security system itself facing a less-than-secure future, we need to come up with our own strategy for bridging that wide income gap.
The good news: With careful planning, you can set up a constant stream of retirement income for yourself that’s guaranteed* to be around as long as you are.
The sky won’t fall…but your account balance might.
Squirreling away as much as possible into your 403(b) is a great start—but it can be a real challenge turning those hard-won savings into pension-like income. Simply making withdrawals from your accounts, as needed, is a bit like watching acorns drop from a tree. Even if you have a lot hoarded up, you don’t need to be Chicken Little to feel alarmed.
Some retirees choose to observe the 4% rule—meaning, they systematically withdraw 4% of their nest egg each year. But that’s only $4,000 of initial annual income on a $100,000 portfolio. And subsequent withdrawals may be less than $4,000, depending on the account balance. And that’s at the mercy of your portfolio’s underlying investments, and how well (or poorly) they perform.
Even if you think you have enough saved up to keep making 4% withdrawals indefinitely, what happens if a health situation arises where medical expenses eat away at your principal? It’s so hard to predict what might happen in five years; impossible to know how different your life could be 10 years out. Even the most meticulously planned withdrawal strategy can end up depleting your capital. Because we’re living longer, especially as women, it’s natural for us to worry about our nest eggs dwindling to a mere shell of their former selves. The very idea is enough to make Chicken Littles of us all.
What’s the alternative?
Luckily, there’s a tried-and-tested way for retirees to receive steady annual income—and the comfort of knowing your money won’t ever run out. It involves converting at least part of your nest egg to lifetime income, also known as an annuity. An annuity is in fact the only financial product that can provide you with lifetime income when you retire. Think of it as an easy button for releasing a regular stream of income, direct to your checking account, for the rest of your life.
The 4% method, and retirement planning in general, can be a headache—especially as you get older and become more vulnerable to cognitive decline. Many seniors simply don’t want the burden of being too involved. With its autopilot aspect, an annuity can enable you to devote your time and resources to planning vacations and enjoying your free time instead.
Unlike the 4% strategy, an annuity can protect you from several major risks:
- Longevity (the risk of outliving your income)
- Market risk
- Inflation risk
- Risk of cognitive decline (mental ability to manage the other risks)
What are the two general types of annuity?
Both fixed and variable annuities can provide lifetime income for you (and your partner or spouse), but there’s a key difference between the two:
Fixed annuities – This is the classic style of annuity: It’s “fixed” because it guarantees a certain income floor—the amount you get paid each year no matter what; and the sum won’t ever fall below it. The reliability of unchanging payments has obvious appeal to anyone with bills to pay. With a fixed annuity, your money isn’t subject to market fluctuations; you’re basically transferring investment risk to the insurer—and the (sometimes high) fees they charge you for that security should be a major factor in your decision. The flip side of not worrying about market ups and downs is you can’t take advantage of investment gains—your income won’t rise to keep pace with inflation and the purchasing power of your annuity payments will diminish over time. That being said, some fixed annuities do offer a cost of living allowance (COLA), meaning that your income does rise with inflation.
Variable annuities – This kind of annuity varies in terms of how much annual income you get. Since it’s tied to the market, which historically offers good growth potential, the hope is, your annuity will capture market gains and go up in value—much like your 403(b) mutual funds are designed to do. However, your balance and payments may fluctuate depending on the ups and downs of the market.
Next-gen annuities: Combining the benefits of both
There’s a relatively new feature, offered by some variable annuities, that gives you some of that minimum-income protection provided by a fixed annuity. If you opt for guaranteed lifetime withdrawal benefits (known as GLWBs), your income rises when your underlying investments do well, but can never fall below a certain level. Crucially, a GLWB can provide liquidity of assets in case of an emergency.
Consider a 65-year-old settling $100K in a single-life GLWB contract instead of going for the 4% withdrawal strategy. Based on recent interest rates, it could pay out $5,000 (5%) in the first year. 2
Over the next year, if the account balance grows to more than $100,000, then the following year’s payment will increase to 5% of that high point—which means a higher income floor is established. And if the account balance is $100,000 or less, then the payment remains at its current floor of $5,000. This continues each year for the rest of your life. And beyond that, any remaining account balance becomes part of your estate.**
Clearly, a GLWB can provide more protection and peace of mind than the 4% strategy, but it comes at a cost. Make sure you fully understand all the administration and investment fees and factor them into your analysis of what might be best for you. Getting your financial advisor involved in this complex matter is definitely a good idea. Some annuities are pricey, and some are low cost—you need to do your due diligence and shop around.
Part of a balanced portfolio
You may already have an annuity product as part of your 403(b) or IRA—fixed-income funds can be a crucial component of a diversified portfolio. Just like other funds in your 403(b) or traditional IRA, your pretax contributions and earnings aren’t taxed until you make withdrawals. And unless you specifically opt for it in advance, you can wait until retirement to decide whether you want to cash out your annuity or convert it to lifetime income.
Both fixed and variable annuities have their pros and cons, and you may decide to use one or both, along with mutual funds and cash, as part of a well-balanced portfolio. Even in retirement, you should keep a portion of your wealth liquid, for the unexpected expenses that will inevitably come up. The point of an annuity is having a lifetime income stream apart from Social Security—which, for many people, simply isn’t enough to get by on.