Several studies have suggested that purchasing an immediate annuity can improve the odds of sustaining inflation-adjusted withdrawals from a retirement portfolio. In this article, I will present several charts to demonstrate this.

Returns Sequences

I will start with four returns sequences. All have an annualized return of 6%.

A 6% annualized return is chosen to simulate a 50% stocks, 50% bonds balanced portfolio. Stocks may earn a return of 8% and bonds may earn 4%. The blended overall return may be 6%.

And here is a chart (figure 1) showing how $1,000,000 grows using the returns sequences from table 1.

This chart was created by my Annuity-Scenarios.xls spreadsheet.

As you can see from figure 1, no matter which path was taken, at the end of the period, all four scenarios accumulated the same amount: $5,743,000. The reason is because no deposits or withdrawals were made. However, what happens when we take withdrawals? We learn the answer to that question in the next section.

Withdrawals

In the next chart (figure 2), the same four scenarios from table 1, along with their corresponding returns sequences, are applied to the portfolio. However, this time, we will take withdrawals over a 30-year period starting at age 65. The initial withdrawal is $40,000. This corresponds to a 4% initial withdrawal rate (IWR) from the starting portfolio value of $1,000,000. In each subsequent year, the amount withdrawn is increased by 3% each year. The 3% annual increase is used to simulate inflation. So the second year withdrawal will be $41,200, the third year withdrawal will be $42,436, and so on. In this way, constant purchasing power is maintained throughout retirement.

This chart was created by my Annuity-Scenarios.xls spreadsheet.

From the chart above (figure 2), we see that three of the returns sequences may pose no concern to the retiree. However, it is the “worst case” returns sequence (blue line) that has the potential to cause worry for a retiree. This is where purchasing an immediate annuity can help. ( See Note 1 for details about the “worst case” returns sequence. )

Purchasing a Fixed Immediate Annuity

On December 16, 2007, I obtained quotes for fixed immediate annuities from Berkshire Hathaway. The following amounts are for a 65-year old male residing in the state of Iowa. For example, a $20,000 annual income for life will require a lump sum payment of $266,158.

In the next chart (figure 3), I kept “Scenario 1” from the previous chart (figure 2). This was the “worst case” returns sequence with no annuity. Then I added four scenarios in which a fixed immediate annuity was purchased at the start of retirement.

For example, in “Scenario 2”, $266,158 was used to purchase a fixed immediate annuity to generate a $20,000 annual income for life. The investment portfolio then becomes $733,842 ($1,000,000 - $266,158). It is from this amount that the remaining inflation-adjusted annual withdrawal gets funded. The investment portfolio stays with the same 50% stocks, 50% bonds allocation.

In “Scenario 4”, $798,474 was used to purchase a fixed immediate annuity to generate $60,000 in annual income for life. However, only $40,000 was required for the first year withdrawal. The remaining $20,000 from the annuity was added to the investment portfolio. So, the investment portfolio starts at $221,526 ($1,000,000 - $798,474 + $20,000). The investment portfolio stays with the 50% stocks, 50% bonds allocation.

This chart was created by my Annuity-Scenarios.xls spreadsheet.

Please note, these examples are for illustration purposes only. Some of these chart examples show a substantial part of the portfolio being used to purchase a fixed immediate annuity. However, many financial advisors recommend that retirees limit their purchase of annuities to around half of their nest egg.

Buy Now or Later?

Once the decision to purchase a fixed immediate annuity is made, the next question is whether to purchase now or later. One reason sometimes given to delay is the concern that current interest rates may be low. And thus, you would be locking in less favorable terms than if interest rates were to rise in the future.

Another reason given to delay is that one can get more favorable terms when one is older. The older you are, the shorter your life expectancy will be. Thus, the insurance company can offer a lower quote for the same annual payout.

To show how quotes become more favorable as one ages, I have obtained quotes for fixed immediate annuities from Berkshire Hathaway. The following amounts were quoted on December 16, 2007 and are for a male residing in the state of Iowa. For example, at age 65, a $20,000 annual income for life will require a lump sum payment of $266,158. But the same $20,000 annual income for a 75-year old male will require a lump sum payment of $201,843 (or 24% less).

The following chart (figure 4) shows the portfolio value for the four scenarios in table 3. In this chart, the portfolio grows at a constant 6% annualized return. Like in the previous charts, 4% inflation-adjusted withdrawals (assuming 3% inflation) are taken from the portfolio every year starting at age 65.

This chart was created by my Annuity-Scenarios.xls spreadsheet.

The above chart (figure 4) shows that there doesn’t appear to be much of a difference when interest rates are similar. However, if interest rates were to rise in the future, the annuity buyer may gain more favorable terms. Then again, higher interest rates could be caused by higher inflation. If this were to be the case, the $20,000 annual payout may be worth far less in terms of purchasing power in later years.

Recall that in the preceding chart example (figure 4), a constant 6% annualized return was applied to the investment portfolio. But let’s see what happens when we instead apply the “worst case” returns sequence.

This chart was created by my Annuity-Scenarios.xls spreadsheet.

Purchasing an annuity at the start of retirement (blue line in figure 5) lessened the demands of the investment portfolio to provide inflation-adjusted withdrawals. Thus, the negative impact of poor early returns is greatly diminished. In contrast, delaying the purchase of an annuity (in scenarios 2, 3 and 4) caused the investment portfolio to suffer the full brunt of poor early returns from which it did not recover.

Buy in Stages?

Rather than delay an annuity purchase, another strategy sometimes suggested to take advantage of possible favorable quotes is to buy in stages. For example, let’s say that a retiree wishes to obtain $40,000 in annual income for life from a fixed immediate annuity. He can either pay a lump sum for a $40,000 annual income stream at age 65. Or he can split the purchase by paying a lump sum for a $20,000 annual income stream at age 65 and another lump sum at age 70. On December 16, 2007, I obtained quotes for fixed immediate annuities from Berkshire Hathaway.

In table 4 below, “Scenario 1” shows the quote for purchasing a lump sum for a $40,000 annual income stream at age 65. “Scenario 2” shows the quote for delaying purchase to age 70. And “Scenario 3” shows the quotes for buying in stages ($20,000 at age 65 and another $20,000 at age 70).

The following chart (figure 6) shows what happens under the three scenarios as described above and in table 4. Here, we will look at the “worst case” returns sequence.

This chart was created by my Annuity-Scenarios.xls spreadsheet.

From figure 6, we see that buying in stages (green line) turned out better than delaying (pink line). Keep in mind that interest rates are similar for the three scenarios. But what if the retiree is able to obtain more favorable quotes in the future? This is explored in the next example.

In table 5 below, scenarios 4 and 5 are added. These scenarios make the assumption that the retiree will be able to obtain more favorable quotes at age 70. The quote in “Scenario 4” is $421,645 which is 10% lower than $468,494 quote in “Scenario 2”. Similarly, the quote in “Scenario 5” is $210,822 which is 10% lower than $234,247 quote in “Scenario 3”.

The following chart (figure 7) shows what happens under the five scenarios as described above and in table 5. Again, we will look at the “worst case” returns sequence.

This chart was created by my Annuity-Scenarios.xls spreadsheet.

In figure 7, we see that there was some improvement when more favorable quotes (at 10% discount from today’s interest rates) were obtained at age 70. Specifically, “Scenario 4” (red line) wound up higher than “Scenario 2” (pink line). Likewise, “Scenario 5” (black line) wound up higher than “Scenario 3” (green line).

However, we notice that despite these improvements, buying the $40,000 annual income stream at age 65, as shown in “Scenario 1” (blue line), wound up the highest of all other scenarios.

Conclusion

When inflation-adjusted withdrawals are taken from a retirement portfolio, purchasing a fixed immediate annuity may improve the odds of portfolio survival. This article explored different possible scenarios.

For scenarios where investment returns do not cause undue concern, a portfolio may survive without the need of an annuity. However, poor returns early in retirement could reduce the odds of portfolio survival. Purchasing an annuity at the start of retirement may be helpful in this case.

Please realize that once an annuity purchase is made, the act is irreversible. So great care must be made in this decision. Therefore, the reader is urged to perform thorough research in order to make a wise and appropriate decision.

I have additional articles on this topic that you may find of interest. Annuities: A Primer describes the four basic types of annuities. Pros and Cons of Immediate Annuities offers a more in-depth discussion of the advantages and disadvantages of immediate annuities. And finally, Immediate Annuities Links Page provides a wealth of resources for you to conduct further research.