A few years back, a friend asked me to help him with his retirement income plan. Naturally, my first step was to calculate his retirement income gap — the difference between his desired retirement income and his sources of guaranteed lifetime income. When I saw that he had two pensions in addition to Social Security, I knew my job had become much easier. More importantly, once I understood that his portfolio needed to generate a relatively little amount of additional retirement income, I knew I had a green light to make investment allocation decisions based mostly on his growth objectives and risk tolerance.
Unfortunately, my friend is the exception not the norm.
As of March of 2023, only 15% of private-industry workers had access to a defined benefit plan. And with an estimated average monthly Social Security benefit of only $1,907 per month, or about $23,000 per year, the majority of your clients undoubtedly have a significant retirement income gap. In such cases, you have to decide how you are going to structure your clients’ portfolios to close this income gap.
There are many ways to generate steady income. Bonds pay interest, stocks pay dividends, and retirement plans are designed to be a source for spendable withdrawals. But bonds eventually mature, stock dividends can get cut, and retirement plans can get depleted. Therefore, any retirement income portfolio that does not include guaranteed lifetime income must be structured with great care and constantly re-evaluated when things don’t go as planned. Such as a client receives lower-than-expected portfolio returns, generates higher-than-expected expenses, or lives beyond his or her life expectancy.
Pre-retirees Seek Safety and Guarantees
A recent Alliance for Lifetime Income and Cannex consumer report confirmed what every advisor already knows: As clients near retirement, they are less willing to put their retirement assets at risk. Consequently, years like 2022, where the traditional 60/40 portfolio declined 16%, are extremely scary to clients nearing or already in retirement.
In fact, the consumer report found that 51% of investors surveyed question whether or not the traditional 60/40 portfolio is still viable. In addition, 80% of consumers want their retirement savings that will cover their needs in retirement to be invested in safer investments.
Additional Reading: Annuitied Continue March Upward
Essentially, your clients want you to assure them that they will be okay — and to retirees, okay equates to not running out of money. Not surprisingly, the consumer report also reported that:
- Nearly all consumers (97%) said that having a guaranteed income in addition to Social Security is valuable.
- Consumers protected by a pension and/or an annuity have a significantly more positive outlook on their retirement prospects.
Why guaranteed income for life is so important
Every retirement income plan has three assumptions:
- Age: How long will you live? Estimating length of life is subject to significant error. Sure, it is easy to go online and look up a life expectancy. Based on an investor’s current age, sex, and the answer to a few health-related questions, many online tools will give an estimate of life expectancy. However, this is just an average and actual results can vary widely.
- Expenses: What will expenses be in retirement? How will they change? As people get older, they spend less on things like travel and entertainment. However, they spend more on healthcare —sometimes significantly more. In life, the unexpected happens. Oftentimes, the unexpected can be very expensive.
- Growth potential: How much will retirement assets grow each year?Will stocks go up or down? What about interest rates? A huge factor in the success — or lack thereof — of any retirement income plan is timing. Anyone who retired in 2009, just as stocks were beginning their 12-year climb, has likely benefited from equity performance. But anyone who retired in 2007, just before stocks fell by roughly 50%, may have had to cut back on expenses for several years to get back on track.
By creating a guaranteed income for life, an investor will be less impacted by inaccuracies in these three assumptions. Whether the investor lives longer than expected or there is an unanticipated drop in stock prices, an annuity that offers lifetime income allows for comfort in knowing there will be a stream of periodic income, regardless of age, expenses, or current portfolio.
Income Benefit or Traditional Annuitization?
There are two ways to receive lifetime income from an annuity. Helping clients understand how they work can help make sure they choose an option that works best for them.
Generating income with annuitization
The most traditional way to receive lifetime income from an annuity is through a process called “annuitization.” When an investor annuitizes an annuity contract, some or all of the value of the contract is turned over to the insurance company in exchange for a monthly, quarterly, or annual check, depending on the time period the investor selects. Typically, these payments will last as long as the investor lives, or as long as the investor and their spouse live.
As an example, a couple, both age 65, may be able to secure income of up to $13,000 per year upon annuitizing their contract with an account value of $200,000. This annual payment would continue as long as one of them is living. In addition, the couple could elect to add a refund option to make sure they receive the full account value of their annuity even if they both experience an unexpected or early death.
This option allows for either continued income payments to their beneficiaries, or a lump sum payment of the $200,000 annuitized amount reduced by the amount of income payments already paid. Including this option would reduce the amount of the annual income payments, but it can provide peace of mind that the insurance company will, at a minimum, pay back the entire amount that was annuitized.
Generating income with an income benefit
However, only a small percentage of the annuities that are purchased in the United States are ever annuitized. As attractive as getting periodic income for life may be, most people have a hard time turning over a significant percentage of their retirement savings to an insurance company. If the goal is to generate an additional $50,000 in annual retirement income, it could take an annuity contract with an account value as much as $800,000 to accomplish this, depending on the investor’s age and interest rates. It can be hard for some investors to lock up that amount of capital in exchange for a future stream of income.
Understanding the difficulty of such a choice, insurance companies now make it possible to add an income benefit to most annuities. For an extra fee of typically 0.75%–1.5% per year, the insurance company guarantees an income payment for as long as the investor lives, in the form of a withdrawal amount from the account value. When an income benefit is added, an investor doesn’t have to annuitize the contract in order to get the income guarantee in the future. Instead, the money in the annuity continues to earn interest, and the income taken out each year is withdrawn from that account value.
The allowable withdrawal percentage depends on the terms of the rider and age of the client, but typically is 5%-7%. Should the withdrawals cause the investor to liquidate the account value before he or she dies, the insurance company will continue to send the agreed upon income amount out of its own reserves. One way to think of it is as income insurance — the fee the investor pays each year for this benefit is essentially the premium they pay to ensure they will receive income payments for as long as they live.
What Clients Want You to Explain
The Alliance for Lifetime Income and Cannex consumer report found a disconnect between how interested investors are in a guaranteed income solution and how interested advisors think they are. Notably, only 19% of financial advisors thought their clients were extremely interested in exploring annuities as a guaranteed income solution, while 50% of all consumers indicated that same level of interest.
Key considerations
Retirement income is not cheap: It takes a lot of money to generate meaningful lifetime income, especially in an environment of low interest rates. If investors think of their retirement accounts as a safety net and/or a source of funds to pass directly to heirs, it will likely be difficult for them to annuitize and turn a significant amount over to an insurance company. However, if they think of their retirement account as a means to generate retirement income, then they can consider the annuity purchase as a repositioning of assets to achieve that goal.
Annuities are long-term investment vehicles: Investors should be prepared and able to hold an annuity through the full length of the surrender charge period, which is typically between three and 10 years. Early withdrawals that exceed the free annual withdrawal amount during the surrender charge period may trigger surrender charges, fees, and/or tax penalties. And they may be subject to negative adjustments, which could be substantial. Withdrawals and distributions of taxable amounts are subject to ordinary income tax and, if made prior to age 59½ , may be subject to an additional 10% federal income tax penalty.
Receive quotes from several highly rated insurers: An insurance company’s appetite to provide for guaranteed income changes over time. A company with competitive rates today might not offer as appealing rates a few months down the road. Also, investors should always keep in mind that all references to guarantees arising under the annuity contract, including optional benefits, are subject to the claims-paying ability of the carrier.
Get informed: Every annuity comes with numerous income options and features; therefore it is important for investors to understand and explain the various trade-offs of each option to find a good fit for their retirement income plans. Investors should review the annuity’s offering document, disclosure document, and buyer’s guide for important contract details, including fees and charges.
Scott Stolz, CFP, RICP, is a managing director on the annuities solutions team at iCapital. He previously headed insurance solutions at SIMON Markets LLC, a financial technology company acquired by iCapital in August 2022. Before that, Scott served as the president at Raymond James Insurance Group, where he leveraged his 40 years in the annuities industry to manage the due diligence, sale, and operational functions for annuities and life insurance distribution. A frequent speaker and panelist on any topic related to annuities, Scott has also authored two books on annuities: Unlocking the Annuity Mystery: Practical Advice for Every Advisor (2020) and Rest-Easy Retirement (2023). He received his MBA and BSBA in Finance from Washington University in St. Louis.
