Like it or not, almost all of us will pass through the pre-retirement and retirement life stages. For most of us, the pre-retirement stage probably starts sometime in our fifties and the retirement stage starts in our 60s and continues until we…well, no longer need to worry about paying for our consumption of goods and services.
If there’s one thing the last 20 years have taught us, financial markets are volatile, unpredictable, and can be dangerous. Depending upon when you begin to withdraw your savings in retirement, you may or may not run out of money. Many households entering retirement in the past few years with excessive equity allocations will find themselves under-financed and their financial plan (if they had one) obsolete. This approach to financing retirement is the hopeful accumulation model. Remember, running out of money is not an option, especially at his stage in a person’s life.
Depending upon your net worth and your consumption needs, the hopeful accumulation model has some merits and should be part of a household’s plan if a stream of guaranteed income exists to finance a reasonable floor of consumption. However, you know that nobody will accept “hopeful accumulation” as a currency to purchase what you need to live when you’re in retirement.
I’ve spent some time recently studying the variable annuity market. Variable annuities generally have a bad reputation – they’re complex and often very expensive. But they can serve a very important role in a household’s retirement plan: the insurance company will send you a check every month – guaranteed – as long as you live. I spent three hours this week with someone at Met Life, and we had to call an annuity expert to get to the bottom of all of my questions, many of which my interlocutor had never been asked. Believe me, the questions I asked needed to be answered e.g. what’s the death benefit to my spouse if I take off early, for my kids, can I get low fee investment options etc. Annuities are complex, but the benefit is very straight forward – protected income for life. You’ll probably need an expert to help you make the best decision.
So here’s the deal with variable annuities: essentially, you write the insurance company a check to create an account, you pay about 2% per year in fees to have a guaranteed 5-6% return per year (that’s the floor, will be higher if your portfolio’s return is higher) until you elect to start to receive payments (thereafter, the guarantee disappears but the upside still exists), you allocate your assets using a fairly open platform of investment options (with some constraints on equity allocation, and in some cases, some pricey options – look for indexes), and sometime in your 60s or even later, you elect to begin to receive a monthly check of 5% times the value you’ve accumulated up to that point. And the check keeps coming until you’re…well…no longer in need of the check. I don’t remember the exact term, but essentially people who live a long life benefit from the payments of people who live a short life. This is the nature of pooling risk and why the insurance company can make money offering this service/product. Oh, and you can withdraw your account, although the penalties for this vary.
But remember, the point of an annuity is to avoid a situation where you outlive your assets and cannot afford to consume. An annuity creates some protection by guaranteeing an income. With so few people able to count on a pension and wondering how to address the unpredictability of the markets, a variable annuity should be considered as a potential element of a smart retirement plan.
