Annuities: Strengthening the three-legged retirement stool

The three-legged stool of retirement planning has grown a bit wobbly over the years as fewer workers can rely on a pension during their post-employment years.

But research has found that incorporating guaranteed lifetime income into the retirement investment mix can strengthen two of the stool’s legs while giving retirees more money to spend.

The three legs of the retirement stool are Social Security, pension and personal savings. Adding an annuity into the strategy protects against longevity risk and market volatility.

Michael Finke, Frank M. Engle Chair of Economic Security at The American College, and Jason Fichtner, executive director of the Retirement Income Institute at the Alliance for Lifetime Income, conducted the research on behalf of Equitable.

The concept of the three-legged stool needed a rethink as defined benefit pensions are on the decline, Finke said.

“Now that the DB plan is now your defined contribution plan, you have to start converting some of those DC assets into protected income along with claiming Social Security. That’s what gave us the motivation to rethink the three-legged stool and talking about how you take some of that income and have protection as an asset class, income as an asset class and have a conversation with advisors so they can start thinking about this as well. What kind of products can help replace that DB income so that people can have a personal pension when they retire?”

By focusing on increasing lifetime income, a retiree can reduce reliance on using savings and investments to fund a lifestyle, the researchers wrote. A simple change from a 60/40 equity/bond portfolio allocation to a 50/30/20 equity/bond/protected income portfolio allocation may provide necessary guaranteed income to pay essential expenses in retirement.

By increasing the income legs of the three-legged stool of retirement planning, retirees can gain greater lifestyle security.

Fichter said the research is not only for today’s retirees but also for the retirees of the future.

“We jokingly call millennials the 401(k) generation. They don’t have a pension and they are a larger generation than today’s baby boomers. So the problems we're seeing with the retirement income challenge today for boomers is only being magnified for Generation X, and then even more magnified for millennials. We need to sort of change the culture and the discussion around retirement income today, not just help boomers, but to help the generations that follow.”

The authors of the study described how adding protected lifetime income strengthens the personal income and Social Security legs of the stool.

Personal income

Annuities can substitute for bonds and cash investments within an investment portfolio that consists of stocks, bonds and cash, providing a higher and more secure lifetime income because annuities are designed to protect against longevity risk.

An annuity allows a retiree to spend more each year without the fear of running out of money because an annuity transfers the risk of an unknown lifespan to an insurance company. In addition, a retiree can spend more by transferring the risk of an unknown lifespan to an insurance company because they don’t know how long retirement will last. If a retiree is not willing to risk the possibility of running out of savings in old age, they will need to spend cautiously. Pooling this risk through an annuity lets the retiree enjoy their lifestyle without the fear of running out of money.

Because retirees spend more from the portion of their savings allocated to an annuity, they can meet a greater percentage of their income goal from a smaller percentage of their investment portfolio. They can also take greater investment risk from the remaining portfolio since they now have a stream of income that covers less-flexible expenses, allowing them to invest more aggressively to cover more flexible expenses and legacy goals.

Social Security

Retirees can strengthen the Social Security leg of the stool to take even more pressure off the investment leg by waiting until age 70 to claim Social Security benefits.

Retirees who claim Social Security early cut down one of their income legs for the duration of retirement in order to extend the investments leg temporarily. A more balanced approach that equalized the Social Security, private income and investments legs could provide better outcomes throughout retirement.

Individuals can delay claiming by either drawing from the personal income leg of the retirement stool with a flexible annuity or by temporarily increasing withdrawals from investments. This so-called Social Security bridge will result in a lower portfolio value at age 70, but the increase in Social Security wealth will allow the retiree to withdraw less from their investments after age 70 and take greater investment risk, resulting in higher expected portfolio values and a higher inflation-protected income base later in life.

A flexible annuity strategy with a guaranteed minimum income benefit can allow a retiree to increase withdrawals early in retirement while also maintaining the ability to receive an annuitized lifetime income benefit later in retirement. This can reduce the need to withdraw a significant amount of bridge assets from an investment portfolio while maintaining a base of lifetime income, in addition to the higher Social Security floor.

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Susan Rupe is editor in chief, magazine, for InsuranceNewsNet. She formerly served as communications director for an insurance agents' association and was an award-winning newspaper reporter and editor. Contact her at susan.rupe@innfeedback.com.