What Should Your Clients Look For In A Retirement Plan?

A retirement plan has two major objectives. One is to provide assurance that you will not run out of money at an advanced age. Reflecting this objective, and because only an annuity pays you until you die, with few exceptions every retirement plan should contain an annuity.

The second objective is to avoid leaving more money in your estate than you would have chosen if you knew with certainty and well in advance the exact day of your death. The excess in your estate might be the difference between a rich and rewarding retirement, and its absence.

Most Retirees Need An Annuity

If you have a defined-benefit pension, you already have an annuity and may not need another. The only other substitute for an annuity is sufficient wealth relative to your plans and needs that you don't need a retirement plan - you can spend what you like when you like with no risk of ever running out. This article aims at the much larger group of retirees, or soon-to-be retirees, who have limited wealth that requires careful management. They need an annuity to eliminate the risk of running out of funds while avoiding excessive bequests to their estates.

Many retirement advisers avoid annuities because the rate of return on annuities is low relative to the return they believe they can earn elsewhere. The average return on a diversified portfolio of common stock during 985 five-year periods between 1926 and 2012 was 8.6 percent, whereas annuity yields are generally in the 3 percent to 5 percent range.

Annuity yields, however, are guaranteed as long as the retiree remains alive, and the yield rises with longevity. For example, an immediate annuity I priced recently for a female at age 62 yielded 3.6 percent if she lived to her expected life of 86, and 5.5 percent if she lived to 104. In contrast, stock yields are subject to significant downside risk. In 10 percent of the 985 five-year periods referred to above, the return was 2.2 percent or lower, and in 2 percent of them it was negative. The downside is less pronounced when the period covered is longer.

The Annuity Hazard To Be Avoided

The market for annuities is extremely inefficient, as indicated by large differences in price quotes by different insurers on the same transaction. For example, I recently shopped monthly payouts on a 15-year deferred annuity costing $812,000 with 11 companies. The high and low quotes were $11,092 and $9,683, a difference of $1,409 - every month!

Bottom line, retirees should be sure that the provider of their retirement plan has the means to find the best price on their annuity. If your adviser has a deal with one or two insurance companies, run like a thief!

While not many of us will live to 104, for the peace of mind you deserve, the retirement plan should assume that you will.

Spendable funds consist of draws from financial assets, annuity payments, and (in some cases) draws on a HECM reverse mortgage. Monthly projections of these items require their integration, with the asset draw period evolving seamlessly into the annuity period. If a HECM reverse mortgage is included in the plan, it must be integrated as well. Retirees also should have the option of adding an annual inflation adjustment to their spendable funds.

Advisers should offer multiple projections designed to provide the retirees with options and guidance. As one example, projections based on different rates of return on the retiree's financial assets will help the retiree select the best annuity deferment period. With high returns, a long deferment period works best, and vice versa. The retiree should be the one making the decision.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at mtgprofessor.com.