Augmented Annuities

A single premium immediate annuity (SPIA) locks in success. But it gives up the ability to leave an inheritance.

In this study I split funds between an immediate annuity and an investment account. This allows you to capture the upside of investing with a high degree of safety.

This is appropriate for traditional retirees for whom an annuity makes sense. It is inappropriate for early retirees for whom the insurance feature of an annuity offers little benefit.

A Traditional Annuity

If you are 65 or older, a low cost single premium immediate annuity makes sense. Your annuity income is matched to your statistically determined life expectancy. You benefit if you live longer. You do not have to worry about outliving your income.

This is in stark contrast to those who seek to live entirely off their own investments. They must make sure that their income lasts their entire lifetime, no matter how long.

A typical annuity with an inflation matching clause might provide an income stream of 6.5% of your premium (i.e., the original balance).

Vanguard allows you to price annuities online without obligation on your part. Here is a link.

Vanguard Annuities

First Allocation Choice

Suppose that you wish to withdraw 5% of your original balance (plus inflation) over your lifetime. You are likely to be able to buy an immediate annuity that pays 6.5% of your premium for life, but which leaves nothing to your heirs.

To withdraw 5% of an original balance, you would annuitize (5/6.5)*your original balance. You would reinvest (1.5/6.5) times the original balance for your heirs.

Today’s P/E10 is 24. The Stock Returns predictor shows a Year 30 real, annualized, total return ranging from 4.5% to 6.5% (inner confidence limits). This is a multiplying factor of (1+total return)^30 = 3.7 to 6.6 (with a 60% probability). If your original balance were $100000, you would have $23077 to invest. The Year 30 balance would range between $85400 and $152300 (in terms of today’s buying power).

Assuming that you lived long enough, you would recover your entire original balance (plus inflation) at Year 30 (using the inner confidence limits).

At Year 20, the real, annualized, total return ranges between 1.1% and 5.1% (inner confidence limits). The multiplying factor is (1+total return)^20 = 1.2 and 2.7. Your Year 20 balance would have grown from an initial investment of $23077 to a Year 20 balance of $27700 to $62300 (in terms of today’s buying power).

Second Allocation Choice

Compare this to annuitizing one half of your original balance. It throws off 3.25% of the original balance. The remaining investment must supply 1.75% of the original balance. This amounts to a 3.5% withdrawal rate on that portion.

Look at the Year 30 Retirement Risk Evaluator (the Year 30 SWR button on the left). With P/E10=24, Switch Option A and Switch Option B produce Safe Withdrawal Rates of 3.5% and 3.6%. They maintain 60% of the original balance at Year 30.

Again, look at the Year 15 Retirement Risk Evaluator (the Year 15 SWR button on the left). With P/E10=24 and withdrawing 3.4% to 3.8%, you will maintain 60% of your original balance at Year 15 with a high degree of safety.

Considering that you invested $50000, your Year 15 balance would be above $30000.

Scenario Surfer Runs

All of this suggests that Valuation Informed Indexing could boost a retirement portfolio anchored firmly with an annuity that covers basic expenses.

I brought up the Scenario Surfer. I invested $50000 and I withdrew 3.5% of that (or $1750) each year while varying allocations according to valuations. I assumed a TIPS interest rate of 2%. I used the P/E10=26 Bear Market since P/E10=24 is not available. I have included fixed allocations as a reference.

Run 1.
20% rebalanced: 40,301.
50% rebalanced: 86,647.
80% rebalanced: 141,183.
Variable allocations: 93,530.

Run 2.
20% rebalanced: 32,665.
50% rebalanced: 55,368.
80% rebalanced: 72,865.
Variable allocations: 100,108.

Run 3.
20% rebalanced: 29,271.
50% rebalanced: 44,908.
80% rebalanced: 50,627.
Variable allocations: 148,638.

Run 4.
20% rebalanced: 29,126.
50% rebalanced: 45,127.
80% rebalanced: 49,124.
Variable allocations: 141,372.

Run 5.
20% rebalanced: 34,389.
50% rebalanced: 63,946.
80% rebalanced: 92,677.
Variable allocations: 118,842.

Conclusions

Augmenting an annuity with an investment account is a good idea. The annuity can meet basic needs. The investment account provides an inheritance.

Varying allocations provided excellent results. In one out of five runs, an 80% fixed stock allocation did a little bit better.

Investing one half of the original balance offers an added benefit. There remains a good balance in the early years. There is little difference at Year 30.

Early retirees should keep these results in mind as they grow older. At some point, it makes sense to invest part of one’s funds into an annuity. This is especially important if one is concerned about declining abilities.

Have fun.

John Walter Russell
June 10, 2008