Why too much guaranteed retirement income can be a bad thing

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A financial planner told me that retirees should devote no more than a third of their savings to annuities. But wouldn't it be better if retirees just kept a reasonable amount of cash for emergencies and then invested all or almost all of the rest of their savings in annuities from top-rated insurers? Aside from providing income guaranteed to last for life, this strategy would also allow retirees to ignore the turbulence of the stock market. --Kim

Over the years, I've seen all sorts of guidelines and estimates for how much of their nest egg retirees ought to devote to immediate annuities that turn savings into reliable lifetime income, with some suggestions as low as 25% and others upwards of 80% or more.

But frankly, I don't think there's any valid rule of thumb for how much of your savings should go into an annuity, any more than there's a universal standard for how much you can safely withdraw from your retirement stash each year or how much of your savings should be invested in stocks. Individual retirees' financial circumstances and personal preferences about income security vary too dramatically for such rules of thumb to be of much use.

As for your idea of putting all or nearly all of your savings into annuities, I think such an extreme strategy would likely be a big mistake for the overwhelming majority of people.

For one thing, by focusing on income annuities you would be putting all or nearly all of your savings in a vehicle that, while great for guaranteed income, doesn't offer much in the way of long-term capital growth. Even though you mention setting aside a reasonable amount of savings for emergencies and such, what if it turns out you need a lot more for unanticipated expenses (health care, home repairs, etc.) than you estimated? Or how about if over the course of a long retirement now-dormant inflation re-awakens to the point that your annuity payment can no longer cover as much of even your day-to-day expenses as it once did?

Fact is, keeping some of your retirement savings in a diversified portfolio of low-cost stock and bond funds (ideally, index funds) gives that portion of your nest egg a reasonable shot at higher gains, which in turn can boost its value and provide protection against rising prices over the course of a long retirement, not to mention help assure that you'll have sufficient assets to tap for emergencies or even the occasional splurge.

Of course, given today's anemic yields and low projected returns, a portfolio of stocks and bonds probably won't generate the level of gains that it did in the past. But the long-term return on a mix of stocks and bonds is still likely to be higher than the return you'll get on money you invest in an annuity, as annuity payouts are largely tied to high-quality bond yields.

The point is that by putting some of your savings into an income annuity and investing the rest in a diversified portfolio of stocks and bonds, you get the best of what each has to offer -- i.e., the peace of mind and higher level of retirement happiness an annuity's guaranteed lifetime income can provide, plus the long-term financial security that comes with the higher long-term returns of a mix of stocks and bonds.

Annuity payments: Income for life

So how do you decide how to divide your retirement savings between these alternatives?

My suggestion is to start by getting a handle on your retirement expenses, which you can do by going to an online retirement budget calculator. For example, Fidelity's Retirement Income Planner tool has a budget worksheet that has spaces for more than four dozen different expenses and allows you to designate which outlays are essential (housing, utilities, medical costs, etc.) as opposed to discretionary (entertainment, travel, whatever).

Once you've tallied up your essential expenses, you have a pretty good idea of the minimum income you need to sustain your lifestyle in retirement. If the amount you're collecting or will collect from Social Security is enough to cover all or most of your everyday expenses, then you may not need any more guaranteed income at all. Instead, you may be able to get by just fine by withdrawing money as you need it for non-discretionary items, unanticipated expenses and other non-scheduled expenditures from a diversified portfolio of stocks and bonds. (As a practical matter, you'll also probably want to keep, say, one to three years' worth of living expenses in cash so you don't have to tap your investment portfolio during severe market setbacks.)

If, on the other hand, there's a gap between the income required to cover basic living costs and what Social Security will provide, then you may want to consider devoting enough of your savings to an immediate annuity to fill all or most of that gap. This annuity payment calculator can give you an idea of how much lifetime annuity income a given sum will get you, based on your age, gender and other factors. Whatever amount is left, you can then invest in a blend of stocks and bonds that jibes with your tolerance for risk. For help in creating such a portfolio, complete this risk tolerance-asset allocation questionnaire.

You could always decide to devote more of your savings to an annuity, say, if you just feel more comfortable knowing that a larger portion of your income will flow in regardless of how the financial markets perform. Or you could opt for less guaranteed income, which you might want to do if your nest egg is so large relative to your expenses that your chances of running through your savings are minimal.

The goal is to arrive at a balance that's right for you: enough assured income from Social Security and an annuity to provide the level of security and comfort you need, but also enough in a portfolio of stocks, bonds and cash to give you flexibility to meet unanticipated expenses and to prevent inflation from eroding your living standard over a long retirement.

You don't have to arrive at the right balance immediately upon retirement. Research shows that you still get most of the benefits of an annuity as long as you invest within 10 years of retiring, so you shouldn't feel rushed to buy into an annuity. Indeed, even assuming you've established that having some money in an annuity makes sense, you may be better off starting with a small amount and devoting more later if you find that your retirement spending needs are greater than you expected. Investing in several annuities gradually over the course of several years (or even longer) rather than all at once also makes it less likely that you'll put all your money into an annuity when interest rates (and payouts) are at a low point.

Related: Are you behind on retirement saving?

However much, if any, of your savings you decide to invest in annuities, you should also take care not only to stick to top-rated insurers, but to limit the amount you invest with any one of those insurers to the maximum amount of coverage provided by your state insurance guaranty association.

For more advice on the best way to add guaranteed income to your retirement income plan, check out this earlier column on how to choose the right annuity. And to avoid ending up with an annuity that benefits the person selling it more than you, make sure to get answers to these three questions before you invest.

If you go through this process, you should be able to divvy up your savings in a way that gives you adequate guaranteed income while at the same time providing you with the long-term growth and financial flexibility necessary to maintain an acceptable lifestyle over the course of a retirement that may well last 30 or more years.

You'll still have to deal with the market's ups and downs in the portion of your portfolio that's invested in stocks and bonds. But knowing that you'll have at least enough assured income to cover essential living expenses should make the market's swings a lot less frightening.

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