Tilney, a highly-regarded financial planning firm in England where workers are automatically enrolled in employer pension plans unless they opt out, surveyed 1,300 employees in 2018 regarding what they planned to do with their pension when they retire. The results were as follows:
- 40% said they didn’t know what they would do.
- 22% said they expected to keep most of it invested, taking some withdrawals.
- 10% would potentially cash it all in.
- 10% would use the pension to buy an annuity.
When the word “annuity” was removed as an option and replaced with a “pension that provided a guaranteed income for life,” 79% of respondents said that this was more appealing than a plan where the value and income varied each year. This was the result despite the disclosure that a traditional investment plan offered the prospect for higher returns.
Income Optimization is the Appropriate Benchmark
Annuities have long been misunderstood. Fixed income annuities in particular are often rebuffed by investment professionals with little or no annuity education whose goal is to maximize investments under management and who don’t practice holistic retirement income planning.
Their use of investment returns as a frame of reference results in inevitable non-apples-to-apples comparisons to traditional equity-based investment portfolios. These individuals fail to acknowledge the fact that it’s impossible to calculate the return of a fixed income annuity until an annuitant has passed.
Income optimization, rather than investment return, is the appropriate benchmark that should be used when evaluating fixed income annuities for inclusion in a retirement income plan. The goal is to design a comprehensive strategy that uses the least amount of assets to purchase the greatest amount of sustainable after-tax lifetime income that’s projected to pay for expenses not covered by distributions from investment and other assets.
Purchasing Guaranteed Lifetime Income is Unnatural
In addition to being misunderstood, the concept of purchasing guaranteed lifetime income, especially when the income start date is deferred, is unnatural for most people. That’s generally the case until they realize that’s exactly what they’re doing with Social Security. In order to receive Social Security retirement benefits, you must purchase them.
What do I mean? Either your salary is reduced by a deduction for Social Security tax or, if self-employed, you’re subject to a self-employment tax until the maximum Social Security wage base, currently $132,900, is reached. Social Security withholding and/or self-employment tax is used to fund Social Security retirement benefits. In essence, you’re purchasing your benefits.
It’s more difficult to pull the trigger when you purchase sustainable lifetime income with a fixed income annuity because you’re not exchanging a lump sum for an investment of equal value unless you purchase a fixed index annuity (FIA). Instead, you’re entering into a contract in which a promise is made by a life insurance company to pay you a periodic income stream for life or a specified number of months or years beginning at a future date.
The contract is irrevocable in the case of single premium immediate annuities (SPIAs) and deferred income annuities (DIAs), i.e., your premiums won’t be returned to you by the insurance company unless you’re within the “free look” period. This is generally 10 days following the purchase date with up to 30 days for seniors in California.
Fixed Income Annuities Designed for Sustainable Lifetime Income
When presented in the context of retirement income planning, fixed income annuities have proven to be the most appropriate and natural commercial solution for providing sustainable lifetime income. The three types of fixed income annuities can be used individually, or in combination, to provide a hedge against the unpredictable stock market.
Fixed income annuities are often used in conjunction with other sources of guaranteed income such as Social Security and private or government pensions to allow retirees to sleep better at night. Nonqualified SPIAs and DIAs enjoy a competitive edge since a portion of each income payment is nontaxable.
Fixed Income Annuity or Pension That Provides Guaranteed Income for Life?
Assuming that you’re planning for retirement, would you rather purchase a lifetime fixed income annuity or a pension that provides guaranteed income for life? This is one decision you don’t have to worry about making since they both provide the same benefit, i.e., sustainable lifetime income that’s unaffected by the fluctuations of the stock market.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.