Retirement planning is largely about managing unknowns, and one of the biggest unknowns that a planner must contend with is life expectancy. If a retirement plan assumes too low of a life expectancy, it can easily fail as retirees outlive their assets. Still, overly cautious assumptions about life expectancy can short-change retirees and result in a retirement withdrawal rate that’s much lower than it could be. That translates into a lower standard of living for the retirees and perhaps a bigger inheritance for their heirs. While giving more money away when you die might seem like an ok idea, most would agree that it shouldn’t come at the expense of a comfortable retirement.
This is where single premium immediate or deferred annuities could help. In exchange for a lump sum payment, an immediate or deferred annuity provides a guaranteed stream of payments that continue until the annuitant dies. With an immediate annuity (SPIA), the stream of guaranteed payments begins immediately. In the case of a deferred annuity (SPDA), the payments begin at some pre-specified later date.
With these instruments, the annuitant can transfer the risk of “living too long” to an insurance company. If the annuitant dies early, the insurance company makes out, but if the annuitant lives an unusually long life, the annuitant makes out. Regardless of how things actually go, these contracts can be a good deal for retirees because they allow them to transfer some of the risk of a big unknown to a third party, the insurance company.
While immediate annuities can make sense in theory, the trick is in figuring out if a particular immediate annuity is a good idea in a particular retirement plan. There are so many factors to consider that the analysis can quickly become very complicated. The best way to analyze this type of problem is with a technique called Monte Carlo Simulation. Monte Carlo Simulation uses probability theory coupled with thousands of trial “runs” through a retirement sequence to explore the range of likely outcomes. This approach is widely used by financial planners in retirement planning.
Sounds pretty complicated, right? Well, it doesn’t have to be. You can run the numbers yourself using an online Monte Carlo retirement calculator. These sophisticated planning tools are great for exploring complicated scenarios and boiling the results down into an easy to understand “probability of success.” There’s an online Monte Carlo retirement calculator at www.flexibleRetirementPlanner.com that’s free to use and you don’t need to sign up for anything to use it.
If you’re not familiar with retirement calculators that use Monte Carlo analysis, you might want to visit the Flexible Retirement Planner’s documentation pages to get up to speed. Once you have a solid understanding of how to use the planner, you’re ready to start running some analysis to explore the effects of using annuities in your retirement plan. The trick here is to run one set of numbers without annuities, then a similar set with annuities taken into account. Don’t forget to subtract the lump-sum cost of the annuity from your starting portfolio balance. Finally, you can get instant price quotes for immediate annuities from the Vanguard website. From their main page, click on account types and services, then Retirement, then click the link for Vanguard Lifetime Income Program. (Please note that this is not an endorsement of Vanguard’s annuity products.)
Now that you have a better understanding of single premium annuities, as well as knowledge about how to use a free Monte Carlo retirement calculator, you’re in a much better position to evaluate the costs and benefits of these insurance products. Before you take any action though, it’s probably a good idea to run your results by a financial planning professional to get their thoughts.
Jim is mostly retired from the software industry and is now a part-time undergraduate finance instructor and the author of the flexibleRetirementPlanner.
Tags: immediate annuity, longevity insurance, retirement plan
