ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Do Annuities Reduce Bequest Values?

May 21st, 2013

by Joe Tomlinson

The widely held view that annuities reduce bequest values is too narrow. Adjustments can be made in retirement portfolios to reduce retirement risk without sacrificing the value of one’s bequest. Here’s how retirees can purchase annuities, adjust allocations in remaining assets and achieve improved retirement outcomes.

An example

Let’s take a 65-year-old retired female with retirement savings of $1 million, who requires $30,000 each year with annual inflation increases. I assume that she has a 22-year average life expectancy and treat longevity as variable in the analysis. I use Monte Carlo simulations of investment performance with stocks assumed to earn an average annual return after inflation of 4.8% with a standard deviation of 20.3%, and bonds assumed to earn a 0% real return with a 5.7% standard deviation. I assume investment expenses of 0.15%. These returns are significantly lower than historical averages and reflect the reasoning in my February 2013 Advisor Perspectivesarticle on asset class returns. Because I've assumed lower-than-historical returns, I've reduced the withdrawal assumption to 3%, from the more typical 4% used in retirement planning research. To measure retirement success, I use the probability of running out of money and expected bequest values. In order to facilitate comparisons in today's terms, I calculate bequests as present values and use a discount rate of 2.97% after inflation, which is the estimated return for a 65/35 stock/bond portfolio. All the analysis is pre-tax.

If the woman in this example invests in a 65/35 portfolio, the modeling indicates that she will leave an average bequest with a present value of $524,000 and face a 9% probability of depleting her savings during retirement. If she were concerned about the risk of running out of money, an option would be to be to purchase an inflation-adjusted single-premium immediate annuity (SPIA) to provide an income to meet the withdrawal needs. Based on rates from Income Solutions®, the current payout rate for a 65-year-old female with such an annuity is 4.19%. An annuity generating an initial annual income of $30,000 would cost $716,000, leaving $284,000 to invest. By purchasing the SPIA, she could completely eliminate the risk of depleting her savings, but the present value of her expected bequest would be reduced to $284,000, down from $524,000. Therefore, purchasing the SPIA would be the equivalent of paying a $240,000 fee today to eliminate the retirement shortfall risk.

Given this cost, her reluctance to purchase a SPIA would certainly be understandable. But something is missing from this analysis.

Adjusting for risk

Not only does the SPIA purchase reduce the risk of running out of money, but also it dramatically reduces overall investment volatility. A SPIA is essentially a fixed income investment with the additional benefit of pooled longevity. In effect, the SPIA purchase converts a 65/35 stock/bond portfolio to an 18/82 portfolio, if the $284,000 that is left over is invested 65/35. The reduction in bequest values reflects the shift to fixed income. It does not reflect an inadequate return or other deficiency in the SPIA product.

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