Morningstar - Q4 2021 - 42

Spotlight: Guaranteed Income
rate and test out some different portfolio values
and required withdrawal rates to show
how annuities could fill a bigger or smaller role
depending on someone's circumstances.
Case 1: Annuity Can Help Fill the Gap
Let's say Arturo figures out that he needs
to spend $44,000 per year. The starting value of his
portfolio is $1 million, so that's a withdrawal rate
of 4.4%. After plugging the numbers into the
formula, we find that Arturo should allocate about
28% of his portfolio to the annuity:
% of portfolio to allocate to annuity =
100 " (4.4 , 3.5) / (6.7 , 3.5) = 28.1%
% of portfolio to allocate to annuity =
100 " (2.7 , 3.5) / (6.7 , 3.5) = ,25.1%
can be converted to this type of annuity
to up to $135,000 or 25% of the account value,
whichever is less.
Other Considerations
Of course, the formula above is just a starting
point. Investors will want to carefully think through
the pros and cons of shifting assets to an annuity
before making any decisions.
Most important, once you purchase an annuity
contract, the decision is irrevocable-
meaning that you typically can't get the money
back. Purchasing an annuity means you're
giving up the value of your current assets in
exchange for a guaranteed future income stream.
Before committing to an annuity, it's also worth
thinking through other options for creating
sustainable cash flows in retirement. Reducing
spending is the easiest way, but retirees
can also boost their portfolios' odds of success
by employing a more flexible withdrawal strategy,
such as forgoing inflation adjustments in
years when the portfolio decreases in value or
limiting withdrawals to a certain percentage of the
portfolio's value. More flexible withdrawal
strategies can significantly increase the starting
withdrawal rate.
Before committing to an annuity, it's also
worth thinking through other options for creating
sustainable cash flows in retirement.
Finally, some retirees may be comfortable
with a higher level of uncertainty. Withdrawal-rate
guidelines (including the 3.5% I used above) are
typically based on stress-testing the withdrawals
so they meet a 90% threshold for the odds
of success. But investors who are willing to accept
lower odds-and adjust spending if needed-
may be comfortable with a higher starting
withdrawal rate.
Case 2: Bigger Need for Annuity
Arturo's friend Bernard also plans to spend $44,000
per year and has been able to save $850,000
for retirement. His withdrawal rate would be 5.2%.
That leads to a higher potential annuity allocation,
as shown below:
% of portfolio to allocate to annuity =
100 " (5.2 , 3.5) / (6.7 , 3.5) = 53.1%
Case 3: No Need for Annuity
Arturo and Bernard's friend Chad plans to spend
$80,000 per year and has been fortunate
enough to amass a $3 million portfolio, which
translates into a withdrawal rate of only
2.7%. The formula below yields a negative number,
which means his portfolio is large enough to
support his planned withdrawal rate with an extra
cushion he could use for bequests, charitable
giving, or additional spending. There's no need for
him to fill in any income gaps with an annuity.
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Morningstar Q4 2021
Many people also hesitate to give up assets
for an annuity because if the annuity owner dies
earlier than expected, the money stays with
the insurance company instead of going to heirs.
(People can avoid this by purchasing an
annuity with survivor benefits or a guaranteed
benefit period.)
As I mentioned, the financial strength of
the insurer is another important consideration.
However, most state insurance guaranty
associations will cover at least $250,000 in annuity
benefits if the provider becomes insolvent.
In addition, certain types of annuities come
with limits on the amount of assets you
can convert. For example, a qualified longevity
annuity contract is a type of deferred
annuity funded with assets from retirement
accounts, such as a 401(k) or IRA.
The IRS limits the amount of money that
That said, guaranteed-income products such as
fixed annuities are a critical-and arguably
underused-piece of the retirement income puzzle.
They can play a valuable role in filling income
gaps for retirees who worry about running out of
money, value certainty over flexibility, or still
find themselves short on assets even after cutting
down planned spending. K
Amy C. Arnott, CFA, is a portfolio strategist at Morningstar.
https://www.morningstar.com/authors/2350/amy-c-arnott
Morningstar - Q4 2021

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