To me, the most interesting observation Frederick Vettese makes in his book The Essential Retirement Guide is what to do with the bond allocation of your portfolio at retirement. “It makes sense to liquidate these fixed income investments and buy an annuity.” This seems so logical, but it had never occurred to me before.
The main advantage of an annuity is that it eliminates longevity risk. When the insurance company sets your annuity payments, it can do so based on average lifespans. However, if you invest your money yourself, you have to account for the possibility that you’ll live to be very old. The main disadvantage of an annuity is that its returns are based on long-term bond returns; you can’t get the higher expected returns and inflation protection that stocks provide.
Vettese isn’t the first person to suggest putting part of your nest egg into an annuity. However, what is new to me is the direct comparison to a bond portfolio. To maximize your spending from the fixed income part of your portfolio, it seems like a no-brainer that you should go for the higher payouts of an annuity.
I’ve been thinking about how using an annuity would compare to what I call cushioned retirement investing. The idea of cushioning is to have 5 years’ worth of spending in fixed income and the rest in stocks. Each year you spend from your fixed income investments and replenish them by selling some stocks.
Cushioning protects you if your stocks perform poorly. If this happens, you can cut your yearly spending by a little. This cut creates a fixed income surplus equal to 5 times the cut. At the end of the year, you won’t need to sell as many stocks to replenish your fixed income at a time when stocks are down.
An alternative to cushioning is to just take the amount you planned to put in fixed income at the start of retirement, buy an annuity, and leave the rest in stocks. The stocks will be volatile, but that income volatility will be on top of a solid base of guaranteed income.
I don’t have any good ideas yet for how to quantify the benefits of the annuity plus stocks approach compared to cushioned retirement investing. However, my guess is that the partial elimination of longevity risk might be enough to give the annuity an edge.