Friday, December 13, 2019

Evaluate Annuities as a Component of Your Retirement Income Portfolio

I wish I could convince more of you, retirees and advisers, to give lifetime income annuities strong consideration for your retirement income plan. They solve a lot of problems from eliminating longevity risk to reducing your portfolio's sequence-of-returns risk.

Purchasing a single-premium income annuity (SPIA) is the single most efficient way to maximize retirement income. According to Wade Pfau's Retirement Researcher Dashboard, a 65-year old couple with $100,000 today could spend about $5,750 annually from a life-only SPIA, $4,900 from a TIPS ladder, or $3,000 using the "4% Rule."[1] Of course, only the SPIA guarantees income for as long as you live but it also ends with no value. The TIPS ladder and portfolio can either be depleted prematurely or end up quite valuable depending on your longevity and investment results.

Sadly, it appears that the last company to offer CPI-linked annuities, The Principal, has stopped offering the product. A CPI-linked or "real annuity" also protected against inflation. But as Moshe Milevsky recently asked rhetorically, "Who says you have to get your inflation protection from an annuity?"

Nominal (not inflation-adjusted) annuities can still play an important role. Our goal isn't to ensure that inflation does not ravage our annuity income but to ensure that inflation doesn't ravage our retirement income. As Milevsky's comment suggests, the two need not necessarily be the same.

A frequent objection to lifetime income annuities is that they have no residual value after death, but the terminal net worth issue isn't straightforward. If we look at a simple SPIA in isolation from the remainder of a retirement plan, then clearly its terminal value will be zero. However, Pfau has shown that the most efficient way to generate retirement income for those with adequate resources is a combination of annuities and an investment portfolio. Furthermore, he has shown that purchasing an annuity can actually increase your terminal wealth by allowing your portfolio to grow more aggressively and by reducing sequence-of-returns risk.

For those of us with a bequest motive, our goal should be to maximize terminal wealth (net worth) from all assets whether or not an annuity is depleted. If an annuity provides no terminal value but allows a portfolio to grow larger, then the annuity will have done its job.

I wish I could convince more of you to consider annuities but, frankly, I understand why you might not.

First, unless your adviser also sells insurance, she isn't paid to sell annuities. In fact, your advisor may have a disincentive. An annuity takes away investable assets that do generate fees for most advisers. An uninspired and uncompensated adviser is unlikely to go out of his way to find you a great SPIA or to encourage you to purchase one.

The trick is to find an adviser who will provide unbiased recommendations regarding both investments and annuities and who also has a deep understanding of annuity contracts. That sounds like a big ask but I know a few that I trust. They're out there.

Even the simplest SPIAs are complicated. The contracts are not standardized so each has to be evaluated on its own merits. Pfau's recent book, Safety-First Retirement Planning[2], explains this in a chapter dedicated to different types of annuities and suggests questions you need to consider before purchase. You can also find these questions in an article by Pfau at Advisor Perspectives.[3]

Second, a SPIA purchase is a one-time, lump sum irreversible transaction. That's a tough sell for any product, financial or otherwise.

An annuity needs to be evaluated as a component of the entire retirement income plan and not as a standalone purchase. This means that an annuity contract is neither good nor bad but that it might or might not improve your overall plan.

It's like adding a new risky stock to a portfolio. Whether the portfolio's results are improved depends on how that stock's performance correlates with the existing portfolio of stocks. A stock can be a poor investment on its own but a welcomed addition to a portfolio.

The entirety of the retirement plan includes all household assets available for retirement funding including retirement accounts, taxable accounts, emergency funds, and even home equity. All of these may play a role in deciding to annuitize. You might, for example, elect to generate maximum income by purchasing a lifetime income annuity and then fund a bequest with your home equity.

Should you decide to purchase an annuity a big question will be when to do so. An annuity is basically a bond portfolio with an insurance risk pool that provides mortality credits. These credits are provided to annuitants who live a long time by those that don't. Mortality credits increase over time but are minimal for younger annuitants.

The following chart created by actuary and retirement researcher, Joe Tomlinson shows the expected bond portfolio return for an annuity (blue line) and expected mortality credits by age (orange line) for a 65-year old female.[8]  Keep in mind that the graph will change based on the annuitant's age, gender, marital status, and interest rates, so this chart is only for demonstration purposes.

Moshe Milevsky has studied the issue of when to optimally purchase annuities for nearly two decades and the advice is, well... complicated. He recently noted, however, that annuitizing too much too early seems highly suboptimal. This is because mortality credits are minimal at lower ages, annuity purchases are irreversible, many households have significant annuitized income from Social Security benefits, and annuity payments are exposed to inflation. Most households may be better off holding those assets in TIPS bonds for a while instead of annuitizing at the beginning of retirement. Laurence Kotlikoff's MaxiFi Planner is one of the tools available to help with the timing decision.[4]

Many retirees have strong reservations about the risk of an insurer failing. Tomlinson has also researched the number of annuities that have failed to deliver on their commitments historically. He found that very few have actually failed and those were from weaker insurers.[5] Purchase your annuites from a highly-rated insurer and you are very unlikely to encounter problems down the line.

Some express concerns about a massive failure of the insurance industry like the housing market crash in 2007. Tomlinson points out that insurance contracts are backed primarily by bonds and that there is no macroeconomic scenario in which a massive failure of the bond market wouldn't have an even worse impact on stocks.

While CPI-adjusted annuities may no longer be available, many insurers offer graduated-payment options or "Cost of Living Adjustments." Although these options suggest otherwise, they have no link to actual inflation. Regardless, researchers David Blanchett[6] and Joe Tomlinson[7] find that many annuities with a COLA option are currently priced more attractively than annuities with level payments, in other words, the insurers are accepting a smaller profit margin. The potential savings are worth investigating.

This raises the issue of how to calculate an annuity's expected value and compare it with other annuity options. This is a somewhat complicated process that Tomlinson explains in What Advisors Need to Know About Annuity Mortality Credits.[8] A retirement planner who knows his annuities should be able to perform this calculation for you.

The best annuity purchase you can make will be to defer your Social Security retirement benefits for as long as possible. If that doesn't provide an adequate floor of safe income, then you really should consider filling the gap with annuities. Integrated into your retirement plan, an annuity can solve a several retirement funding problems and mitigate those purchase objections.

To be clear, I don't think that everyone needs to purchase an annuity. Some households will have significant annuitized income from Social Security benefits. Wealthy households may not need them, although they may find the tax benefits attractive. But my guess is that a lot more households would benefit from annuities than purchase them.

I also encounter retirees who fear the stock market and have a strong preference for a dependable, budgetable "paycheck" each month. I generally advise them not to wait to annuitize. It isn't worth the angst to delay.

There are several common objections to life annuities but many of these objections can be mitigated if the purchase is properly integrated into the full retirement income plan and properly timed.

On a personal note, I have some challenges over the next few months that will make it difficult for me to post as regularly as I have in the past or to respond as quickly as I would like to your comments. Please bear with me and know that I will publish and respond to your comments at my first opportunity.  Thanks.


[1] Retirement Researcher Dashboard, Wade Pfau.

[2] Safety-First Retirement Planning,, Wade Pfau.

[3] Safety-First Retirement Planning, Advisor Perspectives, October 18, 2019, Wade Pfau.

[4] MaxiFi Planner software, Laurence Kotlikoff.

[5] How Safe Are Annuities?, Joe Tomlinson, Advisor Perspectives, August 14, 2012.

[6] Inflation-Linked SPIAs Are a Bad Deal, Advisor Perspectives, by David Blanchett, 5/20/19.

[7] Which Annuities Offer the Best Inflation Protection?, Advisor Perspectives, Joe Tomlinson


[8] What Advisors Need to Know About Annuity Mortality Credits, Advisor Perspectives, by Joe Tomlinson, 7/31/17.


  1. Your work and Wade Pfau's have been very helpful to me. Based on some of your prior writings I am in the process of building a TIPS ladder that will cover 10 years. After modeling annuities I am convinced that annuitising a small % of a portfolio (say 10% in my case) is a great addition to my safety net. The question I have is a practical one. It isn't difficult to find the highest rated annuity issuers. However it is unclear to me how one actually buys one. Must one go through a planner/salesman? Can one contact an insurer directly? Also what do you you think of a SPIA in a retirement acount. Like many people my IRA/401k is overfunded and that would seem a practical way to access that money.
    Thank you

    1. You can purchase them either way. You can purchase them on your own through a website like or, for example.

      I often recommend that retirees go through a knowledgeable sales person with retirement planning expertise beyond insurance because even the simplest annuity contracts can be difficult to compare and fit into your overall plan.

      A SPIA held in a taxable account will pay out an amount that includes a non-taxable return of principal for the life expectancy of the purchaser. This proportion is referred to as an "exclusion ratio." If the annuitant lives longer than his/her life expectancy, payments become fully taxable.

      Payments from an annuity held in a tax-deferred retirement account will be entirely taxable, including the return of principal.

      Payments from an annuity held in a Roth retirement account funded with post-tax dollars will be tax-free.

      Despite having to pay taxes on the return of principal when an annuity is held in a tax-deferred account, many people fund annuities from these accounts because most or all of their retirement savings are held in IRAs and traditional 401(k)s.

      It would appear on the surface that a taxable account would be preferable to a tax-deferred account, assuming the taxable account contains sufficient funding, but a knowledgeable source recently told me that conasidered in the contex of the overall retirement plan, he is not sure that is always correct.

      As the post points out, an annuity purchase needs to be an integrated component of the entire plan.

  2. Why wait until the end to mention deferred commencement of Social Security?

    You note:
    “… Purchasing a single-premium income annuity (SPIA) is the single most efficient way to maximize retirement income. …”


    “… Sadly, it appears that the last company to offer CPI-linked annuities, The Principal, has stopped offering the product. …”

    You may want to consider starting with that second to last statement:

    "... The best annuity purchase you can make will be to defer your Social Security retirement benefits for as long as possible. If that doesn't provide an adequate floor of safe income, then you really should consider filling the gap with annuities. ..."

    Deferring commencement of SS to normal retirement age or age 70 seems to be a relatively efficient, mostly guaranteed, inflation-indexed alternative. That is, an individual with a SSPIA of $1,000 who has a SSNRA of age 67, could claim $700 a month at age 62, or defer commencement to age 70, and claim $1,240 a month. That’s a 7.4% per year increase from waiting 8 years. $1,240/month, $14,880/year exceeds the poverty line (except in Alaska).

    To fund the $700/month “gap”, assuming a 3% per year post-retirement CPI increase and a 6% rate of return on investments, would require the individual to earmark just over $90,000 in retirement assets.

    The remainder of retirement savings could be invested more aggressively to reduce sequence-of-returns risk and potentially increase terminal wealth.

    In addition to the “guaranteed”, “inflation-adjusted” income, there is a surviving spouse benefit which also works to increase “terminal wealth”.

    Another positive aspect is that the participant retains full control. Post annuity purchase health/other shocks reduce the value of the annuity. Where the shock occurs between age 62 and age 70, the individual can change her mind and commence benefits.

    Another positive aspect regards the solvency of the “insurer”. With respect to middle-class Americans, no one anticipates Congress will correct funding deficiencies by reducing benefits payable to middle class Americans already in a payout status.

    As you state, all accumulated wealth and all income options should be considered - including annuities.

    1. Sorry you had to wait so long. I was saving the best until last.

  3. You failed to mention one of the greatest reasons to purchase SPIA annuities. Specifically, protection against failing faculties.
    None of us wants to admit that there is reasonable chance that sometime in the future we may be unable to manage our financial withdrawals. We will be the targets of many fraud attempts, will invest and withdraw it inappropriately, or will merely forget that we have the money.
    An SPIA minimizes these risks.

  4. Mr. Cotton: I greatly enjoy your blog posts and always learn something new. As a CPA I completely agree that most clients don't like to consider annuities in their retirement planning. Hope you are feeling better and I look forward to future postings.

  5. Hi Dirk, in your comparison of the 3 different sources of income in paragraph 2, I'm thinking that the "4% rule" is different than the other two because it includes adjusting for inflation each year. However, looking at the CPI-U adjusted nos. for bonds and annuities, it appears your point is still valid: you get more income from SPIA. Am I seeing this correctly?

    1. I believe all three quotes from Wade Pfau's website are adjusted for inflation annually. However, CPI-linked annuities are no longer available. Regardless, you can't generate more income than with an annuity.