Wednesday, February 25, 2015

Buying an Annuity with Some of Your Accumulated Savings—What is the Best Approach to Bolster Your Spending Budget?

This post is an update of my post of September 22, 2013 where I discussed some of the benefits of managing retirement risks by diversifying sources of retirement income.  Today, I will look at the effect on a hypothetical retiree’s budget of several annuity purchase strategies based on annuity purchase rates obtained from
Let’s assume, Mike, our hypothetical single male retiree, is age 65.  He has recently retired with a 401(k) balance of $750,000.  Mike is eligible for an immediate (reduced) Social Security benefit of $1,400 per month ($16,800 per year).  He has no other retirement assets or sources of income. 

Base Spending Budget

Mike uses the “Excluding Social Security” spreadsheet on this website and the recommended assumptions with no amount to be left to heirs to develop a base budget for 2015 of $49,427 ($16,800 from Social Security plus $32,627 from accumulated savings).

Mike is not pleased with this spending budget.  He would like his spending budget to be higher.  He knows that he can use more aggressive assumptions (higher real rates of return or lower expected payout period) or he can plan on a budget that declines in real dollar terms as he ages.  Before looking at these options, he decides to look at what effect several alternative annuity purchase strategies might have on his base budget.  

Strategy #1--Defer Social Security to Age 70

I know I said that I was going to look at several annuity purchase strategies.  So why am I starting with this option?  Because under this approach, Mike would essentially be buying a deferred annuity from Social Security.  And while this deferred annuity deal is generally more favorable for a married worker with a spouse who hasn’t worked in covered employment (because of the joint and survivor nature of such annuity), it is still favorable for Mike because it provides both longevity and inflation protection.   

Mike goes to the “Social Security Bridge” spreadsheet on this website.  If he defers commencement of his Social Security benefit to age 70, it will increase to $1,980 per month before inflation increases and $2,240 after assumed increases of 2.5% per year (or $26,882 per year at age 70).  The spreadsheet tells him that his 2015 spending budget would be $51,412 if he decided to defer commencement of Social Security to age 70 and made no other changes.  If he goes to the “Run-out” section of the spreadsheet, he sees that if all assumptions are accurate, he will spend a total of $124,890 of his accumulated savings to “purchase” the extra annuity from Social Security.  At a 4.5% discount rate, this is equivalent to a single premium of $114,329 payable at age 65.

Another way for Mike to check this result is to go to the Excluding Social Security spreadsheet and pretend that he has $635,671 ($750,000 - $114,329) in assets and a Social Security benefit payable at age 65 of $23,758 rather than $16,800 as in the base budget situation.  Thus, Mike sees that if he spends $114,329 of his assets, he is “effectively” able to purchase an additional $6,958 ($23,758 - $16,800) of Social Security benefit starting at age 65.  But his total 2015 spending budget is only increased by $1,985 ($51,412 - $49,427) as result of his decision to defer.  Mike is somewhat disappointed with this as he has been reading in all the business/personal finance websites that deferring commencement of Social Security is by far the smartest action for a retiree to take.  As discussed above, however, Mike is single and deferring Social Security is generally not quite as good of deal for single workers as for married couples with one primary wage earner. 

Strategy #2--Defer Social Security and Buy an Immediate Annuity

Mike wonders if he can increase his spending budget by purchasing an immediate life annuity in addition to deferring his Social Security benefit.  He goes to and sees that he can purchase $8,250 of annual income payable for his life for $125,000.   If he subtracts $125,000 from the net assets he has after subtracting the present value of the Social Security “bridge” payments, he would have $510,671 remaining.  He enters that amount in accumulated savings and $8,250 as the life annuity amount in the Excluding Social Security spreadsheet.  The resulting 2015 budget under this scenario is $52,332 ($23,758 from accumulated savings as the bridge payment plus $8,250 from the annuity plus an additional $20,324 from accumulated savings). 

Strategy #3--Defer Social Security and Buy a Deferred Annuity (QLAC)

Being familiar with my website, Mike has heard me tout the virtues of Qualified Longevity Annuity Contracts.  They provide a purer form of longevity insurance than immediate annuities.  So, Mike goes to and looks to see how much income he can buy for $125,000 with an annuity starting age of 85 and no pre-commencement death benefits.  He sees that he can buy $47,035 per annum starting at age 85.  He enters that amount and 20 years deferral in the Excluding Social Security spreadsheet together with accumulated assets of $510,671 and the spreadsheet gives him a budget of $53,875 ($23,758 from accumulated savings as the bridge payment plus an additional $30,117 in accumulated savings).  This budget is almost 9% higher than his base spending budget.

What does Mike do?  

First, Mike notices that he seems to get more “bang for the buck” from a QLAC purchase than from an equal-cost immediate annuity purchase in terms of increasing his spending budget.  But, Mike is bothered by the fact that he won’t get any return on this investment if he dies prior to age 85.  Mike decides that he will defer commencement of his Social Security benefit (at least for one year), but he decides that the QLAC annuity market is still not robust enough (and he feels interest rates are just too low) to make the purchase at this time.  He will look at the trend of annuity purchase rates during the next twelve months and revisit the issue again next year.