In response to a recent column of mine, a reader wrote, "Your article on annuities did not demonstrate that an annuity always improves a retirement plan."
True, Warren Buffet's retirement plan would not be improved by an annuity because he will not face the mortality and investment risks of a retiree with limited resources.
Retirees with limited resources face the risk that if they live too long, and/or their assets earn less than expected, they will run out of spendable funds. There is also the risk that if they die too soon, and/or their assets earn more than expected, they will leave financial assets to their estate that they would have preferred to spend on themselves.
Retirees exposed to these risks can reduce or eliminate them in only one way: by using some of their assets to buy an annuity, which pays them as long as they live.
This is a core feature of the Retirement Income Stabilizer (RIS) which I have been developing with Allan Redstone. With RIS, the retiree uses some of her assets to buy an annuity, payments from which are deferred for a period ranging from 5 to 25 years. The remaining assets are used as the primary source of spendable funds during the deferment period, with the amount drawn each year adjusted based on earnings during the year.
In this column, I will compare retirement plans with and without an annuity for a hypothetical retiree of 65 who has $1 million in her 401(k), half of it in common stock and half in intermediate-term government securities. She is deciding between the following options:
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--A RIS-based withdrawal plan that includes a 10-year deferred annuity
--Following the 4 percent withdrawal rule, which is advocated by many advisers
With the RIS alternative, part of the $1 million purchases an annuity deferred 10 years. During the first 10 years the retiree draws on the assets remaining after the annuity purchase. At the end of the 10 years, those assets are gone and the annuity kicks in.
With the 4 percent rule alternative, the retiree makes monthly withdrawals equal to .04/12 of the initial balance, plus an annual inflation increase. I applied a 2 percent inflation adjustment to both schemes.