M* Amy Arnott on Lifetime Income from an Annuity

[Admin/YBB]

M* Amy Arnott on Lifetime Income from an Annuity

M* has recently done several pieces on lifetime income from annuities. This one from Amy Arnott is quite thoughtful. It suggests the use of income-gap (= total expected income - total expected expenses) and then uses a simple formula to estimate how much to annuitize. Basically, if the income-gap is much higher than what can be provided with safe withdrawal rate (SWR) from a portfolio, then a portion of the portfolio may be annuitized.



where AR = annuity payout rate (%), SWR = safe withdrawal rare (%), WR = required withdrawal rate from portfolio (%)

Annuitizing is an irrevocable decision. Single-life annuities can be risky, but guaranteed withdrawal periods of 10, 15, 20 years are available (typically, these must be less than the life-expectancy) (having a joint-life annuity is another option). Make sure that the insurance company has a high credit-rating.

QLAC from IRA, 401k or 403b are also mentioned - the amount annuitized is limited but is removed from the RMD calculations. Variable annuities are not discussed - these can range from basic to complex.

www.morningstar.com/articles/1056871/do-you-need-an-annuity-for-retirement-income
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YBB Note

The formula above is derived by equating the withdrawal at WR from portfolio P with that from a combination of withdrawal at AR from annuitized z*P plus withdrawal at SWR from the remainder (1 - z)*P; z = fraction of portfolio annuitized.

WR*P = AR*z*P + SWR*(1 - z)*P

Then, the fraction of portfolio annuitized, z = (WR - SWR)/(AR - SWR), or 100z%.

Note that if WR > SWR, z > 0, i.e. annuitization is necessary when the withdrawal rate (WR) exceeds the safe withdrawal rate SWR.

If WR < SWR, then z < 0, then annuitization is not necessary (but some may partially annuitize anyway to cover basic expenses).

[Admin/YBB]

Inflation-Adjustment

It is not easy to find inflation-adjusted annuities. But the above formula provides an insight on how a DIY inflation-adjustment may be created. In a inflation-adjusted annuity, the initial annual withdrawal goes up annually by COLA % that may be CPI or PCE measure, or a predetermined amount such as 2-3%. This can be supported by the unannuitized portion of the portfolio in a conservative/moderate-allocation fund that can be used to draw annual (SWR + COLA)%; note that COLA applies only to the annual amount withdrawn (supported by the unannuitized portfolio), not to the total balance. For this to work, 

% unannuitized portfolio >> WR %,

and a factor of safety of 2 may be used, so,

% unannuitized portfolio > 2*WR %.

As a rule-of-thumb, this should work so long as the % of portfolio annuitized is up to 85% (to account for variations in how the unannuitized portfolio is invested). The unannuitized portfolio may grow significantly over the years and must be left untouched for this to continue to work (i.e. avoid temptation to tap it for other purposes).