The Fundamental Logic of Annuities with Lifetime Income

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The following is excerpted from Chapter 5 in Wade Pfau’s recently updated book, Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success. It is available at Amazon and other leading retailers.

Before digging deeper into different types of annuities, it is worth first focusing on how a basic life-only income annuity works and how it fits into retirement planning. A simple annuity can effectively replace bond holdings in a retirement plan that are earmarked to meet the lifetime spending goal. The question is why should a retiree hold any bonds in the portion of their asset base designed to cover ongoing retirement spending goals?

Premiums for the income annuity are invested in bonds (the insurance company adds your premium to its bond-heavy general account). The annuity then provides payments precisely matched to the length of time they are needed. Stocks provide opportunities for greater investment growth. Individual bonds can support an income for a fixed period, but they do not offer longevity protection beyond the horizon of the bond ladder created. Bond funds are volatile, exposing retirees to potential losses and sequence risk while still not providing enough upside potential to support a particularly high level of spending over a long retirement. Risk pooling with an income annuity can support a higher level of lifetime spending compared to bonds. Stocks also offer the opportunity for higher spending, but without any guarantee that stocks will outperform bonds and provide capital gains during the pivotal early years of retirement.