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Have you ever suggested an immediate annuity to a client only to have him/her pooh-pooh the idea stating “I can do much better than an annuity by investing and managing my retirement portfolio myself?” This is a widely-held belief, but it may be based on a misapplication of economic data.

We have all seen the statistic that money invested in the stock market for a long period – say 10, 20, or 30 years – will grow at an average annual rate of 10% or 12% per year, based on past history. Mutual funds like to show charts demonstrating what $1 invested 5, 10, 15 years ago would be worth today. Even taking into consideration an inflation rate of, say, 3% this is a good return and makes immediate annuities look puny by comparison.

Or does it? The above statistic is based on a very important, but often overlooked, assumption: the average annual growth rate of 10 or 12% per year is based on the assumption that the money remains 100% invested for the entire period. When planning for retirement income, the basic assumption is precisely the opposite: it is anticipated that a certain amount of money will be withdrawn from the retirement fund each year.

Many folks believe they can invest their retirement money in the stock market, average a 10% or 12% annual return, withdraw a healthy income each year and still have more money for heirs at death than they started with. What they are forgetting is the essential nature of the market, which has been brought home with a vengeance the past year; that is, the market doesn’t grow at a constant rate, but goes down as well as up.

Many readers are familiar with the concept of “dollar-cost averaging” which tells us that depositing money into a fund in a level, periodic manner results in the lowest, average per-share cost in an up and down market. Unfortunately, pulling money out of a fund in the same manner, has the opposite effect.

Here’s an example to illustrate the above point. Suppose Mary retired January 1, 2000. She had a retirement portfolio worth $300,000. She calculated that in order to supplement her social security check, she would need an additional $2,000 per month retirement income. She figured that as $2,000 per month is 8% of $300,000, she could invest her retirement fund in the stock market, provide herself the needed income, and actually “grow” her nest egg.

As of March 2001, Mary finds her retirement fund has suffered roughly a 25% loss plus she has drawn out her required $2,000 per month for retirement income. Her account balance is $200,000. Her required withdrawal, $2,000 per month, is now equal to 12% of the fund. It is unlikely her fund will ever recover from the setback and it probably will not last her lifetime.

Wouldn’t Mary have been better off with an annuity guaranteeing her required retirement income?

According to IRS tables, in a married couple, both age 65, the survivor can be expected to live, on average, another 25 years. But, this number is only an average; who knows what the actual numbers will be? Will both spouses live 10, 20, or 30 years? Will one live only five years while the other lives thirty-five? There is a lot of uncertainty and the security of a guaranteed income, whether it be single life, joint life, or joint and survivor life, can be helpful in eliminating some of the risk.

Suggest to clients doing retirement income planning that they calculate their needed income, and provide for any supplement to social security and company pension payments by purchasing an immediate annuity. Any additional retirement funds can then be invested for long-term growth without concern for pulling out money during a down market. This fund could also be safely used for “extra” purchases such as vacations, family emergencies, or gifts to children without endangering the client’s standard of living.

Printed with permission from Advanced Underwriting Consultants

Last Updated: 12/15/2002 11:49:00 AM