Portfolio 10

Differing Types of Retirement Annuity Payouts

Portfolio 10

At Index Fund Advisors, we have assisted many clients in making the crucial decision of how to take a payout at retirement—as an annuity or a lump sum. Of course, every client is different, and there is no right or wrong answer. For many investors, taking (or buying) an annuity is appropriate, and in this article, we will explore the different options and trade-offs associated with annuities.

We will start with the simplest type of annuity—the single premium immediate annuity (SPIA). This vehicle provides a stream of constant payments until the annuitant dies. Normally, the yield available on a SPIA will exceed the yield on a low-risk bond because the annuitant is benefitting from a mortality credit. As other annuitants die, the funds that they forfeit become available to provide the surviving annuitants with income. It’s not quite the same as a tontine (where the sole survivor collects all of the funds and the members who die get nothing) but pretty close to it. Also, since women live longer than men, they get a lower annuity payout for the same deposit, but then again, they also pay less for life insurance, so they should not complain.

Annuities come with many different options (riders) that can be combined in a myriad of different ways. A general rule of thumb is that the more options you add, the lower your payout will be. Some of these riders (such as a cash refund upon death) are really just a form of life insurance, and since the purpose of an annuity is to protect against the risk of longevity, they are often unneeded and more costly than simply buying term life insurance. Just as life insurance should be kept separate from annuities, so should investments. That is why IFA usually discourages clients from buying immediate variable annuities and deferred variable annuities, as they often entail owning investments at an unreasonably high cost.

Two options that should be carefully considered are inflation-protection and a joint life payout where payments partially continue upon the death of one of the spouses. Inflation-protection can be purchased as either a straight annual percentage increase (say 3%) or as a variable percentage increase that is tied to changes in the Consumer Price Index (CPI). For a married couple, a joint life payout where it decreases by say 25% upon the death of either of them can make a great deal of sense. This protects both of them from longevity risk while giving them a benefit for foregoing part of the payout which probably would not be needed anyway.

To put some concrete numbers on what a retiree can expect from an annuity, considering the different annuity payout options, we visited the annuity section of Vanguard’s Website and put in a few different scenarios for a 67-year-old retiree with $500,000 of qualified money to spend on an annuity. All of the amounts shown in the table below are offered by A-rated insurers, and they are net of a 2% commission.

 

Recently, IFA began offering the Dimensional Managed DC program from Dimensional Fund Advisors (DFA). Here is how DFA describes it on their Website:

“Dimensional Managed DC is a personalized investment strategy designed to help participants convert their working income into an inflation-protected retirement income. It creates and regularly updates a custom portfolio allocation for each participant, steadily targeting a monthly income in retirement.”

Upon retirement, the balance that is in the participant’s account is used to purchase an annuity with inflation-protection or invest it as they please. One advantage of Dimensional Managed DC is that the annuities available to retirees are institutionally priced without a middleman collecting a commission. Thus, the payouts would be superior to the numbers shown above by at least 2%.

To learn more about Dimensional Managed DC, please take a few minutes to watch the video below.

If you would like to learn more about how IFA can help you establish a fiduciary-guided retirement plan that is truly in the best interest of plan participants, please fill out IFA’s Retirement Plan Scorecard.