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Investments + Annuities = Healthy Retirement?

Many advisers still treat annuities and investments as apples and oranges–that is, not to be mixed up in a single retirement fruit salad. But researchers Michael Finke, Wade Pfau and Mark Warshawsky offer recipes for combining them.

Some U.S. workers have saved so much for retirement that they don’t need an annuity, while many others have saved so little that they can’t afford to tie up any of their money in an annuity. In between, however, are millions of retirees who could probably “maximize their utility” by holding a mix of investments and annuities.


Two recent articles by major retirement researchers offer fresh ammunition to advisers who believe that a combination of annuities and investments could help give many of their clients the most income and the most financial confidence in retirement.

Mark Warshawsky’s paper is called “Government Policy on Distribution Methods for Assets in Individual Accounts for Retirees Life Income Annuities and Withdrawal Rules.”1 The prolific Wade Pfau and Michael Finke have co-authored an article, “Reduce Retirement Costs with Deferred Income Annuities Purchased Before Retirement” in the 2015 July issue of the Journal of Financial Planning.2

Although both reports advocate annuities, these two articles approach the retirement financing problem differently. Warshawsky thinks it would be good public policy to prescribe a ladder of immediate annuities, plus investments, to retirees in general. Pfau-Finke demonstrate that buying a deferred income annuity up to 20 years before retirement, can buffer a retired couple’s longevity risk and market risk.

But both articles offer useful starting points for advisers who are curious about embedding a guaranteed* income product into their clients’ retirement portfolios. The articles will appeal to advisers who aren’t satisfied with the 4% withdrawal rule, and who don’t want to fudge the risks of retirement by simply assuming that their clients will live to the average age and experience average market returns.

Annuity lamination plus investments


A blend of life annuities and withdrawals from an investment portfolio is recommended as the best policy not just for individual retirees but also as an exit strategy for participants in financially challenged public employee pensions, according to the paper by Warshawsky, which was published by the Mercatus Center at George Mason University.

Warshawsky’s name should be familiar to retirement mavens. A former Assistant Secretary of the Treasury official and director of retirement research at Towers Watson, he wrote Retirement Income: Risks and Strategies (MIT Press, 2011). He recently founded ReLIAS LLC, a retirement consulting firm.

In the new paper, Warshawsky works toward his conclusions about the advisability of a combination annuity-systematic-withdrawal de-accumulation strategy by first comparing Bengen’s famous 4% rule (perhaps the most-analyzed strategy in financial history) with the purchase of a joint-life immediate annuity with a 50% continuation of the benefit for the surviving spouse.

In isolation, each method has significant drawbacks, Warshawsky found. The 4% strategy fails to protect fully against longevity risk; the immediate annuity fails to protect against inflation risk. So he recommends a compromise: Retirees should put part of their money in a ladder of annuities and the rest in a diversified investment portfolio.

In an interview, Warshawsky said he envisions the ladder as “a sequence of purchases of immediate life income annuities.” That, along with a “fixed percentage distribution from investment portfolio provide the flow of income to the retired household. The specifics of the sequencing and the percentage would be customized to the preferences, goals and resources of each retired household.”

Warshawsky is aiming at public policy recommendations, not just for individuals but also for the legions of workers in underfunded local public pensions. He advises cash-strapped municipalities to resolve their crushing pension liabilities with a lump-sum buyout for each participant. The money would be placed into a “mix of systematic withdrawals from a dynamic portfolio…, and gradual laddered purchases of immediate life annuities.”

The lump sum would not be for the full present value of the pension, but something more affordable for the municipality.

Dedicate half your bond allocation to a DIA


While Warshawsky leans toward immediate annuities as the raw material for his partial annuitization strategy, other researchers have been looking at the use of a newer type of income generator: the deferred income annuity, or DIA.

Writing in the Journal of Financial Planning, Pfau, a professor at The American College, and Finke (left), who teaches at Texas Tech University, try to calculate if, or under what circumstances, a 65-year-old couple could lower their cost of retirement at age 65 by purchasing a DIA with half of the assets from their portfolio’s bond allocation.

The authors use a lot of computing power to test this proposition under a wide range of possibilities: 50,000 different ages of death for the second-to-die; 50,000 sequences of asset returns; a DIA purchase date at age 45, 55 or 62; and 11 different overall stock allocations, from zero to 100%. The DIA is a joint-life contract with a 10-year period certain and a return-of-premium benefit if neither spouse survives to the date when income or payouts are scheduled to begin.

The tables they generated, which are reprinted in the journal, showed that the benefit from using the DIA peaked when it was purchased at age 45, when the allocation to the DIA was 35% to 45% of the original assets, and when the total cost of retirement was high (i.e., when longevity was great and market returns were unfavorable). The maximum reduced cost of longevity was about 11%.

In other words, the insurance did exactly what it was supposed to do: protect against calamity (long life, poor returns). It had the least value—in hindsight, as it were—when the owners had short lifespans, enjoyed bull markets, and maintained either a very high or very low allocation to stocks.

“A short-deferral DIA can be a valuable complement to a conventional portfolio withdrawal strategy,” Finke and Pfau conclude. “Similar to the benefit of allocating bonds to single premium immediate annuities, this analysis shows that a short deferral DIA that provides lifetime income can lower the cost of funding retirement by softening the financial blow of a long lifetime or poor market returns.”

These research results from both articles support the consideration of annuities as part of (not the only factor) retirement strategies, both for younger workers and for those near or even in retirement. Individuals will need to determine their own strategies for use of annuities and continued exposure to the stock market, as best suits their financial situation and longevity risks.

*Annuity guarantees rely on the financial strength and claims-paying ability of the insurance company that issues the contract. Lifetime income may be a benefit of the base policy, or a rider may be available for purchase that provides that benefit.


© 2015 RIJ Publishing LLC. All rights reserved.

1 Warshawsky, Mark J. “Government Policy on Distribution Methods for Assets in Individual Accounts for Retirees Life Income Annuities and Withdrawal Rules.” Mercatus Center, George Mason University, June 2015.

2 Pfau, Wade and Michael Finke. “Reduce Retirement Costs with Deferred Income Annuities Purchased Before Retirement.” Journal of Financial Planning, July 2015.

If you cannot access these articles on line, call 1-866-223-2121 to request a copy.


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