"Retirement requires a change in how people think about their money. Low cost annuities can, and in many situations, should, play a big part in generating and guaranteeing retirement income," said Maliz Beams, TIAA-CREF's Executive Vice President for Individual Client Services. "A low cost life annuity is often the clear choice for maximizing and guaranteeing retirement income."
Yet when it comes to their expected future income needs, many investors believe they can simply draw down money from individual accounts without considering an annuity.
That leads to the first myth.
MYTH: I don't need an annuity, I can figure out how to take withdrawals on my own.
While there is no doubt that some investors have the will power and financial know-how to allocate and spend retirement savings adequately, no one knows how long he or she will live. Therefore no one can possibly apportion their retirement savings on their own with 100% accuracy.
FACT: There is a greater than 50 percent chance that a retiree will run out of money if they were to take systematic withdrawals equal to the income payments one would receive from an annuity.
A life annuity can help maximize the amount of income individuals can generate from their accumulated savings.
Exhibit 1 shows the financial impact of two retirement income strategies for a hypothetical 65-year-old: purchasing a fixed life annuity versus taking systematic withdrawals from the retirement accumulation. To make this an apples-to-apples comparison, we assume that each year's withdrawal is equal to the life annuity payment, and that both accounts have the same net investment earnings rate. As you can see, under these assumptions the 65-year-old who takes systematic withdrawals will run out of money in the 23rd year, even though life expectancy is 24 years.
| Exhibit 1: Systematic Withdrawals Equal to Fixed Annuity Payments1 | |||||
|---|---|---|---|---|---|
|
Annuity* Information |
Account Information for Systematic Withdrawal | ||||
| Age |
Annuity Payment |
Beginning of Year Account Balance |
Total Income Paid During Year |
Total Interest Credited |
End of Year Account Balance |
| 65 | $7,343 | $100,000 | $7,343 | $4,864 | $97,521 |
| 66 | $7,343 | $97,521 | $7,343 | $4,734 | $94,912 |
| 67 | $7,343 | $94,912 | $7,343 | $4,597 | $92,166 |
| 68 | $7,343 | $92,166 | $7,343 | $4,453 | $89,276 |
| 69 | $7,343 | $89,276 | $7,343 | $4,301 | $86,234 |
| 70 | $7,343 | $86,234 | $7,343 | $4,142 | $83,032 |
| 71 | $7,343 | $83,032 | $7,343 | $3,974 | $79,663 |
| 72 | $7,343 | $79,663 | $7,343 | $3,797 | $76,116 |
| 73 | $7,343 | $76,116 | $7,343 | $3,611 | $72,383 |
| 74 | $7,343 | $72,383 | $7,343 | $3,415 | $68,454 |
| 75 | $7,343 | $68,454 | $7,343 | $3,208 | $64,319 |
| 76 | $7,343 | $64,319 | $7,343 | $2,991 | $59,967 |
| 77 | $7,343 | $59,967 | $7,343 | $2,763 | $55,387 |
| 78 | $7,343 | $55,387 | $7,343 | $2,522 | $50,566 |
| 79 | $7,343 | $50,566 | $7,343 | $2,269 | $45,491 |
| 80 | $7,343 | $45,491 | $7,343 | $2,003 | $40,151 |
| 81 | $7,343 | $40,151 | $7,343 | $1,722 | $34,530 |
| 82 | $7,343 | $34,530 | $7,343 | $1,427 | $28,614 |
| 83 | $7,343 | $28,614 | $7,343 | $1,117 | $22,387 |
| 84 | $7,343 | $22,387 | $7,343 | $790 | $15,833 |
| 85 | $7,343 | $15,833 | $7,343 | $446 | $8,936 |
| 86 | $7,343 | $8,936 | $7,343 | $84 | $1,676 |
| 87 | $7,343 | $1,676 | $1,676 | $0 | $0 |
| 88 | $7,343 | $0 | $0 | $0 | $0 |
| 89 | $7,343 | $0 | $0 | $0 | $0 |
An average life expectancy means that approximately 50 percent of the people will live past the average, and 50 percent will not live to the average. As noted in our example, using systematic withdrawals equal to what one would receive as an annuity payment, this hypothetical 65-year-old runs out of money at 88. While this may look like the retiree only comes up one year short, it is important to note that since the 89 year life expectancy of a 65-year-old is an average, approximately 50 percent of 65-year-olds will live past 89. Using the hypothetical systematic withdrawal in the chart above that means more than 50 percent of 65-year-olds would outlive the retirement income their savings could generate.
Hypothetically, let's say the retiree lives exactly as long as expected – to 89. As the chart reads now, the life annuity will have paid $183,575 to the retiree, whereas systematic withdrawals would total $163,222, both coming from the same original investment of $100,000, with the same 5.25 percent interest. If the retiree lives longer than expected, let's say to 95, the life annuity will have paid $227,633 to the retiree, while the systematic withdrawals would have run out in their 88th year (still totaling $163,222), leaving them without payments for the last eight years of their life.
Whereas systematic withdrawals can generate no income beyond the original investment plus interest, the life annuity can, in cases of longer lives, pay out far beyond what the original investment could have supported.
Of course, to make retirement savings last longer, one could take smaller systematic withdrawals. However, this results not only in lower annual payments than those paid by the life annuity, but one can still never know how long they will live, therefore can never be sure how small those systematic withdrawals would need to be to last a lifetime.
The Life Annuity Principle
Exhibits 1 and 2 demonstrate two important aspects of the "life annuity principle.”
(1) There is a greater than 50 percent chance that the retiree will run out of money if he or she takes a withdrawal equal to the life annuity payment. In other words, there is a greater risk (mathematically) of outliving income than dying before reaching average life expectancy and losing the accumulation, (a concern that is addressed in the next article in this series, Myth vs. Fact: Eliminating the Potential Risks of Annuitization).
(2) A life annuity can allow a retiree to maximize income. Since most retirees want to be sure that they do not outlive their income, they would have to plan on withdrawals lasting quite a bit longer than just their life expectancy. For example, a 65-year-old might want to plan on having income last for at least 30 years, even if his or her life expectancy is only 24 years. Assuming a 5.25 percent interest rate and an initial investment of $100,000, a retiree using systematic withdrawals would have to limit his or her withdrawal amount to $6,358 per year to receive income for 30 years. This strategy is examined below in Exhibits 2 and 2a.
| Exhibit 2: Life Annuity vs. Systematic Withdrawal2 | |||||
|---|---|---|---|---|---|
| Annuity Information |
Systematic Withdrawal Account Information (with payment to last 30 years) | ||||
| Age | Annuity Payment |
Beginning of Year Account Balance |
Total Income Paid During Year |
Total Interest Credited |
End of Year Account Balance |
| 65 | $7,343 | $100,000 | $6,358 | $4,916 | $98,558 |
| 66 | $7,343 | $98,558 | $6,358 | $4,841 | $97,041 |
| 67 | $7,343 | $97,041 | $6,358 | $4,761 | $95,444 |
| 68 | $7,343 | $95,444 | $6,358 | $4,677 | $93,763 |
| 69 | $7,343 | $93,763 | $6,358 | $4,589 | $91,994 |
| 70 | $7,343 | $91,994 | $6,358 | $4,496 | $90,132 |
| 71 | $7,343 | $90,132 | $6,358 | $4,398 | $88,172 |
| 72 | $7,343 | $88,172 | $6,358 | $4,295 | $86,109 |
| 73 | $7,343 | $86,109 | $6,358 | $4,187 | $83,938 |
| 74 | $7,343 | $83,938 | $6,358 | $4,073 | $81,654 |
| 75 | $7,343 | $81,654 | $6,358 | $3,953 | $79,249 |
| 76 | $7,343 | $79,249 | $6,358 | $3,827 | $76,718 |
| 77 | $7,343 | $76,718 | $6,358 | $3,694 | $74,053 |
| 78 | $7,343 | $74,053 | $6,358 | $3,554 | $71,250 |
| 79 | $7,343 | $71,250 | $6,358 | $3,407 | $68,299 |
| 80 | $7,343 | $68,299 | $6,358 | $3,252 | $65,192 |
| 81 | $7,343 | $65,192 | $6,358 | $3,089 | $61,923 |
| 82 | $7,343 | $61,923 | $6,358 | $2,917 | $58,483 |
| 83 | $7,343 | $58,483 | $6,358 | $2,737 | $54,861 |
| 84 | $7,343 | $54,861 | $6,358 | $2,546 | $51,050 |
| 85 | $7,343 | $51,050 | $6,358 | $2,346 | $47,038 |
| 86 | $7,343 | $47,038 | $6,358 | $2,136 | $42,816 |
| 87 | $7,343 | $42,816 | $6,358 | $1,914 | $38,372 |
| 88 | $7,343 | $38,372 | $6,358 | $1,681 | $33,695 |
| 89 | $7,343 | $33,695 | $6,358 | $1,435 | $28,772 |
| 90 | $7,343 | $28,772 | $6,358 | $1,177 | $23,591 |
| 91 | $7,343 | $23,591 | $6,358 | $905 | $18,138 |
| 92 | $7,343 | $18,138 | $6,358 | $618 | $12,399 |
| 93 | $7,343 | $12,399 | $6,358 | $317 | $6,358 |
| 94 | $7,343 | $6,358 | $6,358 | $0 | $0 |
| 95 | $7,343 | $0 | $0 | $0 | $0 |
| 96 | $7,343 | $0 | $0 | $0 | $0 |
| 97 | $7,343 | $0 | $0 | $0 | $0 |
| 98 | $7,343 | $0 | $0 | $0 | $0 |
| 99 | $7,343 | $0 | $0 | $0 | $0 |
Notice that to stretch systematic withdrawals out for 30 years one would need to take significantly lower payments than would be provided by the life annuity (13.5 percent lower). Not only would the retiree receive smaller payments, but if they exceed their life expectancy significantly and surpass the 30 years they had apportioned their withdrawals for, they would again risk outliving their savings. The life annuity continues payments regardless.
Of course, the person utilizing systematic withdrawal could have a better result if the investment fund earned more than the interest rate underlying the life annuity. However, it would have to be a lot more. To achieve 30 years of withdrawals equal to the payments provided by an annuity ($7,343), the account would have to earn over 6.7 percent in interest, or almost 1.5 percent per year higher than the life annuity.
Know the Facts
While many investors may have the will-power and know-how to adequately employ systematic withdrawals from their retirement savings, the fact is that no one knows how long they will live. This makes it very difficult to maximize one's retirement income using systematic withdrawals. A life annuity not only can maximize your retirement income payments, but guarantee that you receive those payments for life.
As shown by Exhibits 1 and 2, by choosing systematic withdrawals over a life annuity you either have a high risk of outliving your savings (using withdrawals equal to life annuity payments) or you force yourself to take lower withdrawals to stretch out savings (which still cannot fully ensure that you won't outlive your savings). When compared with those two less-than-optimal options, a life annuity is the clear choice for maximizing and guaranteeing retirement income based on the scenarios illustrated.
Read more in Myth vs. Fact: Eliminating the Potential Risks of Annuitization.
Annuity Basics
Annuities are contracts sold by insurance companies that are designed to provide regular payments to the contract holder (also known as the annuitant) and his or her annuity partner (if there is one). The basic principle behind annuities is simple: a number of different annuitants provide funds, either in a lump sum or through regular premium payments, to an insurance company which issues the annuity contracts. This creates a pool of assets that the insurance company manages to generate payments to the annuity owners. With any annuity, all payments are based on the claims-paying ability of the insurance company.
TIAA is one of only three U.S. insurance companies to hold the highest ratings from all four major rating agencies,3 meaning TIAA has the claims paying ability individuals count on to provide lifetime income.
The two primary types of annuities are fixed, or guaranteed, and variable. In fixed or guaranteed annuities, the funds are invested in the insurance company's general account, which typically contains fixed-income securities like bonds. The issuer, not the contract owner, assumes all investment risk. Fixed annuities offer a guaranteed payment, with the payout amount based on the assumed future returns of the investments and the annuitant's life expectancy. Variable annuities provide the contract owner with the ability to invest in both fixed-income and stock-based accounts whose values change depending on the performance of their underlying investments. While variable annuities offer the potential for higher long-term returns than fixed annuities, generally their payouts will fluctuate more dramatically from year to year. Unlike a fixed annuity, the contract owner of a variable annuity assumes the investment risk.
Learn More
© 2008 and prior years, Teachers Insurance and Annuity Association - College Retirement Equities Fund (TIAA-CREF), New York, NY 10017
