One of the biggest challenges in retirement is building a reliable stream of monthly income to support you for what could be a very long time. While retirees have long relied on bonds for this purpose, a retirement income expert recently told MONEY that there’s a better solution: income annuities.
In a recent Facebook chat with members of the Retire With Money group, Wade D. Pfau repeatedly made a case for what he considers a better alternative to cash or bonds for retirement income: a single premium immediate income annuity (SPIA) or single premium deferred income annuity. Both are plain-vanilla types of income annuities, an insurance product where you trade a lump sum payment for guaranteed monthly income for life. (Income annuities are not to be confused with their complex—and often way too expensive—cousins, the variable annuity and the fixed indexed annuity.)
Pfau, a chartered financial analyst (CFA), is definitely someone worth hearing out. He helped develop the Retirement Income Certified Professional program at The American College of Financial Services, where he oversees training financial advisors on best practices for retirement income. He is the founder of Retirement Researcher, an educational site that helps do-it-yourself investors explore academic research. And this fall, he will publish his third book on retirement planning strategies, with income annuities as a featured topic.
Funding the Spending Gap
Why might a simple annuity be helpful in retirement? For many households, the guaranteed income from Social Security (and a pension, if you’re lucky enough to have one) won’t cover 100% of basic living costs. A popular strategy to fund that essential-spending gap has been to move a chunk of money into cash and/or bonds to cover those living expenses for a few years.
Experts call this the “bucket approach,” with the money for near-term expenses parked in cash or cash equivalents and rest of your money in stocks. That way, you won’t have to worry about stock fluctuations affecting your ability to pay your bills in the near term, yet you can still capture stocks’ long-term growth to help your portfolio outpace inflation over time.
But cash and bonds aren’t the only option for your “safe money.” In fact, annuities can be preferable, Pfau says. In response to a question about using a bond ladder, Pfau noted that an annuity that delivers monthly income for life (and if you choose, the life of a spouse) is a more efficient way to generate guaranteed lifetime income. That’s because bonds in a ladder eventually mature, and you may not be able to reinvest at the same (or better) interest rate.
When another member asked about using municipal bonds or a ladder of certificates of deposit (CDs) to fund living costs, Pfau noted that, “both (are) struggling to compete with something that can provide guaranteed income.”
Pfau suggested considering using money from your current bond allocation to buy the annuity, because it replaces the bonds as an income generator. Following that advice will increase the portion of your remaining investment portfolio invested in stocks. Pfau said that can be smart, too. Because you’ll have your living costs covered with guaranteed income, you can afford to have more invested in stocks. “If we draw from our bond holdings to buy an immediate annuity, it can generally better support retirement spending,” he said.
For retirees, the case for income annuities becomes even stronger in today’s low interest rate environment, Pfau told MONEY in a follow-up email. This is because annuities’ payouts (known in the industry as “mortality credits”) are not affected by interest rates.
Annuities have another benefit to retirees as they age: even if you’re a do-it-yourself investor, “with cognitive decline, continuing to manage retirement income can be difficult,” Pfau noted. Annuities are easier to manage than bonds, since the latter require regular reinvestment as they mature, while annuities’ monthly checks continue without any effort on the recipient’s part.
Tapping Your Principal
Pfau also threw a bit of cold water on another popular retirement income strategy: investing in stocks and bonds with the intention of only spending the income they throw off. Retirees are often loathe to tap their principal, but they shouldn’t be, he says.
“When you invest for income, you start tilting to riskier parts of the market….you might have a higher dividend rate but you might be more exposed to capital loses and ultimately a lower sustainable income level.” Pfau suggested that a total return approach to retirement income could be a better way to go.