Retirement Investor

The Income Annuity is the Constrained Investor’s Life Jacket


Imagine that you have joined some friends for a day of fishing. About two miles offshore, you sense that something is wrong. The small, single engine boat’s handling has changed. There seems to be more drag. The water level is higher than normal. It’s becoming obvious that a serious problem is unfolding. 

One of your friends determines that the bilge contains more water than normal. And it’s filling rapidly. Then, the reason is discovered. The bilge drain plug is missing. Panic sets in. Immediately, you recognize that you are too far out to swim to shore. You have been thrust into a crisis. Frantically, you begin opening hatch covers and doors to various compartments. You quickly locate several life jackets. Snatching one, you say to yourself, “This is the one and only thing that can save my life.” And it does.

While filled with high stakes circumstances, this little story had a happy conclusion. You survived thanks to a tool that, when it was most needed, simply did its job. 

For many a retiree, the financial equivalent of the life jacket is an annuity. It is the one and only tool that can save a retiree’s income. And for this reason alone, its popularity should be far greater than it is.

The fishing trip tale represents how I think about the role of an annuity in the context of a constrained investor’s planning for retirement income. In this earlier article, I wrote about the characteristics that describe constrained investors and some of the big risks they must plan for.  

And in a separate article, “How to Think About Annuities,” I suggested questions you should ask of the financial professional who recommends that you purchase an annuity. The  Q&A process I outlined should result in you gaining an accurate understanding of the annuity that is being proposed. The process should lead you to a thoughtful decision on whether the annuity is the right thing for you. 

Now, I want to merge these subjects and delve deeper into the constrained investor’s retirement security challenges by giving you a simple framework for determining if you are, in fact, a constrained investor. Then I will focus on a problem that is particularly dangerous to constrained investors: longevity risk. 

Are You a Constrained Investor? 

The good news is that constrained investors reach retirement with savings. The not-so-good news is that the amount of money they’ve accumulated is not high compared to the level of income the retiree needs his or her savings to produce. For the purposes of the following example, I will define “income the retiree needs” as the amount of annual income required to fund one’s minimally acceptable lifestyle. 

Social Security and any pensions will cover part of the income a retiree needs. The remainder must be generated by the retiree’s savings. The difference between the two is what we refer to as the income gap.

Consider the example of a recent retiree we will call Anne. At 66 years of age, and a widow, Anne is in good health. She has seen firsthand the reality of someone spending many years in retirement. That’s what happened to Anne’s mom. By the time she passed at age 96, Anne had an acute sense that her own retirement could endure for decades.

A disciplined saver, Anne has accumulated a nest egg. But she doesn’t know how much she can safely spend each month, nor how much risk to take. As a result, Anne is reluctant to spend more than needed to meet her minimum needs. 

Anne has accumulated savings of $875,000. She also has a Social Security monthly retirement benefit of $2,100. Importantly, for her peace-of-mind, Anne requires a total monthly income of $5,200. 

Subtracting her Social Security income from her  total monthly income goal,  we find that Anne has an income gap of $3,100 per month or $37,200 annually. 

$5,200 – $2,100 = $3,100 ($37,200/year)

The Income-to-Assets Ratio

The income-to-assets ratio offers an uncomplicated way to determine if you are a constrained investor. Just divide the annual income you need your savings to produce by the total amount of savings available to produce income. If the resulting percentage is 3% or more, you are a constrained investor. In Anne’s case, it looks like this.

    $37,200 ÷ $875,000 = .0425, or, 4.25%

4.25% is greater than 3%. Therefore, with an income-to-assets ratio of 4.25%, Anne is a constrained investor. 

Now that we know that Anne is a constrained investor, what does it mean? In a word, caution. Anne’s savings are going to be under pressure to deliver the level of income she desires. In practice, Anne has little or no margin for error in terms of investing mistakes. She really will need the help of a financial advisor who specializes in retirement income planning.

Anne should ask her advisor for a formal, written plan which describes how her income will be created. To be financially successful over the course of retirement, she will need to be consistent with her investing strategy, remaining invested through all market conditions. At times, for most investors, this can be a challenge. 

An income plan that balances safe investments with appropriate exposure to stock market growth potential can offer Anne several significant benefits including safe monthly paychecks throughout retirement. I described such a plan here. The aspect of safe monthly paychecks adds a strong degree of emotion management that makes it easier for retirees like Anne to remain consistent with investments. Because they promote staying power, income plans that balance safety, and an appropriate degree of risk are generally the best option for Constrained Investors. 

Anne’s Longevity Risk

Is living a long life really a risk? In financial terms, it absolutely is an incredibly significant risk. Recall that Anne’s mom lived until she was 96 years of age. What would happen if Anne outlived her mom by, say six years? That would mean that Anne would live until 2058, at which time she will be 102 years of age. Sounds far fetched? It’s not. 

In 2020, there were 920,000 people in the United States who reached age 100. It is projected that there will be more than five million by 2058. Anne could very well find herself among that group of American centenarians. 

Longevity and Inflation

Adding to Anne’s longevity risk is the issue of inflation. You know that it has been surging of late, reaching 7.5%., a level not seen in the United States since the 1970s. 

Let’s be optimistic and assume that Anne indeed outlives her mom by six years. In order for Anne’s purchasing power to be the equivalent of what $5,200 per month purchases today, by the final year of her retirement, Anne’s monthly income must grow to $15,071. And that is based upon the assumption of a 3% rate of inflation. 

The twin risks of longevity and inflation should motivate any constrained investor to find that balance between safe investments and exposure to equity growth potential. This is vital because, for decades, stocks have proven to be an investment that keeps pace with inflation. An income planning specialist is accustomed to helping investors construct this type of balanced plan.

Retirement doesn’t have to end up like a disastrous fishing trip. The key to success begins with  recognizing the type of investor you are. If you determine that you are a constrained investor, you should be confident about your financial security in retirement. But don’t wait to take the planning steps that will provide you the best chance of having an income that both keeps pace with inflation and lasts for life.

David Macchia

David Macchia is an author, public speaker and entrepreneur focused on improving the current state of retirement income planning. He is the founder of Wealth2k, Inc, and the developer of the widely used retirement income solution, The Income for Life Model®. Recently, David developed Women And Income™, the first retirement income solution developed to address the differentiated needs and preferences of female investors. David is the author of the consumer finance book, “Lucky Retiree: How to Create and Keep Your Retirement Income with The Income for Life Model®.”

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