Relax in Retirement By Replacing Bonds With Annuities

For decades, the venerable 60/40 portfolio (that is, 60% stocks and 40% bonds) has gained something along the lines of a default status as a suitable asset allocation for retirement. This has produced good returns, but it exposes your portfolio to longevity risk.

But what if you replace some of your bonds with income annuities?

I work closely with our clients to personalize their asset allocation. I incorporate my own investment experience and insights gained from the field of behavioral finance. However, it’s not hard to see the appeal of the 60/40 portfolio over the past four decades or more. The years have been an historically atypical period. Declining interest rates have resulted in the 60/40 portfolio producing a total return very close to that of an all-stock portfolio with much less volatility.

Lately, though, financial pundits have increasingly been shouting that the 60/40 portfolio is “dead”.

I maintain that it is ALWAYS best to ignore pundits. Especially when they say something is “dead”.

The 60/40 portfolio is NOT “dead”. Still, let’s look at an example of a simple change I always examine for clients transitioning into retirement. In many cases, I find this analysis often produces a dual benefit, First, it can reduce the risk of a retirement income shortfall, Second, it can increase the expected value of the client’s bequest to heirs and/or charity.

What happens we move some of the portfolio from bonds into high-quality income annuities instead?

Income annuities, like a single premium immediate annuity (SPIA) often have advantages for clients. They produce a highly predictable stream of income, like a bond ladder but without the reinvestment risk. Because SPIA produces income for the life of the client we can use a SPIA to reduce longevity risk. This is the risk of outliving the portfolio’s ability to produce sustainable income.

To illustrate, let’s look at a hypothetical client named Ellen Terry. At age 66, Ellen has a net worth of $1 million invested using the traditional 60/40 allocation. If we assume that Ellen’s total expenses in retirement are roughly $76,000 and increase at the rate of inflation, her portfolio has a 54% probability of success. Success in this context means that either the portfolio lasts until she is 95 years old without running out of money OR she has take some reduction in income at some point during retirement.

If Ellen uses $200,000 of the money currently allocated to bonds to purchase a single premium immediate annuity with a payout rate of 4.2%, Ellen’s probability of success goes up from 54% to 69%.

And because this annuity income is life-long, Ellen is freed from worrying about outliving her money.

Annuities have a poor reputation, in part because they are often sold by insurance agents paid on commission. As a fiduciary fee-only planner, we don’t have that conflict of interest.

If you think your portfolio might benefit from having us take an unbiased look at your retirement income, schedule a free call with us.