Most people convert to a registered retirement income fund (RRIF) as opposed to buying an annuity.Ryan Remiorz/The Canadian Press
Excerpted with permission of the publisher, Wiley, from The Essential Retirement Guide: A Contrarian's Perspective by Fred Vettese. Copyright (c) 2015, John Wiley and Sons, Inc. All rights reserved.
Buying an annuity is usually a better bet than managing your own investment portfolio after retirement and drawing an income from it (the portfolio option). You lose a little upside potential but you also eliminate some major risks.
There are, however, two possible situations when annuitizing might not be for you. First, if you want to make the largest possible bequest in the event of early death, the portfolio option provides a better benefit, though you can attach a fairly substantial death benefit to an annuity as well. The other situation when you should pass on an annuity is if you have good reason to believe that your life expectancy is shorter than average.
Assuming neither of these circumstances applies to you, the questions you should be asking are (a) whether you convert all of your retirement savings into an annuity or just a portion, and (b) when is it best to annuitize.
Annuitizing All or Some
You no doubt are investing some of your retirement savings in fixed income investments, such as a bond fund. If you are close to retirement, the fixed income portion of your savings is probably 40 or 50 per cent of your total portfolio and possibly more. It makes sense to liquidate these fixed income investments and buy an annuity, provided that the amount of assets is large enough to make this worthwhile–say, $100,000 or more. There are several reasons why you would buy an annuity instead of holding bonds.
First, the implicit yield underlying the annuity is better than the yield from regular fixed-income investments in your portfolio, once you adjust for differences in level of risk. Second, the annuity provides a steady income stream and eliminates the chances you will outlive your money. Third, to the extent that you annuitize, you are avoiding the problem described in Chapter 16–that you might do something foolish with your investments when you reach an advanced age.
Why stop at annuitizing just the fixed-income portion of your portfolio? Why not apply all your retirement savings toward buying an annuity and get rid of the headache of investing your own monies after retirement? There is something to be said for pursuing this strategy, especially if you are risk-averse, but most people will want to hedge their bets. If all their income is in the form of an annuity, they no longer have a rainy-day fund in case of ill health, a desire to provide a one-time cash gift to their children, or unexpected inflation. Having no degrees of freedom can create an uneasy feeling. Even if you do not want to derive all of your income from an annuity when you are 65, you might change your mind later on for the reasons given below.
When to Annuitize
Just as there are good and bad times to buy stocks, there are also better times and worse times to buy an annuity. The trick is to identify the best possible time. One of the signs will be when the gap between the yields on long-term government bonds and inflation is relatively high–that is to say, when the real yield on long-term bonds is high.
You might wonder what long-term bonds have to do with annuities. The interest rate that determines the cost of annuities is never advertised by the insurer but it happens to be closely tied to the yield on long-term government bonds, which is readily available. The gap between long-term bond yields and inflation is currently rather small, even though inflation is low which means that now might not be the best time to buy an annuity. Note that the nominal yield on bonds is not important, just the real yield. Hence, you are better off buying an annuity when long-term bond yields are 4 per cent and inflation is 2 per cent than when long-term bond yields and inflation are both 5 per cent.
A second reason why now may not be the best time to buy an annuity is you are competing with the big defined benefit plan sponsors. Many of them have closed their pension plans to new entrants in recent years and are currently in the process of derisking those plans. This process could involve buying a group annuity to cover all of their retirees so that the company can get the risk off their books. Another de-risking strategy is loading up on long-term bonds to emulate the effect of buying an annuity within the pension fund. The upshot of all this activity is that it seems everyone wants to buy long-term bonds these days and this has depressed the yields that those bonds offer. This unusually strong demand should eventually taper off since there are only so many defined benefit plans out there and once they have derisked, the buying pressure on the bond market will ease. I would give this process 5 years.
Another factor in the timing of an annuity purchase is to know how the insurance companies are currently pricing their product. At certain times, some insurers will price their annuities more aggressively, thereby giving the consumer a better deal. This is essentially like taking advantage of a sale on annuities. This type of situation might occur toward the end of a year when the insurance company has not yet met its sales quota (not unlike a car dealership), or it might happen when the insurer has access to an especially favorable private fixed income investment, which they want to pass along to the consumer in the form of an annuity purchase to lock in their own profit. Your insurance broker might have some insights as to whether certain insurers are motivated to provide a better price on annuities at a given point in time.
In spite of this, you can never know for sure whether you bought an annuity at a good time, except in hindsight. This is not unlike purchasing a house. If you are retiring and know that you can buy an annuity big enough to meet your income needs, you might decide to proceed with the purchase immediately without worrying if the price might be better 6 months from now.
One reason you cannot afford to wait too long to make your annuity purchase is that you never know when you might become cognitively impaired. Waiting too long to close the deal is a phenomenon that I referred to in Chapter 16 as rational roulette. While you should obviously annuitize before your ability to make sound financial decisions starts to fail, you may not realize it when it starts to happen. Prudence suggests acting sooner rather than later. One approach may be to decide in advance to annuitize at age 75.
Excerpted with permission of the publisher, Wiley, from The Essential Retirement Guide: A Contrarian's Perspective by Fred Vettese. Copyright (c) 2015, John Wiley and Sons, Inc. All rights reserved.