With Interest Rates Near Zero, Annuities Help Pick Up the Slack

A headline in The New York Times the other day caught my eye. It read: Rates at Rock Bottom Are Expected to Linger in Fed's Latest Forecast.

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The question that would be worthy of an in-depth article is, What Do Low Interest Rates Mean to Current and Future Retirees?

Based on conversations I've been having about exporting our Income Allocation planning method to Japan, which experienced the “Lost Decade” of ultra-low (and even negative) interest rates, this is on the minds of investors around the globe. I tell them — and you — that an Income Allocation plan for retirement income that includes annuity payments should help address their concerns.

What to do with the cash in your retirement portfolio earning almost no interest?

Investors have a few reasons to hold a portion of their savings in cash or money market accounts:

• You are trying to time the market, pushing your cash to the sideline, waiting for the right time to get back into the market. Successfully timing the market is often a result of dumb luck. Good for you if it worked out once, but who today can predict what stocks — rocketing up one day, plunging the next — are going to do tomorrow, much less over the next few years?
• You want your funds to be liquid in case of an emergency. Everyone should have some cash stashed away for when the roof needs replacing, or your grandson's car blows an engine. It is also important to build cash flow (not simply cash alone) for expenses that are scheduled and that you can anticipate, like in-home health care as you age.
• You have invested in higher-risk income sources and you hold cash as a secure source of income to supplement the riskier sources. But at zero percent returns, it is contributing almost nothing to your cash flow.

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A better strategy: Include annuity payments in your retirement mix

Strong retirement plans include a mix of products to produce the results you seek. Annuity payments can address the issues above. But often investors (and their advisers) don't consider certain products because of a lack of understanding or just misinformation.

Also, they repeat certain myths like, “Don't lock in a long-term annuity payments contract when interest rates are low.”

Let's look at the real economics, and the process of adding annuity payments to your income sources.

Digging into annuity payments

While you're waiting for interest rates to go back up, you could adopt a plan that includes annuity payments to generate five to six times the amount of interest you are earning now from your 20- to 30-year Treasuries, as well as an even higher multiple on short-term cash.

Here is an example for a 70-year-old woman who has $1 million in savings in U.S. Treasury securities, split between short- and long-term. Another $1.5 million is in the market, and she hopes that a part of that investment will make up for her low earnings on the interest portion of her savings.

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With the $1 million, her Treasury investment as of July 18, 2020, will return $11,100 a year. But with annuity payments, her investment applied as a premium on the same date could generate as much as $66,400 after tax. In other words, each year in Treasuries costs her $55,300 in cash flow. For two years it's over $110,000, or 11% of the original $1 million.

How might she apply this strategy in her portfolio? It's unlikely that she uses all of the $1 million to purchase the income annuity in the example above. Here are some possible approaches:

1. In light of current low interest rates, she could consider a review of her plan for retirement income and consider income annuities as part of the sources of income.
2. She could take a small step and allocate, say, 25% of the fixed income portfolio to income annuities. With that, she's more than doubling the cash flow on that part of her savings.

The cost of waiting

What must happen in the stock and bond markets for her to find that additional 11% that she would have gotten with annuities? Unfortunately, if and when interest rates go up, the price of the underlying bonds will likely go down, decreasing the value of the portfolio. Based on our studies, there's almost no scenario that works better than adding annuity payments to her retirement mix.

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The Fed says it plans to keep interest rates low until 2022. That's a long time for retirees and others who are hoping their savings will earn enough to cover costs for the rest of their lives. And the period of low interest rates could last much longer.

As you can see, there is a huge cost in waiting.

(COMMENT, BELOW)

Jerry Golden is the founder and CEO of Golden Retirement Advisors Inc. He specializes in helping consumers create retirement plans that provide income that cannot be outlived.