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How Much Should I Allocate to an Income Annuity?

Q. How Much Retirement Capital Should I Allocate to an Income Annuity?

A. It depends. This is a common question with both a long and a short answer.

The short ALEX.fyi answer is this: our view is that in most cases, an allocation of a third or less of your retirement assets is appropriate.

Importantly, this is simply a guideline. Buying an income annuity is meant to be a risk-reducing strategy. At the same time, committing a majority of your nest egg to a protective but illiquid asset would potentially introduce other risks. The proper amount to allocate comes down to your cash flow needs, target returns and risk tolerance, along with your assumptions about inflation and personal longevity.

An annuity is meant to be a guaranteed income floor- not the whole building. You (or your financial advisor) are best equipped to determine your essential living expenses and amounts to set aside for unexpected events. You will want to keep some flexibility in your portfolio to adjust for your changing needs or preferences.

The long answer is that portfolios vary.

Unlike planning the accumulation (or saving up) phase of retirement planning, in which one need only account for a few variables – savings rate, time horizon, and expected returns – planning for the decumulation (or spending down) phase can be more complex, with far more variables and far less margin for error.

For the decumulation phase, annuities are one means to provide stability in the form of contractual guarantees and safety of principal. In exchange for a lump sum of capital, an insurance company will provide you with a monthly payout that you can’t outlive, regardless of what happens to the market or interest rates in the future. Importantly, payments rely on the long term financial strength of the life insurance company. Choosing the right carrier is an important element of your decision-making process.

According to a 2018 study by Milliman Research , using immediate annuities to create a guaranteed income floor can provide retirees with the confidence to keep other assets invested for growth to meet future income needs or provide for legacy plans. The study shows that such an arrangement can increase the chances of meeting a retirement income goal from 45% to 55% based on life expectancy of 35 years. It can also increase the average bequest to heirs by as much as 25% over a mutual fund-only portfolio. The idea is that, while an income annuity and Social Security pay for your basic needs, your investment portfolio can pay for your lifestyle comforts and any legacy you want to pass on to your heirs or a charity.

While there is no one-size-fits-all approach for creating an optimal income portfolio, some suggest a blend of traditional assets and an income annuity. A portfolio might start with a traditional retirement asset allocation strategy of 40% stocks and 60% bonds, with adjustments made to account for your risk profile and your need for guaranteed income.

In practice, this might look like the scenarios below:

For a conservative investor:

Increase your stock allocation to 50 percent and split your bond allocation to 25 percent bonds and 25 percent income annuity.

For a moderate investor:

Increase your allocation to stocks to 60 percent and split the bond allocation to 20 percent bonds and 20 percent income annuity.

For an aggressive investor:

Increase your allocation to stocks to 70 percent and split your bond allocation to 10 percent bonds and 20 percent income annuity.