What is the perfect mix of retirement products that would ensure that your clients accumulate enough wealth to pass a legacy on to their heirs while maintaining a comfortable income stream as long as they live? This is the million-dollar question that every financial advisor aims to answer. According to Peng Zhou, Ph.D., an actuary at Sun Life, it’s not simply a matter of investing in the proper mix of assets and then establishing a withdrawal strategy. Based on research he conducted at the University of Connecticut, Zhou says that financial advisors should consider aggressively using several different types of insurance products as part of an overall retirement plan. In a paper he recently presented to the Society of Actuaries Practice Forum, Dr. Zhou said that a comprehensive plan should include investments in stock funds, immediate annuities, and deferred annuities.
An annuity, in its purest form, is a contract between you the consumer and an insurance company. You invest your money into an annuity and in exchange the insurance company guarantees your principal plus a certain fixed rate of interest. The annuity also guarantees income upon retirement. In addition to offering guaranteed income that the contract owner cannot outlive, annuities are shielded from taxes. The annuity grows tax-deferred and taxes only come into play when the money is taken out.
Since much of Zhou’s research revolved around the aspect of income, it’s important to note that feature of annuities in more detail. For this discussion let’s assume the deferred annuity is a Fixed Index Annuity (FIA). Annuities are the only product of its type available for retirees in that they provide guaranteed income for life. This can be done in a couple of ways. First, any FIA can be annuitized. By annuitizing your annuity, you are basically giving over control of the money to the insurance company. In return, the insurance company takes on the risk of you living too long by guaranteeing an income stream that you can’t outlive. The second way that an FIA can guarantee income for life is through income riders. These riders, also called Guaranteed Withdrawal Benefit Riders, are added to your annuity for an additional fee. They are often considered more consumer friendly than annuitization because the annuity owner retains control of their principal while still receiving an income stream for life, even if their principal is depleted.
The other annuity that Zhou recommends as part of a complete retirement plan mix is an immediate annuity. Immediate annuities work very similarly to annuitizing a deferred annuity. Simply put, you give your money to an insurance company and they take on the risk of you outliving your principal. The insurance company will pay you a set amount for life, but if you die too soon then the insurance company may get to keep what wasn’t paid out.
In Zhou’s study, titled “Stochastic Modeling of Post-Retirement Financial Planning,” research shows how mutual funds and insurance can work together to limit investment risk and preserve an estate’s value. He used Monte Carlo simulations, which are algorithms that are used to approximate the probability of certain outcomes. The results of his research show that the best mix of assets includes 25% to 45% in immediate annuities, deferred annuities, or some type of laddered combination of both. Zhou’s research shows us the importance of diversification in different financial instruments, including annuities.