If you've got a client in the market for an income annuity, there's no need to shop around. The best deal going – hands down – comes from an unexpected source: Social Security.
Annuities can help boost retirees' guaranteed income in retirement. But your clients can “buy” that annuity at a much more attractive price from the Social Security Administration (SSA) through a delayed filing for benefits, which leads to much higher monthly benefits later on.
This annuity's “cost” is spending portfolio assets and/or income from work during the early years of retirement to fill any gap in living expenses. The strategy can also stretch the life of the retiree's portfolio by as much as 10 years.
A research brief published last month by the Center for Retirement Research at Boston College (CRR) compared an array of strategies for generating retirement income:
--Preserving principal and living on the interest;
--Investing in stocks and bonds and drawing out a portion as income;
--Buying an immediate income annuity in the commercial market;
--”Buying” annuity income from Social Security.
The Social Security annuity handily beat the other three choices.
Social Security benefits are calculated using a formula called the primary insurance amount, or PIA. Seniors who wait to start receiving Social Security until their full retirement age (currently 66) receive 100 percent of PIA; taking benefits at 62, the first year of eligibility, gets them 75 percent of PIA. By waiting until age 70, they'll receive 132 percent of the PIA – nearly double the monthly income for the rest of their lives. Those benefits are enhanced by an annual cost-of-living adjustment, which is added back in for any years of delayed filing.
Filing later means fewer total years of benefits, or course. But cumulative lifetime benefits are most often higher and create a hedge for longevity risk, according to a research paper published recently in the Journal of Financial Planning. The authors are William Reichenstein, a professor at Baylor University who has written extensively on Social Security planning, and William Meyer a financial services industry veteran. They are co-founders of SocialSecuritySolutions.com, a fee-based service that advises seniors on maximizing their benefits; the company licenses a version of its software to advisors.
The CRR brief was written by Steven Sass, program director of the center's Financial Security Project. He concluded that traditional retirement income strategies – preserving principal and living on the interest, or investing in stocks and bonds and drawing out a portion as income-- both fell short when compared with a Social Security annuity.
The live-on-interest option is a loser because it fails to keep purchasing power even with inflation. And relying on a portfolio with a mix of stocks and bonds also presents interest rate problems, in that bond yields are low, and any increase in rates reduces the bond’s value.
Sass also found that a Social Security annuity beats a commercial income annuity, for several reasons:
--Interest rates. Pricing of commercial annuities depends on current interest rates, and in the current environment makes them much more expensive. The step-up in income available through a delayed Social Security filing, by contrast, is a basic actuarial calculation and isn't tied to interest rates.
--Actuarial “fairness.” The extra benefits that come from delaying Social Security filings are “actuarially fair,” in that no extra cost is born by the system due to participants' claiming the benefit at different ages, notes Sass. Social Security's annuity “pricing” also benefits from the system's efficiency.
“Social Security doesn't have any marketing costs that need to be priced into the annuity,” he says. “Commercial insurance companies have marketing, management and risk-bearing costs that must be priced into the expected present value of the income the annuity will provide.”
Social Security's “price” also benefits from its unisex mortality ratings. In the commercial annuity market, women pay more because of their longer life expectancy. Insurance companies also must charge more for inflation protection and spousal and survivor features – all of which are provided at no charge by Social Security.
Sass compares the annuity rates for commercial annuities and the return on the delayed Social Security filing (the “price” of the Social Security annuity is the savings drawn down to cover living expenses in the early years of retirement). An example: a 66-year-old woman could buy an inflation-protected income annuity carrying a 4.7 percent annuity rate. But by delaying her Social Security benefits by one year (from 65 to 66), she would earn a 7.1 percent rate of return on annual benefits.
Although purchasing a Social Security annuity requires more portfolio draw-down in the early years of retirement, it can boost portfolio life significantly over the long haul. That's because the big boost in Social Security income reduces pressure to use portfolio assets for living expenses.
Meyer and Reichenstein found that portfolios ranging from $200,000 to $700,000 enjoyed the greatest life extension. “Most people think they shouldn't be drawing down their portfolios,” says Meyer. “But we found that using portfolio assets in the early years can make a portfolio last anywhere from two to 10 years longer.”
The strategy works best for mass affluent clients because Social Security represents a larger proportion of total net worth than it does for wealthier households. But that doesn't mean the strategy can't help very affluent families, Meyer cautions.
“The average mass affluent will receive over $1 million dollars in Social Security over their life,” he says. “The difference between a good and a bad filing decision can mean over a $100,000 more dollars.” He adds that for a portfolio with $1.5 million in assets, a smart Social Security decision added one to two years of portfolio longevity.
One important caveat here for planners: pay close attention to taxes levied on Social Security benefits. Meyer cautions that households with lower savings ($200,000 to $700,000) can be more significantly impacted by taxes based on portfolio withdrawals.
Up to 85 percent of Social Security benefits are subject to income tax, depending on a formula that measures the client's combined income (defined by the government as adjusted gross income plus nontaxable interest plus one half of of Social Security benefits).
“Advisors need to be careful to consider taxation on Social Security to insure they don't bump their clients' taxes on benefits from 50 percent to 85 percent,” he says. If you withdraw from the wrong place each additional $1 can incur a 85 cent penalty.”
Even in cases where portfolio extension is smaller, Reichenstein and Meyer found that the strategy of buying additional Social Security annuity income is especially helpful as a hedge against longevity risk, since surviving spouses continue to enjoy the higher benefit level as a survivor.
“Even families that consider themselves wealthy can be at risk in old age,” Meyer says. “Two or three years of nursing home care can burn through a big pile of assets.”
Mark Miller is a journalist and author who writes about trends in retirement and aging. Mark edits and publishes RetirementRevised.com, featured as one of the best retirement planning sites on the web in the May 2010 issue of Money Magazine. He is a columnist for Reuters and also contributes to Morningstar and the AARP Magazine. Mark is the author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living (John Wiley & Sons, 2010).