Retirement income planning is still a relatively new field with different dynamics than traditional wealth accumulation. After a lifetime focused on maximizing wealth or beating a benchmark, your goal becomes creating sustainable income over an indefinite length of time—the rest of your life. Retirees must manage risks like market performance along with their own longevity and the uncertainty about their spending requirements.

The Wall Street Journal once quoted me referring to income annuities as “super bonds,” which is not the most academic term. Recently, I started calling them “actuarial bonds.” My experience with retirement income has led me to conclude that income annuities have the potential to improve retirement outcomes over what is possible with bond funds.

In thinking about retirement income, we extend the efficient frontier of modern portfolio theory beyond its single-period focus to consider lifetime risk and reward measures.

Lifetime risk can be framed simply as the possible shortfall in the amount you will need to spend, which can happen when market returns are bad or your life is unusually long. Reward, on the other hand, can be defined by any liquid financial assets available to support your additional spending for contingencies or fund legacy objectives when you have otherwise been able to meet your lifestyle spending goals.

There can be a trade-off between these objectives. You can lock in spending or reduce your portfolio volatility to protect yourself during downturns. This generally means sacrificing some of the potential growth on the upside. You can meet these objectives by using stocks, bonds and annuities in combination. Some allocations can be more efficient than others in accomplishing the objectives.

My research article on the efficient frontier for retirement in the Journal of Financial Planning concluded that combinations of stocks and income annuities produce more efficient outcomes than combinations of stocks and bonds. Income annuities effectively serve as a replacement for the fixed-income allocation in a retirement portfolio. When retirees know what they will receive upon purchasing an income annuity, they are in good shape if they have enough saved to lock in their income objective.





As I said before, the focus is no longer on maximizing wealth but on sustaining a desired income, so any interest rate risk becomes inconsequential, existing only on paper for those doing the additional present value calculations for the annuity income. Meanwhile, rising interest rates lead to falling bond fund prices, and some losses may be locked in when retirees sell assets to sustain spending objectives.

In addition, income annuities provide longevity protection, which is unavailable with traditional bonds. Trying to meet a spending objective from a bond fund will inevitably lead to portfolio depletion down the road, while income annuities provide income for your entire life.

Since the insurance company providing the annuity is investing those funds primarily in a fixed-income portfolio, we can essentially think of income annuities as part of the retiree’s bond allocation. Here, income annuities offer something bond funds cannot: mortality credits. Those who wind up experiencing short retirements subsidize the income payments of those with longer retirements.

This is known as “longevity protection.” The income annuity is able to make payments, anticipating that someone will reach his or her life expectancy, because of this risk pooling feature. Thus, as I said earlier, income annuities are “actuarial bonds.”

This is how the reward component of the efficient frontier works. Counterintuitively, liquid financial assets can be larger later in retirement if there is a partial annuitization. To show this more clearly, I offer an example in Figure 1 that compares a retirement strategy with only investments to a strategy that includes partial annuitization.

I profiled a couple, as an example, who share a birthday. They are approaching 65 and ready to retire. With a nest egg of $2 million, they would like to fund $89,586 of spending from their portfolio—with a 2% annual increase to cover inflation—for the rest of their lives. I assume that there will be a fixed inflation rate of 2% and real compounded returns of 6% for stocks and 1% for bonds. (These are actually quite generous return assumptions that would favor an investments approach.)

The couple considers two possibilities for funding their spending goals in retirement. Option 1 is to use investments only: withdraw from a 50/50 portfolio of stocks and bonds, rebalanced annually. Option 2 is to annuitize half of their portfolio at retirement to cover the fixed-income allocation and keep the other $1 million in stocks.

Based on the numbers at my Retirement Dashboard for the start of 2015, the payout rate for an annuity that pays 100% to a surviving spouse after the first spouse dies and has a 2% annual cost-of-living adjustment is 4.4%. The annuity income grows from a base of $44,000, and the remainder of the couple’s spending goal is covered through systematic withdrawals from their investment portfolio.

With both investments only and partial annuitization, the couple is able to fund their $89,586 equally well. Figure 1 tracks the amount of liquid financial assets remaining for them after they have met this spending objective. In early retirement, liquid financial assets will clearly be less with partial annuitization. Half of the retirement assets were annuitized with no refund provision in the event of early death.

However, over time, partial annuitization shows better portfolio growth. The greater risk capacity afforded through partial annuitization allows remaining assets to be invested more aggressively. By the time the couple has reached 84, their liquid financial assets are actually higher with the partial annuitization strategy. Using data from the Society of Actuaries’ RP-2014 mortality tables for healthy annuitants, I calculated a 59% chance that at least one member of this couple will survive beyond age 84. This places the odds in favor of having more liquid financial assets at death when the couple’s assets are partially annuitized.

Note that by the time the surviving spouse reaches age 105, the portfolio with only investments is depleted. This is because I chose annual spending amounts that allow the portfolio to last 40 years. But even if the portfolio were depleted, the partial annuitization would allow some income continuation and also allow increasing upside potential in the event the surviving spouse lives a long life. The excess money that spouse receives from the income annuity—the “mortality credits”—supports an increasing percentage of the lifetime spending, more than what bonds would have been able to provide. The real legacy value at the person’s 105th birthday is more than $5.7 million with the partial annuitization.

In reality, clients would likely decide to use smaller annuitization amounts than 50%. They may also consider deferred income annuities rather than immediate annuities in order to better leverage the mortality credits at a lower cost to the portfolio. (Also in reality, clients would probably not be comfortable with a 100% stock portfolio.)

Nonetheless, the basic story will still hold. When retirement ends up being short, partial annuitization means a smaller (though perhaps reasonable) legacy. For longer retirements, it offers sound spending support while also fortifying a larger legacy. It is a more efficient retirement income strategy, and that is why I believe income annuities serve as a solid replacement for bonds in a retirement income portfolio.

Wade D. Pfau, Ph.D., CFA, is a professor of retirement income in the Ph.D. program in financial services and retirement planning at the American College in Bryn Mawr, Pa. He is also a principal and director at Watermark Adviser Solutions, helping to build model investment portfolios that can be integrated into comprehensive retirement income strategies. He actively blogs at RetirementResearcher.com. See his Google+ profile for more information.