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a very important concept and a concept not understood by many is the differences between talking about a withdrawl rate and talking about return or interest on your money.
in retirement it all boils down to how much can i spend?
even the folks with a million bucks are just about equal to their neighbor who has no savings at all and a 40k a year pension.
whether you believe it or not is debatable but the rule of thumb safe amount considered that one can draw from a portfolio is about 4% a year for spending if that portfolio is to last a lifetime.
that rule is highly debatable but for now lets leave it at that..
that 40k you pull out a year from that million to spend is called your withdrawl rate.thats the money you get to spend. since 40k on a million bucks is 4% thats called a 4% withdrawl rate.
a return or interest rate is the money that million bucks can earn in gains.. on a million bucks the return is 4.5% interest in 30 year bonds
withdrawl rate is what you spend, return on your money is the gains it makes.
in retirement the most important part to me is all about how much can i spend a year. the gains grow your portfolio hopefully so you can get a raise each year .
now lets simplify things to illustrate what annuities talk in terms of, thats withdrawl rate.
lets suppose you buy 30 year treasuries .. the interest you get is about 4.5%.
that is the return on your money .
a 4% withdrawl rate is 40k on those bonds ...
so thats what you can spend.
but if you wanted more income you need to hit your principal. if you wanted 5500.00 a year to live on you would have to sell bonds but that leaves you with less interest next year and less principal.
you can run the numbers but ill tell you eventually in the not to far off future your broke, possibly well before your demise.
so, suppose i said to you ,ill give you that 5500.00 a year. in fact i wont reduce that amount next year ,or the year after.
in fact after i give you back the amount you gave me ill continue to give you that 5500 a year for as long as you and your spouse live on my dime.
only hitch is if both of you die and i havent given you back all your money yet i keep whats left.
in a simple form thats an annuity.
in this case your withdrawl rate is 5500.00 a year . the annuity would be advertised as 5.5% but you need to understand they arent talking gains like interest they are talking spending money in relation to how much you gave them.
my actual return or gain on my money the first roughly 13 years is zero , but my withdrawl rate is 5.5%... for tax purposes they may credit you with some interest and principal each year but the fact is its all your own money your getting back in the early years effectively. do the math yourself, you have no gains at all during that time frame despite the fact the irs likes to call some of it interest. 100k put in gives you 100k back at that withdrawl rate about 13 years later. real returns or interest are zero on my calculator..
starting year 14 now im seeing some gains as your on someone elses dime now. those gains for 14 years are miniscule. im now ahead 5500.00 bucks in 14 years. clearly the annuity is not about interest,its about buying a pension.
you have been living all those years on 5500.00 bucks which is an amount equal to 1.3 million that you would have needed on your own in bonds to achieve. since all you had is 1 million the annuity is giving you a higher withdrawl rate then you can normally take on your own safely according to debatable theory. .
the trade off comes down to whether you want more income now hense a higher withdrawl rate or do you want a lower withdrawl rate and more money at the end.
hopefully you are all alot smarter now and when you see those annuity pitches you understand you may be thinking in total returns and interest and they are talking in amount of spending money or withdrawl rate you get.
Last edited by mathjak107; 03-26-2011 at 05:36 AM..
only thing i want to add is how your annuity is taxed.
basically buying an annuity is like buying a pension or buying a continuing paycheck.
with a traditional pension the entire amount is taxed. if you got 40k well 40k is taxed each year.
with an annuity you are basically still receiving a 40k "pension " but because you bore the costs of it, instead of the entire amount being taxed like a regular pension the irs divides what you payed in over the number of years on their expected life expectancy chart and subtracts out a piece of that cost each year from the taxes due on your annuity income and calls it a return of principal. the rest is taxed just like any other pension would be.
it has nothing to do with gains,an interest rate or a return on your money. its merely taxing your "pension" like any other and subtracting out your costs a piece at a time that you payed in..
Last edited by mathjak107; 03-27-2011 at 05:23 AM..
The rate of return is only one of the factors you need to consider when determining the safe rate of withdrawal. You also need to consider the future rate of inflation and your lifespan. So all of the factors are just gross estimates.
An informative post and it should be helpful to many people. I would add that folks need to understand that their withdrawal needs to also reflect inflation (real inflation for their situation, not the government's calculation) or they are losing purchasing power through time.
Annuities I am familiar with (and I am by no means familiar with all the variations available) usually offer either a flat annual amount (no increase for price changes) or the option of an annual inflation increase based on the CPI-W or CPI-U. The first instance is really bad as the flat amount will decline in purchasing power (assuming inflation is not 0 over long timeframes).
The second option, while much wiser (and will lower the amount the annuity company offers to pay), only has an inflation adjustment that reflects the CPI value. The CPI unfortunately rarely reflects an individual's real cost increases and one still remains with less income than is necessary to maintain their purchasing power. The BLS is analyzing a CPI geared to retired folk's actual cost experience (CPI-E) but it is strictly a research project - don't hold your breath in expecting any changes in the foreseeable future.
What to do? I suggest that folks focus on their "big four" cost components in retirement; namely medical, energy, housing and food and develop a strategy to cover those expenses through time. The CPI is great for economic analysis on a macro basis but of limited value in dealing with one's personal cost experience. Case in point, while last year's official inflation rate was supposedly flat or declined, my health insurance premium went up 9.9%, my co-pays increased 25%. The price of my heating oil went up about 4%, real estate taxes about 6% - I think you get the picture. Even an annuity with the inflation adjustment would have left me under water regarding covering my expenses.
Annuities (which I personally don't care for as a mechanism for income flow, but that's just my preference) do not provide real world inflation protection as currently constructed. An individual's withdrawal rate needs to reflect their real world cost increase experience or you will come up short.
i agree 100%.. i found a 75% your own money 25% a 3rd party annuity takes care of the inflation issue and takes enough market risk and cash flow risk out of the equation to take that porfolio well up into the 98% range of success. the swings of the markets and interest rates reduce doing it on your own into the lower 90% range. but as i said earlier we are and have been living thru that 10% chance of failure now and this past decade.
Yep, your structure sounds like a very sound strategy. I am always concerned that folks don't realize that one needs (IMHO) a personal CPI type awareness of their real cost increase exposure. Hopefully our compatriots in retirement will do their homework.
if they arent aware they are in for some surprises like my buddy who retired 15 years ago. didnt believe in investing,only banks. never imagined alot of things are costing him double now. last time i saw him he was driving car service.
Yeah, I've unfortunately seen the same situations, its depressing. Financial literacy is absolutely required to survive, most especially in retirement. The quality of financial advice available, for the most part, does not gladden my heart.
Given the US's demographic profile, its not cheering to contemplate the future of many of our age peers. I don't have a magic solution for it but definitely expect it to cause some serious social and political issues going forward. C'est la vie.
only thing i want to add is how your annuity is taxed.
basically buying an annuity is like buying a pension or buying a continuing paycheck.
with a traditional pension the entire amount is taxed. if you got 40k well 40k is taxed each year.
with an annuity you are basically still receiving a 40k "pension " but because you bore the costs of it, instead of the entire amount being taxed like a regular pension the irs divides what you payed in over the number of years on their expected life expectancy chart and subtracts out a piece of that cost each year from the taxes due on your annuity income and calls it a return of principal. the rest is taxed just like any other pension would be.
it has nothing to do with gains,an interest rate or a return on your money. its merely taxing your "pension" like any other and subtracting out your costs a piece at a time that you payed in..
Actually, the distinction you make between the computation of the income tax on a pension and the computation of income tax on an annuity is only true if you did not contribute a cent toward your pension (which is unlikely).
If a portion of your salary was withheld by your employer to pay for your pension then you use the same life expectancy charts to determine what percentage of your pension is taxable and what percentage is basically a return of principal (your previous deductions/contributions). In my case, I contributed just over $170,000 toward my pension during my 31 year employment, so this amount will be untaxed as it is returned to me over the next 30 or so years.
Better stick to finance and not taxes (j/k).
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