Creating Retirement Income Without an Annuity
One of the biggest challenges in retirement planning is figuring out how to generate income once you stop working. Many people turn to annuities as a solution, but new research suggests that if you’ve saved enough during your working years, an annuity might not be the best choice for you.
Annuity Basics: What You Need to Know
Annuities can be complicated, so let’s break them down simply.
An annuity is an insurance contract where you pay an insurance company a lump sum or monthly premiums in exchange for guaranteed payouts in the future. There are two main types:
- Fixed annuities provide a guaranteed payout, unaffected by market performance.
- Variable annuities have payouts that depend on how well the investments made with your premiums perform. While there’s usually a minimum guaranteed payment, the growth is uncertain.
When it’s time to receive payments, you can often choose between a lump sum or annuitized payments. Some annuities pay out for a fixed period, while others provide lifetime income.
Who Should and Shouldn’t Use Annuities?
When you retire, your monthly income will likely decrease significantly. While Social Security (or the Canada Pension Plan and Old Age Security) provides some income, it may not be enough. Annuities are designed to fill this gap.
However, if you’ve saved enough money, an annuity might not be necessary.
According to research, if your total savings exceed 25 times your annual retirement expenses, an annuity won’t add much value. That’s because you can effectively self-insure against outliving your savings.
Annuities are also unnecessary for those who already have stable, inflation-adjusted income from pensions and Social Security.
When an Annuity Might NOT Be a Good Choice:
1. You Have Other Reliable Income Sources
If you receive a pension, Social Security, or have a well-diversified investment portfolio, an annuity may not be necessary.
2. You Need Liquidity
Annuities lock up your money. If you need access to your savings for emergencies, healthcare, or unexpected expenses, an annuity can be restrictive.
3. You Can Get Better Returns Elsewhere
Annuities often come with high fees and lower returns compared to investing in the stock market. A well-diversified portfolio of stocks and bonds generally provides better long-term growth.
4. You Have a Shorter Life Expectancy
If you have health issues or expect to live a shorter-than-average life, you may not receive enough annuity payments to justify the upfront cost.
A Better Alternative: The 4% Rule
Instead of locking your money in an annuity, consider the 4% rule, a simple and effective withdrawal strategy for retirement.
Here’s how it works:
- Calculate your annual expenses. Let’s say you need $50,000 per year.
- Multiply that number by 25 to determine your target retirement savings:
$50,000 × 25 = $1,250,000 - Invest that amount in a broad-based index fund, such as the S&P 500.
- Historically, the S&P 500 has returned about 8% per year on average. On a $1,250,000 portfolio, that’s $100,000 annually.
- Withdraw 4% per year (in this case, $50,000). This allows your portfolio to continue growing over time, ensuring your income increases year after year.
Final Thoughts
An annuity can provide peace of mind, but it’s not always the best choice. If you’ve saved enough, a well-diversified stock market portfolio following the 4% rule offers better returns, greater flexibility, and long-term financial security.
Before committing to an annuity, consider whether your existing savings can generate the income you need without the restrictions and costs of an insurance contract. Your money should work for you—not for an insurance company.
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