How Much Should I Allocate to Annuity

How much of my assets should I invest into an annuity? How much of my retirement nest egg should be invested into annuities?

Allocating your retirement savings and investments is difficult enough when you’re young: Should you invest it all in stocks and mutual funds? If so, how much should be in small caps vs large caps, dividend paying versus long-term growth, and foreign or domestic equities?

It gets more challenging the closer you get to retirement. You have to balance the need to minimize market risk, which could deplete your savings, with having to make those assets last for a full retirement, which is difficult to predict. The process can seem a lot like baking a cake without a recipe: You throw in the ingredients you know you need in quantities you feel are right and hope for the best when you pull it out of the oven.

One of the common questions asked just before or during retirement is how much of a person’s assets should be contributed to an annuity. No matter your situation, the one sure answer is not to use all of your assets toward buying an annuity. Annuities provide little liquidity. This means if you really need the money you contributed to the annuity, you’ll pay a steep penalty for accessing it. If you purchased an immediate annuity that begins making payouts right away, you’ve essentially surrendered control of the premium you paid to the insurance company. Once you begin receiving payouts, you are locked in a contract that pays a regular income stream. Therefore, you should always have other liquid funds available in case of emergency.

The variables of determining the right percentage

Otherwise, there are many variables to determining the right percentage, including:

Your age now and when you decide to retire. The older you are when you begin receiving income from an annuity, the higher the payouts will be. That means the younger you are, the higher percentage of your assets you will spend to get a certain amount of income.

How much you currently have saved. Although you can usually buy an annuity for a minimum of $10,000, generating a significant amount of income from an annuity will require a premium payment of many times that amount.

Where that money is invested. For example, if you have an old IRA that you haven’t contributed to for awhile, you can transfer that directly into an annuity without owing taxes on the IRA distribution. If you put it in an immediate annuity, it pays income right away and you’ll pay tax on those distributions. If you put it in a deferred annuity that won’t pay out for several years, you’ll still benefit from tax-deferred growth and won’t pay any income taxes until you being withdrawing funds, just as you would with an IRA.

The type of annuity product you intend to buy. If you buy a deferred annuity that offers free withdrawals up to a certain percentage, you can allocate more of your assets to an annuity because it provides some access to funds.

Start with a plan and projections

Making a prudent decision requires a comprehensive retirement plan that takes into consideration how much you currently have saved, how much more you can accumulate before retirement and how much your accounts can grow during retirement, and what you anticipate needing for retirement income.

One rule of thumb is that a retiree’s fixed expenses should be covered by guaranteed sources of income, be it Social Security, pensions and fixed income annuities. Those would include any living expenses, such as housing and food. So if you know you’ll have $5,000 a month in fixed expenses and your current fixed income sources amount to $4,000, you should consider an annuity that will pay at least $1,000 a month. You can then use your other retirement accounts and savings for variable expenses such as entertainment, travel and unforeseen medical bills.

Another strategy involves projecting what your investment portfolio will be worth at retirement and how much income you need in after you’ve factored in Social Security and pensions.

The idea behind this strategy is that you shouldn’t withdraw more than 3 percent of the assets from a retirement account that doesn’t offer a fixed rate of return or lifetime income, such as a 401(k) or IRA. This is considered a sustainable withdrawal rate that will not deplete your retirement assets too soon.

If your income needs will total more than 3 percent of your starting asset base, then you will have to either reduce your expenses or create more income. One way you can do the latter is by using some of your retirement account for an annuity.

For example, assume that at retirement your accounts total $1 million. You determine that, after including Social Security, you still need $40,000 in annual income. This is 4 percent of your retirement account, slightly more than the sustainable withdrawal rate.

But if you moved $500,000 of that account into an annuity that could provide $25,000 in annual income, you would only need $15,000 a year to reach your $40,000 goal. Withdrawing $15,000 from a retirement account that would still have $500,000 in assets would be equal to 3 percent. So in this scenario, you would be allocating half of your retirement assets to an annuity. The percentage could be higher or lower depending on what you’ve saved and what you will need for income.

It’s best to work with a licensed insurance agent and/or financial planner to help you make the proper allocation of your assets into an annuity.