April 9, 2010

Safely Build Your Own Pension with Bonds and Annuities

After the recent plummet of the stock market many people close to retirement age found themselves without nearly enough money to retire as they had planned.   Most employees today have only a 401k and no traditional pension plan.   So their retirement is left primarily in their hands and depends on their investment choices.  There is no guarantee that your 401k will perform well enough to give you the money you need at retirement.  Personally I think it would be nice if every worker had a safe pension plan.  But you can effectively build your own pension using your 401k or IRA investments.   If you combine bonds and annuities then you can create a retirement savings plan that models a pension and is very safe with little risk of loss.   

Investing in Bonds

The bond investment is quite safe.  High credit rating AAA bonds only rarely default and investing in bond funds reduces the risk of loss from defaults considerably.   Historically AAA rated bonds returned 6% annually.   You don't have to worry about a recession or economic 'bubble' bursting and wiping out half of your retirement.   On the other hand the returns from bonds are lower than what you might expect from investing in stock market equities.

There are some downsides to investing in bonds that we should be aware of.   The return rates from bonds are not as high as stocks.   This is part of the trade off.  You won't have as much potential for gains but of course you won't have the high risks of losses from stocks.   Bond investments are not guaranteed and there is a chance a bond fund could be mismanaged or that direct bond investments can be defaulted on.  However the risk of loss in bonds is lower than the risk of loss in the stock market.

Save 15% of Your Income

In order for this strategy to work you will have to put away around 15% of your pre-tax income.  If you get 6% annual return on bonds and save 15% of your income then over 40 year working career it should add up to enough to replace around 50% of your working income.   Saving 15% of your income may sound like a lot.   Your employer 401k matching funds can help get you to the 15% mark.  For example if your employer matches up to 3% of your contribution then only 12% of the savings comes out of your own pocket.   Investing in a 401k also means this is pre-tax funds so it is less out of pocket than if you had paid taxes on it.

Buying Annuity at Retirement

A fixed immediate annuity is a contract between yourself and an insurance company.  You pay them a lump sum of money and they in turn agree to pay you fixed monthly payments for a given time period.   Traditional pensions work in a similar way.   By buying an annuity at retirement you take away the risk that you may outlive your retirement nest egg.

The major down side to annuities is that you end up with no money at the end of your life.   While your retirement income will be secure you will not retain any wealth to pass to heirs.  I would also be careful to research your annuity purchase to make sure you are not paying excessive fees and that the insurer is sound.

Hopefully Add some Social Security

The future of Social Security is uncertain for sure.   I for one do not think that SS is going away any time soon.   But it would be far too optimistic to assume it won't change to some degree in the future decades.  I would not depend on SS benefits to be unchanged in future years. 

Here is the basic outline of the plan: 

1. Save 15% of your take home pay in a tax sheltered account.
2. Invest your retirement funds in bond funds with an expected return of 6% annually.
3. When you retire use your retirement savings to purchase a lifetime annuity for guaranteed retirement income.

Following these 3 simple steps  should get you a retirement income of around 50-60% of your pre-retirement earning level.    If you add today's Social Security payment rates on top of that then you could expect it to contribute another 25-30% to get you up to 75-90% total.
Example :
Lets take a look at a family that has made median income level for the past 40 years and is about to retire.   If they had made median income and saved 15% of it in bonds and you made 6% annual average return on your money.   If you had done this for the past 40 years then you would have approximately $500,000 in your retirement account.   I got some quotes on annuities at Immediate Annuities.com.  A couple in their mid 60's could buy an annuity with that $500,000 to give them approximately $2,600 monthly income for the rest of their lives.   You can use the Quick Calculator at the Social Security benefit calculator page to estimate your SS income at retirement.   If your income is $58,000 at retirement then you would get a SS check of around $1,400 a month.  Between the annuity and the SS income you would be getting monthly income of $4,000.   This is 82% of your pre-retirement income.   That is a very health post retirement income level considering that SS portion is mostly untaxed and that you are not paying SS/medicare taxes.

Note:  The numbers I use are based on several variables and most of them are not set in stone.   I'm assuming you save starting in your 20's and many people don't get such an early start on retirement.  I'm assuming that bonds average 6% long term in the future based on historic trends but theres no guarantee on that. I'm also working with current annuity pay out rates which are also likely to vary in the future. 

Safety Comes at a Cost

The safety of this strategy comes at the cost of settling for a lower return on your investment.   Buying bonds has a much lower historical return than investing in the stock market.   If you have a low risk tolerance or want to ensure that you have at least a minimum level of retirement income then using bonds and annuities is one way to go.   But if you want to take on some risk then buying stocks or a mixture of bonds and stocks will very likely result in higher returns over a long period.

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