Introduction: John and Mary are a couple who are approaching retirement age. They have diligently saved and invested over the years, and now they are looking forward to enjoying a comfortable retirement. However, they are concerned about the potential impact of market volatility on their retirement income. They have heard about annuities as a way to provide a stable income stream during retirement, but they are also intrigued by the potential high returns of investing in the stock market. In this case study, we will compare how an annuity and investing in the volatile stock market can affect John and Mary’s retirement income, particularly during a sequence of poor market returns.
Scenario: John and Mary have a retirement savings portfolio worth $1,000,000. They estimate that they will need $50,000 annually to cover their living expenses during retirement. They plan to retire at the beginning of 2020 and anticipate a retirement duration of 30 years.
Option 1: Investing in the Volatile Stock Market
John and Mary decide to invest their entire retirement savings in a diversified portfolio of stocks and bonds. They hope to achieve an average annual return of 7%, based on historical market performance.
Market Performance:
Years 2020-2022: +10%, +5%, -15%
Years 2023-2026: +8%, -12%, -5%, +9%
Years 2027-2030: +12%, +6%, +4%, +7%
Result:
Due to the sequence of market returns, John and Mary’s retirement portfolio experienced significant fluctuations, leading to a diminishing effect on their income stream.
By the end of 2030, their portfolio balance drops to approximately $612,000.
At this point, their annual withdrawals are drawing down the portfolio much faster than they had anticipated, increasing the risk of running out of money before their retirement horizon.
Option 2: Annuity for Guaranteed Income
John and Mary decide to purchase a fixed immediate annuity with a lifetime payout option. They use a portion of their retirement savings to buy an annuity, which guarantees them an annual income of $50,000, adjusted for inflation, for the rest of their lives, regardless of market performance.
Result:
Despite the market volatility, the annuity ensures that John and Mary receive a stable and predictable income stream throughout their retirement years.
They receive $50,000 annually, inflation-adjusted, without worrying about market fluctuations or the risk of outliving their savings. They retain a portion of their portfolio in a balanced investment strategy, providing some potential for growth to combat inflation and leave a legacy for their heirs.
Comparison: Investing in the Volatile Stock Market or Annuity for Guaranteed Income
Sequence of Returns Risk: The stock market’s volatility exposes John and Mary to the risk of retiring during a period of negative market returns, depleting their portfolio faster than expected. The annuity protects them from this risk by providing a steady income stream.
Guaranteed Income: The annuity ensures a fixed income for life, irrespective of market performance. This guarantee provides peace of mind and financial security throughout retirement.
Inflation Adjustment: The annuity’s income can be inflation-adjusted, safeguarding their purchasing power over time, while the stock market returns may not always keep up with inflation.
Conclusion:
In this case study, we compared two retirement income strategies: investing in the volatile stock market and purchasing an annuity. While the stock market offers the potential for higher returns, it also exposes retirees to the sequence of returns risk, which can significantly impact their retirement income. On the other hand, an annuity provides a reliable and guaranteed income stream, protecting against market volatility and the risk of outliving one’s savings. Are you more concerned with the return on your money or the return of your money?
John and Mary opted for the annuity to ensure a stable and stress-free retirement. However, it’s essential to note that everyone’s financial situation is unique, and the choice between an annuity and investing in the stock market depends on various factors, including risk tolerance, financial goals, and other sources of retirement income.
It is always advisable to consult with a financial advisor to tailor the retirement income strategy to one’s specific needs and circumstances.
