News from the financial world has been confusing lately. Is the economy strong or about to bust? Is the inevitable recession close or still years off?
What will the Fed do about interest rates? We do know that over the past eight months, interest rates have decreased.
- That helps homebuyers, and homeowners who are refinancing their mortgages.
- It hurts retirees who count on interest from savings to provide a substantial part of their income.
- And it typically raises questions for new retirees who are ready to set up their retirement income plan and make other lifestyle decisions.
These new retirees for the most part have seen 401(k) and IRA balances grow. But now they must convert retirement savings to income. For them, the question they often ask is, “Do I set up my plan now or wait until interest rates go back up?’’
My answer:
When it comes to retirement income planning, don’t try to time the market. Set up your plan with the flexibility to change, and in turn gain the peace of mind to stay the course.
Of course, my planning method is based on Income Allocation and includes annuity payments in the mix. I often have conversations with advisory clients who are attracted to annuity payments as a source of secure lifetime income; most, however, want to buy when 10-year Treasuries are peaking. Sure, it’s nice to imagine earning the top rates on everything, but as you will see, that doesn’t usually work. And it’s not necessary.
On November 8, 2018, 10-year Treasuries were at 3.24%. As of July 23, 2019, they’re at 2.08% — or more than a 35% drop. People who retired last fall are disappointed because they were planning to use up to 30% of their savings to purchase annuity payments. Because they waited, they’re going to have to revise their plans or reduce their budget. Or so they think.
They may not be worse off. Here’s why.
- Purchase rates for income annuities do not follow interest rates directly. In fact, while 10-year Treasury rates went down 35%, annuity purchase rates went down only 4% to 5% (see explanation below).
- The taxable portion of annuity payments fell by up to 50% during the period, reducing the overall projected tax bill.
- And the value of the new retirees’ balanced portfolio of stocks and bonds increased by over 7.0% over the period, giving them more savings to apply to the annuity purchase and other sources of income.
Putting all those elements together, an Income Allocation plan actually could support more income than back in November.
Of course, not every eight-month period will operate with falling interest rates and an improving stock and bond market. My point is that when all of the financial elements of a plan are priced at the market (and income annuities are typically priced biweekly by annuity carriers to reflect current annuity crediting rates) then the key driver is how to bring those elements together in a plan to work for the consumer.
How annuity payments are calculated and set by insurance companies
Annuity payments are made up of three components.
- Interest credits. These are guaranteed by an annuity issuer for the life of a contract. That interest rate is generally set every two weeks for new contracts. (Once you buy a contract, that annuity crediting rate is set for life.)
- Return of principal. A portion of each payment is a small slice of the initial payment you made.
- Survivor credit. In the simplest terms, your annuity contract is pooled with other income annuity purchasers. You get credit if you survive. For new contracts, those credits may be reviewed every few years. That amount doesn’t change with market interest rates.
So, two of the elements change very seldom if at all. The annuity purchase rates do change because of changes to annuity crediting rates. While the Federal Reserve’s actions affect short-term interest rates, there is no direct correlation to how annuity companies invest or how they price income annuities.
Build your retirement plan around income and not assets
An income allocation plan differs from asset allocation in that you create a plan designed for lifetime income with less market risk. Annuity payments replace a portion of the fixed income portion of your investment portfolio to provide guaranteed income for life. Not only does replacing bonds with annuity payments mean you don’t have to follow the ups-and-downs of the market, it also means you can be more aggressive, if you wish, in the stock portion of your plan.
On top of that, income annuities purchased out of personal savings offer benefits from the IRS that you won’t get from other fixed-income investments. The portion of your annuity payment that is a return of principal comes to you tax-free. While interest payments from municipal bonds also are tax-free, income annuities can help decrease your overall tax rate and offer better returns, as this article explains. So when building your plan for retirement income, consider annuity payments — whatever the Fed does.
Go2income analyzes the income annuity marketplace every month. We reverse-engineer the pricing of annuity payments to determine the level of annuity crediting rates. If you’d like to find out how insurance companies are incorporating interest rates into their annuity purchase rates contact me at Ask Jerry.